Private equity infusion: A question of balance of growth vs. control for doctors

More private investor money is being pumped into the health care sector, but the jury is out on whether physicians will reap rewards from changes.

By Katherine Vogt — Posted Oct. 23, 2006

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For the last few years, a growing pool of private equity investment money has been pouring into health care firms, swelling these enterprises until they are big enough to crest in rewards for investors.

The dollars have streamed into biotech, pharmaceutical, device and equipment companies as well as into hospitals, ambulatory surgery centers and even physician networks, providing relief for businesses that were thirsty for capital to grow and expand.

But implications for physicians are murky. Certainly some physician-led enterprises have benefited from the financial infusions. Yet those physicians may also be losing some control of their businesses as the private equity investors gain a stake. And, the increased leveraging of those enterprises may spell more risk for the physicians who have to make the businesses financially successful.

The same possible benefits and risks may be true for other health care companies that receive private equity infusions. Observers say physicians who do business with those companies may see anything from no change to drastic transformations with the investment strategy.

Though definitions vary, in broad terms private equity investment means a capital investment into a company by a private group of investors. This could mean anything from a large-scale buyout of a public company to take it private, such as the $33 billion offer that the hospital giant HCA accepted last summer, to smaller capital infusions into private enterprises, to companies selling off divisions. In such an example, Emdeon Corp., formerly WebMD Corp., announced Sept. 26 that it agreed to sell 52% of its business services division -- which provides claims clearinghouse services to physicians and hospitals -- to General Atlantic LLC, a private equity firm, for $1.2 billion in cash.

Venture capital, sometimes referred to as seed money for emerging companies, is included as a subcategory in the broadest definitions of private equity. The growth in this arena has been significant. According to a report by PricewaterhouseCoopers, the National Venture Capital Assn. and Thomson Financial, venture capital investment from seed money to later stage deals in the biotech and medical device and equipment sectors grew from about $5 billion in 2002 to $5.9 billion in 2005. By contrast, in 1995 there was just $1.4 billion of venture capital in those sectors.

But the biggest share of private equity funding comes from so-called buyout funds, which, as in the case with HCA, purchases stakes in publicly traded or otherwise mature businesses through a combination of equity and debt, in the form of bond offerings.

Another report from Thomson Financial and the NVCA examined buyout fund raising and found that 93 funds raised a total of $31.4 billion in the first quarter of 2006, the lion's share of which came from 42 buyout vehicles that raised $24.9 billion. In fact, buyout funds, which often represent the megabucks behind private equity investment, posted a record the quarter before, when they raised $31.9 billion.

The trend may be fueled in part by advances in technology and medicine that have created more opportunities in the health care sector, said Richard Gundling, vice president of the Healthcare Financial Management Assn., a Westchester, Ill.-based association of health care financial executives.

On a broader level, the trend in health care may be mimicking an overall surge in private equity investment, said Paul Hughes, a corporate health care attorney with Wiggin and Dana in New Haven, Conn. "The overall, macro driver is probably funds having more funds to invest."

Hughes said the dollars are going into ventures that are driven by the aging population or in places where there is fragmentation in the market, such as home care and elderly-focused behavioral health. He also has seen private equity money in ventures related to in-office ancillary services and PPOs.

The money also is flowing into health care services such as integrated health care delivery systems, said Craig Frances, MD, a principal with the Palo Alto, Calif.-based private equity firm Summit Partners. "You're seeing the resurrection of people believing after all there is a lot of value to some of these physician networks that are built differently, ... as long as you are able to appropriately align incentives with doctors," said Dr. Frances, who was trained as an internist but no longer practices medicine.

In general, he said there seems to be more private equity interest in organizations where physicians are in the engines. That includes physician-led ambulatory surgery centers and other types of ancillary facilities.

Of course there is less private equity interest in the smallest ambulatory surgery center operators, said Dr. Frances. But the industry has grown so much in recent years -- as physicians have been forced to seek alternative streams of revenue -- that larger businesses, including chains of ASCs, have sprung up in many places.

The increasing availability of capital likely means that such physician enterprises also will see more competition. "If there are easier sources of capital, that's one barrier that comes down from a competitor entering," said Gundling. The competition could be good news or bad news for physicians, depending on whether they are the ones getting squeezed, he added.

Another potential problem is that although the capital infusion may provide an inroad for physicians to achieve business goals, it may also be a road in for outside investors, Gundling said.

"The difference with private equity is that although it's a good source of capital, it also comes with owners and investors. And they will want results," he said. "Those private equity investors may want a seat at the table to govern changes. And you may have to give up some control."

Additionally, Gundling said physicians should be aware of the obligations of paying back capitalization to investors under these deals, even if they end up struggling to make the business profitable.

