Middle Market Growth - May/June 2019

MAY/JUN 2019

// THE OFFICIAL PUBLICATION OF ACG

Baby Steps Ob Hospitalist Group is working to improve women’s health care, one hospital at a time

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FROM THE EDITOR

Private Equity Finds Its Niche

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KATHRYN MULLIGAN Editor-in-Chief, Middle Market Growth kmulligan@acg.org

he private equity model thrives in industries that are fragmented, inefficient and vulnerable to technological disruption, so it’s no surprise the health care sector continues to attract investment. In this edition of Middle Market Growth, we spotlight niche subsectors that are drawing investor interest.

Women’s health care, for one, is primed for investment.

Historically, female-targeted health care companies haven’t received much funding, leaving plenty of room for growth. And recently, rising maternal mortality rates in the United States have made headlines, shining light on flaws in the care available to pregnant women.

Ob Hospitalist Group, the subject of our cover story (p. 20), is on the front lines of addressing those challenges. With support from PE firm Gryphon Investors, the middle-market company provides fullservice OB-GYN programs in hospitals across the country. Hospital systems are increasingly looking for ways to boost efficiencies while improving patient care, a trend that’s driving a number of PE deals.

Another trend is the consolidation of physician practices. Medical specialties like dental, ophthalmology and dermatology are attracting top dollar from PE investors eager to roll them up into larger platforms. As one source put it, “pretty much anything that ends in ‘ology’” is drawing investor interest. Although this phenomenon is hardly new, we look at the demographic and technological drivers behind the trend and the unique aspects of buying a physician-owned practice (p. 10).

The enthusiasm for health care investing has led some PE firms to look outside the United States for deals, but as reporter Benjamin Glick writes in Quick Takes (p. 17), pursuing a roll-up strategy in Canada comes with regulatory caveats.

Also attracting PE curiosity is the opportunity zone program created by the 2017 tax reform legislation. More than 600 people registered for an ACG webinar on the topic, presented by Wipfli earlier this year, but it seems the allure of the program’s tax benefits hasn’t yet translated into much action. For our second feature story (p. 26), writer Bailey McCann asked firms about how they plan to use the new vehicles and what impact they expect opportunity zones to have on local communities.

Many of you may be reading this edition during ACG’s InterGrowth conference in Orlando. MMG will be reporting from that event on May 6-8, so look out for coverage on middlemarketgrowth.org and via the Middle Market Growth Conversations podcast series, available through Apple Podcasts and Google Play. //

MIDDLE MARKET GROWTH // MAY/JUN 2019

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EXECUTIVE SUMMARY

Building a Network Without Borders

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ANGELA MacPHEE Chairman, ACG Global Board of Directors, and Partner, Baker Tilly

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middlemarketgrowth.org

his year has been a challenging one for the global economy, amid Brexit negotiations, increasing trade protectionism and slowing growth in many countries.

Yet European private equity M&A activity continues to be strong.

European PE deal value in 2017 reached €414.9 billion, before slipping to €396.3 billion last year, according to PitchBook. It’s no surprise investment remains high, given the international nature of business today. But doing a transaction in another country requires having access to deals and understanding local employment rules, tax laws and other nuances. Having the right partners is critical.

For 48 years, ACG’s InterGrowth conference has served as the essential event for North American deal-makers in the middle market, and today is no different. Members of the ACG community will gather in Orlando, Florida, on May 6-8 to strengthen relationships, find deals and tap into a network of advisers that support M&A transactions.

To build on that event’s success, ACG added EuroGrowth, a conference focused on cross-border dealmaking that brings InterGrowth’s relationship-building and deal flow opportunities to Europe. Now in its seventh year, EuroGrowth will be held June 11-12 in London to bring together European middle-market professionals, along with North American deal-makers looking to invest across borders. Doing a deal outside your home country is complicated, and EuroGrowth is the place to meet the right people to help your transaction succeed.

If you’ve found InterGrowth to be productive, consider heading to London next month to expand your network even further.

EuroGrowth is part of ACG’s broader strategy in Europe. Through our strong North American chapters and InterGrowth, ACG has served as the go-to resource for members of the middle-market M&A community. We aim to play a similar role in Europe. To that end, ACG formed its European Task Force to review our current activities and explore opportunities for growth.

ACG is committed to supporting its European chapters through increased marketing and awareness campaigns, and by forming a steering committee that will foster collaboration among those chapters. If you’re an ACG member in Europe, or a North American deal-maker who does business abroad, expect to see more from ACG. As cross-border M&A activity continues to grow, we plan to play a greater role in connecting capital with deals and providing resources to ensure those transactions succeed. //

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MAY/JUN 2019

DON’T MISS QUICK TAKES Investing in Canadian Health Care 17

A QUALIFIED OPINION Health Care Regulatory Outlook 18

POLICY POINTS A Q&A with ACG’s PAC Committee Chairman 32 Above photo by: Fred Rollison. Cover photo: Anne Ackermann

GROWTH STORY

IN THIS ISSUE

Baby Steps

From the Editor 1

By providing OB-GYN departments with qualified physicians who are on site around the clock, Ob Hospitalist Group is changing the way women’s health care is delivered, one hospital at a time, and helping to combat rising maternal mortality rates in the United States. With support from PE firm Gryphon Investors, the company is making operational improvements and expanding its hospital footprint beyond the more than 160 locations it serves today. 20

Summary 2

Executive

TREND

Executive Suite 8 The Round 10 Vertical View 15 Midpoints by John Gabbert 16 Growth Economy 36

In the Opportunity Zone

In Focus: RKON 38

The new opportunity zone program aims to

The Portfolio 42

stoke investment in underserved areas. But as investors await clarifications from regulators and weigh how the program fits with their strategy, the overall impact of the initiative remains unclear. 26

ACG@Work 48 The Ladder 54 It’s the Small Things 56

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D E A LS

W IT H O U T

B O R D E R S .

LA S T T O

CH A N C E

R E G IS T E R .

1 1 – 1 2

J U N E

H I L T O N

2 0 1 9

L O N D O N

B A N K S I D E L O N D O N ,

U K

E U R O G R O W T H .O R G

© 2019 Association for Corporate Growth. All Rights Reserved.

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ASSOCIATE, MARKETING & COMMUNICATIONS

Is There a Role for Private Equity in Canadian Health Care?

MMG talks with Adrianna Czornyj, a partner

NEWS MMG WEEKLY The latest middlemarket trends, ACG events and timely industry content.

THE LADDER Monthly publication about professional development

with Persistence Capital Partners, the only private equity firm in Canada focused exclusively on health care investing, and the focus

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the podcast, Czornyj addresses the question she’s asked most frequently: How do you invest in health care in a country with a public health care system?

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EXECUTIVE SUITE

Taking the Pain out of Routine Legal Work F What are the costs of

TROY POSPISIL Title: Founder and CEO Company: InCloudCounsel Location: San Francisco, California Expertise: Pospisil oversees efforts to scale up the legal technology company, bringing its global, end-to-end solution for negotiating and managing routine legal work to some of the world’s leading companies.

high-volume legal work?

Negotiating and managing recurring legal documents, such as non-disclosure agreements, joinders and engagement letters, can impose significant costs on companies, but established solutions—whether handled internally or outsourced to traditional law firms—are imperfect.

Corporate law firms were created to address complex matters, not routine legal work. Such work is usually delegated to junior staff, and negotiation turnaround time is negatively impacted by competing, higher priority tasks.

Plus, the work is usually billed at costly rates. Some companies assign in-house counsel or employees in business roles to handle the work. Unfortunately, routine processes face speed and efficiency issues while they compete for time with higher impact tasks.

Employees in business roles often lack formal legal education, which may result in subpar negotiation outcomes and increased noncompliance.

Without standardized processes or systems, inefficiencies will arise.

People in an organization may take different positions on the same document type with the same counterparty and be unable to answer critical compliance questions. And they cannot quickly reference and benchmark against historical precedent to improve the efficiency and outcome of future negotiations.

F How is legal tech solving these

pain points?

Alternative legal service providers, or ALSPs, offer solutions to help

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companies address the opportunity and monetary costs imposed by routine legal work. These solutions utilize a range of technologies, including cloud computing, document management software and data management tools. Some ALSPs use one technology to address a single pain point, while others offer comprehensive solutions to automate entire processes.

Implementing a legal technology solution can unlock abundant benefits.

For example, document management software can improve workflow efficiency and allow companies to track the status of ongoing negotiations.

Cloud technology enables scalable, cost-effective solutions by creating virtual networks of experienced corporate attorneys.

F What other benefits can legal

tech provide?

Legal technology companies can help create new value. One example is data extraction technology. Enabled by artificial intelligence, companies can leverage legal and business terms in their recurring agreements to gain insights about market trends based on historical contracts.

Private equity sponsors often want to analyze the terms of their stock purchase agreements. Collecting data on indemnity caps, baskets and survival provides insight into where the market has settled in various scenarios. Companies can identify trends in agreements over time or explore a subset of documents and data that match specific criteria for use in future negotiations and when managing compliance obligations. //

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THE ROUND

Private Capital Stitches up Physician Practice Space Industry pressures and shifting attitudes drive consolidation

By Kathryn Mulligan

P

rivate equity firms continue to flock to physician-run practices, a fragmented space where demographic and technological trends are converging, and one where sellers’ expectations can make a deal vulnerable to failure if not managed properly.

Buying physician practices and consolidating them into larger platforms has been a private equity strategy for two decades, but in the last several years, PE involvement has extended to a wide-range of specialty areas— dermatology, ophthalmology, orthopedics and oncology, among others.

The physician practice management, or PPM, space appeals to PE investors looking to build regional or national businesses through add-on acquisitions. PE firms can help with marketing initiatives and brand awareness, and by reducing operating costs through back-office improvements. A larger organization may also have greater leverage with payers.

Dentistry was the specialty that reinvigorated interest in PPM investing about seven years ago, says Michael Cole, a managing director and health care industry leader in Alvarez & Marsal’s Global Transaction Advisory Group. He attributes the appeal of dental practices, in part, to their retail-centric model, one that’s easy to understand. “I think PE funds,

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maybe those that weren’t traditional health care investors, they got it quickly,” he says.

Dental care typically involves fewer government payers and less insurance involvement compared with many health care specialties, yielding a less complex revenue stream.

For Dana Soper, a serial health care entrepreneur, dentistry was an attractive market to enter because of its fragmented nature.

“A healthy dental practice can service 2,000 to 3,000 patients with a single practitioner,” she says. “If you start putting those number together, you need a lot of dentists, so [the industry] is ripe for consolidation.”

She and a partner co-founded Cordental Group, a dental support organization that affiliates and

manages back-office functions for dental practices, with backing from private equity firm New Mainstream Capital. The company made its first acquisition in July 2017 and has since grown to 10 practice locations.

Despite the M&A activity in dentistry, only 7.4 percent of U.S. dentists were affiliated with a dental support organization as of 2017, according to the American Dental Association.

Up-and-Coming Specialties Dermatology is another medical specialty where investors have been active, Cole says. It’s one with a mismatch of supply and demand.

There is a nationwide shortage of dermatologists, even as higher rates of skin cancer and other diseases have increased demand for services.

Successful dermatology investments have led investors into other specialties. “The phrase we hear a lot is ‘this sector is the new derm,’” Cole says.

Over the past six months, he’s heard the “new derm” label applied regularly to orthopedics. As baby boomers age, the need for hip replacements, spinal surgery and other services has grown.

That trend, coupled with technological advancements that enable more outpatient procedures, has spurred demand in the orthopedic space—and PE investment has followed.

Private capital can help companies enhance technological capabilities, build new revenue streams, and make acquisitions, says Ryan Buckley, a partner with investment bank Livingstone. “In an evolving landscape with competitors, hospitals and health systems, and payers—which in many respects are becoming providers as well—having the financial firepower that private equity investment brings is critical.”

Buyer enthusiasm has driven up prices. For a large business, Cole says he’s seeing valuation multiples in the 11x to 14x EBITDA range. Recently, an investment banker told an Alvarez client it would need to bid at 15x EBITDA to get to the next round of the auction for a platform-sized target. “It’s funny, everyone keeps saying prices have to come down, but they ­haven’t,” he says.

