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Episode notes
Health care services experts David Khtikian and Josh Sommerfeld join host Thomas Mucha to explore the industry's transformation, diving into consolidation, tech innovation, value-based care, and the benefit of their public/private collaboration.
1:30 – Evolution of health care services
3:30 – Next generation of digital health companies
6:45 – Public market: Leveraging private market insights
8:35 – Private market: Collaborating with public investors
11:20 – Top down macro and regulatory environments
16:20 – Health care in Trump 2.0
19:45 – Value-based care in private markets
23:15 – Impact of income inequality
Transcript
THOMAS MUCHA: Health care accounts for about a fifth of the US GDP, with spending increasing by about 4% a year. This wide-ranging sector includes biotech and pharmaceuticals, medical devices and equipment, and health care services. Now, like many industries, rapid innovation is happening in both these highly dynamic public and private markets. It's easy to understand why investment research in health care requires then collaboration, as well as a deep understanding of science, industry, technology, consumer trends, regulation, and of course, geopolitics and policy. We can never forget that here on WellSaid. So here to talk about this exciting field and the collaboration required to navigate it are Dave Khtikian, Global Industry Analyst, portfolio manager and a member of our health care team, and Josh Sommerfeld Deal Lead for health care on our late stage growth private equity team. Welcome to you both. And thanks for being here.
DAVID KHTIKIAN: Thank you.
JOSH SOMMERFELD: Thanks for having us.
THOMAS MUCHA: All right. Let's get some definitions out of the way, guys. David, to your mind, what constitutes health care services today and how does it differ from, let's say, a generation ago?
DAVID KHTIKIAN: Sure. I try to think about health care services as simplistically any company in the health care ecosystem doesn't sell a product. It's companies like insurance companies, health systems, hospitals, post-acute providers. And then the other side of the house is really companies that service or act as a kind of intermediary within the pharmaceutical supply chain. So anywhere from drug distribution to retail pharmacy companies that are actually selling these drugs to the members. And then we also have contract research organizations, these are companies that are providing outsourced, R&D work for the large biopharma companies. And then the last component within health care services is the health care IT industry. Health care IT companies do sell products, but they're more kind of software and service providers, and some of them are kind of niche within the various verticals that I think about. But servicing across the health care services ecosystem.
THOMAS MUCHA: How has this industry evolved over the past years?
DAVID KHTIKIAN: It's evolved a lot. Probably the biggest themes we've had over the last ten years has been consolidation within the industry. I think about it coming from the top, really everything in health care services starts with the managed care industry. They’re the kind of payers they control, the dollar, if you will, within the system. And that can be anywhere from kind of commercial, traditional, health insurance to the government side, which is either the Medicare Advantage side or Medicaid. There's been a substantial consolidation in that industry. We've had payers consolidating amongst themselves. And then we've also had more vertical integration. So payers consolidating other business lines, whether it be PBMs or pharmacy benefit managers or more traditional service providers, to create kind of a more vertically integrated system within health care. Some industries have actually effectively been swallowed up. The PBM industry is probably the most unique industry in that we used to have a really kind of independent cohort of companies servicing the pharmaceutical supply chain. Those are now all under the payer infrastructure across three of the larger payers.
THOMAS MUCHA: So a lot of consolidation in the industry, a lot of rapid change. Josh, from your perspective, how is the private market changing and what does that mean for the future of health care?
JOSH SOMMERFELD: So I'll start by just focusing on the types of companies that I tend to be more interested in as a growth oriented private market investor. These are often called digital health companies or technology enabled services companies. In the early days of digital health a lot of these companies were focused on preventative medicine. And that makes sense because historically, two of the bigger challenges in health care have been access and affordability. And the idea was these digital solutions would be able to leverage the scalability of software to make health care cheaper and also more accessible.
The challenge that we saw a lot of companies run into was the ROI of prevention is not always immediate, and health care costs in this country have been climbing rapidly and people are looking for faster proof of value. So apps that might help you improve your diet or exercise or lose weight to prevent heart disease or prevent diabetes takes years for that ROI to show up. And the payers that Dave was alluding to got impatient. And so increasingly, what we've seen is companies focus on more acute needs, so that the intervention is immediate, and then there's a corresponding ROI that might show up within a few months or even a year.
Some of the areas we're seeing, that are top of mind, are categories like MSK or musculoskeletal health, preventing an injury or, helping someone recover from that injury more quickly, or women's health, particularly infertility and family planning and mental health.
