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Fewer deals, higher prices

Dwindling pool of strong assets leads to selectivity

By Beth Kutscher
Posted: January 25, 2014 - 12:01 am ET

Rising share prices and investment portfolio returns helped drive higher merger and acquisition prices last year, even as the overall number of transactions dropped. The high price tags meant acquirers—while still eager to increase scale or diversify into new businesses—were choosier about where to deploy their capital.

The result: Total deal volume fell by nearly a third, falling to 977 total transactions from 1,430 in 2012, according to the Modern Healthcare Insights' fourth quarter M&A Report, which includes data for the full year. Yet total deal value for the year was 9% higher at $135.3 billion compared with $123.6 billon.

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“One of the realities of 2013 is that while there were many more deals being considered, (the usual acquirers) are being much more selective than in the past,” said Steve Gelineau, senior vice president at the Camden Group, a consulting firm. “But those deals on average were larger.”

While the appetite for deals is as strong as ever, there is a smaller pool of high-performing assets from which to choose—particularly in the provider sector where many stand-alone hospitals and smaller systems are struggling financially. Heightened scrutiny from antitrust regulators and continuing uncertainty around healthcare reform has “been giving people pause,” Gelineau said.

The hefty prices for pharmaceutical and biotechnology acquisitions continue to be the largest driver of total deal value in the fourth quarter, much like throughout the year. Several long-running trends are driving M&A activity among firms that hunt for new drugs and biologics.

Even though the revenue drop from the patent cliff—the expiration of patents on blockbuster drugs with more than $1 billion in sales—finally began to level off as 2013 drew to a close, the residue was still a huge sales gap that needed to be filled. Many companies continued to look to fill that gap by hunting for acquisition targets. The research and development departments at the large pharmaceutical firms have yet to come up with a successful formula for replacing drugs with expiring patents.

In addition, the road to drug approval remains as bumpy and costly as ever. After approving 39 drugs in 2012—the highest in 16 years—the Food and Drug Administration gave the green light to only 27 in 2013. Moreover, those approvals reflected a higher proportion of specialty drugs aimed at niche oncology and neurological disorders—not the large market opportunities represented by new drugs to treat high cholesterol, hypertension and depression.

With payers and pharmacy benefit managers reluctant to pay premium prices for branded products in medication classes where generic alternatives are available, companies have shifted their approach to R&D. For some companies, it reflects a major transformation.

Bristol-Myers Squibb Co., for instance, is in the process of changing itself into a specialty biopharma company from one that focused on primary care and oncology. Best known for drugs like Plavix, an anticoagulant, and Abilify, an antidepressant—which are both among the top-selling drugs of all time—the company said in December it would sell its stake in a joint diabetes franchise to its partner AstraZeneca.

The deal, which covers emerging brands such as Byetta and Onglyza, includes an upfront payment of $2.7 billion. But the final price tag could reach $4.3 billion if certain milestones are met. It was the second-largest deal of the fourth quarter.

These restructurings and spinoffs are likely to continue in 2014. But while paring down to a niche focus can help boost R&D productivity, it also raises the stakes for companies that don't have the benefit of diversification, analysts at Fitch Ratings wrote in a 2014 outlook report.

Meanwhile, the outlook remains bright for small companies developing niche drugs that are showing some success during their development stage. Last year is being hailed as the biggest year for biotech initial public offerings since 2000. There were 25 IPOs in the fourth quarter: 19 for drug developers and six for medical device and diagnostics firms.

But the emphasis continues to be on success—or at least well-documented progress in the long march through the FDA approval process. A handful of companies postponed their listings last year, citing “unfavorable market conditions,” a sign that they didn't get the valuation they wanted amid all the competition from other new issuances. “Some of the companies without a strong story to tell will have a tough time,” said Daniel Kajunski, who specializes in venture finance at law firm Mintz Levin.

While new issuances are expected to continue this year, Kajunski expected M&A to dampen some of the IPO filings.

Rising stock prices, rising cash

The stock market also provided a boost to publicly traded firms, which saw their share prices rise in 2013 alongside the broader market. In addition, pharmaceutical and technology sector firms entered the year with record levels of cash on their balance sheets.

Those two factors, along with low interest rates and a healthy appetite for lending, made it easier for bidders to swallow a large deal with a mixture of cash, stock or debt. But it also drove up price tags for publicly traded targets.

Companies that serve the pharmaceutical sector also contributed to the higher deal value in the fourth quarter. The quarter's largest deal was a cross-border transaction that McKesson Corp., whose core business is in drug distribution, forged with German peer Celesio in a move that would make McKesson a more formidable player in Europe.

The initial price tag on the deal was 23 euros per share, or about $8.3 billion, using the exchange rate at the time the transaction was announced in October. As of mid-January, it had been raised to 23.50 euros per share to appease hedge fund Elliott Management Corp., Celesio's largest investor. But the deal is in limbo as Celesio's shareholders failed to approve it by the necessary 75% margin.

