Todd Briddell, CenterSquare
The US healthcare sector is currently undergoing a period of transformative change which holds major implications for healthcare providers, individuals accessing healthcare services and financial institutions keen to tap the investment potential of the market.
The introduction of the Patient Protection and Affordable Care Act (PPACA) or "Obama Care" by the US government in 2010 was just one catalyst for change. With the longevity of US citizens increasing, demand for more affordable healthcare solutions is greater than ever before.
In monetary terms, the US healthcare sector accounted for $8,915 in spending per person per year in 2012, according to the latest available figures and is expected to grow at an increasing pace.1 This market is large, complex and seems to be growing faster and with less volatility than many other investment sectors. We believe future growth prospects are also strong. Spending on Medicare beneficiaries in the US is much higher among those over 65 years of age2 and it is widely believed that this older group will represent an increasingly larger section of the US population in the future, pushing overall healthcare costs higher.
While the US healthcare market presents some attractive investment prospects it is not as accessible to investors as many other sectors. Exposure to healthcare in public market indices does not reflect the proportion of healthcare spending to GDP in the US.3 Equally, small and medium-sized private businesses often represent the most rapidly growing segment of the industry but are not readily accessible through public market investing.
There are, however, a range of other investment routes which do allow access to the sector. The healthcare private capital landscape can be categorised into three main investment strategies: venture capital, private equity and royalties and structured credit.
Each of these categories may be particularly attractive at any given point in time, and we opportunistically invest based on our views of the capital scarcity or excess as well as the attractiveness of specific opportunities.
While most investment managers who target healthcare do so through venture capital investment strategies, healthcare venture capital returns have historically been lower and more volatile than healthcare private equity returns. We believe that accessing attractive investment opportunities in healthcare may best be achieved through private equity and royalties and structured credit strategies.
Healthcare private equity is a strategy that targets investments in commercial-stage healthcare companies. According to our estimates, there are as many as 50,000 commercial-stage healthcare companies in the US4, which include a wide array of businesses such as service providers, product companies, contract research, product distribution, insurance and outsourced business services.
We also find these companies tend to be widely dispersed throughout the US as companies that focus on providing healthcare services are needed in approximate proportion to population sizes.
A complex market
The healthcare sector is large, complex and fragmented in terms of business types, business sizes and geographic dispersion. These characteristics create structural inefficiencies in deal sourcing and pricing that present the potential to earn attractive returns.
We believe that healthcare private equity will continue to be an attractive investment area for several reasons. Firstly, we believe that the healthcare sector will continue to grow as suggested by available demographic and market forecasts. Secondly, we believe that commercial healthcare companies are well-positioned to capture this growth because their revenue increases will be closely correlated with increased spending. Lastly, the sheer number of healthcare businesses, especially at the small end of the market, can drive inefficiencies in pricing, which we believe can be exploited by private equity.
Royalties and structured credit
The royalties and structured credit strategy is another approach to investing in the healthcare sector. Royalties are contracts to receive payments based on the sales of products in return for use of the intellectual property that underlies those products. Royalty agreements are created when intellectual property rights are transferred between individuals, academic institutions and companies.
Related to drug and biotechnology royalties is an adjacent space that we refer to as healthcare structured credit, which includes loans, typically senior, backed by revenue-generating product assets. These loans usually bear high coupons and contain equity incentives such as warrants. Often these loans have liens against intellectual property, including patents, regulatory filings and other assets as collateral. Royalties have both fixed income and equity-like features. The cash flows are immediate, but they vary based on actual sales of the product.
The royalty market has expanded considerably over the last 20 years due to growth in the drug and biotechnology industries and increases in the number of royalty contracts. We estimate that there is an addressable royalty market in the US of approximately $65 billion5.
While, there are more than ten managers who specialise in royalties and structured credit in the US, deal flow is very lumpy, where large transactions come in waves. This makes traditional private equity fund structures suboptimal because slow capital deployment in the early years of a fund can negatively impact returns. The strong bull market in credit has also resulted in companies with weak collateral being financed through royalty and debt capital.
While the royalties and structured credit strategy is interesting, we have observed first hand some of the challenges it presents. While the strategy enables investors to avoid development risks and capture senior cash flows from high margin healthcare product assets, we believe that a better approach to this strategy is to participate opportunistically and outside of traditional private equity fund structures.
To conclude, while investment in the US healthcare sector does present some challenges, Siguler Guff believes a good method may be to pursue healthcare private equity and royalties and structured credit strategies that focus on commercial-stage investment opportunities.
Within these strategies, our preferred investment approach is one that incorporates a significant knowledge base of and experience in the healthcare sector, broad sourcing capabilities and a strong view on the type of opportunities that are attractive given the sector's rapid evolution and growth.
1. Source: Centers for Medicare and Medicaid Services, 2012. International Monetary Fund, 2012.
2. Sources: United Nations - World Population Prospects: The 2012 Revision; Deloitte - The hidden cost of US healthcare: Consumer Discretionary Healthcare Spending 2012
3. Source: Capital IQ, 2013
4,5. Source: Siguler Guff estimates