Healthcare private-equity deals rebounded after the slump that followed the nation's recession and preceded passage of health reform legislation. Now, investors are scouring the marketplace for companies well-positioned under what many expect to be uncertain and more cost-conscious years ahead for healthcare spending.

Private-equity appetite for healthcare continues to be strong since the passage of the Patient Protection and Affordable Care Act, which calls for far-reaching regulatory and market changes to health insurance—despite potential upsets as opponents push to upend the law in Congress and the courts, private-equity insiders say.

Competition for healthcare deals has grown as investors look to the industry for deals that won't sour when the economy does—as was the case during the recent recession. Fueled by corporate cash stockpiles as the economy recovers and credit markets improve, demand for healthcare deals has boosted prices for acquisition targets, they say.

“The recovery was fairly rapid and significant,” says Tim Dugan, managing partner with Water Street Healthcare Partners, a private-equity firm based in Chicago, of the valuation buyers are willing to pay for recent deals after values slumped during the recession. His firm does not invest outside of healthcare.

“It's a good time if you have a business ready for sale,” he says.

Not all healthcare business, however, will find private-equity firms eager to invest.

Investors did not discount potential opportunity and risk created when the healthcare reform law passed a little more than a year ago, private-equity executives say.

The law increases oversight of health insurers, squeezes Medicare payment to hospitals and calls for significantly expanded insurance coverage by 2014.

Regulations have not yet been drafted for much of the law, and efforts to overturn the law continue. For investors, some uncertainty lingers, but nowhere near the degree that existed during the debate prior to passage, which led “to a dearth of capital in the private markets,” says Brian Miller, a partner with Linden Capital Partners, a healthcare and life science private-equity firm he co-founded. Miller also founded the Healthcare Private Equity Association.

“Certainty is the friend of investing,” Miller says.

Healthcare insurers, medical imaging, laboratory and hospice services do not fare well under some provisions of the law and are likely to have a harder time finding investors, according to private-equity executives interviewed for this story.

Instead, investors will wager on companies they say may deliver greater efficiency demanded by policymakers and employers seeking relief from rising healthcare costs. Investors say companies likely to find financing are those that address demand for more efficient medical care. Pressure to contain costs existed before healthcare reform, and the law is expected to amplify it.

Healthcare information technology, a significant strategic and capital priority in recent years, or services to manage spending or reduce medical errors or hospital readmissions are expected to be among the winners, they say.

“There's a lot of volume coming into the system,” Miller says of the upcoming expansion of insurance coverage in 2014 under the law. But the question remains: “At what price do they come into the system, and can it be handled?”

In 2010, investors poured $12.4 billion into 217 healthcare private-equity deals, according to data from a yearly survey by the private-equity research firm PitchBook. Last year's activity is up sharply from 2009, when the sector saw 170 healthcare private-equity deals that totaled $5.2 billion.

Last year's investment total remains far short of activity at the peak in 2007 when the sector saw $41.3 billion invested in 289 transactions. In 2008, PitchBook reported 284 healthcare deals that totaled $20.3 billion.

Water Street's Dugan says pent-up demand during the recent downturn has contributed to increased competition among investors for deals. “We do see steady and increasing interest from generalist” private-equity firms interested in healthcare, he says.

Surveys of private investors, banks, other lenders and entrepreneurs by the Association for Corporate Growth and Thomson Reuters show many consider healthcare a high-growth market ripe for merger activity. In the most recent survey in October 2010, venture capital and other private investors appeared optimistic about healthcare prospects. Three out of four said healthcare costs had not slowed investments and almost as many did nothing to alter investment strategies after the reform law passed.

Kevin Lavender, a senior vice president and head of corporate healthcare lending for Fifth Third Bank, says he expects healthy dealmaking despite slightly slower activity during the first three months this year, as private-equity firms with cash reserves begin to invest. Lavender says he believes private-equity firms have capacity for more investments, based on his talks with potential partners.

Joseph Ibrahim, a principal with the private-equity firm Riverside Co., New York, says publicly traded companies seeking strategic acquisitions “are back and very active.” Strategic buyers have also raised valuations, he says. “There is a tremendous continued interest in healthcare.”

The past year has brought some notable private-equity investments in the healthcare sector.

Cerberus Capital Management, a New York-based private-equity firm, started on a healthcare buying binge last November. It began with the $895 million deal for six hospitals owned by the Archdiocese of Boston. Since then, Cerberus' Steward Health has added a string of deals to acquire four additional Massachusetts hospitals and officials have offered $1.1 billion for Jackson Health System, a government-owned and financially distressed system in Miami. Cerberus declined to comment for this article.

Meanwhile, the Blackstone Group owns a roughly two-thirds stake in Vanguard Health Systems, Nashville. In late 2010, Vanguard acquired the Detroit Medical Center, a six-hospital, not-for-profit health system.

At the same time, private-investor interest in healthcare appears increasingly mutual. In January, five health systems announced they would privately invest in healthcare companies with the Heritage Group, a Nashville-based investment and consulting group (Jan. 31, p. 6). Three for-profit hospital operators based in Tennessee—Community Health Systems, LifePoint Hospitals and Vanguard—and two not-for-profit systems, Iowa Health Systems, Des Moines, and Trinity Health in Novi, Mich., each committed up to $10 million to the fund, which set its fundraising target at $200 million.

Roughly one month later, Ascension Health, the nation's largest Catholic health system, and Oak Hill Capital Partners announced the formation of Ascension Health Care Network, a fund to invest in distressed Catholic hospitals (Feb. 21, p. 6).

The Ascension network listed seven Ascension Health executives and directors and five Oak Hill partners as officers and directors, according to a Securities and Exchange Commission filing. The new fund reached its initial fundraising target of $500,000, according to the filing.

Oak Hill declined to comment for the article.

The size of the healthcare market also makes it highly attractive for investors in search of deals.

“It's not an industry, it's a segment of the economy,” says Reeve Waud, founder and managing partner of the Chicago private-equity firm Waud Capital Partners. Waud says he first invested in healthcare in 1999 as the economy was slowing. (The U.S. entered an eight-month recession in early 2001.) Healthcare services would not be as vulnerable to outsourcing or downturns as other possible investments, such as manufacturing, he says.

The market is also highly fragmented, with smaller companies competing to emerge through growth or acquisitions as potential acquisitions for a limited number of major players, he says. “It's a target-rich environment.”

Often lacking are skilled healthcare executives, when compared with other more business-savvy industries, he says. Waud Capital scours for deals with strong management teams, he says.

Acadia Healthcare, a behavioral-health company owned by Waud Capital that last month acquired 13 facilities, recently named a few former Psychiatric Solutions executives to top positions including CEO, finance chief and chief operating officer. Universal Health Services, King of Prussia, Pa., acquired Psychiatric Solutions last year in a $3.3 billion deal.

The surge of seniors as baby boomers age also makes healthcare an attractive investment, says Riverside's Ibrahim. Seniors typically require more and more intensive healthcare. “The graying of America is a great investment thesis,” he says.

While the sector's size and fragmentation may be attractive, healthcare's regulation and major public payers are not, private-equity investors say.

Water Street avoids deals for companies heavily dependent on public or private payers and invests primarily in healthcare manufacturers, distributors or specialty outsourcing companies, Dugan says.

Medicare and Medicaid make up significant revenue for healthcare providers, he notes. Should Congress or regulators alter policy, investors fear revenue and profits may disappear “by the stroke of a pen.”