BUSINESS PLANNING & TECHNOLOGY DEVELOPMENT
Despite the ongoing credit crunch in the United States, there has been no shortage of mergers and acquisitions (M&A) activity among medical device manufacturers over the past year. However, the industry is not immune from the recent economic slowdown, which could have noteworthy implications for medtech M&A going forward. For this issue's roundtable discussion, MX called upon a panel of experts to provide their views about the current market conditions surrounding medtech M&A, as well as the sectors most likely to see continued consolidation in the coming years (see sidebar).
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MX: Are the number and size of M&A deals in the medtech industry holding steady, declining, or rising? Are there identifiable causes behind the current trend?
Richard S. Cohen: The medtech sector is reflective of the rest of the worldwide economy. It is being affected by the economic slowdown caused by the subprime mortgage mess; by the difficulty of packaging leveraged loans, which are the loans made to buy out firms; and just by overall recessionary pressures.
Nevertheless, transactions are still being undertaken.
Companies that are well capitalized and forward-looking should be using this time to grow by acquisition as well as by more aggressive, organic meansand some that can afford it are certainly doing so.
J. Casey McGlynn: I agree that macroeconomic forces influence the medtech industry. Nevertheless, we continue to see a lot of companies in serious discussions, and our office is currently involved in a bunch of M&A deals involving a bunch of different companies.
With regard to M&A activities, does the medtech field survive tough economic times better than other industries?
Ben Dunn: Comparing our groups' M&A activities over the past six months, our healthcare group has remained strong, while the other sectors have experienced more of a downturn.
Deals involving companies in the lower-middle and middle markets are probably a little more immune to some economic conditions than are deals involving larger companies. And all of this is related to macroeconomic trends and to conditions in the stock markets and debt markets.
Joseph E. Gilligan: Obviously, mega-billion-dollar deals driven by price-to-earnings (P/E) ratios have kind of been pushed to the side. But strategic buyers are as active as ever--particularly among some of the big medtech companies. And quite a few interesting deals are being done in the price range from the hundreds of millions to the low billions of dollars. That's still a very active space.
Where you have noticed a fall-off in activity, does it seem to be affect- ing different medical device sectors differently?
McGlynn: We have done or are actively working on a number of deals in the spine area, in ophthalmology, in treatments for diseases of the bowel, and in women's health. These are all areas that continue to be very active in starting new companies, funding them, and selling them. We also continue to see a lot of things going on in the cardiovascular and related sectors, but perhaps fewer deals than five years ago.
Gilligan: Cardiovascular and general orthopedics may not be quite the dominant players they were a couple of years ago, but that's not because they're not still critically important and very big areas. It's just that other sectors such as spine have begun to grow.
And I also agree that women's healthincluding reproductive and breast healthis a very hot area.
Are you seeing companies make use of the direct-to-consumer approach to the marketplace in order to attain growth and become ripe for M&A?
Dunn: We see the direct-to-consumer market as a big growth area. Considering the obstacles posed by reimbursement and other kinds of pressures, those types of companies can offer some very attractive possibilities. A lot of medtech companies are looking at the healthcare trend in favor of more care occurring in the home rather than in the physician's office or other clinical settings.
Over the past few years, a number of large companies have made strategic investments in smaller companies, negotiating up-front options for acquisition later on. Is that trend continuing, or are the other trends you've mentioned slowing it down?
Cohen: The model of large companies acquiring options or some equity component of a smaller company is well known and frequently used in the pharmaceutical and biotech industries. Now that it is also used by medtech companies, I think that will become a continuing trend.
The reason this model is attractive is that even large companies need the creativity fostered outside their corporate culture, and they rely on the entrepreneurial efforts of smaller companies to develop niche or specialized products. Large companies often seek out products that are ready to be integrated with their own offerings.
Casey, what proportion of the deals that you get involved in have been set up by those kinds of strategic, early-stage investments?
McGlynn: Although a lot of such deals might be possible, right now we're not doing many of them for the companies that we represent. The reason for this is that there's a great deal of venture capital available, and that makes it possible for companies to do deals that are a bit cleaner. And honestly, the people who own the biggest pieces of those companiesand those who are running themwould prefer to remain a little bit more purethat is, not beholden to the influences of their large-company partners.
Are medical device sectors being re- shaped by mergers and acquisitions?
Gilligan: Some of the recent transactions and big-company activities in the spine sector suggest that this area will be critically important for the future.