Sellers’ Perspective Fortunately for PE firms eyeing medical practices, many physicians are willing to sell, for reasons ranging from demographic shifts to changing industry dynamics.

One driver is succession planning for practitioners nearing retirement, says Frank Williamson, founder of

“IT’S FUNNY, EVERYONE KEEPS SAYING PRICES HAVE TO COME DOWN, BUT THEY HAVEN’T.” MICHAEL COLE Managing Director, Alvarez & Marsal

Oaklyn Consulting. Changes in the health care industry are also playing a role, as increased reimbursement pressure and competition from larger providers have made it difficult to maintain an independent practice.

While innovation in health care has created opportunities for some practices, it has disrupted others.

Williamson cites the impact of Invisalign on orthodontics. Unlike braces, a dentist can provide the teeth-straightening devices—a trained orthodontist isn’t required. Such a threat to a practice’s core scope might prompt a physician to consider an alternative career path. “That’s going to cause someone to think: Rather than continuing to run my practice, am I better off taking an offer and taking what money I can and going and getting a job? Because that’s going to be a whole lot easier,” he says.

After a sale, a physician often becomes an employee of the new PE-owned business, and setting expectations up front is critical for a PPM acquisition to succeed, Williamson says. He encourages sellers to consider how much of their current earnings stem from being a practicing physician versus being the owner of a practice—and to compare those figures with the proceeds from the sale and their future salary as an employee. He suggests they also consider how much they value their social status. “They’re going from ‘I am one of the important partners in

an important practice in the community.’ That’s different from ‘I’m an employee in a big corporate practice group.’”

The first wave of physician practice roll-ups, in the mid 1990s, saw a number of failed investments, largely because of unrealistic expectations.

“There were a lot of factors, but generally speaking, it was physicians not understanding economically what they had done, and frankly, just having a bit of sellers’ remorse,” Cole says.

He doesn’t expect a similar outcome this time, in part because operating independently has become less viable for small practices. Regulatory pressure and third-party billing and collections have made it difficult to survive in today’s health care industry.

There is also a cultural shift underway. In the past, many new medical school graduates intended to own their own practices one day, but a number of young health care professionals today envision a different career path, says Soper. “It’s true somewhat in the dental industry— they really come out expecting to go to work for somebody.”

Those shifting industry dynamics have created an active M&A environment, which Cole has seen firsthand in Alvarez & Marsal’s health care group. “Physician practice deals have been at least 70 percent of what we’ve been doing for the past three years,” he says. “It has been a dominant part of our business.”

MIDDLE MARKET GROWTH // MAY/JUN 2019

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THE ROUND

A-Rod Covers His Bases with Move from Baseball to Business

I

t’s an age-old story: A sports star who once commanded millions goes broke in retirement. Alex Rodriguez had heard that cautionary tale and, early in his career, he decided he wouldn’t let that be his fate.

Rodriguez, the Major League Baseball all-star better known as A-Rod, knew the statistics: The average professional baseball player’s career is 5.5 years. Roughly 80 to 90 percent of lifetime income is earned before he turns 30. And of the 750 players in the MLB, less than 5 percent have a college degree.

“Just with those three numbers, those metrics, I would short the stock,” said Rodriguez, 43, speaking on “The Corp” podcast. “I wanted to put a system in place that would counter that.”

That set him on a path to an investing career and, ultimately, to his current position as CEO of A-Rod Corp, the business and real estate investment firm he founded.

The company was born when Rodriguez, then in his early 20s, purchased a single duplex in Miami.

To finance the down payment, he sold two Rolex watches and raised about $12,000 selling autographs.

“Then I was off to the races. I had my first duplex—a couple of years later I sold it for double. I said, man, this is almost as good as baseball,” recalled Rodriguez, who will give the closing keynote address during ACG’s InterGrowth conference in Orlando.

He continued to invest in real

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estate and built a portfolio of more than 12,000 properties across the Southeast—a successful start that laid the groundwork to expand into other industries.

OFF THE FIELD Rodriguez’s baseball accomplishments are legendary. He hit 696 home runs over his 22-year career and signed a record-breaking $275 million, 10-year deal with the New York Yankees. He is a three-time MVP and a 14-time all-star.

While Rodgriguez’s baseball career was soaring, A-Rod Corp was building a business empire off the field.

Today, the firm’s investments span a range of industries, including real estate, sports and wellness, media and entertainment.

“When I grew up, sports, entertainment and technology were all three different silos. I think today they’re all one. They all complement each other extremely well,” he said during an interview with Middle Market Growth.

A-Rod Corp’s sports and wellness holdings range from fitness concepts to consumer-focused wellness products. In 2017, the firm bought the rights to develop UFC-branded gyms throughout Miami-Dade County.

The fitness centers capitalize on the growing interest in mixed martial arts and the increasing market share of boutique fitness clubs, which accounted for 42 percent of club members in 2016, according to the UFC Gym website.

To provide gym-goers with a way to

keep their sports drinks cold, A-Rod Corp invested in Ice Shaker, a brand of insulated, stainless steel bottles founded by former NFL player Chris Gronkowsi and his brothers—including New England Patriots tight end Rob Gronkowski. The brothers pitched the investment to Rodriguez during his debut on ABC’s “Shark Tank.”

The firm has also bet on up-and-coming verticals. In October 2017, A-Rod Corp invested in NRG eSports, a platform featuring competitive esports and live gaming content channels. Esports is expected to become a $1.5 billion industry by 2020, according to Deloitte.

When it comes to more traditional sports investing, Rodriguez says he wouldn’t rule out buying a professional sports franchise.

“You never say never. It’s always been one of my long-time dreams, to own a team,” he said. Although he has evaluated several opportunities, none has been a fit. “It would have to be an extraordinary opportunity for me to be able to own a team and run a team.

Because that would be my full-time job, 24/7.”

BRAND-NEW WORLD Unlike many investing companies, A-Rod Corp has leaned heavily into its own brand, and that of its CEO. The firm is active on social media— its Instagram account has more than 42,000 followers and frequently posts photos of its founder. Rodriguez is also featured prominently on the A-Rod Corp website, where he’s

shown boxing at a UFC fitness center and lifting kettlebells at a TruFusion studio, another A-Rod Corp portfolio holding.

“We’re in different world today in 2019 than we were in 2009 or 1999.

Institutions really grew up by less is more: Don’t let anybody know your name. Do the deals very quietly,” Rodriguez said. “While a lot of those fundamentals still apply today, I think we live in a world of storytelling and one of our superpowers is our global reach.”

Just five years ago, Rodriguez’s brand power seemed to be waning.

His use of banned substances led to a suspension for the 2014 baseball season, and news of the rules violation tarnished his reputation.

Flash forward to today, and Rodriguez’s comeback is undeniable.

In addition to leading A-Rod Corp, he provides commentary for Fox Sports and ESPN. He co-hosts Barstool Sports’ podcast “The Corp,” appears on “Shark Tank,” and is frequently photographed at events with fiancé Jennifer Lopez.

His second act comes at a time when the line between sports and business has blurred, the result of big data and the popularity of a “Moneyball” approach to building teams.

“When you think about analytics, they’ve taken over sports,” he said.

“We’re taking great talent from people who could be at Blackstone and BlackRock and Apollo—many private

equity and Wall Street businesses— and today they’re running Major League Baseball franchises.”

A-Rod Corp itself has built a bench of experienced financial professionals to work as part of the firm’s 10-person team, led by its founder. Rodriguez’s career as a professional athlete armed him with not only financial capital and brand equity, but a unique perspective on trends shaping the industries in which A-Rod Corp invests—particularly the one that made him a star.

“There are opportunities all over the place in sports,” Rodriguez said, “and there will continue to be as television and live events become even more valuable in the future.”

—Kathryn Mulligan

With disruption all around us, standing still is not an option. Success happens when we push forward.

We will guide you through the ever-changing business world, blending free-flowing knowledge with the power of personal relationships to help you win now and anticipate tomorrow.

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MIDDLE MARKET GROWTH // MAY/JUN 2019

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THE ROUND

Worldpay Broadens Its Payment Processing Footprint Through M&A

I

n one of the largest deals in the payment processing sector last year, Cincinnati-based Vantiv acquired Worldpay Group, a company headquartered in the U.K. The deal, estimated at $10.4 billion, reflected a broader trend of companies using M&A to grow their market share and expand their capabilities.

Just over a year later, the new combined entity, renamed Worldpay, became the target in an even larger transaction. On March 18, Fidelity National Information Services announced it would acquire the company for $35 billion.

According to a press release from the acquirer, known as FIS, “This combination greatly expands FIS’ capabilities by enhancing its acquiring and payment offerings and significantly increases Worldpay’s distribution footprint, accelerating its entry into new geographies.” Those motivations echo goals outlined by Mark Heimbouch, COO of Worldpay, during a discussion of the 2018 Worldpay-Vantiv combination on the Middle Market Growth Conversations podcast.

Speaking with MMG about that merger, Heimbouch described how Vantiv had grown to become a large domestic processor.

Meanwhile, Worldpay had a strong presence in global e-commerce, making it an attractive acquisition target. “It increased the breadth of offerings we have,” he said. “It significantly increased our reach, making us a global player.”

The 2018 deal also helped position the combined entity to serve the legalized betting industry in the U.S. at an opportune moment.

Last year, the Supreme Court opened the door for states to legalize sports betting, setting up the industry for rapid growth. Vantiv was already involved in the legalized gambling market through local and state lotteries and

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legalized online gaming. Likewise, Worldpay was involved in the legal betting market in Europe.

According to Heimbouch, the VantivWorldpay combination faced challenges that stem from the cross-border nature of the deal.

But expecting any two companies to be culturally similar—even if they’re headquartered in the same country—is unrealistic, he said.

During the deal’s integration phase, Vantiv and Worldpay had to bridge differences in how decisions are made and how their respective businesses were structured. Worldpay operated with a hybrid strategic business unit model, whereas Vantiv had a functional structure. The combined entity ultimately decided to adopt a functional model.

Up-front planning played a critical role in the deal’s success. “We spent significant time thinking through the integration effort before closing the transaction,” Heimbouch said.

The company focused on putting governance processes in place, creating dedicated teams around the integration management office, and identifying who would fill senior leadership roles.

Heimbouch credits the pre-planning effort with a smooth integration. “You go through this period of change at the front end, where there’s so much commotion it almost seems like it’s impossible to keep track of everything going on,” he said. “After a few months go by, people kind of start to settle in, in terms of the new company and their jobs. They start working together, and it doesn’t seem as complicated.”

With the FIS deal now underway, that change-management playbook should come in handy. // —Kathryn Mulligan

EVENT For more insights into cross-border M&A, register to attend ACG EuroGrowth in London on June 11–12.

PODCAST Hear Mark Heimbouch discuss the Vantiv-Worldpay combination on the Middle Market Growth Conversations podcast, available in Apple Podcasts and Google Play.

VERTICAL VIEW

Checking up on Health Care M&A Health care deals represented 12 percent of global M&A volume in 2018, second only to technology, according to JPMorgan Chase.

Since the beginning of 2010, 23 private equity In its 2018 Year in Review report, Bain cited notable

firms have recapitalized physical therapy prac-

health care deals announced last year. They included

tices, according to a report from PE firm Provident

Amazon’s purchase of online pharmacy PillPack;

Healthcare Partners. For nearly half of those

Roche’s acquisition of Flatiron, a software provider

practices, the PE investments were the first time

for electronic health records related to oncology;

the practices have received institutional capital.

Medtronic’s purchase of Mazor Robotics, a maker of a robotic system for spinal surgery; and Cigna’s acquisi-

Companies creating technology to address

tion of pharmacy benefits manager Express Scripts.

women’s health care issues—a space known as femtech—attracted barely $100 million in venture

There were 186 IPOs of health care companies globally

capital funding five years ago. In 2018, that figure

in 2018. While slightly fewer in number than the 190

had increased nearly four-fold to $392 million,

IPOs of 2017, the offerings in 2018 earned $24.08

according to PitchBook.

billion—over $9 billion more than the year prior, according to S&P Global Market Intelligence.

Deal value is on the rise in the digital health space, made up of companies that build hardware and software solutions to help individuals track their health and communicate with health care providers. In 2018, $5.9 billion was invested across 24 digital health deals— a sharp increase from the $3.5 billion in deal value in 2017, according to PitchBook.