Private equity firms also saw opportunities in contract research and manufacturing—picking up a theme from earlier in the year. Most notably, JLL Partners teamed up with Royal DSM, a firm based in the Netherlands, to combine their drug development and manufacturing assets into joint venture NewCo with an enterprise value of $1.95 billion.

Outside of the life sciences, a number of deals in the fourth quarter focused on how to bring healthcare closer to patients—particularly as payers and providers are taking on more financial risk for poor outcomes.

Following similar deals earlier in the year, Centene Corp., a Medicaid managed-care organization, scooped up a 68% stake in U.S. Medical Management. The $200 million deal gives it greater in-home care-management capabilities, which will be key to holding down costs for high-risk, chronically ill patients.

CVS Caremark Corp. also forged a $2.1 billion deal to buy Coram, an in-home specialty infusion provider. The retail pharmacy chain already has an urgent-care business through its in-store MinuteClinics, but the Coram purchase allows it to connect with patients at another access point.

The year's biggest deals

In total, there were 246 deals in the fourth quarter, just nine fewer than last quarter, but 31% below the same period of 2012. Deal value, however, reached $36 billion, about two-thirds higher than last year. It still came in below the third quarter, however, when deal value was $38.4 billion.

Even with lower volume, there were 11 deals that topped $500 million, compared with just six in the fourth quarter of last year.

None of the deals in the fourth quarter came close to unseating the largest deal of 2013: Thermo Fisher Scientific's $13.6 billion takeover of Life Technologies Corp. Although it wasn't a drug deal, it similarly highlighted the vast opportunity expected in personalized medicine and genomics as the industry moves to specialty pharmaceuticals.

Publicly traded hospital operators also helped boost the year-over-year deal value. Facing tremendous pressure from declining inpatient volume and a squeeze on reimbursement, two of the stalwarts of the industry forged blockbuster mergers to gain size and scale, as well as new capabilities.

Tenet Healthcare Corp. completed its $1.8 billion deal for Vanguard Health Systems, which will give it access to the smaller company's portfolio of urban hospitals and, just as importantly, expertise in risk-based contracting. And Community Health Systems is nearing completion of its $3.9 billion deal for Health Management Associates, which will allow it to realize back-office synergies that are particularly important in the rural markets where both companies operate.

But blockbuster deals weren't just reserved for investor-owned providers. Catholic Health Initiatives committed a total of $2 billion to buy St. Luke's Episcopal Health System in Houston.

Absent those big deals, deal value in the provider sector fell off markedly in the last three months of 2013 compared with previous quarters. But those numbers belie the larger story: In three out of the last four quarters, healthcare providers were the lone sector that managed to forge more deals year-over-year.

Diversifying service offerings

For vendors, the opportunity was in information technology. Financial data provider Experian made a bold move into the healthcare space, paying $850 million—or seven times last-12-month revenue—for Passport Health Communications, a revenue-cycle management firm.

That deal follows transactions such as Vista Equity Partners' $644 million investment in Greenway Medical Technologies, and successful IPOs from Premier and Envision Healthcare Holdings. Each of those firms offers diversified services ranging from group-purchasing and data analytics to staffing and population health management.

Payer deals, meanwhile, were few and far between. Insurers early in the year faced regulatory uncertainty around Medicare Advantage rates, and later on were buffeted by fears that the less-than-successful rollout of the federal and state health insurance marketplaces would lead to earnings pressure from too many older, sicker beneficiaries.

“The rollout of healthcare reform has been such a distraction to all payers,” Gelineau of the Camden Group said. But they're still looking—particularly for nontraditional targets. “They are keeping a careful eye on the provider sector in the market sectors where they're active.”

But in 2013, the deals that were forged tended to focus on the Medicare Advantage and Medicaid managed-care segments. There was also notable interest in adding care-management capabilities. Humana, Cigna Corp. and Centene each pursued opportunities to bring care closer to the patient.

Yet while 2013 saw an uptick in provider deals, it also saw something that wasn't tracked in the M&A Watch: a growing interest in looser affiliations that allow hospitals or systems to retain their independence. These alliances allow the parties to still see some economies of scale through their joint-purchasing power as well as share knowledge, particularly around population health management.

For systems in a position of financial strength, these looser affiliations are likely to pick up steam in 2014. But those hospitals facing a cash-crunch will still need to join hands with stronger financial partners, which should continue to feed another year of robust M&A activity.

There are few financial roadblocks to impede would-be acquirers. Even with interest rates beginning to creep up, the debt and equity markets should remain open to dealmakers. There's little expectation for a significant pullback.

Follow Beth Kutscher on Twitter: @MHbkutscher

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