Exiting a business, whether you are a serial entrepreneur looking to move on to the next project or a healthcare provider like a physician or therapist who has nurtured your practice for decades, can be difficult. After all, corporate transactions are complex affairs that often hang on small details. That’s to say nothing of the emotions that business owners sometimes experience when stepping away from an enterprise into which they have poured their sweat and passion.
For those in the healthcare industry, the complexities only get tougher to tackle. As one of the most heavily regulated industries, healthcare embodies a level of regulatory risk—from merely annoying to existential—that most businesses don’t have to contemplate, making succession and exit plans hard to develop and harder still to execute.
For much of the 21st century, some of the challenges associated with healthcare exit transactions were blunted by an incredibly robust market. Investment capital poured into healthcare, particularly from private equity sponsors, whose investment in healthcare increased fortyfold during the first two decades of the new century, providing ample liquidity for owners looking to exit their businesses. Similarly, whether driven by private equity platform companies or strategic buyers, industry consolidation lent momentum to dealmaking.
Much of this backdrop has changed in the post-pandemic era. The interest-rate environment shifted into a tightening cycle, and rates have remained elevated far above the pre-pandemic period, frustrating dealmakers who have relied on ultracheap leveraged loans to finance transactions. Additionally, regulatory risk in healthcare remains a concern, especially in the context of mergers and acquisitions. The U.S. government recently revised its regulatory framework for mergers, making the process more complex and likely leading to longer transaction timelines and greater time and expense in getting deals across the finish line. The cumulative impact of increased regulatory scrutiny and deteriorating financial conditions took its toll in 2023. According to Becker’s Hospital Review, no fewer than two dozen hospital and health system deals fell apart over the past 24 months, many due to threatened or actual regulatory intervention.
Smaller transactions are also attracting the attention of regulators. In March 2024, the Department of Justice, Federal Trade Commission, and the Department of Health and Human Services jointly launched “a cross-government public inquiry into private-equity and other corporations’ increasing control over health care.” The agencies have specifically called for public comment and information concerning “transactions that would not be reported to the Justice Department or FTC for antitrust review under the Hart-Scott-Rodino Antitrust Improvements Act,” presumably because the values of companies are too small. This puts smaller deals—the current HSR size-of-transaction threshold is $119.5 million—squarely in the crosshairs of this new regulatory emphasis.
State governments have joined the FTC, DOJ, and HHS in ramping up scrutiny of healthcare-industry transactions, demanding greater transparency. Notably, California’s newly created Office of Health Care Affordability (OHCA) has implemented extensive reporting requirements for qualifying material change transactions. While the reporting threshold is already quite small—$25 million—the reporting requirements are triggered for even smaller deals in certain circumstances, targeting in particular acquirers that have been active in M&A in the past (a not-so-subtle shot across the bow of private equity sponsors). In some cases, reportable deals in California go beyond change-of-control transactions and could potentially impact even conventional lending and lease transactions.
While the California regulatory scheme is the latest and perhaps most extensive, other states have made similar moves. As of the beginning of 2024, no fewer than 12 states, including New York, Massachusetts, Washington, and Oregon, had imposed reporting requirements for healthcare transactions.
One might assume these headwinds have put the brakes on the healthcare deal market, but deals are still crossing the finish line. The windows of opportunity are narrower—and the negotiations are tougher—but there are some things that business owners can do to improve their position when contemplating a sale.
Know Thyself
One of the common pitfalls for exit transactions is when owners/sellers are not aligned on their ultimate goals, whether short or long term. For owners merely interested in maximizing the price of the deal, the process becomes a fairly straightforward exercise in valuation, but owners normally have far more complicated aims. For example, some want to retain a stake in the business while giving up control and day-to-day management; others want to preserve and enhance the position in the market while retaining the culture they have built. These aims become important when considering the types of transaction available to the owner; simply put, not all transaction types—and not all buyers—are compatible with all the goals an owner might have for the sale.
Financial and Operational Hygiene
Just as sellers’ goals can be idiosyncratic and individualized, buyers also have concerns that can be various and sometimes difficult to quantify. All buyers want to negotiate the best deal possible, and for some, this is the extent of things—they are merely bargain hunting. Others have an interest in growing market share or ESG and are looking for targets that maintain the same orientation. In order to solicit the widest possible interest for their business, owners need to be able to articulate the lines of revenue and processes that create the value of the business. Buyers want to see strong businesses with professionalized operations that require little investment post-closing so as to easily integrate.
Transparency is the key. Particularly in the healthcare industry, buyers must engage in a thorough due-diligence process in order to avoid unforeseen liabilities associated with the target’s business. Sellers can turn this into a smooth process by being prepared and having ready governing documents, financial statements, policies and procedures, and compliance-related information that will be requested by the buyer. It’s also important for the seller to perform its own reverse due diligence so as to confirm the seller will meet the goals the seller articulates, as described above. Much of the transactional activity in healthcare is consolidative, and so by nature acquirers are often larger (sometimes much larger) than target companies. The more organized and prepared the seller, the clearer the signal of the underlying business’s quality—and the justification of a higher premium for it.