That’s one thing we've seen. I think the other shift is the shift from point solutions to platforms. So ten years ago, a lot of companies started as direct to consumer businesses with a very niche problem that they were looking to solve. And I think where they ran into some difficulty was consumers, at least in the United States, aren’t accustomed to paying for their health care and they're used to their employer or their health plan paying for it. And so a lot of these businesses shifted to what we call a B to B to C model, a business to business to consumer model, where they would then go and sell to an employer or a health plan, who would then go and market that benefit to their employees or their health plan members.
And over the last decade, there's been a explosion of companies that have figured out that this is a more efficient go to market strategy, and they're constantly bombarding HR managers and benefits folks at health plans, and it's just too much.
I would expect most people listening to this probably have the ability to get telemedicine appointments from two, three, maybe four different vendors and I would expect in the coming years for there to be more consolidation. Some of these point vendors being rolled up into platform plays, and I would also expect to see some of the bigger, more successful vendors increasing their R&D budgets to start developing adjacent offerings to expand their product suite.
THOMAS MUCHA: So you've both just mentioned consolidation as an important trend, but you've also keyed in on technology. And I'm wondering, you know, with the rapid innovation in science and technology becoming endemic, why is the collaboration between the private and public perspectives here, so value to you both as investors? And David, let's start with you.
DAVID KHTIKIAN: I like to say is in health care, the more things change, the more they stay the same, right? You have what you would expect to be this massively advanced thinking industry. But really there is so much friction in the system that creates a really slow dynamic as it relates to kind of evolution in the implementation of technology to advance the system.
So our collaboration is really extremely helpful for me. And I, you know, hope extremely helpful for him as it relates to sort of what are the things that are going to truly, potentially disrupt the industry, an industry that it's very difficult to disrupt. Right. You've had massive consolidation. You have balance of power imbalance as it relates to who controls what, and kind of thinking about what are the innovations, what are the things that can really move the needle versus just create kind of noise in the system. Right. And so having these conversations and talking about companies that are trying to do things in certain industries that we either think there is some level of, need for innovation or probably more likely, some inefficiency that could be solved or exploited. That's really how I think about the collaboration we have.
And then, you know, as we get closer to kind of making decisions and looking at companies really trying to figure out, like, are these companies going to be long term independent companies or are they going to be part of a larger enterprise? Right. And typically, the latter is the outcome in health care services. So and then trying to think kind of dynamically between the two of us, like who are the likely suitors for this company? Where would they best fit within kind of a strategic, acquisition? But when I think about collaboration, it really kind of starts and ends with the discussion around disruption sort of what's real and viable.
THOMAS MUCHA: Josh, same question, but the different perspective. How do you think about working with your colleagues on the public side? And, maybe you can give us a recent example of a collaboration that tells this story here.
JOSH SOMMERFELD: Sure. In order for me to do my job well, for our clients, there's really four activities that I have to nail. One is sourcing, getting us in the right potential investments. Two is diligence, asking the right questions. Three is pricing the deals correctly. So we get it in a price where we can generate an attractive return. And the last one is exiting those investments. And really across all four of those things, I think we've collaborated, and the strength of our partnership allows me to be better at my job, for our clients.
A recent example, I'll give two, you know, one on the diligence side, there was a company in the employer benefits space and there was a very narrow valuation range where the company was willing to transact with us. And so I went to Dave and another one of our public market colleagues, Jason. And, you know, we spent time together unpacking the financial model, looking at the valuation comps, thinking about where might this company trade if it were to go public in the near future. And essentially what we realized is there was not a universe where the valuation range that the company put forward to us was one where we thought we could generate an attractive return, and we were able to very efficiently make a decision to pass on doing more work.
I think one area we've been collaborating more is working with companies to help them think about what the public market exit might look like. And there was a call that Dave and I took with a company just last week, actually, where they were looking for our feedback around when should they think about testing the waters, and what are some of the key milestones they should need to achieve before that process is likely to result in a good IPO? And in particular, one of the questions they wanted some help thinking through was how to balance investing in growth and growing more quickly versus getting to cash flow breakeven and getting profitable faster. What would the public markets reward, and how should they make their own capital allocation decisions to maximize their value on exit? We had a really fruitful conversation with that company. And I think to their surprise, actually, where we landed was an IPO in the near term might not be the best answer for you. And instead of focusing your time preparing for an IPO, that might be difficult. You should actually spend more of your time thinking about whether or not you could create more value for your shareholders through an M&A exit. Maybe you should hire a banker and explore that. So I think kind of push the company in a very orthogonal direction to where they were thinking when they approached us.