For instance, Kyphon's acquisitions of Disc-O-Tech and St. Francis Medical Technologies had an important roll-up effect on the sector that led to Kyphon's acquisition by Medtronic. Meanwhile, some of the smaller spine companies have really become just small independents, and fewer and fewer of those qualify to become real premium targets.
All of these activities are helping to reshape the spine sector.
Dunn: Turning back to last year, I think the merger of Cytec and Hologic has really reshaped the landscape in the field of women's health. That deal combined two women's health powerhouses into one company, and creates a dominant player in that sector.
McGlynn: In the sectors that we're talking aboutspine, in vitro diagnostics, and women's healththe development of technology has really accelerated over the past few years. That's really the first-mover force here, and the interest of the big companies is really just a response to these changes in technology.
In the IVD sector, some of the ac- quired companies have been among the largest in the business. But the more typical model is for a start-up company to grow to maturityhowever that might be definedand be acquired by a larger player. Are both of these kinds of M&A deals going on simultaneously? How long can the market sustain both levels of activity?
Cohen: The model in which a start-up company develops, gains traction, proves its value in the marketplace, and attracts the attention of a larger acquiring company will remain forever.
Today, large companies are considering potential acquisitions far more strategically than they did in the past. In the bigger transactions that we're doing, the corporate chain of command is imposing a much higher level of scrutiny to prove that the acquisition fits in well with the company's core product lines. Those companies are venturing less far afield than they might have in the past. There may be some interest in diversification, but only in complementary areas.
Dunn: For larger deals, the issue is simply one of supply and demand. There are only so many large companies in certain medtech sectors. The supply of companies and potential deals may be subject to some cyclical pattern, but for the foreseeable future I think we'll see a downturn in larger deals.
Gilligan: For large-company deals, another factor to consider is the valuations involved in those transactions. Large medtech companies are being very careful about accepting valuations that have been in the market for the past couple of years. Before committing to such a large and expensive acquisition, companies really have to be able to justify and rationalize the economics of the deal.
In this regard, it would be difficult to overemphasize the impact of Boston Scientific's acquisition of Guidant, and the tough times that Boston Scientific has had since that deal was consummated. There's no question that this example has made many of industry's largest deal participants very careful.
When they are starting to do a deal, what specific concerns do medtech executives find most disturbing? For instance, are they most concerned about the complexity of the deal requirements, the simple unavailability of credit, or what?
Dunn: For large deals, current market issues include any transactions that require debt financing. We're in the market right now with a deal that requires debt financing, and difficulty in obtaining it is causing a real hiccup in the negotiations and the ability of the buyer to pay, so the debt markets are a major issue right now.
Another factor is a higher level of due diligence, especially among strategic buyers. The buyers want to make sure that the deals really do fit and make sense. And a lot of those companies need to be sure that their deals will be accretive immediately or in the very near term.
Do currency fluctuations also have an effect on M&A activities in a given region? Because of the weakening dollar, for instance, is it easier and more attractive for overseas investors to acquire U.S.-based companies?
Gilligan: Absolutely. We are seeing much more activity now. The interest is coming primarily, but not exclusively, out of the Euro zone.
Although sovereign wealth funds are becoming active investors in a lot of industries, we haven't seen them express interest in the medtech space yet. That's partly because the medtech sector isn't ripe for smaller-level strategic investments by those funds, particularly if they don't have significant industry expertise.
Is that foreign interest helping to support pricing of some medtech deals?
Gilligan: It's both helping to support the pricing and, frankly, just helping to get the deals done. Every auction takes on a different feel when there's more than one participant.
Cohen: It's hard to generalize, but we tend to involve foreign buyers in every transaction in which we represent the sellerbecause of the weak dollar and the opportunity for a foreign acquirer to establish a U.S. platform.
At least in our transactions, however, I think acquirers have been careful not to let currency benefits eclipse the core fundamentals of the deal. So other considerations have a play there. American companies might benefit from exchange rates, but I don't think current conditions are enabling any deal to happen that wouldn't otherwise pass operational muster.
What do you tell executives about how to attract the attention of potential acquirers?
Gilligan: Executives who ultimately hope to engage in a sale or IPO absolutely cannot spend enough time getting their companies' IP in shape. Companies must be able to demonstrate that they have strong and enforceable IP.
Dunn: Compared with companies in the past, a lot of companies today are already smarter when they're starting up. They are already thinking about their ultimate exit and putting measures in place so that when the time comes to make an exit, they've got alternatives.
