The healthcare sector went on a tear beginning in 2011, thanks in large part to the passage of the Affordable Care Act and its impending implementat
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Mar 6 2012 | 9:29am ET
Masood Sohaili and Eric Newsom co-chair the private equity and venture capital practice at the California-based law firm Manatt, Phelps & Phillips. FINalternatives' Senior Reporter Mary Campbell recently interviewed with the two p.e. experts to discuss the current climate in the industry, regulatory changes, the increasing importance of due diligence, and the “Romney” effect, as the high-profile GOP presidential candidate’s private equity background puts the spotlight on the publicity-shy sector.
How would you characterize the current climate for private equity?
Newsom: I would characterize the prevailing feeling as one of cautious optimism. There remains quite a bit of uncertainty and skepticism about governmental responses to the European debt crisis and other potentially destabilizing influences. Monetary policy declarations made by central governments whipsawed the public markets on a monthly basis in 2011. Concerns over such actions will temper the private equity market somewhat in early 2012. That said, the private equity market itself looks to be strengthening as we move into 2012. On the whole, valuations in the U.S. market appear more attractive, and we are seeing an increase in investment activity of sector-focused private equity funds, as well as the formation of new funds with targeted industry focus. The last quarter of 2011 even saw a somewhat surprising uptick in leveraged buyouts.
Sohaili: I agree. P.E. investment held steady in 2011, despite the generally difficult and uncertain market, partly due to the significant p.e. capital overhang of nearly $500 billion. While the uncertainty surrounding Europe is still present, and personally I believe Europe will continue to deteriorate, there appears to be strength in the underlying domestic economy. With the capital overhang still a driver, (including a significant amount of overhang from 2008 vintage funds), sourcing deals will continue to be a priority. I think domestically focused businesses in industries such as healthcare, information technology and energy could provide attractive opportunities. Also, exits should continue in 2012, at an increasing pace, providing additional investment opportunities.
Geographically, where are you seeing the most interesting opportunities?
Sohaili: I believe 2012 will be much more domestically focused in general because of the improving fundamentals in the U.S. and issues in Europe (which will impact China and to a lesser extent India). Within the U.S., geography is not very important, except to the extent it impacts the particular industry fundamentals.
Newsom: I would agree that geography matters less and less these days. Our deal flow in any given industry is as likely to come out of our New York office as our Los Angeles office. That said, San Francisco and the Silicon Valley remain a hotbed of investment activity in the healthcare IT and food and beverage sectors, both areas where Manatt has seen an increase in deal flow over the last 12 months.
I understand p.e. investors are beginning to look at opportunities in regulated industries and sectors that have not historically been targets, can you tell me something about this?
Sohaili: This is a trend that we have been tracking over the last few years. As competition for prime deals mounts, private equity players are discovering greater relative opportunity in regulated and/or specialized industries. The healthcare, energy (including cleantech) and information technology areas, for example, have principally been the domain of smaller specialty funds, due in large part to the regulatory and/or industry specialization overlay, and the perceived complexity and greater transaction costs required to actually close deals in such industries. In an increasingly competitive private equity environment, however, larger general market funds have built teams around these industries and brought their financial might to the table. We view this as a healthy development, as these markets are themselves growing, and will eagerly absorb the additional capital.
Newsom: With this in mind, many general market funds are creating sector-specific strategies and focusing their recruiting efforts on industry leaders in their targeted sectors. As part of this more disciplined investment focus, and in order to demonstrate their commitment to a given sector, private equity funds are building deal teams (bankers, auditors, lawyers and other service providers) that can deliver an integrated work product in these industries, i.e., industry-specific regulatory experience as well as top-tier deal expertise. And once a transaction is underway, a deal team well-versed in a particular industry can help its private equity clients foresee opportunities and speed bumps that other professionals, who may lack the specialized practice, fail to notice.
How does this affect a private equity firm’s due diligence? What additional demands does it place on lawyers/investment banks/outside partners?
Sohaili: Diligence for transactions in regulated industries can be daunting and complex. To a degree, this can take a private equity firm, and even its law firm, out of its comfort zone. Initially, funds would react by engaging separate industry counsel to conduct regulatory and commercial diligence alongside the fund’s traditional corporate counsel. This sort of tag-team representation, however, can result in a certain level of dysfunction and disruption in the flow of the deal, and can be cost prohibitive for smaller middle market deals.
Newsom: Agreed. The regulatory burden on many industries is so heavy that it can and often does materially affect the timing and even the underlying economics of given transaction. Transactions in the healthcare space, for example, can take many months to consummate, with daunting diligence and regulatory issues ranging from Medicare regulations to canon law. Transactional counsel unversed in such issues, who are accustomed to more fast-paced strictly commercial transactions, commonly find themselves frustrated at the tempo and tenor of regulated deals. This can create tension among the deal team, an inherent risk when you have two sets of lawyers working on any deal. We have found that integrated deal teams, with regulatory counsel and transactional counsel who have a history of working together, can reduce this friction and ease a deal more efficiently from LOI, to diligence, to documentation and ultimately to closing.
Mitt Romney’s presidential bid has put the spotlight on the private equity sector—what do you make of the sudden attention? How do you respond to allegations that private equity is “job destroying?”
Newsom: I find the media attention fascinating but unsurprising, given the election year upon us and Mr. Romney’s primacy in the polls. To be sure, there are lessons to be drawn from the negative coverage. This highly politicized notion that private equity exists only to acquire, leverage, pillage and liquidate simply does not reflect the bulk of what the private equity industry does. Personally, I believe the industry should emphasize the message that it is about renewal and innovation, two concepts that are at the core of the American value system. This theme of renewal could play an important role in re-shaping the public’s perception of private equity. While critics can and will always point to one-off stories of excess, there exist countless stories of successful turn-arounds, paradigm-shifting innovations and a return to disciplined management. So in my view, the current level of criticism presents the industry with its strongest opportunity yet to emphasize its value in the American economy. Whether this happens depends on whether this publicity-shy industry will let this storm pass, or be drawn out to address this issue head-on.
Sohaili: In the long run I think the focus can be a good, in terms of educating people as to what p.e. does and how it can be positive for the markets and the economy. Unfortunately, given that this is an election year and that the “carried interest” issue is also under intense scrutiny, it may be difficult to provide a fair analysis of the constructive role PE can play in a market economy.