Healthcare IT: Trends Shaping M&A and IPO Activity in 2016

As the healthcare IT industry continues to mature and grow in strategic importance, companies and shareholders are seeing increased opportunities to achieve attractive valuations through being acquired or accessing public equity markets.

Monday, November 28, 2016

On the heels of a record 2015, M&A activity in healthcare IT has continued at a robust pace throughout 2016. In addition to secular tailwinds related to the growing importance of information technology as a tool for driving essential cost savings across the healthcare system, the high levels of M&A activity have been supported by strong interest from an expanding universe of buyers and a record amount of cash available for acquisitions. Across this active deal-making landscape, buyers are aggressively pursuing companies that are demonstrating their ability to balance above-market revenue growth with profitability and have a compelling ROI story. Meanwhile, sellers have become more proactive in using sell-side tools, such as indemnification insurance or sell-side earnings quality reports, to differentiate themselves and accelerate buyer due diligence and negotiation. 

In the public markets, there have been 14 healthcare IT IPOs since 2013. While these IPOs collectively have underperformed the broader market, the healthcare IT IPO classes have outperformed the S&P 500 in three of the last four years. Public investors remain hungry for high-growth companies with focused business models and disruptive technologies. Against this backdrop, we examine certain trends that are shaping deal-making and capital-raising activity in the healthcare IT industry.

Broader, Deeper Set of Strategic and Financial Buyers

Across industries, M&A activity remains healthy following 2015’s record levels, as strategic buyers and financial sponsors are sitting on record amounts of cash and debt markets continue to provide capital at historically low interest rates. The strength of the overall market has certainly carried over to the healthcare IT sector, which is on pace for another record year for M&A activity. Buyers have increasingly turned to acquisitions to increase their market share, diversify their service offerings, and expand into new customer segments. With healthcare IT industry revenue expected to grow at a compound annual rate of more than 5% through 2020, many healthcare IT companies have seen a surge of interest, driving increased competition and asset prices.

One of the biggest drivers of the heightened interest is a strategic buyer universe that has expanded beyond the traditional players over the last decade. Companies like IBM, Roper, Cardinal Health, Hearst, Wolters Kluwer, and Premier have been aggressively pursuing strategically important healthcare IT opportunities in the last several years. Healthcare IT provides a relatively low-risk way for companies to gain exposure to the massive and expanding healthcare industry. Unlike other aspects of the healthcare ecosystem, software and software-enabled services often have relatively minimal direct exposure to reimbursement risk or other legislative risks.

According to the Centers for Medicare & Medicaid Services, national health expenditures rose from 15.5% of GDP in 2005 to a record high of 17.5% in 2014. As costs increase, so too does the pressure on providers to operate more efficiently, and investments in IT are seen as one of the best ways to bend the cost curve downward. Historically, the healthcare industry has been slow to adopt and implement technology solutions, so there is a widespread need for increased investment.

In addition to increased interest from strategic buyers, the healthcare IT industry is seeing robust demand from financial sponsors. Financial sponsors are attracted to the financial profiles of healthcare IT companies, and like strategics, financial sponsors see these assets as a great way to tap the healthcare market without exposure to regulatory risk. Private equity coffers currently hold a record amount of capital that needs to be put to work, and in an environment of low interest rates and well-functioning debt markets, financial sponsors are pursuing healthcare IT assets more aggressively than ever. In fact, contrary to the assumption that strategic buyers will pay more for an asset in anticipation of synergies, we have completed several recent transactions where financial sponsors outbid or outmaneuvered strategic buyers for high-quality assets.

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Value Drivers in Healthcare IT M&A

As the healthcare IT industry continues to grow and mature, an increasing number of companies are reaching the stage where they are potential targets for buyers. Over the past few years, several characteristics have emerged as qualities that buyers focus on when identifying and evaluating potential acquisitions.

  • Access to Multiple Markets. Traditionally, healthcare IT companies have focused on servicing narrow segments of the overall market (only hospitals, only physician groups, etc.). Recently, however, companies have found success selling into multiple constituencies across the healthcare continuum, including hospitals, physician groups, insurance companies, self-insured employers, or post-acute-care facilities. Having access to multiple distribution channels increases the size of the total addressable market and reduces risk through diversification.
  • Increased Focus on Profitability. In recent years, revenue growth drove the conversation for buyers, overshadowing concerns about current and future profitability. Today, buyers are much more focused on profitability; most of the companies that are receiving premium valuations in today’s M&A market either are currently profitable or have a clear path to substantive profitability in the next year or so. All else equal, companies that can show both revenue growth and profitability can make themselves attractive acquisition targets.

