Healthcare-focused private equity funds achieved a higher median net IRR than generalist funds in six of the past 12 years
(Update: This story has been changed in paragraph 6 to correct a date.)
November 8, 2024 (Preqin News) – The healthcare sector is not immune to the economic headwinds that have shaken private equity and venture capital (VC) markets. Healthcare fundraising and deal flow surged in 2020 and 2021, buoyed by an increased interest in the sector due to the pandemic, which exposed weaknesses in existing systems and opened the door to the adoption of new technologies.
Since this boom, the cost of capital for investing has risen and exits, both on public markets and through M&A, have become much harder to realize. As such, GPs have found it more challenging to raise healthcare-focused vehicles. Fundraising by funds focused on the sector in the first three quarters of 2024 has been slow, with 119 vehicles raising $41.8bn, just over half (51.6%) of the aggregate money raised in 2021, when 536 funds raised a record $81.0bn.
‘There was the bubble of 2019–2021 where things just went a little bit crazy with the combination of cheap money and an intense focus on healthcare because of the pandemic,’ Tom Goodman, a Partner at California-headquartered law firm Cooley, told Preqin News.
However, healthcare-focused private equity funds are regularly outperforming their peers. Funds with a core focus on healthcare, where most deals and assets acquired by the fund are healthcare-related, have outperformed funds with some exposure to healthcare, and those with no exposure to healthcare, in six of the past 12 years, based on median net IRR.
Private equity health check
Private equity core, exposed, and not exposed healthcare funds by net IRR (%), 2010–2021
Source: Preqin Pro. Data as of September 2024
Healthcare-focused private equity fund performance peaked for 2018 vintage funds with a median net IRR of 22.6%. These vehicles would have entered their investment phases before the market boom in 2020 and 2021, when the performance of healthcare-related companies over the pandemic and an active M&A market led to increased valuations in both public and private markets.
The average entry EV/EBITDA multiple on buyout deals increased from 13.7x for transactions completed in 2018 and 2019 to 16.2x for deals in 2021 and 2022, according to Preqin’s Transaction Intelligence data.
Performance data for 2014 vintage healthcare funds, which have a median net IRR of 22.3%, indicates a similar outperformance. These funds were established seven years before the 2021 boom year, when the investment period of private equity funds would typically be ending with a focus on divestment and exits. According to Preqin’s Allocator Hub, net cashflow for 2014 vintage healthcare funds turned positive after 7.5 years – or in mid-2021.
Funds with no healthcare exposure had the highest median net IRR in only one year – 2020 – although, it’s still too early to reliably determine the lifetime performance these more recent vintages.
VC has historically thrived in disruptive, innovative sectors, taking a high-risk, high-reward investment approach in software, technology, and fintech companies, among others.
Investments in healthcare for VC funds paint a different picture than private equity, with core healthcare-focused funds outperforming exposed and not-exposed vintages just twice by median net IRR (21.4% in 2010 and 10.7% in 2020). Funds with exposure to healthcare, and those without exposure each topped median net IRR in five years since 2010.
Healthcare VC underperforming
VC core, exposed, and not-exposed healthcare funds by net IRR (%), 2010–2021
Source: Preqin Pro. Data as of October 2024
A sector for all cycles
‘It’s anticyclical in terms of the economics. Everybody needs healthcare at some point, and the aging population is only going in one direction, it’s growing,’ Ramesh Jassal, a Healthcare Partner at UK-based corporate finance advisory and private equity firm Heligan Group, told Preqin News.
Private equity managers are drawn to healthcare due to its defensive stability and inflation resilience, and the demographic changes driving long-term demand in developed countries. Across OECD countries, healthcare spending as a proportion of GDP increased from 8.7% in 2015 to 9.2% in 2023.
The sector is a critical component in the playbook of private equity fund managers. Healthcare deals have accounted for 17.4% of total private equity and VC deal value globally since 2018, pulling in $1.99tn – the second-largest sector behind the $3.11tn IT industry.
The dearth of exits after 2021 was felt across private equity sectors, and although healthcare was not immune, the decline was less severe. Healthcare exit deal value fell from $247.0bn in 2023 to $200.8bn in 2023, an 18.7% drop, according to Preqin data. By contrast, the overall private equity and VC exit market saw a steeper decline of 48.6% from 2021 ($1.26tn) to 2023 ($644.7bn).
‘People were waiting in 2023 to see what would happen with inflation and interest rates. Some took their foot off the gas in terms of going to market, and some of the advisors decided to delay until 2024, at least until after the election in the UK,’ said Jassal. ‘There's another election in the US. So, I think the geopolitical stability, as well as the inflationary and the debt challenges, did put some pressure on investors.’
Biotech in bloom
The healthcare sector is experiencing rapid innovation in tech-based subsectors. Biotech companies are increasingly using machine learning and AI to improve drug research discovery, cell therapy capabilities, and gene engineering therapies, according to a McKinsey report, ‘What early-stage investing reveals about biotech innovation’, published last December.
‘The private equity market has become a lot more experienced, and a lot more deeply entrenched in life sciences,’ James West, London-based Managing Director at investment bank Lincoln International, told Preqin News. ‘We’re really seeing them build some world leaders.’