MIDDLE MARKET GROWTH // MAY/JUN 2019

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MIDPOINTS by John Gabbert

Health Care Investors’ Digital Dilemma

A

JOHN GABBERT Founder and CEO, PitchBook

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bout 10 years ago, the private equity industry received a generous gift from the federal government in the form of the Affordable Care Act (ACA). One of the better-known changes the law brought to the health care industry was an incentive program to digitize medical records, with the goal of making patient data easier to track over time and accessible to multiple providers.

Although the technology behind electronic medical records (EMRs) was available at the time the ACA was drafted, adoption was less than expected, despite the obvious cost-cutting benefits. In the run-up to the law’s passage, EMRs were low-hanging fruit that were about to be implemented on a national scale.

Sensing an opportunity, private equity investors jumped in, sparking a wave of leveraged buyout activity involving EMR providers between late 2010 and early 2011. As an asset class, PE thrives on predictability, especially when it’s backed by the government.

But in this case, the excitement wasn’t centered on government spending per se, as there was relatively little of it on electronic records. Instead, the incentives and attention on the issue were enough to draw private capital. Hospitals and health care providers that didn’t use electronic records would now stick out like a sore thumb.

Over time, a large swath of the medical community migrated online.

Today’s industry is largely digitized, hence PE activity with EMRs plateaued between 2011 and 2014 before falling off over the past few years.

Today, most records are stored online, and protecting them has become paramount. According to health care cybersecurity adviser Clearwater, individual medical records are worth 10 times more than credit card numbers on the black market. In the past few years, dozens of hospital systems have been attacked by hackers and data breaches. The Department of Health and Human Services counted more than 400 “major breaches” from 2017 to 2018, and other experts predict many more are on the way.

This impacts private equity on a number of levels. Cybersecurity certainly presents another investment opportunity, and one that PE will likely take advantage of over the next few years. Perhaps more immediate is the impact on firms’ existing portfolios, which still include many electronic record providers. But many of those companies’ systems are no longer state-of-the-art, and given enough time, hackers will find a way to break into just about any database. Tens of thousands of these valuable medical records are stored

by PE-backed hospitals, providers or third-party vendors.

If a portfolio company is hacked, bad publicity is only part of the fallout. PE firms have a fiduciary responsibility to limited partners to protect their companies as much as possible. That’s now a tall order for health care investors, who have become significant stakeholders in an industry they helped digitize—and one that’s now increasingly vulnerable to cyberthreats. //

QUICK TAKES

Persistence Pays off in Canadian Health Care

A

s provinces and territories across Canada face rising health care costs, they are turning over portions of their public health care system to private operators, creating an opportunity for private equity investors that can navigate the country’s complex regulatory environment.

Despite having a large public payer system, around 30 percent of annual health care activity in Canada—about CA$85 billion—still occurs in the private sector, according to estimates from Persistence Capital Partners, Canada’s only PE firm solely dedicated to health care.

Canadian law requires provinces and territories to provide medically necessary health coverage to all residents, but each province interprets the law differently. And as health care costs continue to outpace the growth of GDP, provinces are reducing coverage for services such as optometry, d ­ ermatology and physical therapy, creating a highly fragmented health care market primed for private capital investment.

Some segments are many years behind the U.S. in terms of consolidation, says Adrianna Czornyj, a partner at Persistence. Over 30 percent of the U.S. dental market, for instance, is consolidated, she says, compared with less than 5 percent in Canada.

According to Czornyj, a successful strategy for PE investors is to partner with a regional company in a niche health care segment and then grow it across the country. But that’s easier said than done. Canadian health care companies are seldom easy to scale due to regulation.

For example, PE investors unfamiliar with Canada’s regulatory landscape might see an opportunity to expand an MRI clinic from Quebec into Ontario—except private MRIs are not provided there. “If your strategy is to grow a service in one province and bring it into another that doesn’t allow it or reimburses differently, it’s going to be a challenge,” she says. “You need to spend a lot of time and a lot of energy to understand the environment.”

That can be difficult for American PE investors, according to Czornyj.

“They see Canada as an area of growth in the health care space, but a lot of them just don’t know how to enter it without in-depth knowledge and experience.”

Another obstacle for some PE firms is the size of the companies within the Canadian health care market.

Many generate less than $10 million in EBITDA. And while most large Canadian PE funds have money to

spend, opportunities to scale in health care just aren’t there yet, she says.

“Which makes for a huge opportunity for the middle market in the smallcap space in Canada.”

Canada’s health care market may be small, but it’s growing and drawing increasing investor interest. The first fund Persistence raised was CA$85 million. For its latest fund, which recently closed, it raised CA$225 million.

Despite the regulatory challenges and small market, Czornyj says Canadian health care is a great space for experienced PE investors looking to find a niche. “It’s coming, they’ll get there.” // –Benjamin Glick

PODCAST Hear Adrianna Czornyj discuss the Canadian health care market on the Middle Market Growth Conversations podcast.

MIDDLE MARKET GROWTH // MAY/JUN 2019

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A QUALIFIED OPINION

Michael C. Hardy Partner, Duane Morris LLP Michael C. Hardy is a partner in Duane Morris’ Corporate Practice Group and co-chair of the firm’s Private Equity Group. He has extensive experience advising private equity sponsors and their portfolio companies in a broad range of industries, including health care and life sciences. Hardy corresponded with MMG about how shifting reimbursement models and regulatory risks are shaping health care M&A.

GROWING EMPHASIS ON COST CONTROL AND VALUE-BASED CARE IS DRIVING CONSOLIDATION AND CREATING NEW OPPORTUNITIES FOR PE INVESTORS.

Q A

What’s driving the shift from traditional fee-for-service to value-based care?

State and federal payers and private insurance payers have been grappling with how to deal with dramatic health care cost increases.

The solution that has evolved among payers is to set an affirmative goal of providing the most effective and best care at the lowest cost possible using a value- and outcome-driven reimbursement model.

Q A

MORE ONLINE Find more interviews at middlemarketgrowth.org.

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How is roll-up activity in the health care sector related?

The shift in the reimbursement model is having a number of important effects. One of the biggest is the consolidation of health care providers. Another is the “spinning out” of non-core hospital services from hospitals to other facilities.

Consolidation in health care provider services has increased substantially in recent years. Hospitals and other single-location facilities have looked to join larger groups because stand-alone facilities don’t have the economies of scale to deal with regulatory burdens under the new model and can’t be as efficient as larger platforms. As revenue shrinks due to cost containment, they need larger partners to survive.

Q A

What opportunities are available to private equity funds and deal-makers?

Consolidation will likely continue as the emphasis on cost control and value-based care continues to grow. The opportunity for institutional investors is to fund the growth of the newly created and expanding businesses and participate in the consolidation and streamlining of businesses into more profitable enterprises. Because of the general growth of the health care industry, managers who focus on the space should be able to generate strong returns for their limited partners based on that growth.

Health care has historically been insulated from the fluctuations of the business cycle. Consequently, private investment in health care may be attractive as a hedge against an economic downturn. Because consolidation is likely to persist, M&A activity will continue to present opportunities for buyers and sellers.

Q A

Which services has this shift affected most?

The impact has been across the board. In terms of industry participants, hospitals have felt it in every area. Some clinicians, such as those in the preventive care space, are

wrestling with how to apply a valuebased approach when there’s no outcome data to measure against in real time.

Even businesses that don’t face patients but provide services to health care providers have been impacted.

For example, a large hospital system that uses a third-party vendor to test its radiology equipment may not be comfortable dealing with a small “mom-and-pop” testing company.

That same mom-and-pop testing company will struggle to be cost-­efficient without certain economies of scale. In order to survive, it will need to grow organically, or by merger.

Q A

How will these secondary-level service providers affect M&A? The opportunity for PE investors is to help the smaller organizations grow organically and/or by acquisition by providing the capital and strategic guidance to do so. The level of interest on the part of PE in this aspect of the space will have a big impact on both investment and M&A activity. Unlike investments in health care providers, secondary service providers aren’t subject to many of the regulatory burdens that tend to chill the interest of some investment funds in areas such as clinical treatment, pharmaceuticals and medical devices.

Q A

Are there any regulatory changes you foresee playing a larger role in the future?

As a general matter, regulatory burdens are likely to increase.

For many participants in the health care industry, this will add costs, which in turn will tend to fuel consolidation. Down the road, as the value-based care system becomes more ubiquitous, it is possible that lawmakers will need to rethink some of the current laws and regulations designed to address concerns about overuse, misuse and excess spending, as those rules were implemented with an eye toward the old fee-based system and may actually hinder full adoption of the value-based method. //

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Ob Hospitalist Group CEO Lenny Castiglione

Photos by Fred Rollison

Baby Steps A Ob Hospitalist Group is working to improve women’s health care, one hospital at a time

BY S.A. SWANSON

s CEO of Ob Hospitalist Group, Lenny Castiglione has come across plenty of misconceptions about patient care.

Here’s a common one: If a pregnant woman arrives at an emergency room, there will always be an experienced obstetrician there to help. The reality, he says, is that OB-GYNs are sometimes on call, and they have a 30 minute-window to get to the hospital, even in an emergency.

“When a woman presents with severe complications, we have to intervene in less than a 10-minute period to either save the baby or save mom, or both,” says Castiglione, whose company handles an estimated 35,000 emergency interventions every year.

Ob Hospitalist Group wants to speed up that response time by providing an outsourced service to hospitals: OB-GYN departments staffed with board-certified physicians who are on site around the clock, every day of the year. The company, also known as OBHG, currently runs OB-GYN departments in more than 160 hospitals across 33 states.

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OBHG aims to improve care at the hospitals it serves, and to support the work of private practice physicians. With OBHG staff at hospitals to handle deliveries—both high and low risk—private practice physicians are summoned less frequently in the middle of the night. The company says it wants to allow those physicians to use their time more efficiently, with the ultimate goal of improving patient outcomes.

RISING MATERNAL MORTALITY There’s a gap in care, Castiglione says, and it’s reflected in the growing number of maternal deaths in the United States. A study of 48 states (excluding California and Texas) published in Obstetrics & Gynecology showed the maternal mortality rate increased nearly 27 percent between 2000 and 2014.

One contributing factor is the age of women when they give birth. Mothers today are slightly older on average, which can increase the chance of complications. In 2016, OB HOSPITALIST the Centers for Disease Control and Prevention GROUP found that for the first Business: An outsourced service time, women in the U.S. in to hospitals—OB-GYN departtheir early 30s had slightly ments staffed with board-certimore births than women in fied physicians their late 20s.

CEO: Lenny Castiglione Another risk indicator is the number of mothers Headquarters: Greenville, SC covered by Medicaid: A Geographic Footprint: More 2017 CDC study found that than 160 hospitals in 33 states Medicaid was the payment use OBHG programs source for 43 percent of deliveries. Compared with PE Investor: Gryphon Investors women who have private insurance, mothers using Medicaid are less likely to receive prenatal care and are more prone to health problems that create pregnancy risks.

By providing board-certified obstetricians in a hospital 24 hours a day, OBHG physicians are able to act quickly to protect mothers during delivery. After adding OBHG programs to seven of its hospitals between 2011 and 2016,

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Ascension, a large nonprofit health system, analyzed the impact on “severe harm events”—situations that cause death or permanent injury to the mother or child. When Ascension compared data collected before and after OBHG’s programs were implemented, it found the frequency of such events dropped by approximately 30 percent on average.

For hospitals, using OBHG may also reduce their exposure to malpractice risk. “It’s very hard to defend yourself as a hospital when a woman comes with complications and a doctor wasn’t there to render immediate care,” Castiglione says.

ALLAYING PHYSICIAN FEARS Castiglione estimates OBHG has spoken with around 3,000 U.S. hospitals about its services.

Discussions can continue for years before they turn into a partnership, which isn’t surprising: Using OBHG’s programs requires a substantial investment from hospitals and a willingness to rethink decades-old procedures. “We’re changing the way that the labor and delivery unit operates,” Castiglione says.

One area of concern he hears from hospitals considering using OBHG’s services is how local OB-GYN physicians will respond.

