These are flush times for American private equity funds. Through November, they have raised more capital than any other fiscal year. But a good portion of that cash has not been put to use – yet. One reason is that many takeover targets have simply become too expensive, a dynamic reflected in the drop in deal activity for 2019. According to RSM Bloomberg, the median implied M&A transaction multiple from 2017 to 2019 was 12.2 times a firm’s EBITDA, while from the preceding two-year period it was only 10.4.
But another is that general partners are raising capital, known as dry powder, to deploy in the next downturn. With the American economy now in the longest expansion in its history, Bloomberg estimates the chances of recession at 33% over the next 12 months.
That possibility is leading private equity managers to consider which businesses will be most insulated from a possible economic slowdown. Two industries — technology and health care — offer attractive opportunities.
Private equity funds are raising record amounts of capital
Many private equity firms see technology as the most efficient way to execute operating agendas and have used artificial intelligence, machine learning, robotics and automation to do so. And the Bloomberg US Financial Conditions Index shows that credit conditions remain accommodating, so, with or without a recession, general partners will be making deals, and increasingly those will be in tech. Tech companies, especially business-to-business software companies, remain an attractive opportunity: they are often asset-light, require less capital to scale, and can achieve rapid growth, even in tough economic times.
According to PitchBook, technology-focused private equity dry powder has surged since 2016 and through March 2019 totaled $93.1 billion, up 93% from $48.2 billion. Tech funds today comprise 22% of all private equity capital raised in 2019. With corporate profit margins weakening steadily in the United States, from a 10-year high of 15.3% in the fourth quarter of 2014 to 11.1% in the third quarter of 2019 — many believe that technology will be the conduit to drive better earnings. And indeed they have; over the past 10 years tech buyout private equity firms have earned 5% more than non-tech funds.
The health care sector has historically been insulated from fluctuations of the business cycle and may be an attractive hedge against a possible economic downturn. This industry is also fragmented, so there is opportunity for increased scale through vertical integration. For example, we expect to see continued consolidation in behavioral health, ophthalmology and dermatology on the provider side. Digital health care is of particular interest as changing demographics lends to a growing desire for immediate health care access, especially in remote areas.
Still, much has changed in health care since the last recession. In the years since the Affordable Care Act expanded coverage for millions of Americans, the U.S. population has aged and Medicare enrollment has grown by 14 million people. The commercially insured patients that remain, who historically generate more favorable margins for providers than those covered by Medicare or Medicaid, are increasingly strained by high premiums and high deductibles. The average deductible for single coverage has increased to $1,655 in 2019, up from $756 in 2008, according to the Kaiser Family Foundation. At a time when most Americans would need to use a credit card to pay a $400 medical bill, this increased out-of-pocket financing should affect sponsors’ diligence on commercial populations and provider business models.
There are also significant changes potentially coming out of Washington. Sponsors should be watching at least two issues: drug pricing and surprise-billing reform. Both issues have bipartisan support and are popular. While Congressional or administrative action on drug pricing could help alleviate some of the out-of-pocket concerns with commercially insured populations, some proposals that have been discussed could drastically alter the health care supply chain framework. Proposed solutions around surprise billing could affect providers’ ability to share costs between commercially insured patients and those covered by Medicare and Medicaid.
As private equity deal volume in health care has eased…
The capital raised for health care takeovers has risen…
In the same way, private equity deal volume in tech has dropped off…
But firms continue to raise capital for tech takeovers…