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Challenges & Opportunities: Healthcare Transactions in a Challenging Capital Market

William J. Spratt, Jr., for HealthLeaders Media, November 3, 2008

Although healthcare transaction activity has slowed during the downturn in the economy—particularly with regard to acquisitions by private equity buyers—investment banks, private equity houses, hedge funds, and lenders continue to aggressively seek healthcare deals.

According to the research firm Levin & Associates, the first quarter of 2008 saw 27% fewer healthcare mergers and acquisitions compared to the final three months of 2007. Still, the number of healthcare special purpose acquisition corporations has increased steadily, denoting a healthy interest in this segment of the market.

Against the backdrop of these developments in the healthcare industry, the tightening economy and credit markets combined with the current political uncertainty and regulatory changes surrounding healthcare are adversely impacting investors, sellers, and lenders.

Lenders

Lenders are now requiring lower debt-to-equity ratios and are taking additional steps to minimize the risk of default, with particular attention to ensuring that due diligence is conducted thoroughly and competently. Whereas the risk tolerances of healthcare lenders have been lowered, the healthcare industry does have the benefit of relatively better access to credit when compared to other areas of the economy. Thus, healthcare transactions can still be financed as long as they involve realistic cash flows and leverage ratios.

Investor activity

With the present uncertainty in the market and the tightening of credit, healthcare investors are being more discriminating in their acquisition targets.

When acquisitions by private equity firms were at their peak, strategic corporate buyers were often priced out of the acquisition market. Now, as private equity acquisitions recede, valuations of target companies are falling, bringing them into ranges that allow for strategic mergers. The relative shortage of well-financed buyers means that there is a real buying opportunity for investors with readily available financing. Moreover, the rate reductions that the Federal Reserve has made over the course of the past year will allow companies that do have access to financing to benefit from historically low interest rates.

Due to these factors, the current healthcare acquisitions market may provide opportunities for many companies to emerge from the present downturn stronger than they were before it began if they focus on making sound strategic acquisitions.

Enhanced due diligence process

In the past, many buyers understood their targets very well from a financial perspective, but not as well from an operational perspective. Leveraged buyouts of targets with significant upside potential left a considerable amount of room for growth.

This lack of full operational understanding is no longer adequate, and due diligence efforts must now focus on ensuring that true strategic value is present. The current tighter credit market conditions will be considerably less forgiving than they have been in the past.

SPACs

Special purpose acquisition corporations—companies formed for the purpose of acquiring a company using the proceeds derived from the SPAC's initial public offering—also present a vehicle for acquisitions while affording the shareholders an opportunity to review and approve the proposed acquisitions. Hedge funds have been the primary investors in SPACs, and the number of SPACs has increased steadily since their introduction several years ago.

SPACs can be attractive to sellers because they allow the potential for the acquired company's management to continue operating the business and benefit from the upside value that results from future growth. At the same time, the company has the opportunity to expand through its public company structure and access additional capital for further development.

Regulatory and political change

Beyond tight credit markets, the two primary factors influencing the healthcare marketplace are regulatory changes announced by the Medicare program and potential political changes that are likely to follow tomorrow's national election. The Centers for Medicare & Medicaid Services have recently published sweeping changes to the Medicare program that will require some transactions to be restructured or unwound. Those regulations are affecting physician investment in healthcare transactions and structuring relationships between healthcare systems and physicians.

Additionally, the presidential election injects some level of uncertainty in that polls show that many voters favor some form of universal healthcare coverage. Such initiatives would certainly lead to changes in the healthcare industry and, ultimately, may affect investment in certain segments of the industry. However, investors should keep in mind that past political and regulatory changes have not caused radical shifts in the healthcare industry and that the current situation creates as many opportunities as risks.

When taking advantage of acquisition opportunities, it is now more important than ever for all participants in healthcare transactions to retain expert counsel and advisors with extensive knowledge of the market to conduct due diligence, thoroughly analyze the regulatory and reimbursement posture of the target, and to provide detailed guidance to understand and minimize risks.


William J. Spratt, Jr., is a former healthcare administrator and has served as general counsel and special counsel to represent institutional and non-institutional healthcare providers. He may be reached at william.spratt@klgates.com.
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