For OB-GYN care, most women visit the offices of private practice physicians. They come to a hospital for labor and delivery or for treatment if an urgent health issue arises when their physician’s office is closed.

Private practice physicians want to ensure their patients receive reliable care if they show up at a hospital. They’re also wary of new competition. “There are two really big fears that community physicians have: ‘Do you have well-qualified physicians that I can trust? And are you going to steal my patients?’”

Castiglione says.

OBHG tries to allay those fears. During the five to six months that it takes the company to get a team in place at a hospital, OBHG works to build relationships in the local medical community and with nurses in the hospital’s labor and delivery department, he says. “We have to gain

With support from Gryphon Investors, OBHG has invested in leadership training

their trust very, very rapidly for them to allow us to be a part of that patient’s care.”

Before they began working alongside OBHG physicians about eight years ago, doctors at LowCountry Women’s Specialists were skeptical. “We all had concerns about qualifications,” says Christopher Accetta, a senior partner with the Charleston, South Carolina-based private obstetrical practice. He and his colleagues questioned whether they could become comfortable with an outsourced group of doctors assisting and managing care for their patients.

Observing the work of OBHG doctors helped dispel those concerns. “It became clear that the physicians they recruited for these services were clearly seasoned and qualified,” Accetta says.

He remembers one patient who arrived at the hospital with a sudden onset of obstetrical bleeding. That required an emergency C-section, which was performed by an OBHG physician.

“Competent emergency care immediately available in the hospital saved that infant,” he says.

OBHG doctors help address another challenge faced by private practice OB-GYNs: fatigue.

Without an outsourced service, hospitals often

“WE MAKE INVESTMENTS IN HUMAN CAPITAL BECAUSE A CRITICAL ASPECT OF OUR BUSINESS IS HELPING CLINICIANS AND PHYSICIANS BE BETTER LEADERS ON LABOR AND DELIVERY.” LENNY CASTIGLIONE CEO, Ob Hospitalist Group

rely on local OB-GYNs to be on call overnight in case of an emergency. Having OBHG’s physicians in the hospital reduces that burden.

OBHG doctors manage labor and delivery for all patients from 5 p.m. until 8 a.m. They’re the only OB-GYNs on site during that time, which means Accetta and his colleagues are on call as backup.

“We come in if they need help with a C-section or if they are in a situation where two or three deliveries may happen in a short time,” Accetta says. “We are still on call, but as their backup. The number of times that we have to come in is much less than previously.”

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E Today OBHG serves more than 160 hospitals and has more than 700 employees

This model also helps obstetricians extend their careers and continue delivering babies, rather than reverting to general women’s health care or retiring. “A notorious part of the obstetrical field is that as physicians become older, they become too fatigued to provide the long hours of care, and many drop obstetrics and focus on just gynecology,” he says. “It deprives patients of their expertise and experience.”

Accetta, now 60, says that without OBHG’s service, he would have stopped obstetrics a few years ago. “Now I don’t see stopping it until I fully retire.”

What has surprised Accetta most is patients’ acceptance of the hospitalists. “[Patients] are more interested in having safe, competent care available readily from any physician over having their personal physician there,” he says.

THINKING OUTSIDE THE HOSPITAL Since it was founded in 2006 by OB-GYN Chris Swain, Ob Hospitalist Group has grown with support from private capital. Summit Partners acquired the company in 2010 and later sold it to Ares Management in 2013. In 2017, OBHG joined Gryphon Investors’ portfolio.

The deal closed in about four months, in part because Gryphon had been watching hospital outsourcing closely, says Kevin Blank, partner

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and general manager for health care at Gryphon.

“In today’s environment speed really counts,” he says. “It’s critically important to do your homework so you’re prepared to move.”

Health care is one of Gryphon’s four investment areas, and it has been a theme in Blank’s career—he previously served as president of Women’s Health USA. Gryphon was tracking industry trends that favored OBHG, including hospital consolidation and standardization. As large hospital systems continue to acquire smaller hospitals, they look for ways to standardize approaches across their holdings, says Blank, who is executive chairman of OBHG’s board.

When Gryphon acquired OBHG, the company served approximately 100 hospitals—today it’s in more than 160, and the number of OB-GYNs it employs has increased from 500 to more than 700.

At the outset, Gryphon saw that investing in leadership training would bring value to the business. Gryphon’s internal human capital team worked with an outside strategy firm to put OBHG’s management team through two days of in-person training, followed by a six-month coaching process. “We don’t consume a lot of capital. We don’t build buildings. We don’t have factories. I’m not acquiring other companies or other groups,” Castiglione says. “We make investments in human capital because a critical aspect of our business is helping clinicians and physicians be better leaders on labor and delivery.”

Castiglione, a member of the board of directors, says OBHG has benefited from the rest of the board’s acumen. In addition to three Gryphon leaders, the board includes industry experts, an Ares partner and OBHG’s co-founder.

“These are professionals that have been in the industry for 20, 30 years … They can see the landscape in front of us and help us navigate that and help us open doors,” Castiglione says.

“But probably most important, they can help us understand what mistakes we are going to make along the way, and how to avoid them.”

INDUSTRY IN INFANCY Hospital outsourcing businesses have attracted PE investment for years, and that trend will continue, according to AJ Shekar, a vice president at investment banking firm Provident Healthcare Partners. Early investments in this space included anesthesia services and emergency department management, both of which have experienced significant outsourcing.

With downward pressure on health system reimbursement, hospitals turn to outsourced physician services as a way to gain efficiencies, says Shekar. He expects that trend will encourage PE firms to expand their investments in outsourced health care service providers.

Women’s health represents a more recent area of interest for private equity. In a deal that closed in 2017, Shekar’s firm worked with Audax Group, which created Axia Women’s Healthcare through a roll-up of two companies. The following year, private equity firm Madison Dearborn Partners acquired Solis Mammography, one of the largest independent providers of breast cancer screening and diagnostic services. Advances in mammography technology and the increasing awareness of breast cancer help make this a compelling area for investors, says Shekar. But it’s also part of a greater focus on women’s health services overall.

“Obviously there’s a pronounced need for those services across the country and kind of a lack of access to care in many parts of the U.S. But I’d say that, overall, it’s a newer sector from a consolidation perspective,” he says.

He expects activity to continue across health care services for women. There are many large outsourced physician services providers in the market that act as consolidators, and acquiring women’s health care services could add to their offerings. “I wouldn’t be surprised if at some point down the road they seek to continue expanding their services out of what’s historically been the core focus of anesthesia, emergency department management and radiology,” Shekar says.

the company’s annual revenue to be about 20 percent greater than in 2018. He estimates OBHG can expand its client base by more than 40 hospitals a year, and he would like to see the company handle more labor and delivery, freeing up physicians in private practice to do what they do best. Currently, OBHG performs about 15 percent of total deliveries in the hospitals it serves, but Castiglione believes it could help with a much larger percentage. It could also play a role in providing follow-up care after delivery.

“As the industry starts to evolve, I think you’re going to see the specialty of OB-GYN change,” he says. “Meaning, how does the community OB-GYN allow the hospitalist to do more on their behalf, in the hospital?”

That mission creates a sense of shared purpose at the company, which is reinforced at OBHG board meetings. They each feature a 10-15 minute discussion of how OBHG provided meaningful care that affected the life of a mother or baby. “I’ve been on 15 boards in my career and never experienced that,” Blank says.

In this line of work, something heroic happens every day, he adds. “There are moments of truth in how you manage that patient that can make a real difference.” //

MAKING AN IMPACT

S.A. Swanson is a business writer based in the

With year-to-date revenue approaching $280 million as of February, Castiglione expects

Chicago area.

“[PATIENTS] ARE MORE INTERESTED IN HAVING SAFE, COMPETENT CARE AVAILABLE READILY FROM ANY PHYSICIAN OVER HAVING THEIR PERSONAL PHYSICIAN THERE.” CHRISTOPHER ACCETTA Senior Partner, LowCountry Women’s Specialists

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IN THE

Opportunity Zone A new federal program aims to stoke investment in underserved areas—but will it catch fire?

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BY BAILEY McCANN

ower corporate tax rates may have been the most celebrated aspect of the 2017 Tax Cuts and Jobs Act in the business community, but a new program created by the law has continued to attract investor interest, even as key parts of the provision remain undefined.

The opportunity zone program, which went into effect on Jan. 1, 2018, incentivizes investors to redeploy profits from the sale of property or investments. By investing their capital gains into economically disadvantaged communities, they can defer capital gains taxes and reduce their tax bill.

The program was intended to spread wealth beyond large cities and spur economic development in underserved regions across the United States and U.S. territories. Using census data, state governors designated more than 8,700 tracts as qualified opportunity zones. But despite the appeal of the tax and social benefits, many investors are biding their time as they await updated guidelines and determine whether the program fits with their investment model.

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Others are moving forward using the available guidance. Funds currently in the market include a mix of real estate and private equity-focused vehicles targeting opportunity zones. Alongside dedicated funds, family offices and other sponsors are making direct investments in zones where they see potential for high growth.

Real estate funds were the first movers, in part because the real estate industry is already set up to maximize tax incentives. For private equity, capitalizing on opportunity zones has been harder. Most PE firms and sponsors of operating businesses are in a holding pattern as they await updated guidelines from the Treasury Department and the Internal Revenue Service about which investments qualify under the program.

As currently written, the opportunity zone regulations require a business to operate and generate revenue within a zone. Those rules are easy to interpret as they relate to a barbershop or a nail salon, but they’re less clear for a software company or a provider of distribution services. The program was designed to bring economic development to underdeveloped areas and keep it there, but it can be challenging for a company to prove it meets the qualifying criteria when the jobs it creates go to knowledge workers, or when it sells its products online.

“RIGHT NOW, THERE’S A BLEND OF OPTIMISM AND UNCERTAINTY ON THE BUSINESS SIDE.” JOHN LORE Managing Partner, Capital Fund Law Group

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“Right now, there’s a blend of optimism and uncertainty on the business side,” says John Lore, managing partner at Capital Fund Law Group, based in New York. He expects the new guidelines, which likely will be released this summer, will bring added clarity about what it takes for a business to qualify for opportunity zone funding. Even then, PE investors will have other questions to reckon with. “Once the regulatory questions are answered, private equity’s real work begins: picking the individual projects that will be successful within a given zone,” he says.

There are also questions about whether a company qualifies for investment after it scales to multiple locations, including areas that may be outside a zone. For that reason, venture capital could have an advantage over private equity when it comes to opportunity zones—venture sponsors can start with a small company that needs time to build up in its current location.

Craig Bernstein, founder of OPZ Capital, a private equity fund dedicated to opportunity zone investments, points to another way PE firms can participate in the program. Once the guidelines have been clarified, PE firms may be able to invest in businesses that are already located in an opportunity zone by doing a material redevelopment that would meet the compliance requirement. “You could see firms do some site and operational improvements that are significant enough to meet the threshold,” he says.

NARROWING THE FIELD Not all opportunity zones are created equal. The zones were designated based on 2010 census data, the most recent aggregate federal data on nationwide demographics. But a lot can change in a decade. Oakland, California, for example, has opportunity zones, but the city today looks much different than it did in 2010. As the tech industry has continued to soar, rents have skyrocketed while other local assets command a premium. Over the 10 years since the last census, other cities like Denver and Austin have flourished and are now growing rapidly.

Opportunity zones within their city limits may

end up adding fuel to the fires rather than creating tiny sparks nationwide.

But for a firm looking for strong returns, investing in a fast-growing city can feel less risky than betting on an economically depressed area.

“For us, of those 8,700 or so tracts, a subset of them are investable,” says Brett Messing, a partner at SkyBridge Capital, which launched an opportunity zone fund this year with subadviser Westport Capital. The fund is looking at a combination of industrial projects and multifamily housing.

Messing notes that the economics are best in cities where there is pent up demand for construction. “I still have PTSD from 2008, but nationally, we’re under-homed. We’re looking at secondary cities—Savannah, Nashville, areas that are growing fast and need supply,” he says.

“There are firms out there in cities that aren’t seeing massive growth yet, working from a ‘build it and they will come’ thesis, but we are going forward conservatively.”

Messing’s comments reflect the mindset of many fund managers and business operators.

