Healthcare Investment Q&A: Outlook and trends in private equity interests, valuations, sectors, and more

As part of a new report with Pitchbook, Claudine Cohen, managing principal and leader of CohnReznick’s Transactions & Turnaround Advisory practice, and Caroline Znaniec, managing director in CohnReznick’s healthcare practice, shared their perspectives on the healthcare market, private equity interest in the market, and the impact of COVID-19 on the sector.

Read the full Q&A below, and register to receive the full report, which offers additional insights.

Please share your thoughts on the current healthcare services market. (Specifically, what has changed for the sector compared to pre-COVID-19?)

Caroline Znaniec: Thinking about it from the provider perspective, COVID-19 has brought attention to where healthcare financial operations were weak. When you take relief funding and the grants out of the picture, the surviving providers are those that prior to COVID-19 had better cost discipline, liquidity, larger geographic presence, and diversification of service offerings. The pandemic is also changing how providers are delivering care and how payment models are adapting. Both of those changes are forcing providers to not look at their situations as “business as usual.” The more successful provider will be one that is nimble and strategic.

More broadly, there’s this perception that the increase in healthcare investing by private equity is lowering the quality of care. That’s not how I see it. I don’t think providers intentionally give poor care, many just do a bad job of demonstrating the quality of care they provide. Providers are judged more now than ever on the metrics and outcomes they report. Coming out of COVID-19, there is going to be more focus on the quality-of-care discussion, and providers that can demonstrate good results around the value of quality of care will be rewarded.

Claudine Cohen: It’s also worth noting that COVID-19 caused an increase in the cost to do business, including the need to invest in technology, which for many providers is not feasible. Many management teams that survived last year decided to put their companies up for sale, which is helping to fuel broader consolidation trends.

In the same vein, how has PE interest in the sector changed compared to pre-COVID-19?

Cohen: At the end of the day, what COVID-19 revealed was how resilient the sector turned out to be. Businesses did far better than anyone expected, and private equity interest increased as a result. Valuations are climbing, with some small physician groups with $3 million of EBITDA trading at eight or nine times in the current market. It’s unheard of.

Let’s dive further into that. What has been COVID-19’s impact on healthcare services valuations?

Cohen: There is still absolute demand in the market, with an abundance of capital and a shortage of great assets. That’s one reason why smaller providers are trading at such high levels. The buy-and-build strategy is still out there, which comes with attractive arbitrage opportunities – investors can blend down the multiples paid for their platforms. I don’t think the focus of our clients has changed much due to COVID-19, aside from more focus on digital health. There isn’t a lot of history around valuing digital health companies. The digital health companies that are performing well are trading at very high valuations.

Znaniec: To Claudine’s point, say a handful of mom-and-pop providers are being rolled up into a new platform, money has to be invested in their digital capabilities. Many smaller providers haven’t invested their own money into these large technology platforms, but there’s an opportunity to do that once they’ve been consolidated into something bigger. And as providers improve their digital presence, they can further reduce other costs attributed to inefficiencies that come with the lack of technology.

How does telehealth capability change a company’s potential valuation?

Cohen: The bankers who I talk to have indicated that those multiples are much higher than what traditional providers are fetching. Those businesses can be marketed as tech-enabled services. If you can successfully merge technology into your current model, you’ll likely see more interest from potential buyers. Bankers are taking advantage of labels like “healthtech” and “medtech” in terms of marketing, not only to PE or strategic buyers but also to special purpose acquisition companies (SPACs).

Znaniec: And as telehealth grows and patients become more comfortable with it, remote monitoring will also become more important. When doctors need to talk about test results, or patients are hooked up to heart monitors and doctors need to discuss something in real time – those capabilities will be very important going forward. That’s what consumers will be asking about and basing their decisions on.

Did COVID-19 prompt some PE investors to get into healthcare services – perhaps for the first time?

Cohen: That was definitely the case with home health and hospice. Home health isn’t the most attractive business model, in terms of managing healthcare aides and the reimbursement questions in the sector. With the ongoing pandemic, we’re seeing so much activity from investors. Many patients don’t want to be in a hospital right now, and current technology can facilitate that.

Znaniec: I’ve had conversations with investors who weren’t really in healthcare before, but they’re gravitating toward it now. We sometimes talk about the questions investors should be asking – I get worried about the questions investors aren’t asking. Healthcare is one of the most regulated industries in the country, and when you think about the potential audits coming out of COVID-19, you get the sense that many people don’t appreciate the importance of the results and how that can change an investor’s circumstances. There are lots of nuances involved, and you can’t jump into it simply because it’s growing.