On the other hand, bringing in those outside investors also could help relieve financial headaches by allowing physicians to reduce how much of their own money is tied up. "Now they have access to bringing on capital and they can sell off a minority stake in the company and diversify their wealth," said Dr. Frances.

Hughes said the infusion of money may have two seemingly opposing effects: providing funding for more physician-led ventures and producing more consolidation among smaller ancillary services providers, forcing them to become more professional and provide better services.

"The physicians can benefit on both sides of that by being involved in the provision of services or, as a consumer of them, having them available at a higher level," he said.

Using similar logic, some observers say that physicians may see a benefit from more private equity money in device and equipment companies, as well as in hospital chains.

For example, manufacturers and pharmaceutical companies that have more money may be able to create new and improved products. "[Physicians] will feel that, longer term, when some of those products come to the marketplace and they can prescribe them or those devices come out and they can use them," said Jeffrey Kraws, chief executive of the New York-based research firm Crystal Research Associates.

But Hughes said that as other health care companies get more private equity investment, there may be more consolidation, which would mean fewer choices for the physicians who do business with them.

Still, many observers say it's hard to predict how companies will react to private equity infusions. When HCA agreed in July to a massive leveraged buyout offer by a consortium of private investors, analysts were unsure about whether the new ownership structure would change the company in any way that physicians or patients would notice.

Dr. Frances said the Nashville, Tenn.-based hospital chain would have new owners focused on the bottom line but that wouldn't necessarily affect the quality of care. Still, he said there was not "enough data either way" to predict what changes might arise.

For now, many observers predict that the surge in private equity investment in health care will persist.

"The wind is at our back with the aging of the population and all that. So with the macro factors so strong, it really allows us to really look forward," said Dr. Frances.

In the meantime, many of the ramifications of that trend remain up in the air.

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Growth of funding

A Thomson Financial and National Venture Capital Assn. report on the recent performance of private equity and venture capital fund raising found:

Amount Number
of funds
First quarter 2006
Raised by venture funds $6.5 billion 51
Raised by buyout vehicles $24.9 billion 42
First quarter 2005
Venture funds raised $5.4 billion 59
Buyout funds raised $14 billion 49

Source: Thomson Financial and National Venture Capital Assn.

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Physicians in venture capital

As the biotech industry blossoms, venture capitalists who provide capital for such endeavors are hiring physicians to help them understand their investments.

The National Venture Capital Assn., a Washington, D.C.-based trade group, estimates that there were 9,266 venture capitalists working in about 860 firms last year. Roughly one-third of those people were in life sciences, an area that includes the biotech industry and often draws on physicians and scientists for expertise.

"Today you don't have to go to school to become a venture capitalist. Venture capitalists typically enter the asset class horizontally, so they come from the industry," said Emily Mendell, vice president of strategic affairs for the association.

Among the physicians who have made the transition from medicine to venture capital is Drew Senyei, MD, who was trained as an ob-gyn but now works as a managing director with Enterprise Partners Venture Capital, a San Diego-based firm that manages about $1.1 billion in assets.

Dr. Senyei said he was one of the first physicians to go into venture capital when he signed on with the firm in 1986. Dr. Senyei had a series of patents licensed by Eli Lilly, became a consultant to that company and then started his own company, Molecular Biosystems, which went public in 1983.

Soon venture capital funds began calling, attracted by Dr. Senyei's scientific background and experience with an initial public offering in biotech.

Here are his thoughts on how doctors fit in:

How did you find your way from medicine to venture capital?

It resulted from having sort of a dual career early on. I was both in medical school doing research, and I started a company as a third-year medical student. At the time, it was unusual to do that.

How has your medical background helped your venture capital work?

It has allowed me to evaluate ... with a perspective that other investors don't have.

What is the demand for physicians in the venture capital arena?

ust about every venture fund now that does health care has an MD partner associated with it. I think MDs bring sort of a unique perspective from the investor and health care delivery standpoint.

Most of the time the route into venture capital is through being in a device or pharmaceutical company, or you're a chief medical officer or have an important role in making that company a success.

There are more opportunities consulting, because the number of general partner or managing partner positions is pretty small. It's a difficult and often opportunistically-driven chance to get into this.

What advice do you have for physicians who are trying to bring their ideas to venture capitalists for funding?

First of all, it's helpful to have them come through someone the venture capitalist knows, either a lawyer or other service provider. We get about 5,000 service proposals per year, and we try to look at all of them. But if it comes from someone we know, it tends to get a little more attention.

You have to have an elevator pitch. You have to be able to succinctly state your value proposition in the time it takes to get to the first floor -- or maybe the eighth floor -- in an elevator.

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