While the tax deferral incentives with opportunity zones are significant, for a number of investors the program is still primarily a means of offsetting up-front capital costs. Projects still have to work on paper, and that case is harder to make in an area that isn’t already on a growth trajectory.

Regulators tried to work around some of these concerns by requiring funds to invest over a

10-year investment period in order to realize the full tax incentive (although partial benefits are available for shorter investment durations).

The law sought to draw patient capital that could help cities overcome obstacles to growth, a strategy that isn’t entirely new: Using tax incentives to attract private capital dates back to the 1970s, when legislation like the Community Reinvestment Act and the Home Mortgage Disclosure Act pursued similar goals, with mixed results.

Chris Loeffler, CEO and co-founder of real estate investment firm Caliber in Scottsdale, Arizona, says the structure of the opportunity zone program has opened the door for collaboration with municipalities that want to approach projects in a new way. “We’re getting cities coming to us now and saying, ‘This our land, these are our goals, how can we work with you?’

That’s not usually the case for developers. So we are taking advantage of that.”

That willingness among cities to think outside the box can mean more mixed-use developments or arrangements where funds invest in a real estate project and then work with retail tenants for a small interest in the revenue.

Entertainment and hospitality projects have also emerged as key targets.

Working alongside local investors is another approach, one that family office McNally Capital is employing as part of its Capital Across America strategy.

“We’re working in several cities and

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“IF YOU HAVE A BAD DEAL AND IT’S AN OPPORTUNITY ZONE PROJECT, THERE IS THE POTENTIAL FOR OTHER OPPORTUNITY ZONE PROJECTS TO BE JUDGED IN THAT WAY.” QUINN PALOMINO Co-Founder, Virtua Partners

partnering with local families that understand those communities,” says Frank McGrew, managing partner at McNally, which invests in real estate and operating businesses within opportunity zones directly, rather than through a fund.

“They are often interested in supporting the business investment side and real estate because of those local ties. They understand what the total opportunity set is.”

EXPANDING IMPACT Much of the activity around opportunity zones is still centered on vetting deals, finding sites and setting up what will eventually be a project pipeline. Still, some early movers are breaking ground. Virtua Partners, a global PE firm focused on tax-advantaged investment strategies, plans to open a Marriott-franchised hotel in the Phoenix metro area this summer. The project is one of the first near completion. According to Quinn Palomino, Virtua’s co-founder, the project stands on its own and would have been done regardless, but the opportunity zone structure sped up financing.

Virtua won’t invest in a deal unless the firm feels like it’s a solid transaction, not just an “opportunity zone deal,” according to Palomino.

She adds that for the opportunity zone program to achieve its goals, there needs to be a way to

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evaluate what communities need and how private capital investments have or haven’t helped.

That means establishing metrics for tracking opportunity zone deals and the types of jobs they generate, and creating greater transparency around these investments.

Palomino describes Virtua as both a firm focused on tax-advantaged strategies and a longterm investor that supports community development. She says the success of the program could hinge on the quality of investments made. “If you have a bad deal and it’s an opportunity zone project, there is the potential for other opportunity zone projects to be judged in that way,” she says. “There is a lot of attention focused on this space.”

Palomino emphasizes the potential for longterm hospitality careers to result from Virtua’s hotel investment. Darryn Jones, vice president of business development at the Greater Phoenix Economic Council, who worked with Virtua on the project, adds that the city is collaborating with other businesses to build up tourism around the hotel site as a way of expanding the impact throughout the zone.

City and state officials in Arizona also plan to modernize business incentives for companies that want to operate in the area but do not qualify for funding through opportunity zones.

“Municipalities in our area are being aggressive about educating businesses and landowners on what the options are with opportunity zones and other incentives,” Jones says. Meanwhile, they are increasing their outreach to attract companies in leading industries.

While it’s still too early to predict opportunity zones’ overall impact, many municipalities are using the incentives to step up their marketing efforts the way Arizona has. Raising awareness could attract local firms that can make new investments—even if big-name PE funds aren’t yet ready to invest. // Bailey McCann is a business writer and author based in New York.

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POLICY POINTS

ACG’s 2019 Public Policy Priorities

T MARIA WOLVIN Vice President and Senior Counsel, Public Policy, ACG Global

BEN MARSICO Manager, Legislative and Regulatory Affairs, ACG Global

GET INVOLVED Contact Maria Wolvin at mwolvin@acg.org to learn more.

MORE ONLINE Visit middlemarketgrowth.org and acg.org/public-policy for regular ACG advocacy updates.

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he start of the 116th Congress brought a new crop of lawmakers, a changing political landscape, and increased opportunities and challenges for the middle market. Meanwhile, federal agencies are moving ahead with their deregulatory agenda under President Donald Trump. ACG’s 2019 public policy priorities reflect this dynamic, multifaceted environment and are designed to maximize our impact in Washington, D.C. Education Important policy discussions in Congress have historically focused on small and large companies, while the middle market has been left out.

Lawmakers acknowledge the important role of small businesses in the economy and have made efforts to address their interests. Meanwhile, large companies have the financial resources to keep their issues front and center. That’s why informing policymakers about the critical role the middle market plays in the U.S. economy is the cornerstone of ACG’s work in Washington.

At the forefront of ACG’s congressional education program is the bipartisan Congressional Caucus for Middle Market Growth. Championed

by ACG in coordination with the National Center for the Middle Market, the caucus serves as a platform to raise awareness on the outsized impact the middle market has on the U.S. economy. Additionally, the caucus educates members of Congress and their staff on the various ways

policy proposals affect the middle market. During the last congressional session, the caucus held briefings on tax reform, cybersecurity and the options available to middle-market businesses looking to raise capital.

In this Congress, ACG will engage in broad efforts—including through direct ACG member involvement—to grow membership in the caucus.

Protecting the Reputation of Middle-Market Change-Makers With a divided Congress comes an increase in the possibility for political messaging bills designed to rally a party’s base and force a vote that can later be used against opponents. As the Democrat-led House Financial Services Committee turns its focus toward consumer protection and anti-Wall Street sentiment, those who create value in middle-market firms stand the chance of being caught up in a variety of political messaging bills.

ACG will continue to meet with policymakers to refute misinformation and set the record straight on the economic benefits of those who participate in the middle-market ecosystem. With a data-driven advocacy platform that includes research such as GrowthEconomy.org—a dynamic database tracking the immense growth spurred by private capital—we are able to provide hard evidence of the positive impact ACG’s members make in specific congressional districts.

Proactive Regulatory Engagement A divided Congress means more highly publicized legislative activity

and fewer bills passed into law. On the regulatory front, however, there is more opportunity to obtain relief and favorable policies for ACG members. There will be several key opportunities for ACG to engage with regulators in 2019, as the Securities and Exchange Commission focuses on accredited investors and advertising issues, the Treasury Department works to implement the 2017 Tax Cuts and Jobs Act, and policymakers evaluate laws such as the Volcker Rule and a host of other regulatory issues.

Broadening Our Reach While policies that promote access to capital are core to ACG’s advocacy efforts, ACG will continue to evaluate opportunities to participate in

broader policy conversations that impact the success of the middle market. With an increased focus by policymakers on issues such as manufacturing and the definition of a joint employer, there comes an increased need for middle-market representation. ACG works to elevate the voice of the middle market in broad policy discussions to ensure the continued success of our members and the greater middle-market ecosystem.

Peer Collaboration With the wide swath of issues affecting midsize businesses, there is often the opportunity to join forces with other groups to maximize the impact of ACG’s advocacy. To most effectively harness the resources available

to ACG’s public policy department, we plan to continue to identify peer organizations to work with in pursuit of our policy goals. This sort of coalition-building is essential to achieving success in Washington.

Strengthening the ACG PAC The ACG PAC was formed in 2016 in order to strategically pool personal, voluntary funds from individual ACG members to help support and elect candidates that are champions of the middle market. The ACG PAC is a critical tool to promote ACG’s federal advocacy efforts to drive middle-market growth. In coordination with the ACG PAC committee, ACG plans to further strengthen the ACG PAC in 2019. //

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POLICY POINTS

Gaining Ground in Washington, D.C. The ACG PAC committee chairman on amplifying the voice of the middle market on Capitol Hill

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ith a new Congress in session and the 2020 elections looming, MMG asked Tom Turmell, the chairman of the Association for Corporate Growth’s PAC Committee, about the PAC’s role in supporting a healthy climate for middle-market businesses and to describe its goals for 2019.

The ACG Political Action Committee was formed three years ago as a policy tool to help advance the interests of the middle market in federal policymaking.

The PAC contributed to four candidates in the 2018 midterm elections, and all of those up for re-election won their seats. Turmell, a managing director at TMT Capital Partners and a former member of the ACG board of directors, discussed how the ACG PAC is an important policy tool in Washington, D.C., and he outlined the policy positions it supports.

E Tom Turmell, Chairman of the ACG PAC Committee

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Q. How does the ACG PAC benefit the middle market, and what type of candidate does it support?

Tom Turmell: The ACG Political Action Committee represents the interests of ACG members in the middle market. Our goal is to educate lawmakers on both sides of the aisle about the importance of middle-market companies and private capital, which drive U.S. economic growth and job creation. We need to do what we can to ensure the formation of private capital, and that its investment in small and midsize companies remains fluid.

To that end, the ACG PAC supports candidates from both parties who champion issues that are important to driving middle-market growth, such as modifications to the Dodd-Frank Act. In particular, the ACG PAC helps ensure that federal legislators who support policies that foster middle-market growth—like those that would improve access to capital for small and middle-market companies,

and that would relieve unnecessary, burdensome registration requirements for ACG members’ firms—get re-elected. Community banks should be encouraged to make prudent business decisions on how to invest in their communities, and private capital providers should be allowed to focus on their core competencies—supporting companies and management teams with the capital, operational and managerial resources they need to achieve profitable business growth.

The ACG PAC also supports candidates who promote smart tax policies that incentivize investment and business innovation while rewarding investors for their risk. In addition, the ACG PAC creates another pathway for engagement with federal legislators on issues of importance to the middle market. For example, ACG advocates for sensible joint-employer policies that place risk and liability on those who have direct jurisdiction over, and responsibility for, business decisions. Current joint-employer policies simply aren’t

logical and seem to have been created to punish arms-length related parties, which does nothing but create risk and deter investment in good companies that need access to capital.

Q. What has the ACG PAC’s activity involved to date?

TT: The ACG PAC is still young, but we’ve begun to engage ACG

legislation. Parts of early drafts were very different from what was ultimately passed. It’s a little scary to think what could have passed had ACG not been in a position to have a voice.

The ACG PAC allows ACG to participate in fundraisers and events that provide another avenue for building relationships with lawmakers on both sides of the aisle. This enhances

“WE NEED TO DO WHAT WE CAN TO ENSURE THE FORMATION OF PRIVATE CAPITAL, AND THAT ITS INVESTMENT IN SMALL AND MIDSIZE COMPANIES REMAINS FLUID.”

members in our effort. We received contributions over the past couple of years that enabled us to support four candidates in the 2018 congressional midterm election. To be eligible to contribute, an individual must be an American citizen or green card holder and a paying member of ACG. Being able to donate to the campaigns of members of Congress who support ACG’s mission provided the opportunity to engage in advocacy efforts in a new and meaningful way, as well as deepen our relationship with several legislators. The importance of relationship-building on Capitol Hill cannot be overstated. In 2017, ACG joined forces with other organizations to educate Congress as it formulated and passed the 2017 tax law, developing relationships with members of Congress and their staff while advocating for pro-growth tax policies. ACG members were on Capitol Hill the day the Republicans published their initial draft of the

ACG’s ability to increase education about private capital and to advocate for positions that are helpful to ACG’s membership.

During the 2018 election cycle, the ACG PAC contributed to the campaigns of four incumbent candidates—two Democrats and two Republicans. All four were incumbents with demonstrated track records of supporting policies that were helpful to our members and the interests of the middle market. All recipients who were up for re-election won their races.

The ACG PAC committee is hopeful that through our communication and engagement efforts we will be able to raise significantly more money in the coming year, positioning us to be even more active during 2020.

