Health Care: 2003’s Portfolio Prescription –

While the appetite for sectors like technology and telecom tends to vacillate, the health care industry has been more immune to big ups and downs, at least recently. With small price fluctuations and an interminable customer base, LBO shops view it as a profitable but low-risk investment.

“The health care sector is not going away,” says Doug Rogers, a founding member of Blackstone Healthcare Partners, The Blackstone Group’s recently developed health care investing arm. “Its barriers to entry and staying power will always keep investors interested, and it will stay a vibrant area for investing.”

Bob DeSutter, a managing director with USBancorp Piper Jaffray and co-head of the firm’s Health care M&A division, agrees. “Illness isn’t tied to the economic cycle,” he says. “That’s why [investors] like it and will pay more for it during economic downturns.”

The sector’s buoyancy today is also assisted by subtle changes in demographic trends and spending. “More and more baby boomers are aging, and we’ve seen health care spending rise substantially. Even during the economic downturn, health care spending continued to grow in the double digits,” says Lester Knight, a founding partner with Roundtable Partners, a fund dedicated exclusively to health care.

After a smattering of deals to start the decade, the industry has finally begun to produce a material uptick in health care transactions. Through mid-November, 35 health care acquisitions accounted for 14% of this year’s sponsored LBO volume. This number represents a jump from the sector’s 7% representation in 2002, a year in which 21 total deals were related to health care.

Health Care Costs Spur Activity

The cost of health care has always been an issue, reaching a peak in the early 1990s when Hillary Clinton made a stab at creating a national health care plan. Today’s stories of senior citizens sneaking across the Canadian boarder for cheaper prescription drugs hint that not much has changed, and generally the costs associated with health care are considered the albatross hanging across the industry’s neck.

The high costs, though, have created a number of opportunities for buyout shops, who have tried to keep these issues in mind with their investments.

“Investors want to capture both the industry’s growth and its efforts to improve efficiencies and reduce costs,” says Parthenon Capital Vice President Casey Lynch, who adds that investments in outsourced service providers is one way firms are attempting to do that.

In July, Parthenon paid $64 million to acquire EDiX Corp. as an add-on deal to its Total eMed medical transcription outsourcing platform. Also, in a larger deal, One Equity Partners spent $1.8 billion to buy Quintiles Transnational, a contract research organization that makes its money conducting clinical trials for pharmaceutical companies.

“Basically anything that reduces costs is an interesting place to go, due to the amount of spending that’s going on and current cost issues,” says Roundtable’s Knight.

Other hot spots include diagnostic providers, pharmaceutical names, and medical device and product makers. Some of the more recent notable deals in those subsectors include Welsh, Carson, Anderson & Stowe’s $711 million acquisition of cancer diagnostics outfit AmeriPath; GTCR Golder Rauner’s $200 million purchase of Morton Grove Pharmaceuticals; and The Carlyle Group’s recently announced agreement to buy Colin Corp., a Japan-based provider of medical devices.

Dangers Lurk

To be sure, the industry has its share of pitfalls. For example, buyout pros point to companies with exposure to reimbursement issues, such as nursing home care concerns.

“What’s tricky is that the demand [for the businesses] will generally be there, but you have the government trying to pull back on Medicare and employers trying to push costs to their employees,” says Knight. “There will be a tremendous amount of people who go into nursing homes or long-term care centers in the future, but in the last three years the reimbursement has been cut substantially, and a substantial number of those companies are bankrupt.”

Still, some in the industry are willing to take that risk. Trivest’s purchase of Regional Diagnostics, for example, is exposed to the fluctuations of reimbursement levels, with about a third of the company’s revenue subject to Medicare.

“Reimbursement is always an issue, but the changes usually won’t take you by surprise,” says Mark Abbott, a senior managing director with Trivest. “Typically it takes a while to percolate, but you generally have a sense of changes coming down the road.”

Another factor inherent in health care investments is the canniness generally needed to invest in the sector. Most agree it is difficult for a generalist fund to pursue health care buyouts without seasoned knowledge of the industry. “It’s clearly an important part of the economy, but if you’re going to invest in health care it is helpful to have a strong background-not only to understanding the various sectors, but also so you will possess a wide network within the industry,” says Abbott.

Blackstone’s Rogers took it one step further. “[The buyout] industry is moving toward specialization on the whole, [which] makes it easier to analyze a deal and generate exclusive deal flow,” he says. “For health care, the sector has its own language, maybe more so than other industries, so it lends itself to specialization.”

The 2004 Pipeline

As LBO investors look ahead, most expect the sector will continue to provide a steady flow of transactions. The bigger pharmaceuticals are expected to release some of their slower growing lines into the market as they move to free up cash for research and development. Names like Tyco and Bristol Myers Squibb could be among those divesting to private equity buyers. Also, the lack of an accommodating IPO market may also help to supply buyout shops with a stable flow of acquisition opportunities.

However, as the economy starts to pick up, some potential targets may bypass LBOs, as strategics open up their purse strings and private equity sellers and the middle market companies opt to test the public waters instead.