THOMAS MUCHA: All right, David, I'm going to pull the lens out a little bit. And talk about company fundamentals, obviously, they matter for every active investor. But this industry in particular, I think is heavily influenced by top down macro conditions, the regulatory environment. How do the various dynamics from this top down perspective influence security selection on the public side?
DAVID KHTIKIAN Yeah. It's an important question that, you know, I think it's become a lot more important in recent weeks, frankly.
THOMAS MUCHA: And you're talking about the election, obviously.
DAVID KHTIKIAN: Yes. Of course. The political and regulatory landscape is sort of top of mind in front center in all of health care services. And why is that? It's effectively a regulated industry. Right. So companies for the most part, rarely don't have some touch points where the government is involved in the decision making. And that decision making can be the rules, the regulations or even directly to the pricing. So when it comes to sort of securities selection, you know, there's always going to be a combination of top down and bottoms up. But really they're kind of one in the same. Because the government component of it is just always there.
Historically in health care services, there have been very, opportunistic times to buy securities when the market overreacts to something that has happened from either a regulatory standpoint or, a political standpoint. And why is that? There's a broad level of kind of misunderstanding of what DC can and can't do. And so typically headline risk is really high in this industry. Right. So it brings a lot of sentiment risk into it which compresses the multiple.
So you have two things in a stock. You've got the fundamentals. What are the numbers look like and what is the market willing to pay. And there's always been periods of time where something's going on in the industry where the political landscape or the regulatory landscape is either perceived to be changing or is changing. And typically that creates an overreaction in the stock price. And so as analysts, our job is to really kind of wade through the noise, understand, like what has happened in this kind of comes back to my the more things change, the more they stay the same. Like everything moves at a glacial pace, so when the headline comes out is this is going to be the worst thing to happen in the history of health care? Typically, the end result is something much, much smaller, right? And so when you have these dislocations in pricing, that's really where kind of you can get sort of geared in the fundamentals. And then look at how the sentiment has impacted the security valuation. And that's typically where you have your larger opportunities to make investments.
THOMAS MUCHA: I want to get into the specifics of a Trump 2.0 and what that means for your way of thinking about this. But before I do, Josh, what of that that you just heard resonates with your process? And here I'm thinking about risk, investment horizon valuations, the rates and funding environment. How are you taking this top down approach and applying it on the private side?
JOSH SOMMERFELD: Yeah, well, for one, there's so many additional considerations you have to think about in a regulated industry like health care as an investor. And one of the reasons I feel really grateful to be a Wellington is just having all the support and resources folks like Dave around me to intelligently assess all those decisions. And I think the stakes sometimes are even higher on the private side, because when we make an investment, it's fundamentally illiquid, we're kind of marrying these companies.
On the public side, you have the benefit of, you know, maybe you start a position, you kind of see how regulation change will play out. And if it doesn't go your way, you can kind of always unwind that trade. We don't have that luxury. We make an investment. And if things don't go well, if anything, the company just keeps coming back asking for more money while they try to figure their business out. And so the risk is your losses can grow.
And, so I think the things as a private market investor, I really look for Dave's help with are understanding the pace of change and what we might expect. And then understanding the magnitude of some of these changes and how it might impact these private companies.
And I think just categorically the one thing we're most careful about here on our private side is in making an investment where there's a potential binary risk that we didn't see. I think about, just maybe pick on one area that's very timely. We've been seeing a number of companies that are doing GLP1 compounding. Some of them are public, but some of them are private. And these private companies are growing at unprecedented rates like we've just never seen companies grow this fast, get profitable this fast. You know but there are some questions around the regulations of compounding and whether or not these drugs will remain on shortage lists and whatnot, and for how long. And, you know, it's kind of a stroke of a pen decision that a regulatory body or a drug maker can make to remove those from the shortage list, or to no longer allow compounding of those drugs specifically for whatever reason, you know, and that would be just a cataclysmic event for those companies. And so, that might be an area that we would certainly want to think really long and hard about those risks, that binary nature of that risk before we would proceed with a illiquid private investment.
THOMAS MUCHA: Or just ask Dave.
JOSH SOMMERFELD: Yeah, right.
THOMAS MUCHA: All right, Dave, you mentioned the election. Let's dig into that a little bit. I think it's the point you just made about headline risk is really important from an investment perspective. So how are you thinking about the actual variables that will matter to the sector in a Trump 2.0? I mean, how are you decoding the signal from the noise here?