ACG PAC has three overarching goals this year. The first is to establish an active, supportive committee made up of a diverse cross section of ACG members. The second is to develop and execute a communications program that engages local chapter leadership and informs ACG’s members about our public policy initiatives and the importance of the ACG PAC to our organizational goals. Finally, our third goal is to use our education and engagement efforts to help us build a pool of funds that we can use to support candidates on both sides of the aisle who understand and advocate policies that are beneficial to the growth of the middle market.

Next year is going to be an important election year. Voices are getting louder and support seems to be growing for policies that would intensify regulatory oversight, increase the size of government, elevate economic risk, impede the flow of investment in small and midsize companies, and make business activities more expensive. These types of policies are bad for businesses of all sizes, the U.S. economy and job creation. The middle market needs an advocate in Washington to represent its interests, and ACG is that voice. //

GET INVOLVED Q. What are the goals for the ACG PAC in 2019?

TT: Working in conjunction with ACG’s public policy committee, the

To learn more about the ACG PAC and how to get involved, visit acg.org/public-policy/acg-pac

MIDDLE MARKET GROWTH // MAY/JUN 2019

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GROWTH ECONOMY

TENNESSEE // 1998–2017 The number of jobs created by private equity-backed businesses in Tennessee grew more than 10 times the rate of the broader business community over the past two decades. Sales growth was also strong. The revenue of private equity-backed companies grew more than six times the rate of other businesses in the state. The $3 billion purchase of Surgery Partners by Bain Capital and the $6.1 billion take-private of Team Health Holdings by Blackstone contributed to the surge in deal value, but rising activity indicates growing investor interest in the state’s local companies.

SALES GROWTH % BY SEGMENT

SALES

1.9% 26.3% 48% 9.5%

ACG TENNESSEE

14.3%

JOB GROWTH % BY SEGMENT 0% 4.5%

303.1%

SALES GROWTH IN PE-BACKED BUSINESSES

49.5%

SALES GROWTH IN ALL BUSINESSES

3.8% 18.8% 72.9% Small: Less than $10M in sales MM Seg 1: $10-50M in sales MM Seg 2: $50-100M in sales MM Seg 3: $100M-1B in sales Large: More than $1B in sales

JOBS

GROWTH IN PE-BACKED BUSINESSES

GROWTH IN ALL BUSINESSES

281.7% 25.9%

JOBS CREATED

BY PE-BACKED BUSINESSES

62,381

MORE ONLINE See the impact of middlemarket private equity on your state at GrowthEconomy.org.

All stats are from PitchBook and the Business Dynamics Research Consortium at the University of Wisconsin-Extension.

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Member FINRA/SIPC MIDDLE MARKET GROWTH // MAY/JUN 2019

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From left, RKON Managing Directors Chris DeMichael and George Florea with CEO Jeff Mullarkey

Photos by Matthew Gilson

IN FOCUS RKON

Technology, Private Equity Style RKON helps middle-market investors unlock value through IT

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usiness executives and technologists usually speak different languages. The former use words like “investment thesis” and EBITDA, while the latter talk about gigabytes and cloud computing. So it’s not surprising that sometimes the two groups have a tough time communicating.

RKON Technologies is the rare tech company that speaks “business” fluently. When talking about even the most complex technology, the company’s principals put it in business terms.

Take RKON managing director George Florea when describing the role of technology in a private equity add-on strategy. “In a buy-and-build situation, cloud computing can be an important part of a private equity firm’s growth thesis and value creation because it allows them to scale IT across all the companies at a predictable cost,” he explains.

Founded in 1998 by Jeff Mullarkey and Marc Malizia, RKON has been building, securing and managing mission-critical IT for Fortune 500 companies for 20 years. It got involved in private equity when a large PE firm bought a division of one of RKON’s Fortune 100 customers. The company’s chief information officer went with the carve-out and suggested that the PE firm use RKON to transition IT systems from the parent to the new business. RKON did it in four months, beating the transition service agreement (TSA) deadline by two months.

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“The private equity firm said that had never happened before, and they asked if we could do it again,” recalls Mullarkey, RKON’s CEO. That was 12 years ago. Today, RKON has a substantial business in middle-market private equity, especially in carve-outs and roll-ups. It has never missed a TSA deadline, according to Mullarkey.

The company’s ability to understand and explain how IT enables business, along with the team’s decades of experience building and operating technology for very large enterprises, make it well suited to serving the private equity market.

“It’s like the advantage that a master chess player has,” Mullarkey says. “We can see nine moves ahead, so we know what moves to make right now to set up the win.”

STRATEGIZE, IMPLEMENT AND STICK AROUND RKON’s experience running IT for large companies gives it insight that large consulting companies—which private equity firms often use for auditing and other services—may not have, Mullarkey says. “These consultants are broad-based and advise across all these different swim lanes, including human resources, finance and IT,” he explains. A consultant might design a high-level IT strategy but may not have the expertise to implement the technology, so it brings in outside IT experts to build it. “Because they don’t understand the complexity involved,

MIDDLE MARKET GROWTH // MAY/JUN 2019

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E Jeff Mullarkey co-founded RKON in 1998

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they make bad decisions, and then they are not accountable for the outcomes,” he says. “They come in, bring in other people, then walk away.”

Many consultants may underestimate what IT can do, and some advise against IT transformation during transition. But given the timelines under which private equity firms operate, RKON suggests undertaking a transition and IT overhaul simultaneously. “We’ve proven that we can do both at the same time,” Mullarkey says.

Private equity firms also benefit from RKON’s ongoing experience with a broad client base.

Because it manages and supports the IT of hundreds of businesses, including Fortune 500 companies, RKON is constantly learning, and it uses that knowledge for the benefit of all of its clients.

RKON is often hired to conduct IT due diligence before an acquisition, for example, so it knows how to make sure that IT systems are in top shape when the time comes to sell a portfolio company. “Because of our experience, whoever purchases that company next will not

middlemarketgrowth.org

find any red flags,” says Christopher DeMichael, RKON’s managing director and chief architect.

RKON has built its own cloud platform, which can be an important advantage for private equity firms. RKON’s cloud means IT systems can be standardized, which makes them easier to install across stores or businesses. That not only reduces costs but also makes the company more attractive to potential buyers.

Cloud costs are based on consumption, a model that gives portfolio companies a chance to access enterprise-grade technology. “Small and midsize companies still need sophisticated IT systems in order to grow, but they don’t have the same budgets as their Fortune 100 counterparts,” says Nils Lindokken, manager of strategic growth on RKON’s private equity team. “We give them access to what they need at a price point they can afford.”

That consumption-based model also makes it easier to quantify IT expense. “That means if you’re buying a new company with 600 employees, you can extrapolate per-employee costs—such as the number of Microsoft Office 365 licenses you need,” Florea explains. “You start to bake that into your numbers and you get a lot more control in negotiating the price of that particular company. You also have good benchmarks for how to manage it through the hold period.”

ENABLING GROWTH FOR RETAILERS Florea cites the story of a multistore retailer as an example of how this works. When one of RKON’s private equity clients purchased the company—which sells premium gifts, stationery and crafting supplies—it found that IT systems were inconsistent and varied in quality from one store to another.

RKON standardized IT on its cloud platform and provided a model for equipping new stores with technology. That enabled the PE firm to pursue its aggressive strategy of adding 20 new stores a year. “We were able to ship—practically in one box—the entire IT footprint for a store and get them up and running within a couple of days,” Florea says.

E Nils Lindokken (left) and Sarah Marinacci (center) with RKON executives in the firm’s Chicago office

The stores also needed to become compliant with the Payment Card Industry Data Security Standard, known as PCI DSS, in order to continue handling credit card transactions. RKON helped all of the company’s stores meet the requirements and pass the audit in 60 days.

Today, all of the retailer’s stores run the same IT systems and report the same data. “That gives them a wealth of analytics on how the business is running,” Florea says. And the PE firm can predict costs, he adds. “Outside of real estate costs, they now have a really good model for what it costs every time they spin up a new store.”

This combination of IT expertise, cloud platform technology and a deep knowledge of private equity gives the staff at RKON not only the ability to build and operate cost-effective, high-quality IT from the acquisition of a company to its eventual sale, but also the confidence to stand behind their promises.

“We tell you what it’s going to take, then we sign on the dotted line and own the outcome,” Mullarkey says. “We are there from start to finish.” //

Three Ways IT Impacts Valuation ɋɋ Security: Nothing can suck value from a company faster than a data breach. And more and more midsize businesses are in the cross-hairs.

“Our PE clients are telling us that they are being targeted,” Mullarkey says. Hackers are monitoring M&A activity to identify companies in transition, then targeting staff with fake emails. Compliance with security standards is increasingly important in deals, he says. Without demonstrable compliance, customers will buy elsewhere. ɋɋ Cost synergy: New ownership creates an opportunity to revamp IT to reduce costs and increase efficiency, directly impacting EBITDA. ɋɋ Competitive advantage: Technology is changing business models in many industries. Think about how Uber used smartphones and connectivity to disintermediate the taxi industry. According to Mullarkey, “There is potential in every industry to use IT as a competitive tool and market disrupter.”

MIDDLE MARKET GROWTH // MAY/JUN 2019

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THE PORTFOLIO

Building a Deal-Proof Business SOUND DECISIONS // The role of talent and culture during M&A

I Mike Ross Manager, Innovation and Development, Insperity

n an ideal world, all business deals would be successful. But a quick scan of current business news will tell you that’s not the case.

Large and small companies alike too often find themselves on the failing side of a deal. Even with best efforts to clearly articulate strategic objectives, successfully conduct due diligence and procure the best talent, the success of a deal is impacted by whether or not the company is built to withstand such activity.

A successful deal is not just about increasing revenue, minimizing costs, taking a stronger competitive position or improving market penetration. For a company to survive a deal, it needs to have the right talent and culture, along with a human capital strategy built to handle the complexities of an equity deal.

Internal Alignment The foundational priority for building a company that can survive is alignment. It is imperative that there is clarity and agreement within the business about the goals IF YOUR for the deal, its business objectives, COMPANY’S and long-term strategy. In addition, CULTURE IS A there also needs to be alignment between the company strategy “FLAVOR OF THE and the human capital strategy.

MONTH” MODEL, Success beyond the deal comes EMPLOYEES WILL when the right people are in the right roles doing the right activities.

QUICKLY LOSE Misalignment in the organization SIGHT OF THE leads to ineffective key performance ORGANIZATION’S indicators, misallocation of capital CORE VALUES and, ultimately, business inefficiencies that hinder the growth and AND PRIORITIES. profitability of the company.

with new challenges and obstacles. All stages of the deal will look different as the needs of the business change. In order to ensure that companies manage through a deal successfully, the strength of a company’s culture is critical.

If your company’s culture is a “flavor of the month” model, employees will quickly lose sight of the organization’s core values and priorities.

This causes your talent to fail, which will impact productivity and company success.

A strong company culture—one that enables a company to succeed after the deal—is employeecentric and built on strong values, and it embraces innovation. This creates empowered employees who are allowed to think strategically, which increases the productivity and profitability of the business.

Developing Talent Beyond the Deal The last area where companies need to adjust to survive beyond the deal is maximizing their human capital strategy. It is critical that the business strategy is integrated with the human capital strategy. The company must map the short-term and long-term needs of the business and then create development plans for employees. If this process is neglected, the power of human capital to become a force multiplier in the business will be lost, and the company will outpace its leadership team.

A comprehensive human capital strategy built and executed will help to develop leaders with the skills and competencies necessary to run a successful post-deal company. // Mike Ross is manager, innovation and development, at Insperity. He has a background in corporate finance and strategy and is responsible for

The Right Culture As a company grows and moves from one stage of the business life cycle to the next, it is faced

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M&A activity at Insperity.

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THE PORTFOLIO

Allocating Co-Investment Rights FOCUS ON FUNDING // Demand for co-investment is high, but tread carefully

F Julia Corelli, Esq. Partner, Pepper Hamilton LLP

or most private equity managers, co-investments are an essential part of attracting limited partner investors and funding investments. In a 2018 Private Funds Management survey, co-investments were front and center, with the vast majority of PE respondents saying they actively seek opportunities to offer co-investments.

But determining the amount to offer to co-investors is a sensitive topic not often discussed openly. On one hand, investors are looking for more opportunities to co-invest; on the other, managers want to earn fees that are often associated with fund investments, but not with co-investments.

