Saturday, November 28, 2009

Risk Takers Take to Health Care

What motivates innovation and entrepreneurship? A good business plan, capital—and a propensity for risk taking. Although bright ideas are plentiful, market activity has hardened since the onset of the financial crisis. Capital flows, once voluminous, have eased to a trickle.

Risk taking comes from asking a simple question: "Should I, or shouldn't I?" Should I, or should I not, commit my own wealth to an uncertain venture?

For now the 'Shouldn't Is' fall into the majority. In fact, many economists expect risk aversion to linger for quite some time.

Yale economist Robert Shiller, in a January opinion piece to the Wall Street Jouranl, describes the 'Should I, or I shouldn't I' back-and-forth in terms of market trust, or "animal spirits" as Keynes put it:

[L]ost in the economics textbooks, and all but lost in the thousands of pages of the technical economics literature, is this other message of Keynes regarding why the economy fluctuates as much as it does. Animal spirits offer an explanation for why we get into recessions in the first place—for why the economy fluctuates as it does.

He argues that without market trust the economy cannot recover fully.

By holding back, industry suitors and investors (suppliers of capital) diminish future opportunities for themselves and their targets. This process perpetuates a vicious cycle of hand-sitting, and suppresses economic momentum.

As we know, the economy encompasses many different pieces, and while its composite may stagnate, certain pockets expand and absorb whatever excess capital exists.

Since the recession's start nearly two years ago, risk takers that exist have mostly targeted health care. Consider this, first, in terms of trends in venture-backed companies and mergers and acquisitions. Next, think of the potential catalyst this creates in altering health care's fundamental economic model.

Venture-backed companies
In the second quarter (2009), health care surpassed information technology as the largest industry in money raised for the first time in a decade. For every dollar health care companies collected in 2008, IT firms brought in $1.37. So far, in 2009, the levels are equal.

The table below illustrates the relative portion of funds raised between the two industries over the past seven quarters, and compares this to the dollar amount for all venture-backed companies. (Source: Dow Jones VentureSource)


Health Care






Information Technology






Total Raised (million)


Health Care





Information Technology





Total Raised (million)$4,082$5,420$5,086

While health care and technology accounted for about 70 percent of funds in each quarter, the mix shifted. Health care increased its portion by nearly 50 percent, from 26 to 37 percent of total.

Comparing the first three quarters of each year, total dollars shrank by 42 percent, from $26 billion to $16 billion. Money invested in IT narrowed by 45 percent, but decreased by a more modest 25 percent in health care, from $7.1 billion to a $5.3 billion.

Mergers and acquisitions
Though more quiet in recent months, the biopharmaceutical industry featured several large-scale, strategic transactions in the first half of 2009. This next table showcases the biggest deals.

StrategicAbbott Labs
Advanced Medical Optics
$2.8 billion
StrategicJohnson & Johnson
Mentor Corp
$1 billion
$67 billion
$41 billion
Johnson & Johnson
Cougar Biotechnology
$1 billion
$47 billion
PipelineBristol-Myer Squibb
$2.4 billion
Fovea Pharmaceuticals
$500 million

Through October, across all industries, bankers closed nearly 5,800 deals in the US worth $620 billion. Despite levels down considerably from 2008 and 2007, health care's share is a robust 21 percent, six percentage points higher than industrials (second rank) and seven points better than financials (third rank).

Debt placements totaling $58 billion have fueled buyout firms, making 2009 a peak year, surpassing 2007. Just in November, Goldman Sachs financed TPG Capital and Canada Pension Fund's $5.2 billion acquisition of medical data provider IMS Health—the largest private equity transaction so far in 2009.

Expect the following market dynamics to expand deal activity throughout 2010:
  • Portfolio pressure among private equity firms: Costlier financing and shareholder pressure are likely to force firms to realize exit strategies in the coming months. "2010 and 2011 will see a big explosion in dealmaking activity' as the debt deals that financed the buyouts begin to approach the end of their five-year term," commented "Until now, there has been little incentive for private equity owners to try to sell or otherwise capture any profits on their health care acquisitions; doing so would have required them to dismantle their existing cheap financing and replace it with more costly capital."
  • Drugmaker shortfalls: A reticent FDA and looming patent expiry are forcing big pharma to look to mergers and acquisitions for growth. Products totaling nearly $200 billion in sales are expected to go off-patent in the next five years. Proprietary drugmakers are now paying richly for products to add to pipelines "to offset the revenue they’re losing to lower-priced copies". (Source: Bloomberg News)
  • Unspent capital: Despite health care's relative buoyancy, private equity firms still boast over $400 billion in unallocated money, noted Bloomberg News. Cost cutting, demographics and the prospect for health care reform are creating new opportunities.
  • Dollar weakness: Foreign purchasers may take advantage of the greenback's tailspin. Against the euro, yen and other major currencies, the dollar has lost more than a third of its value since its 2002 peak.
  • Scarcity premium: The recession may have ended, but the recovery process has begun slowly. Health care growth—about 10 percent per annum—ensures a more stable outlook than other industries.
  • Expanded health care coverage: Both the senate and house reform bills expand coverage to over 30 million people, establishing a large revenue base for many different companies. Health insurance companies are facing margin contraction on more regulation, but many other players could see incremental growth.
Economic model
Health care's sheer economic weight guarantees that its innovators and entrepreneurs will access at least a disproportionate amount of capital relative to other industries. However, even in a dominant risk-taking environment, industry suitors and investors would still require adequate compensation.

In current conditions, suppliers of capital are much less forgiving. Strategic buyers are searching for acquisitions that are immediately accretive. Financial buyers, expecting capital costs to increase, are screening for lasting high returns on capital.

Less evolved companies, or companies confronting uncertain cash flow, will have a tougher time finding shareholders and suitors. Take, for example, private equity portfolios. The private equity universe holds about 100 companies valued in excess of $500 million (Source: About a quarter of these companies are publicly traded. The rest would need to demonstrate not just clear, but immediate returns to prospective buyers.

But it's not just a question of financial strength. Companies should also boast an innovative business model. This business model, moreover, needs to center on cost savings—or value—as its money-making mission. Those companies that demonstrate identifiable savings for their clients, no matter their industry segment, should enjoy the best prospects in attracting capital and doing deals.

Until capital constraints ease for the economy as a whole, risk-aversion will firmly control the 'Should I, or shouldn't I' debate. For now, risk takers, in the minority, favor health care, though the degree of their commitment could fluctuate widely depending on returns.

Whether it's the house or senate reform bill, or some combination of both, don't expect legislation to alter health care's fundamental economic framework. Supply and demand still won't transact with each other, and cost growth will only accelerate.

We can be sure that what we know health care to be today will continue indefinitely, at least until the system can no longer afford itself.

Give market dynamics a chance. If financial and strategic investors want to commit capital, then its their choice, and their choice alone—win or loose.

It would be the most effective, and least politicized, way to make health care more efficient.

One day, dealmaking and investing might even repair the economic model.

For observations on the public equity markets, read "The Missing Stakeholder in Health Reform".