Navigating Change: Baird Capital’s Outlook on the U.S. Healthcare Sector

The U.S. healthcare system accounts for more than $2.5 trillion in annual expenditures – nearly 20% of the nation’s Gross Domestic Product (“GDP”). According to economists in the Office of the Actuary at the Centers for Medicare and Medicaid Services (“CMS”), spending is projected to grow at an annual average rate of 5.8% through 2020, which is 1.1% higher than the nation’s projected GDP growth. By 2020, healthcare spending is projected to exceed $4.5 trillion.

Knowing all of this, it should come as no surprise that changes to the healthcare system, such as those the United States is experiencing now, are of particular interest and a potential source of angst to investors in the sector. The U.S. healthcare system accounts for more than $2.5 trillion in annual expenditures – nearly 20% of the nation’s Gross Domestic Product (“GDP”). According to economists in the Office of the Actuary at the Centers for Medicare and Medicaid Services (“CMS”), spending is projected to grow at an annual average rate of 5.8% through 2020, which is 1.1% higher than the nation’s projected GDP growth. By 2020, healthcare spending is projected to exceed $4.5 trillion.

Knowing all of this, it should come as no surprise that changes to the healthcare system, such as those the United States is experiencing now, are of particular interest and a potential source of angst to investors in the sector.

The Patient Protection and Affordable Care Act (“PPACA”), more commonly known as U.S. healthcare reform, has undergone significant scrutiny and analysis over the past few years, and the Supreme Court’s ruling makes the likelihood of near-term repeal or change small. Under the law as it stands, Baird Capital sees potential positive and negative ramifications for venture investment opportunities.

The Good, the Bad and the Likely
A February 2013 report from the Congressional Budget Office estimates over 30 million Americans will receive new insurance coverage, likely leading to more medical procedures; however, this could put already cash-strapped states in even more tenuous positions and force further reductions for reimbursement of those procedures, especially for Medicare and Medicaid programs.

To help put the implications for Medicare alone into perspective, consider this: As the Baby Boom generation approaches and enters retirement, the Pew Research Center estimates ten thousand people in the U.S. are turning 60 years old every day. Most of those people become eligible for Medicare at age 65, though some may qualify even earlier.

This further exacerbates a trend seen since the late 1980’s, when the hospital industry began to subsidize losses from Medicare and Medicaid by demanding premium rates from commercial payers. According to the Kaiser Family Foundation, family healthcare premiums are up 272% from 1999 to 2012, an unsustainable increase at a time when other economic factors are forcing healthcare facilities and systems to drop their operating costs 10 to 15%. This is an increasingly difficult task when margins for procedures continue to shrink.

 

Important Considerations
Any of the above in isolation might reasonably give a healthcare investor pause. But within Baird Capital, we continue to believe the sector presents attractive investment opportunities that require specialization and deep understanding of the technologies, biology, and the regulatory and reimbursement landscapes. Specifically, certain factors must be considered:

1.Shrinking number of healthcare investors.
With the reduction in the number of active venture firms over the past few years, the number of healthcare investors has declined and we believe will continue to do so. This creates advantages and disadvantages for the active investor. In terms of advantages, deal flow has remained strong across every sub-sector of healthcare, and fewer investors can mean better negotiating power for deal terms and structure. However, fewer investors in the market can necessitate structuring deals with longer commitments, making it even more important to ensure you have the right partners.

2. Public and M&A markets.
The public markets have been receptive to healthcare companies over the past few years, and we don’t see that changing on the foreseeable horizon. Recent healthcare IPOs have performed well, and we expect to see a number of tools, diagnostics and medical device companies go public in the coming quarters. The M&A markets across healthcare have also remained strong, as larger companies often seek to acquire as opposed to building from within. The balance of power currently lies in the hands of the strategic acquirer, however, as they are faced with many companies struggling for financing and looking for strategic acquisition or investments. Understanding the key areas of interest for potential acquirers and developing relationships with them are critical to capitalizing on these opportunities.

3. Regulatory environment.
Difficulties getting products through the FDA have been highly publicized in recent years, particularly for biotech and medical device companies. We’ve seen the inconsistency within the FDA first-hand through experiences of our portfolio companies. But more recently there are indications that the FDA has made a conscious effort to turn the corner. Transparency seems better now than in years past, and there is more consistency in the review process. Swifter reviews and approvals have been seen over the past year, and we believe with good dialogue and proper testing, products can be reviewed and approved in a fair and consistent manner. Investors need to be comfortable in taking on a moderate level of regulatory risk, which Baird Capital spends considerable time weighing and modeling contingencies should approvals take longer than anticipated.

4. Reimbursement.
As mentioned earlier, the current pressures facing our healthcare system will only lead to lower reimbursements for medical products and procedures. Our strong preference is to find companies with existing, suitably priced reimbursement codes in place, such that the company does not need to undergo the laborious process of obtaining new ones. Second, the payors and insurance companies are extremely powerful in today’s healthcare economy, making it advantageous to partner and build relationships with key insurance companies. Third, reimbursement must be factored early on in product development with an effort to understand a technology’s clinical utility, both in terms of cost savings to the system and better efficacy to the patient.

5. Globalization.
In our assessment, the need for companies to think about global markets may hold true across all industries, but particularly so for healthcare due to the constraints imposed by U.S. political and regulatory policies. The second article in this series will focus on the opportunities and challenges facing healthcare companies in the global marketplace.

Taking all of these factors into consideration, Baird Capital’s focus within healthcare remains consistent across three specific sub-sectors – Medical Devices, Tools and Diagnostics, and Healthcare Services and Healthcare Care Information Technology (“HCIT”). Our specific outlook for each of these subsectors will be the focus of the third article in this series.

Michael Liang
Michael Liang
Partner
Baird Capital

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