IF MANAGERS ARE GOING TO OFFER CO-INVESTMENTS, THE ONLY CLEAR SOLUTION IS TO OFFER ALL COINVESTMENTS TO ALL FUND INVESTORS IN PROPORTION TO THEIR STAKE. The types of fees and expenses leveled on co-investors varies across funds. According to the pfm survey, only 28 percent of co-investors pay the same management fees as the PE fund investors, while 22 percent pay a lower fee.

Meanwhile, 31 percent of co-investors pay the same amount of carried interest as PE fund investors, while 30 percent pay less.

These scenarios pose potential conflicts of interest. Fees and expenses paid to the manager are an obvious incentive to reduce the PE fund’s investment in the opportunity. Though less obvious, earning no fees and expenses is also an incentive to reduce the fund’s investment.

When negotiating governing agreements, most fund managers will try to leave as much discretion in the manager’s hands as possible.

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But LP investors often want to know exactly what their co-investment rights will be.

Retaining discretion carries regulatory risk in allocating co-investment rights, but granting certainty carries investor relations risk, along with the risk of partnering with the wrong co-investors. And an issue often ignored is the duty a fund manager owes first to LP investors in the fund.

Fund limited partner agreements are getting more specific about managing these conflicts, and they often expressly require that managers not put their interests above those of investors. But what documentation can prove compliance? If managers are going to offer co-investments, the only clear solution is to offer all co-investments to all fund investors in proportion to their stake. If not all limited partners want to participate, funds should have clear procedures for allocating the remaining opportunity. That may include leaving room for strategic investors—and lenders—to co-invest.

There’s also the question of what share of an investment to make available for co-investment, which ultimately comes down to what’s suitable for the fund. Determining “suitability” is an art.

It requires flexibility in the fund’s governing documents and balancing investors’ desire for attractive co-investment opportunities with the distractions and costs of putting together co-investments and the regulatory scrutiny that will test everything after the fact.

Finding that balance can be challenging, yet the market has shown that co-investments have become an integral part of PE investing, and they’re likely here to stay. // Julia Corelli is a partner with Pepper Hamilton LLP’s Corporate and Securities Practice Group and co-chairs its Funds Services Group, a core constituent of Pepper’s Investment Funds Industry Group.

MIDDLE MARKET GROWTH // MAY/JUN 2019

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THE PORTFOLIO

Expanding into Asia: Lessons from Biotech GLOBAL VIEWS // Avoiding costly strategic errors abroad

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iotechnology companies looking to expand internationally have seen some of the greatest successes—and overcome some of the most profound challenges—in Asia.

With immense pressure to innovate and bring treatments to market quickly, these companies are great case studies for any organization wishing to build a multinational presence.

Rob Wellner, Senior Vice President of Sales, Velocity Global

Why Asia Matters to Biotech On one hand, it’s math: Asia contains more than half of the global population and available talent, so the potential value of expansion there is obvious. But this is a complex region with substantial differences in economies, regulatory environments and culture that have made expansion complicated. American biotech companies have traditionally focused on their home markets and Europe, but this is starting to change.

In a 2008 survey of international biopharmaceutical leadership, 94 percent of respondents expressed interest in expansion beyond their home countries, with 90 percent interested in Asia.

Recent commitments for reform favor innovation, intellectual property protection and the biotechnology market specifically. The Asian cancer treatment market alone will jump 40 percent from 2015 to 2020, according to the World Health Organization. The drastic rise in certain ailments and air pollution-related deaths have also made Asian countries—particularly China and India—rich markets for pharmaceuticals.

public investment reforms. Asia’s thirst for innovation and investment is largely selfmotivated: Its populations are seeing much higher treatment needs across a variety of conditions and demographics. When government action begins to align with your market goals, a good match might be emerging.

It’s not just about market size. The enormous numerical advantages of Asia are obvious, but expansion has to be about more than that. Biotech has succeeded in Asia because the continent disproportionately needs biotech, not simply because it is a huge population pool.

Pick partnerships and specific markets, not locales. For most biotech entrants, partnership—as opposed to building their presence from scratch—has been the most desirable strategy. Whether they do this via acquisitions, joint ventures, out-licensing or other methods, this approach offers substantial growth potential while avoiding the effect of going in blind.

Widen Your Global Perspective No matter your destination market, learning from others who have gone before—regardless of their industry—can save time and help you avoid costly strategic errors. Along with the right advice and partnerships here at home, a little global intelligence can change everything. // Rob Wellner, Velocity Global’s senior vice president of sales, draws on 12 years of experience in capital markets to help organizations expand internationally, including using Velocity Global’s

Transferable Lessons for Global Expansion So, how have biotech companies begun to realize the benefits of Asian markets? Here are three takeaways that can inform just about any company’s global expansion approach—no matter your target region: Watch for accelerating regulatory and

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International PEO service to overcome challenges associated with global M&A. With unrivaled expertise in over 185 countries, Velocity Global delivers end-to-end services and best-in-class support to help companies confidently navigate the entire life cycle of international business. For more information, visit velocityglobal.com/acg.

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THE PORTFOLIO

Health Care’s Silver Lining MID-MARKET TRENDS // Sector to see strong growth despite recession fears

R Faraaz Kamran Partner, Twin Brook Capital Partners

obust middle-market leveraged finance activity remained steady in the second half of 2018. However, mounting concerns that a recession may strike within the next 18 months have led investors to gravitate toward health care, with an increasing number of private equity and lending firms eyeing deals in the sector for the first time. Despite a consumerdriven shift, the overall health care industry is expected to perform better than most in response to demographic trends, necessity of care, the inability to send services overseas, and the continued existence of government programs like Medicare and Medicaid, which constitute a growing share of the payer universe.

Lenders with little to no experience in health care are investing in the space with the expectation that the sector will act as a shelter in the storm—an area where opportunities will continue to emerge, and dry powder can be put to work during the toughest of economic times.

WE EXPECT THE REMAINDER OF 2019 TO BRING REGULATORY CHANGES, REIMBURSEMENT CHANGES AND MYRIAD MARKET FLUCTUATIONS. While there was a drop-off of middle-market investment in early 2019, robust opportunities continued for direct lenders. One subsector of health care that has experienced significant M&A activity in the past few years is physician practice management, which includes specialty areas such as dermatology, dental, optical, orthopedic, gastroenterology and urology. We expect the subsector to remain attractive to investors throughout 2019.

There’s also a pipeline of activity in urgent

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care, companies tied to providing services for clinical trials, companies that are providing care to highly acute populations, and the medical device sectors. Finally, deals that private equity firms invested in from 2014 through 2016 should be coming to market in 2019, which should generate significant activity in secondary exits.

Alongside the overall uptick in health care deal flow comes increased lender appetite as new entrants vie for a piece of the pie. And that’s where danger can emerge. Health care companies and private equity firms must conduct due diligence prior to selecting a lender with whom to partner. Expertise and a track record in health care lending is key.

For example, a lender looking at a lower middle-market health care deal for the first time may quote leverage based on the size of a company without understanding some of the fundamental risks, such as potential regulatory or reimbursement changes, or human capital risk. Simply put, it’s important for a sponsor to partner with a lender who has deep experience, expertise and a track record of financing middlemarket health care transactions.

We expect the remainder of 2019 to bring regulatory changes, reimbursement changes and myriad market fluctuations. Whether lenders will run to the health care market or run away from it remains to be seen.

Regardless of where we are in a cycle, we see an opportunity to provide capital for backable, solid deals, and we expect middle-market health care to be a bright spot for investors when the cycle inevitably turns. // Faraaz Kamran is a partner at Twin Brook Capital Partners. He is a member of Twin Brook’s investment committee and focuses on the firm’s health care portfolio.

MIDDLE MARKET GROWTH // MAY/JUN 2019

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THE PORTFOLIO

The Case for PE-Sponsored Sale Leasebacks

BY THE NUMBERS // Attractive returns and investor support drive activity

L Krupa Shah Senior Vice President, JLL

ast year saw strong commercial real estate activity as transaction volumes reached $481 billion, according to JLL’s U.S. Investment Outlook. Overall interest in net-lease assets remained robust: The sector recorded $44.1 billion in transactions, of which sale-leaseback transactions represented nearly 15 percent.

Companies continue to hedge against market uncertainties through sale-leaseback transactions, in which an owner/occupier sells real estate and then leases it back from the purchaser.

Specifically, we’re seeing increased sale-leaseback liquidity for lower- and middle-market companies in secondary and tertiary markets, largely driven by attractive risk-adjusted returns and the support of strong private equity sponsorship.

Benefiting the Seller Sellers often use sale-leasebacks as a preferred way to recapitalize, especially for non-rated, smaller or middle-market companies that may have trouble accessing capital markets.

Executing a sale-leaseback allows them to lighten their balance sheet and use proceeds to pay off other liabilities. Furthermore, it allows these companies to focus on their core competencies and business growth.

Industrial assets are particularly ripe for this type of transaction. They accounted for more than half of sale-leaseback transaction volumes in 2018, up from 35 percent in 2017, according to JLL’s research. Record or near-record pricing and strong investor demand are driving owners to evaluate selling rather than holding their assets.

PE Funds and Add-on Strategies Private equity investors continue to target middle-market acquisitions—companies valued between $25 million and $1 billion— which accounted for $427.9 billion of private equity-backed deal volume in 2018, according

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to PitchBook. Many large platform companies have pursued middle-market companies due to the flexibility they offer for add-on acquisitions; they are large enough to be impactful and still small enough to deter competition. These add-on acquisitions—in which a private equity fund integrates the acquired companies into existing operations—can often be an effective and capital-efficient way to grow a portfolio business. Add-ons accounted for 66 percent of U.S. private equity-backed deals through 2018.

According to PitchBook, 2018 was another healthy fundraising year for the U.S. middle market, with about $110.8 billion total capital raised. Given the scale of the opportunity, nearly 70 percent of capital raised is targeting this deal profile. Increasing activity is taking place outside of primary markets, where companies often own mission-critical real estate, such as industrial production and manufacturing facilities.

Sale-leasebacks have become a sought-after mechanism for private equity firms to finance and enhance those businesses, while also creating a positive arbitrage opportunity for investors. By carving out real estate from a business alongside or after an acquisition, buyers can unlock substantially higher value for the real estate. This is achieved through the disconnect between the lower EBITDA multiple (often 6x to 8x) paid to acquire the business and the higher EBITDA multiple (typically 12x to 14x) achieved from the sale of the real estate.

Fundamentals remain strong in the real estate business, notwithstanding slowing economic growth. We expect sale-leasebacks, especially for middle-market companies, will remain prevalent and that an increased number of investors will target industrial assets. // Krupa Shah is a senior vice president in JLL’s Corporate Finance and Net Lease Group.

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THE PORTFOLIO

Keys to a Smooth Medical Roll-up SOUND DECISIONS // Understanding obstacles can help alleviate risk

I Bryan Graiff Transaction

n the specialty medical practice space, roll-up acquisitions—where smaller medical practices are acquired and integrated into larger practices—have become increasingly popular with private equity firms. However, this investment strategy comes with its own challenges, and understanding the acquisition and post-acquisition obstacles can help alleviate risks and improve the chances for a successful transaction and a smooth transition.

Advisory Partner and Private Equity Industry Group Leader, Brown Smith Wallace LLP

Ron Present Advisory Partner and Health Care Industry Group Leader, Brown Smith Wallace LLP

Writing a Clear Letter of Intent It is critical that the buyer and seller agree to the purchase structure and how the initial indication of the practice’s value is determined. In the medical roll-up space, the legal and tax structure of the selling entity often poses challenges with the purchasing entity structure. When the seller does not understand how the value is derived during the negotiation process, they may ask to be paid for additional items not in the letter of intent and deals can fall apart. It is also important to consider post-acquisition compensation or equity ownership and the impact on value they may have, along with the need for reverse due diligence.

Due Diligence Obstacles After parties agree to a letter of intent, the due diligence process creates its own set of obstacles. Small medical practices often lack a full-time accountant and going through the due diligence process can be overwhelming.

Many times, the quality of the financial information makes it difficult to support the true financial results. In one recent acquisition, the doctor-owner of a $2 million practice maintained the general ledger in a checkbook.