Mind the Valuation Gap
More often than not, there is a basis of data to support one value or another, but when disagreements emerge between buyer and seller over valuation, the resulting interactions can be contentious and emotional, imperiling constructive negotiation toward an eventual sale. Negotiation is not just about leverage; it is also about understanding the nuances of valuation and being sophisticated in how to negotiate. When we use terms like “buyer’s market” and “seller’s market,” it is really just an attempt to baseline which side has the leverage at the beginning of a negotiation. It is important to know what kind of market exists for your business and why a prospective buyer wants to buy it.
Using a Quality of Earnings (QoE) approach is a common method buyers use to determine the valuation of a company and provides substantial room for negotiation. A QoE report offers a detailed review of a company’s financial performance, focusing on the accuracy and sustainability of earnings. It is important for the seller to understand and participate in this process, as it provides an opportunity to identify expenses that should be added back so as not to negatively impact value, such as one-time expenses or non-operational costs. Additionally, negotiations often involve discussing an earnings multiple as a key factor in determining the company’s value and purchase price.
There is a wide divergence of opinion about what kind of market we are in and what the corresponding business valuations should be. In a recent survey of health system leaders, nearly a quarter of respondents cited mismatches of buyer/seller perceptions of value as the number-one challenge to M&A in 2024; it was the factor most frequently cited. More broadly, SRS Acquiom Inc.’s 2024 M&A Deal Terms Study reported that private-target M&A transactions experienced significant pressure on valuations in 2023. Nevertheless, many sellers remain anchored in data and expectations from years past, which has had the predictable result of weighing down M&A transaction volumes. For instance, it has been widely reported that the period of time that private equity funds hold portfolio companies jumped last year to its highest levels ever, and Bain & Company estimates that private equity funds are sitting on an inventory of 28,000 unsold companies worth $3.2 trillion. The exit dynamics clogging up the private equity pipeline also impact private business owners attempting to exit. Just as in a crowded theater, when everyone wants to exit at the same time, it becomes difficult for anyone to leave the building.
Getting to Yes
For business owners who have some flexibility around deal compensation, there are some approaches that can help bridge valuation gaps. Except as discussed below, one of the most common structures involves earnouts, which tie enterprise valuations to future performance, usually by means of pegging deal compensation to some measure of future revenue or earnings over time. While the total value of M&A transactions incorporating earnout provisions fell in 2023 by over 34 percent, it was more a reflection of the overall slump in dealmaking. The percentage of private equity deals with earnouts, for example, actually increased last year to its highest level since 2020, a signal that earnouts have proved useful in resolving recent valuation disagreements, although it should be noted that there is a high rate of disputes when it comes to determining whether the earnout measure was achieved.
As alluded to above, earnouts are not compatible with certain healthcare transactions or appropriate to all situations. First, they are complex structures that require sharp attention to detail and an ability to think through complicated macroeconomic and industry-specific data. Second, they are proscribed by law in certain situations. For instance, the uninformed use of earnouts in the context of a physician group selling to a hospital system could trigger violations of federal and state fraud and abuse laws. Last, the accounting treatment of earnouts can be as complex. Earnouts represent a contingent asset or liability, and both buyer and seller should think through the tax consequences associated with best-case and worst-case scenarios.
While there are other structures that can align the interests of buyers and sellers to help overcome valuation gaps, earnouts provide a degree of risk mitigation and deal customization that is ideal for certain kinds of transactions. For business owners contemplating an exit, using earnouts can potentially lock in a substantial portion of equity compensation, while allowing the parties to negotiate the precise timing, nature, and realization of the contingent value.
Conclusion
Business owners who have the luxury of time can try and wait for ideal economic or financial conditions, but there are no guarantees as to if or when they will ever occur. In the meantime, there are some larger trends that have emerged since the pandemic that are impacting the healthcare deal market. In particular, sellers can’t ignore the close regulatory scrutiny under which private equity participation in healthcare has fallen. Some of the regulatory attention on PE has been overt, such as in September 2023, when the Federal Trade Commission chair Lina Khan wrote in the Financial Times that private equity firms’ serial acquisitions have had “serious consequences for consumers, workers, businesses and communities.” Other forms of regulatory action, such as new disclosure requirements and smaller deal thresholds, have been formulated with private equity in mind but will likely exert market-wide impacts.
Business owners looking to exit will need to carefully consider how these developments could alter the market for and time to close transactions, even when private equity buyers are not directly involved. When a PE firm does emerge as the best candidate to buy your business, it is especially important to partner with skilled professionals who can survey the regulatory landscape such a deal would have to cross.
Despite these headwinds, deals are still getting done. Business owners should not let fears of a valuation squabble—or regulatory risk—dissuade them from entering into the sale process. Even in deal markets with a bloated inventory of unsold companies, highly uncertain economic conditions, and swiftly changing regulations, disagreements over valuation can be resolved when owners know why they’re selling and how to use their leverage in the sale process.
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