According to Preqin data, over $150bn has been invested across 3,312 deals in healthcare as of October this year. Biotech has been the biggest target sector, attracting over a third of the total investment by volume (1,148), followed by medical devices and equipment (710), and healthcare IT (537).
Biotech AUM has grown rapidly over the last 10 years from $63.1bn in 2013, to $293.0bn at the end of 2023, accounting for 61% of VC healthcare AUM.
‘A big trend is the huge step forward in genomic and genetic testing. This is particularly important in areas like fertility and cancer screening. If you get notified early, you can identify specifically what gene mutations you have and how to treat them,’ said West.
Fundraising for healthcare-focused private equity and VC experienced a sharper decrease between 2021 and 2023 than other private equity sectors. In 2021, the sector saw 536 funds raising a record $81.1bn, which decreased to 209 funds securing $61.2bn by 2023. This represents a 24.5% drop in funds raised, higher than the wider industry decline of 17.4%. This trend has continued in 2024, with only 119 funds raising $41.8bn by October.
Despite the tough conditions, three healthcare-focused funds have each raised $3.0bn in 2024. Norwest Venture Partners XVII closed in April 2024, while ARCH Venture Fund XIII and Bain Capital Life Sciences Fund IV closed in September.
Funds of this scale allow GPs to give companies substantial backing early on, as well as at later stages. ‘We’re seeing quite large biotech series A rounds at the moment, and that’s flowing through to later stage rounds but generally only for companies that are beginning to go through the clinical trial process,’ Goodman said.
The fundraising slowdown
Healthcare-focused private equity funds closed and aggregate capital, 2019–2024 YTD
Source: Preqin Pro. Data as of October 2024
The impact of genomic, genetic, and healthcare advancements is reshaping investment priorities within biotech.
Goodman says it’s important to keep filling the pipeline: ‘You need to keep investing in early-stage companies to generate data and therapeutics that will come out 6–10 years later. You can’t just stop doing that, because then you can have a gap in your portfolio down the road. This is driven by Big Pharma companies, which need to constantly refresh their blockbuster drugs. They’re always looking with one eye on the horizon to what's coming next to replenish the pipeline.’
Regulation: risk and reward?
Social and legal attitudes towards private investment in healthcare differ worldwide, particularly regarding primary care provision. At the start of October, California Governor Gavin Newsom vetoed a bill that would have allowed his state to block private equity groups and their portfolio companies from acquiring healthcare facilities (excluding hospitals) and service providers earlier this month.
Although this bill failed, continued private equity investments in healthcare could increase regulatory scrutiny. In October, The Private Equity Stakeholder Project (PESP) highlighted 900 private equity-owned healthcare provider locations across the Greater Philadelphia area, from small clinics to major hospitals.
‘The goal in preparing this data was to begin to measure private equity’s involvement in a city that already knows its risks. Hospitals in Philadelphia and the surrounding area have already seen public attention due to their private equity ownership,’ said Michael Fenne, Senior Healthcare Researcher at PESP.
‘When private equity firms buy out healthcare facilities only to slash staffing and cut quality, patients lose out,’ said Federal Trade Commission (FTC) Chair Lina M. Khan, announcing an inquiry into the role of private equity in healthcare. ‘Through this inquiry, the FTC will continue scrutinizing private equity roll-ups, strip-and-flip tactics, and other financial plays that can enrich executives but leave the American public worse off.’
In Europe, different healthcare provision and legislation models bring challenges for investors and fund managers. Countries like Spain, the UK, and Denmark have universal healthcare provision, while other European countries legislate private health insurance – making investment operations more difficult compared with the US.
However, there can be positives for investors in more controlled systems. ‘Government funding is powerful and provides good visibility on potential earnings that you could have. If you’ve got a contract, and a certain volume of people needs to be serviced, that's good visibility to the cash flows, which is appealing to investors,’ said Jassal.
The public good
To strengthen and encourage healthcare innovation, national governments can play an active role in supporting innovation, enhancing economic frameworks, and creating favorable tax regimes for international investors. In the UK, a leading player in biotech and life sciences, the maintenance and creation of strategic policies continue to foster innovation.
‘It's about ensuring that there’s a healthy research and development rebate regime. So, companies that are knowledge-intensive can claim back some tax. It's such a key part of what keeps the lights on. In addition to external fundraising, it's the ability to get R&D credits, and that’s attracting investment into the UK,’ said Goodman.
The UK is critical to the continued growth and innovation of life sciences and biotech, ranking only behind the US in the number of active biotech companies. In the UK Budget, presented at the end of October, the Labour government announced the establishment of the £520mn ($668.7mn) Life Sciences Innovative Manufacturing Fund (LSIMF).
LSIMF is a capital grants fund that aims to build resilience for future health emergencies and capitalize on the UK’s world-leading research and development capabilities.
‘The UK is great in terms of local, national, and lottery funding. But I think it’s more about the framework,’ said West. ‘Tax break regimes really incentivize investment in early-stage companies. If you get a framework right, the long-term financial gains are far greater for the country and the public purse.’
The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin providing the information in this content accepts no liability for any decisions taken in relation to the above.