Unsophisticated financial controls and significant personal expenses make it easier to commit fraud, which can get missed during

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due diligence if the scope is not designed appropriately.

It’s important to be on the lookout for other sources of risk. For instance, some practices still use paper medical records that pose HIPAA risks. An operational review needs to identify equipment that lacks the latest technology upgrades, and revenue recognition and days sales outstanding are often impacted by insurance reporting and realization.

Working capital is often the most contentious area of a transaction. A working capital target to protect the buyer is typically calculated using a trailing 12-month average, but difficulties can arise in calculations because medical practices often use cash-basis accounting. In many of these acquisitions, working capital is difficult to predict due to inventory, receivables and payables not being accounted for properly—if at all.

Post-Closing Integration Challenges may surface while integrating the new roll-up, even after acquisition. These challenges can arise from insurance contract credentialing, integrating an electronic medical records system, implementing management software and ensuring the physicians are happy with post-acquisition transitions.

Being aware of obstacles and risks in a specialty medical practice roll-up strategy—and planning accordingly to address them—will ensure success for a PE firm. // Bryan Graiff has more than 25 years of C-level experience and has led over 100 buy- and sell-side transactions from both sides of the desk.

Ron Present has over 35 years of health care industry experience. He helps clients prepare and implement solutions for value-based purchasing and care.

MIDDLE MARKET GROWTH // MAY/JUN 2019

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ACG@WORK

H ACG NORTHEAST DEALMAKING AT THE MOUNTAIN ACG chapters from Boston, New York, Philadelphia, New Jersey and Connecticut gathered on the slopes of Spruce Peak in Stowe, Vermont, for the annual ACG Northeast Dealmaking at the Mountain. The two-day event brought together middle-market M&A professionals from across the Northeast to network, converse and deepen relationships in the deal community.

ACG NORTHEAST DEALMAKING AT THE MOUNTAIN F The event, which drew 138 attendees, included a private cocktail reception for private equity investors and investment bankers, a race on the slopes, a bonfire and multiple speakers. Pictured (from left) are Meghan Kelly, Lance Singer, Evan Zwerman, Ben Garcia, Bruce Gibson and Lynn Sommer.

H ACG LOS ANGELES Meanwhile on the West Coast, members of ACG Los Angeles gathered at Mammoth Lakes, California, for the annual ACG LA Mammoth Deals Ski Conference, where more than 64 attendees enjoyed activities on and off the slopes while forming meaningful business relationships.

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H ACG CHICAGO Members of ACG Chicago NextGen attended Trivia Night at Jefferson Tap and Grille. The 86 participants got the chance to network in a casual, relaxed and fun environment. This is the second year ACG Chicago NextGen held the event. Pictured (from left) are members of the winning team: Kayla Siam, Aaron Gillett and Whitney Schmidt.

ACG CLEVELAND F More than 850 attended ACG Cleveland's 23rd Annual Deal Maker Awards. The event attracts attendees from over 20 states from coast to coast and provides an efficient networking opportunity in an uninterrupted format in a concentrated amount of time, which participants can use to coordinate meetings in Northeast Ohio before and after the event.

H ACG HOUSTON ACG Houston’s annual Deal of the Year event focused on celebrating Houston’s booming middle-market deal community. The event honored the deals and deal-makers who drive middle-market growth—resulting in job growth, capital formation and the advancement of meaningful business relationships. Pictured (from left) are Eric Appel, Steve Kesten, Jason Ferguson, Steve Tredennick, Colt Luedde and Jen Sudduth.

MIDDLE MARKET GROWTH // MAY/JUN 2019

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ACG@WORK

G ACG NEW YORK ACG New York’s 6th Annual Women of Leadership Summit brought together 225 women in the middle-market dealmaking community for a day focused on networking and knowledge sharing. The summit focused on a variety of key issues influencing current markets and offered the perspectives of women leaders positioning themselves for future success.

E ACG MINNESOTA ACG Minnesota held its 7th Annual BOLD Awards gala at Muse Event Center in Minneapolis. The BOLD Awards honor and recognize Minnesota companies of all sizes making bold moves through innovation, collaboration, team or talent management, a merger or acquisition, and other ways.

Pictured are attendees at the event’s Nominee Judging Reception.

H ACG ORANGE COUNTY ACG Orange County hosted its annual Private Equity Marketplace Deal Flow & Wine Tasting at the Ritz-Carlton in Dana Point, California. More than 650 private equity and other professionals from all over the country attended the event for fine wine, golf and good conversation.

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E ACG TORONTO ACG Toronto and Stikeman Elliott partnered for the annual Private Equity Mid-Market M&A Trends & Opportunities event. It drew more than 152 participants for an exclusive discussion with private equity firms and deal advisers who shared their perspectives on recent trends and opportunities for private equity-backed middle-market M&A activity in Canada.

H ACG TORONTO In partnership with Aird & Berlis and RSM Canada, ACG Toronto hosted a three-part lecture series about topics and trends related to the USMCA agreement and cross-border investment opportunities across Canada, the U.S. and Mexico. The talks attracted 50 attendees and numerous speakers, including (from left) Morty White, Wynnchurch Capital; Randy Williamson, Aird & Berlis; Alex Kotsopoulos, RSM Canada; Rocco Rossi, Ontario Chamber of Commerce; Carle Felton, Goldman Sachs; and Mike Fenton, president and CEO, ACG Toronto.

MIDDLE MARKET GROWTH // MAY/JUN 2019

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ACG@WORK

H ACG WESTERN MICHIGAN Contenders from Western Michigan branches of ACG and the Turnaround Management Association squared off at the inaugural Econo-Off held at the Amway Grand Plaza Hotel in Grand Rapids, Michigan, where they took turns presenting arguments for the country’s economic outlook in 2019 and beyond. Representing ACG was BDO USA’s Daniel Fuller (right), who presented evidence for continued economic growth, while DWH’s David Nemes (left), representing TMA, argued an economic slowdown is on the horizon.

ACG ATLANTA F ACG Atlanta hosted its annual ACG Capital Connection at the Hotel Avalon Convention Center. The conference featured networking events for its private equity and investment banking participants, along with a new forum, the Middle Market Marketplace, to spotlight fast-growing companies in the region. The conference was held the day after the Super Bowl, so it was fitting that NFL hall-of-famer Terrell Davis gave the event’s keynote address, moderated by EY Tax Partner Ashley Scott.

CONTACT Want to share photos from your recent chapter event? Email us at editor@acg.org.

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S

SAVE THE DATE INTERGROWTH RETURNS TO LAS VEGAS NEXT YEAR! W W W . I N T E R G R O W T H . O R G

THE LADDER

DAMON MCLAREN joined Jefferies as a managing director in the firm’s Los Angeles office to lead coverage of middle-market financial sponsors in the Western United States. McLaren has nearly 20 years of middle-market M&A experience and deep relationships with sponsors. Prior to joining Jefferies, he was a managing director at Lincoln International.

RICHARD YOSKEY joined CFG Community Bank as vice president of leveraged lending. Drawing on more than 16 years of experience, he is responsible for the bank’s leveraged lending team and assists private equity groups with M&A financing and other loan solutions. He previously served as vice president and commercial banker at LH-Finance, a division of United Bank.

KATHLEEN “KITTY” RYAN joined Morrison & Foerster’s Financial Services Group as of counsel in the firm’s Los Angeles office.

Her practice focuses on mortgage and fair lending regulatory compliance and licensing matters. Ryan is the former deputy assistant director for the Office of Regulations at the Consumer Financial Protection Bureau.

Venturi Wealth Management announced CHRIS CREED has joined the firm as senior lead adviser to help new clients organize, plan and manage all aspects of a family’s financial life. He brings more than 24 years of experience to his new role.

Previously, Creed was principal of AFAM Capital, where he ran business development for the firm’s private client group.

BRENT BAXTER (top) and RON ZIMMERMAN joined Nolan & Associates as managing directors to lead and execute sell-side and buyside transactions for Nolan’s business owner, corporate and private equity group clients. Both previously worked at independent investment banks in St. Louis—Baxter for 18 years as managing director and Zimmerman for 10 years as director.

Chaffe & Associates Inc. announced FRANK DEVAY has been promoted to managing director with the mergers and acquisitions team. He brings more than 19 years of experience in structuring and negotiating transactions, valuation of small and midsize companies, and development and execution of competitive processes.

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VERONICA MUÑOZ (top) joined ACG Denver as executive director, effective Jan. 1, to oversee operations of the chapter and to work with its board of directors on business and strategic plans for the organization.

Last year, two other chapters welcomed new executive staff. ACG Chicago hired KIM HAMMOND (center) as CEO, and ACG Dallas/Fort Worth welcomed BRITTANY TIMMERMAN (bottom) as chapter executive.

MORE CAREER INFO Watch for more career information in The Ladder monthly e-newsletter.

DAVID KORAN joined Crestmark as vice president, business development officer, for the East Division.

He brings nearly 20 years of commercial finance experience and most recently served as managing director of capital finance with International Risk Consultants.

BRUCE DURKEE joined InterOcean Advisors, a Chicago-based boutique investment bank, as managing director.

He brings more than 20 years of M&A experience and will be based in the firm’s new office in Atlanta, where he will be responsible for business development and transaction execution related to M&A, capital raising and financial advisory engagements.

ISABELLA MILLER joined Capital One Commercial Bank as vice president and treasury management consultant and will oversee strategy and management for government banking customers on Long Island. She was previously vice president of government banking at Flushing Bank.

MARK S. ALBERT joined law firm Seyfarth Shaw as partner in the firm’s corporate department in Chicago. He will serve in the Commercial Transactions, Corporate Governance and Compliance, M&A, and Private Equity and Venture Capital groups. He served previously as general counsel of Magic Leap Inc.

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Insurance coverage provided by or through UnitedHealthcare Insurance Company or its affiliates. Administrative services provided by United HealthCare Services, Inc. or their affiliates. ©2019 United HealthCare Services, Inc. 8540596.0 3/19 19-11222

MIDDLE MARKET GROWTH // MAY/JUN 2019

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IT’S THE SMALL THINGS

NICHE OPPORTUNITIES IN HEALTH CARE // Just what the doctor ordered

1

23 and Me-dicine?

Driven by the plummeting cost of DNA sequencing,

5

A Good Om-en for Meditation Linked with reduced symptoms of stress-related

growing awareness of genetic-related illnesses

health conditions, meditation and the $1.2 billion

and the benefits of personalized medicine, the

industry behind it—which includes meditation

global genetic testing industry is expected to grow

centers, retreats, an array of digital educational

to $19.1 billion by 2024 from $8.5 billion in 2017.

materials and employer programs—is projected to

Geographically, North America holds the largest

grow more than 11 percent annually to over

share of the market, while the Asia-Pacific region is

$2 billion by 2022. – Marketdata Enterprises

expected to experience the highest annual growth.

– Energias Market Research

2

An increasing number of health care companies are developing health offerings designed specifi-

Emerging evidence from a study funded by the

cally for women. Called “femtech,” this burgeoning

National Institute on Drug Abuse published in

sector attracted more than $1 billion in funding from

September 2018 suggests cannabis may play a role

2015 to 2018 for products that include gender-

in helping those suffering from addiction by alleviat-

specific prosthetics and pharmaceuticals designed

ing withdrawal symptoms and decreasing the likeli-

with women’s metabolism in mind. – Forbes

centers are including cannabis in their treatment regimens. – Cannabis and Cannabinoid Research

Linking up to Blockchain Tracking medical records across the clinics and hospitals a patient visits over a lifetime can be difficult. To centralize records, developers are turning to blockchain, the innovative and tamper-proof technology behind cryptocurrencies, to offer the integrity and continuity of information that medical providers will need in the future. – Forbes

4

The Femtech Revolution

Weeding out Opioid Addiction

hood of relapse. As a result, more private treatment

3

6

Artificial Intelligence, Real Revenue Health care AI startups have seen a steady increase in the number of deals and value of equity funding in the past year, hitting a historic high of more than $500 million across more than 60 deals in the second quarter of 2018. Their innovations include using AI to diagnose chronic diseases over the phone and producing better medical data for physicians and researchers. – CB Insights

—Benjamin Glick

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