Have you noticed anything unique to healthcare in terms of private equity interest, since the beginning of the pandemic? Perhaps investors who weren’t already active in the space but now saw opportunity to create value?

Cohen: From a specialty standpoint, healthcare investing tends to move in cycles. Segments like ophthalmology, orthopedics, and women’s health have seen higher investment demand in the past. From an investor’s standpoint, it’s about the dynamics of particular subsectors at the time. Primary care is more active now, and urgent care, a longtime favorite of PE, has taken a back seat for the moment. Investors pay attention to current trends in each segment, they consider how fragmented they are, and how much those companies are trading for.

Znaniec: Behavioral health is interesting. We used to have mental health and addiction treatment centers, but everything is now under the umbrella of behavioral health. There was higher demand under COVID-19 because of isolation, but there is debate about whether the volume we’ve been seeing will be the same going forward. As things come back to normal, that growth may flatten out – maybe not dropping to pre-COVID-19 levels, but not at the peak we saw last year. The other factor that may drive volume in behavioral health is the heightened awareness around mental health, and the stigma around it has decreased. It is likely that we will see increased access and coverage of those issues from payors compared to prior years. Those increases will drive volume and revenue in this space.

When we talk about behavioral health from a telehealth perspective, we’re also talking about increased access to those services for rural communities. I grew up in a rural area, and we didn’t have psychiatrists where I grew up. If you needed therapy or care, you had to drive hours to the nearest city, or wait months to get an appointment. Access to telehealth is key for those communities, and we may see increased federal funding for those programs in addition to grants at the state level to keep them going. On the reimbursement side, is that something that will be lucrative compared to other subsectors? This is where some debate continues. There will be some states and local jurisdictions that will try to keep that money flowing in support of health equity initiatives, but there are some areas that don’t have the infrastructure to support full telehealth capabilities.

What are your thoughts about the impact of telehealth on valuations?

Cohen: Consider two behavioral health businesses-both providing services to long-term care facilities. One is an in-person facility with a broad physician network.  The business is stable and has grown through COVID-19. The other business is identical to the first one, but works exclusively using its a telehealth platform. Same target market, but everything is remote. They are enjoying much higher growth coming out of COVID-19. If both companies are going to market, it will be very interesting to compare their EBITDA levels and where their valuations line up. The telehealth business, even if it has lower EBITDA that the in-person business, will likely sell for a significantly higher relative valuation.

How has COVID-19 impacted the due diligence process relative to healthcare services deals?

Cohen: For the most part, when we’re looking at due diligence, we’re out of COVID-19. A lot of the noise has faded from the numbers. But there are still areas in healthcare where it’s still difficult to diligence, to really understand what the normalized earnings of the business are. Take urgent care, for example. Some of those businesses had such extreme growth in EBITDA, most of which has been driven by COVID-19. Appointments are made for COVID-19 tests or suspected infections. Even in fall of 2021, people are still going in to get tested. How long does this go on? If a business was doing $10 million of EBITDA pre-COVID-19 on a run rate, but is doing $30 million today, how do you really value the business? That’s what investors are grappling with. The doctors will say that when people come in, you automatically have a COVID-19 test. If someone comes in with flu-like symptoms, the default response is a COVID-19 test. But the patient might just have strep throat or a sinus infection. The doctors will say they’ve earned goodwill from the patient and they’ll be continuing to go to those doctors in the future. From a diligence perspective, the one big aspect to consider is that a lot of providers are still benefitting from COVID-19.

Calculating quality of revenue is critical when diligencing healthcare deals. What is quality of revenue and why is it important?

Cohen: Much of the middle-market and lower-middle-market businesses we diligence are managed by doctors. For them, cash is king. Books and records are maintained on a cash basis. If you’re investing as a PE investor, or even a strategic with shareholders and governance responsibilities, businesses need to be GAAP-compliant. So the quality of revenue analysis is really that cash-to-accrual on the revenue side and building up those waterfalls. You have to go back and analyze historical billing information to build cash flow waterfalls, which facilitates the calculation of your gross-to-net figures and accounts receivable. It’s a standard in the QoE process today. And for businesses with accrual-based financials, we still perform a quality-of-revenue analysis in many situations. In healthcare, there are gross billings and contractual allowances that lead to your net billings. Take an extreme example: hospitals that charge $100,000 for a visit, but by the time insurance pays it net of contractual allowances, the patient’s bill is $3,000. Contractual adjustments are negotiated, but a lot of businesses aren’t tracking contractual allowances properly – they’re making estimates. So their quality-of-revenue numbers are still relevant, it just depends on their sophistication.

