Health Care Re-emerges as Best Defense In Uncertain Market –

The Human Genome Project, the debate over stem-cell research, the significant lack of funding for prescription drugs in President Bush’s $1.6 trillion spending plan released in April – these are among the health issues that make headlines.

But it hasn’t been until very recently that a significant number of buyout firms have focused – or refocused – their investing on the health-care sector, which is en vogue again after years of caution due to federal regulations and unpopularity compared to once-glamorous tech and telecom deals.

Some of this surge in activity is relative to market conditions. Health care, which faces fewer cyclical pressures than nearly any other sector, remains a defensive investment.

“Every other sector has lost favor,” said Carlos FerrerM, general partner at Ferrer Freeman Thompson & Co. LLC, a Connecticut-based firm with a sole health-care focus. Health care has thus regained attention “by default,” he says. But, he adds, health care also gives buyout firms a competitive advantage.

“Other than pharmaceuticals and high-end medical devices, you don’t have too many guerillas competing against you,” he says.

Medical products, including supplies and devices, pharmaceuticals and biotechnology and health-care providers typically define the health-care sector, which as a $1.2 trillion industry represents the largest segment of the U.S. economy and approximately 15% of the gross domestic product. (Investors break down the sector further by diagnostics and health-care services.)

“There are two drivers [of the robust health-care buyout market],” says Jeff Gonyo, a managing director at Wind Point Partners, which formed Benchmark Medical Inc. in 1999. “One, health care is immune to the normal economic cycles industrial sectors and consumer products face; and, two, the reimbursement concerns of the late 1990s seem to have stabilized.”

Also, buyout firms are focusing on segments that are either not highly regulated or reimbursement sensitive, he adds.

“One to two years ago, health care was below Ebitda multiples,” he says. Then health-care multiples remained constant whereas non-health-care sectors came down. So today they’ve more or less converged. It’s non-health care that hit a slowdown.”

Wind Point formed Benchmark Medical Inc. to build a leading provider of outpatient physical rehabilitation services. Benchmark made its fifth acquisition in this market in early July.

Another factor driving investment, however, is that health-care companies almost doubled their research and development budgets between 2000 and 2001, which in turn creates large competitive moats, according to a study by Morgan Stanley Dean Witter. The study examined the S&P Index over a 40-year period and found that the percentage of companies in the 1960 S&P 500 that remain in the Index today was higher for health care than for any other sector. In addition, health care demonstrated both high growth and, importantly, persistency of growth, unlike technology.

Over the past two months alone, at least 10 buyout deals have been reported in the health-care sector, and two large health-care-focused funds have been raised or announced. The funds are RoundTable and Merrill Lynch. Although partners at Merrill Lynch declined to be interviewed for this article, that the investment banking behemoth has chosen to focus exclusively on health care for its first private equity vehicle in more than 10 years speaks volumes about the sector’s new status. Sources close to the firm said the target of the new fund is roughly $900 million, and it will be called Merrill Lynch Healthcare Partners LP.

For its part, Midwestern firm RoundTable was incorporated in February this year and held its first closing in July with $256 million. Its focus is later-stage health-care buyouts. Partners at the firm also declined to be interviewed. And still other new funds, such as the $850 million Morgenthaler Partners VII from the 33-year-old Morgenthaler, plan on focusing large portions of their investment dollars on the health-care sector.

Partners at Morgenthaler said they have noticed more quality deal flow in health care recently, and believe life sciences/health care is a robust area of the economy. In fact, venture capitalists invested $10.6 billion in 982 companies in the second quarter of 2001 with a notable investment increase in the life sciences sector, according to Venture Economics and the National Venture Capital Association (NVCA). During the quarter, 13.8% of dollars invested went to Medical/Health/Life Science companies, whereas only 11.2% went to such companies in the first quarter of 2001 and only 3.95% went to such companies in the second quarter of 2000.

As a result, Keith Kerman, a general partner at Morgenthaler heading up the buyout health-care practice, says he expects to begin a couple of platforms in health care with the new fund, in perhaps medical devices, new drugs or hospital services outsourcing “a growth area,” he said.