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  • ROI Story. While some value drivers have varying levels of importance depending on whether the buyer is a strategic or financial sponsor, every buyer today wants to see a strong ROI story. Regardless of what type of software or services a company sells, if it cannot show a hard-dollar measure of the return it generates for clients, it will be at a relative disadvantage in today’s marketplace. In addition, most acquirers want to see that a target’s solutions can be effective in generating positive ROI both now and in the future as the healthcare industry moves from a fee-for-service environment toward a value-based environment.
  • Vendors as Strategic Partners Offering Technology and Services. Across the healthcare continuum, providers and payers are looking for strategic partners, not just product vendors. The challenges related to value-based care and consumerism are so complex that simply providing a technology solution or a service alone makes it difficult for the user to realize the ROI. This has caused healthcare IT executives and investors to rethink their approach to expanding the total addressable market and generating recurring revenue. Companies such as Evolent Health, Brightree, and Netsmart have had tremendous success in recent years by offering bundled solutions that combine technology with managed service offerings. William Blair served as an underwriter on Evolent’s June 2015 IPO and advised Brightree and Netsmart on their acquisitions by ResMed and Allscripts, respectively, in April 2016.  
  • Avoiding Epic and Cerner. Epic and Cerner are very well-capitalized, and they present a major source of competition in the markets—both functional and geographic—in which they participate. As a result, buyers prefer to invest in companies whose primary businesses do not compete directly with these industry leaders.

Characteristics of Sell-Side Processes

In an environment of high deal volumes and a large supply of companies looking to sell, the more that a seller can do to differentiate itself from the crowd—not only in its business model and technology, but also in how it prepares for and conducts its sale process—the more likely the company is to gain an edge in the eyes of buyers. By taking steps to conduct a more efficient sale process and/or reduce the risk for the buyer, a seller can become more attractive than a comparable asset and improve the certainty of close.

Despite the strong interest from buyers, due diligence processes remain rigorous for healthcare IT acquisitions. No longer can sellers go to market with less-than-optimal financial transparency and expect to attract and sustain a dialogue with a willing and able buyer. Companies thinking about selling should begin preparing for the increased scrutiny and ensuring they have their ducks in a row well before launching a sale process.

Recently, sellers have been much more proactive in their use of sell-side tools to drive more efficient processes. Many sellers, particularly in the middle market, are going on the offensive by commissioning quality of earnings reports or substantiating run-rate analyses via an independent financial expert or accounting firm. We also have seen increased use of reps and warranties insurance packages, customer satisfaction surveys, legal vendor due diligence summaries, and general market studies. In fact, reps and warranties insurance was used in 45% of William Blair transactions in 2015, up from just 9% in 2012. These sell-side tools can reduce the risk of surprises surfacing in a potential buyer’s due diligence and improve the odds of a transaction closing.

In addition to taking advantage of sell-side tools to differentiate themselves from the pack, many healthcare IT companies are opting for narrower processes. Because the universe of potential buyers has become so expansive in the last five years, running a broad process in today’s environment often leads to inefficiency, unwanted market chatter, and elongated timelines; it also has the potential to be unwieldy for a seller. Now more than ever, it is important for sellers to partner with an advisor that brings extensive experience and buyer knowledge in healthcare IT to optimize a sale effort and navigate the many industry-specific complexities encountered during a process.

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IPO Trends

Although the IPO market started slowly in 2016, the second half of the year is showing signs of life: 13 of this year’s 19 technology IPOs have priced since late July. In healthcare IT, performance in the public markets over the last few years has been solid. There have been 14 IPOs in healthcare IT since 2013, and returns of these IPOs have beaten the market in each year except 2015. The companies that went public over that time frame are Benefitfocus, Premier, IMS Health, Castlight Health, Imprivata, Connecture, HealthEquity, Inovalon, Evolent Health, Press Ganey, Teladoc, Cotiviti, NantHealth, and Tabula Rasa Healthcare. William Blair and its current equity capital markets team have been an underwriter on 12 of these 14 IPOs.

The median offering size of these IPOs was $192 million, with a median market cap of $1.2 billion. The median pricing multiples achieved by these companies were 11.3x forward EBITDA and 4.9x forward revenue; the latter figure holds up well against the pricing revenue multiples for all tech IPOs, which have been in the 4x-5x range in recent years. The median projected revenue at one year after IPO for these healthcare IT companies was $175 million, with only one company (Castlight) landing below $100 million. The median projected growth rate one year after IPO was 26%, with only five companies projecting revenue growth of more than 30%.

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On the whole, investors have been primarily interested in healthcare IT companies that showed strong growth and business models that are laser-focused on one area of the healthcare market. As is the case in any technology-related industry today, investors are searching for the next disruptive technology.

As the healthcare IT industry continues to evolve, we will monitor market developments in this space. To learn more about trends shaping the deal-making landscape in healthcare IT, please do not hesitate to contact us.

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