Provider, pharmacy sector see lively quarter

The mergers and acquisitions storm in the life sciences blew in fast and furious in the second quarter and petered out just as quickly. But the ripple effect roiled subsectors of the healthcare industry that previously had been quiet.

After forging just five deals in the first half of the year, pharmacies and pharmacy benefit managers returned to the dealmaking table with 13 transactions in the third quarter. That number was 44% higher than the nine deals signed in the third quarter of last year.

There was a similar uptick in activity for firms that cater to life sciences companies. While the number of deals among pharmaceutical and biotechnology companies declined in the third quarter, there was a spike in transactions in the pharmaceutical products and services space. A total of 21 deals fell into the latter category in the third quarter, compared with 11 in the prior quarter and two in the third quarter of 2013.

The acquisition spree followed a wave of blockbuster drug deals this year. Pharmaceutical and biotechnology firms spent $159.1 billion on acquisitions in the second quarter, the bulk of which was for overseas targets. They saw a window of opportunity—before the Obama administration and Congress could potentially crack down on the practice—to shift their headquarters overseas and take advantage of lower corporate tax rates as well as repatriate offshore funds.

Compared with the second quarter, deal activity initially appeared muted, according to Modern Healthcare's third quarter M&A Watch report, which tracks deal volume and value in four healthcare sectors. But the number of transactions showed that momentum has continued.

Acquisition targets are continuing to demand significantly higher prices, boosting total value. But the high valuations have slowed the sales process, with some buyers balking at the figures after doing their due diligence. Although the M&A Watch tracks deals at the point when they have been publicly announced, dealmakers report that they're taking longer to close.

“The process seems to be taking a little bit longer than it has historically,” said Ken Marlow, Nashville-based chairman of the healthcare department at law firm Waller. A not-for-profit to for-profit conversion process can take up to a year, he added, and larger deals also take longer to close.

Garrick Rice, managing director at private equity firm Sterling Partners, said he is seeing a robust deal pipeline. Sterling Partners focuses on founder-owned healthcare services companies, particularly those that offer healthcare information technology, outsourced services or a lower-cost care setting.

Buyers have the capital to invest and see an attractive market, he said. Owners have seen a rising stock market as a sign that it might be time for an exit strategy. Still, many of the announced deals have fizzled out. “You're not seeing the valuations holding up when you get into due diligence,” Rice said. “If (sellers) don't get the prices, they're more likely to hold onto the business.”

In total, the report tracked 285 announced deals, essentially flat over the second quarter's 287 transactions and 11.8% higher than during the third quarter of last year.

Without the large tax-motivated plays from the U.S.-based pharmaceutical sector, total healthcare deal value plummeted quarter over quarter. The $60.7 billion in deal value—which was concentrated in 76 deals with a publicly disclosed price tag—represented a 73.6% drop over the $229.8 billion in value seen the previous quarter. But $60.7 billion is still the second-highest level of deal value since at least the fourth quarter of 2012.

In the provider space, most of the third-quarter dealmaking value was concentrated in deals involving real estate investment trusts, which have benefited from the stock market boom.

Deal value shot up to $13.9 billion compared with $6.4 billion during the same quarter last year. It also continued to rise quarter over quarter, increasing 41.8% over the second quarter's $9.8 billion.

While the dealmaking wind has calmed for drug developers, the drive for size and scale has shifted to related sectors. “There's definitely a material trend in the specialty pharmacy and pharmacy services space,” said Michael Hess, a Memphis, Tenn.-based attorney at law firm Bass, Berry & Sims who focuses on the specialty pharmacy sector. “We're seeing a pretty large entrance of private equity financing, and we're seeing a trend of nontraditional buyers looking at specialty pharmacy.”

Investor interest in the space also appeared strong. Six of the transactions for a company in the pharmaceutical products and services sector involved a private equity buyer, as did three of the pharmacy and PBM deals. There were 40 private equity deals overall.

Hess pointed to the momentum around the initial public offering for Diplomat Pharmacy, a Flint, Mich.-based specialty pharmacy that filed for a listing in July, as evidence that the large independents are doing well in the market.

But specialty pharmacy is an industry that requires a large amount of overhead. There often will be restrictions on what insurers will pay above the cost of the drug itself. Some of these drugs are only distributed on a limited basis.

Small independent pharmacies, therefore, lack the size and capacity to effectively compete in the market. “There's a certain level where you're not going to get the manufacturing contract; you're not going to get the drug,” Hess said.

Meanwhile, the number of specialty drugs continues to grow, as pharmaceutical and biotech companies realize they're a better investment than small molecule compounds that can be more easily copied by a generic drugmaker. A report from Express Scripts, a pharmacy benefit management organization, found that 19 out of the 28 drugs approved by the Food and Drug Administration last year, or more than two-thirds, were specialty pharmaceuticals. In 2008, only 33% were specialty drugs.

Drugmakers themselves have pared down their dealmaking activity. There were 45 deals for pharmaceutical and biotechnology developers in the third quarter compared with 57 in the previous quarter.

But companies in the life sciences sector as a whole forged 74 deals, only a small drop over the prior quarter's 79. Services companies made up the shortfall. The numbers represented a 42.3% increase over the 52 life sciences deals in the third quarter of 2013. Deal value for the life sciences sector, however, plummeted to $37.5 billion in the third quarter, still above the $24.2 billion during the same period last year.

The third quarter's largest deal also came out of the life sciences space—Merck's $17 billion bid for Sigma-Aldrich. The deal is the fourth-largest life sciences deal of the year so far. It is notable because Sigma-Aldrich doesn't make drugs. Instead it supplies the chemicals and biological materials used in the early stages of drug research and development. The deal helps Merck diversify away from its core drug development business, offering a more predictable revenue stream.

The M&A activity among pharmacies and PBMs helped boost deal volume and value in the provider space. The number of transactions increased 18.3% in the third quarter to 110, up from 93 during the third quarter of 2013. That was a 10% increase over the 100 deals in the second quarter.

Walgreen Co. had the largest deal in the pharmacy and PBM sector when it spent $5.3 billion in August to purchase the 55% stake in Alliance Boots, a Switzerland-based global pharmacy chain, that it didn't already own.

In the provider sector, the quest for size and scale continues to drive M&A among hospitals and post-acute-care providers. With the average hospital margin hovering around 3%, the only way to weather the onslaught of payment cuts is to spread costs around a greater number of facilities.

“There are so many hospitals that are in trouble,” said Cliff Stromberg, a Washington-based healthcare transactions lawyer at Hogan Lovells. “We have not seen the end of it, and the proof of it is if you look at the ratings agencies, many hospitals still have marginal ratings.”

Credit-rating agencies set a higher bar for stand-alone hospitals to achieve the same rating as multihospital systems because they're more exposed to what happens in their market. “They tend to throw a little fuel on the fire by saying bigger is better,” Stromberg said. “If you are in a system, you actually have to achieve a lower level of profitability to get the same rating. The fact is, the little guys are being penalized.”

Even so, many not-for-profit hospitals and systems are choosing not to hand over full control and governance, and instead are pursuing joint ventures with a partner that can provide access to capital and relationships with vendors, Marlow said.

For instance, in Arizona, Ascension Health entered into a three-way joint venture in the third quarter with Tenet Healthcare Corp. and Dignity Health to operate Carondelet Health. Tenet will hold the majority stake in the three-hospital, Tucson-based group.

Follow Beth Kutscher on Twitter: @MHbkutscher