DAVID KHTIKIAN: Well, it's early and there's a lot of noise and potentially a lot less signaling right now. I think if you step back to versus the prior elections, what's been interesting is, health care wasn't really that hot button topic. The health care system from like a coverage standpoint isn't really a question mark. You know, people have insurance coverage. And, when we think about, you know, the economy and tariffs and some of the global issues that the that the country is facing, health care seems to be kind…
THOMAS MUCHA: Further down the list.
DAVID KHTIKIAN: Further down the list. Right. So from that perspective, I'm not thinking about major structural change risk. Right. There have been prior elections with certain candidates where the question was, are we going to upend the entire US health care system and change the way we either finance it, pay for it, access it, etc.? That's not really kind of a baseline expectation of mine, and I don't think that's really a risk that needs to be kind of incorporated into the mosaic, if you will.
The flip side is Trump 2.0 does seem to be very focused on some pretty substantial changes that he wants to get done. Those changes require funding. You touched on one fifth of GDP, where are the dollars? Health care is a big bucket to go after. Right? So when we're talking about paying for trillions of dollars in savings, it's pretty hard to look down the list of potential savings and not see health care as an opportunity for Trump and his administration to go after. And so we're sort of trying to bucket out what areas are they going to go quote after and where they're not. Right.
And then the second question becomes, let's follow like a logic path is if they do quote, go after this, how much of it is headline risk versus what we talked about before, which is what can you actually get done with control and what do you want to get done? And that's where like the, the questions and answers get really complicated. And you're sort of playing this sort of like downstream binodal decision tree exercise, which, I don't know if it's even particularly helpful in the short term because the market's going to sort of probably go to the most extreme case and work its way back. And that's kind of where we are. And then the other big piece we're thinking about is who's going to be in what seats. Right. And I think you were probably just going to ask on RFK Jr.
THOMAS MUCHA: I was.
DAVID KHTIKIAN: Okay, there you go.
THOMAS MUCHA: Did I have a look in my eye?
DAVID KHTIKIAN: Yeah. I mean, it's interesting. I would say one of the most consistent answers and feedbacks we got from the election from DC consultants and everything was he's not going to appoint RFK Jr. And that was like the one thing we felt we had gotten comfortable with. And then of course, that's what happened. It's still very early. I think. First of all, the question is, will he get in? Right. And I think there's probably some potential he doesn't. What is he saying. What does he want to do and what can he do. Right. And so those are kind of three iterations. And we're kind of thinking through that. I don't know if we're going to have a lot of clarity, frankly, in the next couple of months. I think we kind of need to let things settle out and figure out, you know, who is really going to be in what seats. And then from there, it really comes down to how are you going to probability weight, the various risks and outcomes of the different, you know, potential scenarios which we don't even know if they will come.
THOMAS MUCHA: You shouldn't feel alone. I feel the same way about national security positions. The questions surrounding the geopolitical environment, the foreign policy environment got the same questions about trade, about all sorts of things. And so I think this is the new reality from an investment perspective is dealing with more policy volatility. And I agree, I think we'll have to wait and get through the transition before we can have some degree of certainty about the direction here.
So Josh, a major paradigm shift here is this trend towards value based care. So could you explain what that means. And then what you're seeing in private markets, as companies leverage technology to develop this value first proposition.
JOSH SOMMERFELD: Yeah, sure. I mean I think the way the health care system in the United States is fundamentally architected is physicians, hospitals get paid to take care of sick people. And the challenge is there's a lot of things that doctors could be doing to prevent people from getting sick, but they don't get paid to do them. And, you know, we like to think of doctors as people with patient interests in mind, but at the same time, they're also working for or running their own businesses. And they need to, you know, put food on the table. And so I think the real value based care hypothesis is essentially, is there a way where we can create an incentive structure for doctors or providers to do things that keep people from getting sick in the first place? And essentially make them whole for not having to provide that downstream sick care later?
There are a lot of different government programs doing this, but one of the more popular ones is called capitation, or essentially a group will go to a health plan and say, you have some members, I can take care of them for you. Maybe the health plan gets paid $1,000 per month to take care of those members, and they'll say, hey, I'll give you $800 of that to take care of them. And if you can do it better than we can, we'll share some of that additional upside you can create, by doing activities that we as a health plan wouldn't do. And then they go and work with providers and other organizations in the community to do activities that otherwise maybe wouldn't have gotten done to keep that population healthier.