We also advise companies to make sure that they have gotten on the radar screen of larger medtech companies, so that the company's presence is known and understood and can quickly be evaluated.
Joe, what has been your experience in valuing an acquisition target during the period before its products are commercially available?
Gilligan: That is probably the single toughest challenge for valuing medtech deals, because in some cases the company may be not only prerevenue but also pre-FDA approval.
The results of every valuation model depend entirely on the assumptions that go into creating the model. So of course the assumptions that we use are very important. For medtech companies, a lot of those assumptions depend on getting a good view of the regulatory pathway and its timetable.
McGlynn: The company's IP is an important piece in the valuation chain. But companies also need to know everything possible about all of the companies in the marketplace that are like themselves. This is important, because inevitably companies will be asked to demonstrate how they are more worthy than those comparable companies.
And finally, companies should devote time early on to building strong relationships with the key opinion leaders in their particular market segment. Those relationships can help to ensure that the company is viewed as a leader in its field. And that kind of recognition, in turn, makes all of the big companies pay attention to the company when they are hunting for that kind of product.
Some companies approach mergers and acquisitions with strategic goals in mind, but other companies favor a diversification approach. Which of these approaches is most common? Are most companies pursuing a strategic approach now, or are they looking to expand into new areas? Which approach has the greatest potential under likely market conditions going forward?
Dunn: The strategic approach is probably the easiest and most common one, because it permits buyers to stay within their core focus and product areas. Historically that approach has been very strong, and will continue to be so.
The diversification strategy is interesting. Many large medical device companies have reduced their R&D budgets so that they are not conducting development activities internally at the same rate as they did in the past. As a result, in order to come up with new ideas in new areas, those companies need to do acquisitions.
It's important to note that public companies have to be very careful how they articulate their diversification strategy to Wall Street and others in the investment community. Otherwise, the company's share price can really take a hit. Over the past few years, a couple of companies have tried to implement diversification strategies and perhaps didn't communicate them well. As a result, the companies' moves weren't well received by investors.
In some companies almost all growth seems to come out of that complementary acquisition area.
McGlynn: Large medtech companies share a huge problem, which is that their growth rates have slowed down. As a result, their stock prices look pretty moribund. For some of these large device companies, diversification is probably the only way to reignite sales growth.
But most of the mid-tier companies pursue a much more focused acquisition strategy. Most of the acquiring companies that we see are interested in strategic purchases of small start-up companies. They're not usually looking for diversification.
Are some device sectors better candidates than others for that kind of diversification deal? For instance, do large companies actively look for diversification in certain sectors that they think might become hot? You've all mentioned spine products as a hot area, for example, but none of you have mentioned neurotechnology.
McGlynn: The neurotechnology market is really interesting and potentially very valuable. There may be some good stories related to neurological monitoring devices. But for other types of neurodevices, it's still a very small market in many ways.
I'm sure that the neurotechnology area has huge potential, but so far it just hasn't exploded. On the device side, I just don't think we've figured out how to crack that market yet.
So that's not a sector that's ripe for the complementary diversification strategy yet.
Cohen: We have to be careful how we're defining diversification. I think a lot of the diversification acquisitions among medical device companies are really just moves into neighboring or complementary areas in which the companies already feel comfortable.
There are a couple more elements to be considered, and those are geography and emerging markets. Weighting geography in an acquisition may influence how a company can manage its supply chain and whether it will be practical to manufacture products in low-wage countries. And they may also determine the feasibility of moving into new regional markets, perhaps using an acquisition as a platform for opening up emerging markets to new products.
How will the market for medtech M&A deals change over the coming year? How will market conditions affect the number or types of deals ready to be consummated?
Cohen: In the middle market, the M&A landscape is going to be as active as ever. With certain exceptions, that market is relatively immune from broader economic conditions.
I think we'll be seeing fewer mega-billion-dollar deals in the near term than we have in recent years. That will in part be due to the current state of the credit markets. But also, as a company becomes larger, it may be less likely to find a fit with an even larger acquirer. So private equity firms, such as Kohlberg Kravis Roberts & Co. and Blackstone Group, come in to ramp up those larger companies even further.
Dunn: As we look forward 12 months from now, we'll probably see a slight drop in the number of deals over the previous year. But that's not necessarily surprising, as the medtech market's been going at a pretty torrid pace lately. There's still going to be a steady number of deals done. The deal values will decrease, but there will be consistent activity in the lower-middle market, with fewer megadeals on the horizon.