Compare this activity to last year when over the same period only one health-care LBO was reported. Similarly, though a few new funds announced their intention last year to devote a portion of their portfolios to health care, including Nevis Partners, Thoma Cressey and Nordic Capital from Sweden, no health-care-focused funds were raised. One firm that had formerly concentrated on health care since the early 90s, Counsel Corp. of Toronto, abandoned the sector to focus on information technology.

Another indication of the increased activity in this sector can be seen in the IPO market.

Health care has 15 IPOs waiting to price this fall, more than any other sector. The largest health-care IPO waiting to price is orthopedic sports medicine firm dj Orthopedics Inc., which filed recently for an IPO worth as much as $172.5 million in stock. Some others include health benefits company Anthem Inc., which plans to raise $1.15 billion; Phoenix-based Alliance Medical Corp., which filed for a $69 million IPO; San Diego-based Digirad Corp., which also filed for a $69 million IPO; and Boca Raton, Fla.-based Cross Country Inc., which set the price of its IPO at $15 to $17 per share and the number of shares at about 7.8 million. The IPO could amount to as much as $132.6 million.

Private equity firm Charterhouse International invested in medical staffing company Cross Country this time last year. It then acquired TravCorps, which it merged with the former. At the time, the firm said part of the appeal of these businesses was their immunity from reimbursement risk as an outsourcing business.

Lori Livers, senior vice president of Charterhouse, says demand outweighs supply in medical staffing.

“There’s an extreme shortage of nurses,” she says. “Stocks in health care as a general investment group are up since March 2000, as opposed to almost every other group.”

Charterhouse has 20% of its Charterhouse Equity Partners Fund III portfolio dedicated to health care, an area of focus for the firm for the past five or six years.

“Our original investment in Cross Country was $75 million in July 1999, and we expect a $130 million capital raise,” said Livers.

Ernest Jacquet, a managing partner with Parthenon Capital, believes his firm’s recent investment in Total eMed Inc. could also garner an IPO. Total eMed Inc. gives outpatient physicians access to a national data center of medical transcription and health-care information services. The transaction was valued at $6 million in cash.

Parthenon is busy converting the information that Total eMed has into an electronic format, says Jacquet. With the addition of Total eMed to Parthenon’s portfolio in July, the firm now has two health-care investments (the other is in Med Assets) that are together worth $140 million in total equity.

Last year, biotechnology and Internet-enabled companies, or e-health companies, were getting mixed reviews. They still are. Some claim people are more comfortable with biotech, others say that investors are shying away from the industry. But most agree that at a time when buyout firms generally are striving to invest in deals with minimum risks and high rewards, biotech feels more like venture.

“Biotech ran up and came back down. There were a lot of expectations, and many companies failed to live up to expectations,” says Gonyo.

Arthur Kirsch, a managing director with the newly reformed Vector Securities International, described 2000 as “an unbelievable blowout year, in biotech especially, which represented about half of the total [public] deals done.”

Investors predicted last year at this time that the Health Insurance Portability and Accountability Act (HIPAA) would increase opportunities in e-health and other areas of IT. Today investors say HIPAA is only one factor among many.

Kerman says HIPAA will drive some level of activity, but he adds, “I wouldn’t invest in a company because it has a HIPAA platform any more than a company built on Y2K.”

For its part, e-health, like anything e-related, has unsurprisingly fallen out of favor. But investors are quick to point out that e-health does not equate IT, which is and will address systems inefficiencies, in hospitals, for example, in terms of proper coding or billing, to cite two examples.

“Historically, health care has under-invested in information systems,” says Kerman. As a consequence, he believes the use of IT as a tool in the health-care sector will only increase.

And finally, underlying all of these individual trends is “the most substantial backdrop for investing in this industry,” as Ferrer puts it, “the omnipresent demographic factor [that is] the aging population.”

If it sounds cliche, it is nonetheless unavoidable: the American population is expected to increase by about 50% between 1995 and 2050, while the 65-and-older age group is expected to grow by 135% over the same period. In Florida alone, fully one-sixth of state residents, or 18%, is 65 and older today. GPs believe this can only spur demand for health-care products and services, regardless of regulations or market trends that may temporarily detract investors’ attention away from the sector.