Znaniec: What we’re looking at is the performance of the complete revenue cycle. From a timing perspective, we’re trying to understand how long it takes between seeing a patient to putting the charges into the system, versus those charges going to the payor – we’re looking at those various handoffs to see how efficient they really are. In some cases, they may be leaving money on the table. On the other extreme, they may have non-compliant practices that may be elevating what their revenues look like. That would put them at risk of recoupments if they’re audited by a payor. We look at everything from a compliance standpoint, from an efficiency standpoint, and where the business can improve.

On sell-side assignments, we’re looking for improvements on their capture of services and their billing management, to increase what their revenue should be. On buy-side assignments, we’re helping to minimize their risks while highlighting any value that can be captured if adjustments are made.

On the home health side, there’s a movement away from in-patient to out-patient. Is that part of reimbursement?

Znaniec: It’s all about the consumer and comprehensive coordination of care. There are still fragmented areas, and community providers need to cooperate with each other, whether they’re specialists or even hospitals, where we’re seeing more care management. Hospitals are helping set up appointments for patients being discharged. From the hospital’s perspective, even if they’re coordinating with a provider that isn’t in their network, they still want to maintain an affiliation with them. The hospitals that succeed on that front are going to be more integrated and provide those services. That’s what is underlying the idea of value-based payment and value-based care – being able to manage all of that under one network and rewarding providers for providing care based on outcomes and not simply on volume.

Are there any under-valued sub segments that PE should be looking at? Any big potential disruptors to the M&A environment? What do you see as you look forward?

Cohen: I don’t know if disruption is the right word, other than tech-enabled services. I think managed care is intriguing to private equity, but they haven’t really wrapped their heads around it. Caroline, if you understand the model, it could be very lucrative, right?

Znaniec: We are seeing investors in this market creating networks around employer-based plans, so they can create their own network of providers so they can negotiate lower rates. They’re taking different parts of the market and pulling them together.  For example, small and mid-sized employers that, on their own, might not have the volume to themselves to negotiate with larger payors.

When we talk to investors about how to succeed in this market, as soon as they say “I’m going to buy this group and get into value-based care,” we tell them to pause. The market is data-driven and it’s quality-driven, and if you don’t have the information on hand, you’re going to hurt yourself in the long run. That needs to be part of their discussions, even if it’s post-transaction. What’s the ability to scale? How quality is your data? Do you have a quality monitoring program? That’s going to inform you about how much effort will be required going forward. I get a little concerned sometimes listening to clients who don’t have the necessary industry or operational experience. They want to swiftly move their contracts to a value-based model, but there’s a lot of analytics that have to be considered to understand whether you’ll be successful or not.

What kinds of questions are your clients asking you today? What kinds of assignments are you being tasked with now that are new compared to pre-COVID-19 years?

Znaniec: I’m seeing more interest on quality measures. For example, with home health and hospice providers, it’s understanding what their metrics look like and thepieces related to the interdependence of clinical, financial, and administrative operations. Before, they were looking at benchmarks butreasons why they might be considered under-performing. Even if they have great patient satisfaction scores, or if they have reason to believe they’re providing quality care. That’s on paper. It’s important to look at the intersect of clinical operations and your finances. They’re also getting much more interested in understanding governance and reconciliation, the checks and balances–all the different weren’t understanding why they look the way they do. We can help them with an interdependent strategy review, to see if different components are complementing each other or moving in different directions. We can help them pinpoint what the root cause is for any issues that may arise.

Even if they’re performing well, we can identify areas for improvement and what our clients can do post-transaction. That can impact how quickly they can come to scale and make positive improvements to their bottom line.

What about from a transaction perspective?

Cohen: I don’t think we’re being asked anything differently today. One difference, though, is that coding compliance has become more prevalent, and our clients are asking us for that all the time. Some of that might be driven by COVID-19-related reimbursements for telehealth and home health.

While the questions might not be different, more and more investors are turning to healthcare as a thesis, even if they aren’t specialists. And it’s not just in one area, it’s everywhere. One segment we didn’t talk about was lab services, which has picked up tremendously over the past several months.

Overall, I’d say that investor appetite around healthcare investing is probably at an all-time high. The future looks very vibrant if you’re a provider who is looking to sell. The same can be said for a PE investor that can differentiate itself by identifying a market that is underserved (from an investor perspective) and has good fundamentals. If you get it right, you’re going to have a good outcome.