We've kind of seen an evolution of these value-based care models. I think earlier on, some of the businesses doing this had a little bit of an all comers approach. They would just get lives handed off to them by a payer, or they would go and recruit those lives in the community somehow. There's a variety of ways to do that. And it's proven challenging. A lot of those companies had very promising early cohorts where they were showing improvements in cost savings and improvements in care quality, but it didn't extend everywhere. It didn't work in certain markets. It didn't work for certain populations. People with certain diseases. And what we're seeing now is businesses that are more focused on more differentiated models for specific populations. Patients with kidney disease. Can we better take care of and slow the progression of kidney disease? And when people do go on dialysis, can we do that in a more orderly fashion? That is better for the patient, better for the health care system? So I think where we are more interested at the moment is models that are more clinically differentiated, more specific to one type of population and therefore, you know, more likely to work across the country as opposed to in a specific market.
THOMAS MUCHA: Dave, on this point of increasing uncertainty, right? This is the area that I spent a lot of time thinking about. But how do you think about increasing geopolitical tension, higher economic uncertainty, widening wider income inequality, these other socioeconomic challenges that really came to the fore, particularly during the election. You know, what does that cast over the global health care sector from a long-term perspective?
DAVID KHTIKIAN: Yeah, I'd say the of the topics you mentioned this concept of widening income inequality is, I think, probably the most important when it comes to health care. And we talked about it earlier, we don't expect any major changes to the health care system because things are for the most part running okay. But the income disparities in the United States, have certainly created increased issues as it relates to health care access. Right. And health care access is kind of the most important component of seeing the sort of health outcomes broadly. And it gets back to this topic that Josh was talking about the sort of crux of value based care, if you will, is just kind of a realignment of the players in the industry. Right? There's massive misalignment and, a misalignment in the industry the output of that is just a widening disparity in access. And why is that? Lower income people are typically covered by Medicaid or don't have health insurance at all. So if I'm running a business and I have to choose between two patients, you would hope that you would choose the sicker patient that's in more need. But simplistically, one person can pay and one person can't.
Right. There's a misalignment that just exist. Right. So it's become a very large topic. Most of the large managed care players are heavily focused on the Medicaid industry, because it's a very substantial component of total federal spending from a health care dollars perspective. And there's been a real sea change, I think, in the way these companies are thinking about these patients, both on the payer side. But also on the health system side. The federal government has brought more dollars into the Medicaid market to I think support this industry that's really coming at it from the hospital side. So providing the hospitals and the physicians and some of the providers more dollars to support this patient population, effectively leveling the playing field as it relates to kind of you don't want to put a profitability on a person, but that's simplistically how you can think about it.
But it's a really big problem. And if you look at, you know, Josh mentioned GLP1s, and if you look at just obesity rates in the United States and bifurcate it by income level, it's heavily skewed to low income. Why? Because low income people can't afford healthier food. And so there's the natural kind of like breakdown in health equality when you get to this sort of different levels of economic reality.
So I think the government is highly focused on it, which ironically brings us full circle back to like what can and can't thought can't get done. Where's the biggest dollar pocket that the federal government is supporting? The Medicaid population. So is Donald Trump going to use Medicaid as a funding mechanism for some of the offsets he's hoping to achieve? It's the logical dollar point. But if I'm a state governor or senator, okay, you're going after the most vulnerable population in my state, right? That's a really difficult decision to make.
THOMAS MUCHA: This inequality issue in particular is one of the biggest things that I pay attention to, even from a foreign policy perspective. Right, because it's fueling even more political dysfunction, not only in the United States but globally. And then that spills into foreign relations and the geopolitical environment, too. So I think, you know, you're getting, governments and policymakers globally trying to get their hands around inequality. What does it mean? But I don't see a short term fix for this. And I think that's going to mean more policy volatility. And again you know we've touched upon this. But I think that's a key message that we're hearing today.
Obviously a lot to follow here as the ball continues to bounce across health care and across the policy environment. Gentlemen, thanks for joining us and helping to make sense of all this once again: David Khtikian, global industry analyst, portfolio manager and a member of our health care team. And Josh Sommerfeld, deal lead for health care on our late stage growth private equity team. Thanks both for joining us and WellSaid.
DAVID KHTIKIAN: Thank you.
JOSH SOMMERFELD: Thank you, Thomas.
Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced December 2024.
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