From 2010 through mid-2012, there was relatively little merger and acquisition activity within the healthcare sector. During that time, the fate of the Patient Protection and Affordable Care Act (PPACA) had yet to be determined by the courts, so healthcare companies held on to their cash while they waited to see if the legislation would withstand judicial scrutiny.
But since the Supreme Court’s decision last June to largely uphold the law, there has been a wave of M&A activity in the healthcare space. Indeed, the lion’s share of the over $143 billion spent on mergers and acquisitions in more than 1,000 deals occurred after the Supreme Court’s fateful ruling.
This year, healthcare M&A looks set to continue at an even higher pace.
In early March, consulting firm KPMG conducted a survey on M&A outlook, which included a section dedicated to healthcare. Just over half of the respondents reported that they planned to either enter into or consider deals this year, while only a third said they intended to maintain the status quo.
The certainty created by the Supreme Court ruling has also drawn in another type of investor–venture capitalists.
According to data from Dow Jones Venture Source, which tracks capital flows and deal activity, healthcare accounted for 30 percent of total venture capital investment in the first quarter: About $1.9 billion was raised to finance 162 deals. That was sufficient to make healthcare the largest sector allocation among venture capital firms.
So why all the interest in healthcare M&A all of a sudden? The PPACA actually encourages it.
For one thing, the law encourages the creation of Accountable Care Organizations (ACO), which will essentially pool risk with traditional insurance companies and work to help reduce healthcare costs while improving quality of care and outcomes. While the precise structure of ACOs has yet to be determined, they will likely be partnerships between hospitals and health systems as well as other providers. Under the law, they will make money by splitting the value of any savings they create with Medicare.
While there aren’t any ACOs in operation yet, it is expected that Medicare will nudge its patients to the most efficient ACOs since they will be maximizing cost savings for the system. Logically, the largest ACOs are likely to be the most efficient, since they can best leverage economies of scale.
In anticipation of the formation of ACOs next year, the pace of M&A activity among hospitals has skyrocketed. In past years, there would only be a handful of deals per week that involved small, private hospitals combining with or selling themselves outright to larger health systems, or smaller physicians groups being absorbed by larger ones.
So far in 2013, such transactions have jumped to an average of about 15 per week, and a number of policy experts predict that of the more than 5,700 hospitals in the US today, about 1,000 of them will have new owners by the end of the decade.
Not only have ACOs been driving that trend, but the slow pace of Medicare reimbursement growth and reduced patient volume during the recession are driving smaller hospitals into the arms of bigger networks.
Although we have no way of knowing the identities of individual respondents to KPMG’s M&A survey, I wouldn’t be surprised if companies such as LifePoint Hospitals (NSDQ: LPNT), HCA Holdings (NYSE: HCA) and Universal Health Services (NYSE: UHS), some of the largest publicly traded health systems, take part in the coming M&A boom.
Healthcare reform also has the potential to cause subtle shifts in the way the pharmaceutical industry thinks about M&A as well.
After a wave of drug scandals last decade–such as Merck & Co’s (NYSE: MRK) Vioxx, which was linked to thousands of heart attacks and a number of deaths–safety requirements have been significantly tightened. But drugs that treat orphan diseases–those for which few, if any, treatment options exist–have somewhat looser regulation. That’s not to say they aren’t rigorously tested for safety and efficacy, just that they aren’t subject to the same large-scale trials as drugs for more common conditions.
Treating orphan illnesses is also an attractive niche because what such drugs lack in terms of potential sales volume can be more than offset by higher prices.
Major pharmaceuticals have a clear advantage in this market because they can partner with smaller biotech companies to help defray the cost of research and development, and then collect a royalty stream once a drug comes to market. Alternatively, they can simply acquire smaller companies and their products for a ready-made pipeline.
As a result, companies such as Vertex Pharmaceuticals (NSDQ: VRTX) and BioMarin Pharmaceutical (NSDQ: BMRN) that focus their efforts on orphan illnesses are attractive as plays on promising drugs as well as potential takeover targets. With market caps of about $19 billion and $8 billion, respectively, either could easily be scooped up by a larger pharmaceutical company.
So in the coming months and years, there’s huge potential to profit from healthcare M&A whether it’s driven by regulation or innovation.