Canada has cutting-edge healthcare. However, under-investment has left its full potential unrealized. The S&P/TSX Composite lists only three healthcare companies:
- Valeant Pharmaceuticals International, Inc.
- Extendicare Inc.
- Catamaran Corporation
By contrast, healthcare makes up 13% of the S&P 500, with 48 names. Scott Kaplanis, partner and portfolio manager at Epic Capital Management in Toronto, says Canada excels at providing grants for healthcare start-ups, but “what we aren’t so good at is the venture capital funding that has been so critical to the success the U.S. has had.”
That’s partly because tax credits for labour-sponsored funds (also known as retail venture capital) have been phased out. “By some estimates, those funds were upwards of 40% of Canada’s venture capital market. So, as they’ve faded away, less and less money’s going into funds that back early-stage companies.”
Kaplanis adds that Bay Street expertise in healthcare and biotech has fallen off: in 2005, there were 25 ranked sell-side analysts; today there are fewer than five. “So, we have some of the best physicians in the world doing interesting things, but since they aren’t funded properly they can’t get to the commercialization stage.”
That presents an opportunity for private equity investors to fund a sector that’s brimming with talent and on track for explosive demand.
Demographic trends suggest the healthcare sector will see long-term outperformance.
Baby boomers are getting old, they’ll live longer than their parents and there are lots of them. The average life expectancy in North America is 30 years longer than it was in 1900. Those in the 85+ group will likely triple by 2040, according to U.S. government data.
That means public and private healthcare spending will increase. “And this is an extremely powerful secular tailwind for the sector,” says David Fawcett, founding partner at Epic Capital Management. Some of the things this spending will target include:
- prescription drugs;
- long-term care facilities;
- outpatient care and nursing;
- electronic medical records;
- chronic condition reporting and monitoring;
- medical devices;
- hospital workflow software;
- solutions for eliminating preventable medical errors; and
- surgical robotics.
With hundreds of companies to choose from, how do you identify winners? The first step is assessing a company’s value proposition from a purely medical point of view: Does it have an innovative idea the medical market needs? To make such assessments, Fawcett and Kaplanis rely on their advisory board. They also rely on Dr. Gordon Cheung, a former clinical director of MRI at Sunnybrook Health Sciences Centre in Toronto, who also has extensive experience as an entrepreneur in the medical space.
After reducing the possibilities to about 60 for each tranche, Fawcett and Kaplanis assess their business models. Some are eliminated; others have deficiencies that can be remedied; and others are fine as they are.
“Some of the companies really won’t need our guidance after we invest; they have mature management teams that are executing well,” notes Fawcett. “At the other end of the spectrum are companies where we believe in the idea but they could use our help, whether that means us getting a seat on the board of directors or Gordon Cheung leveraging his medical network. Or we can offer our capital markets expertise for structuring deals.”
Since their fund’s inception in 2014, they’ve done detailed due diligence on about 20 companies and have invested in five. They focus on medical technology (medtech) firms in part because their growth trajectories fit the fund’s five-year term.
“Biotech companies can take 10 years to bear fruit, so they’re not a good match,” says Fawcett. And, they’re likely to either flop or soar, but it’s impossible to know which: “Even the top scientists involved don’t know if their trials are going to work out.”
Medtech is more predictable, and still offers potential for outsized returns. (See “Medtech firms with promise,” below) The managers may also invest in public mid-caps with prospects for exceptional gains.
The fund spends the first two years deploying clients’ capital, which won’t be accessible until the term’s up. The principals also have a combined 20% stake.
Finding the exit
The fund seeks 100% to 250% returns over five years. Fawcett and Kaplanis get liquidity in three main ways:
› Strategic sale
» The fund’s stake is sold off with the rest of the company in year four or five of the term. But if the company’s slated for sale after the term ends, Epic usually can’t force an earlier sale. So, the offering document permits a couple years’ leeway.
» In some cases, a company performs exceptionally in a short time, and gets sold two or three years before the fund’s term ends. When that happens, Fawcett and Kaplanis will redeploy the proceeds into another opportunity.
» When a company goes public, the fund’s shares get sold.
› Grey market trade
» Say Fawcett and Kaplanis buy the stock for $1, and when the fund’s term is up, there’s grey market demand at $5. But there’s no guarantee a grey market buyer will be waiting when they want to sell.
Early-stage medtech companies have more upside potential than established names, but they carry greater risk. “If someone comes up with a better mousetrap than the one you just invested in,” says Kaplanis, “you’re in trouble.”
Diversification and weighting adjustments reduce risk. “We give more weight to companies we have more confidence in and that have more revenue potential. So, the company with $25 million in revenue and $4 million in EBITDA will get more weight than a company with a revenue base that hasn’t quite taken off yet.” The former may get a 7% weighting and the latter only 1% to 2%. Epic charges a 2% management fee and a 20% performance fee. The performance fee is charged only after investors get 100% of their capital back.
Convertible debt structure
When investing in early-stage companies, a convertible debt structure can provide an additional layer of protection for clients’ capital, say David Fawcett and Scott Kaplanis of Epic Capital Management. If the company isn’t acquired or hasn’t IPOed by the end of the fund’s term, the conversion structure allows the fund to get its principal back, with interest “a 5% annual coupon,” notes Kaplanis.
The fund would also get what he calls bonus stock. “If we invested $100, we would get about $20 or $30 worth of stock.” But it may not be possible to liquidate it within the fund’s five-year term. Typically, the structure works with early-stage companies with revenue beyond the break-even point—they can afford the 5%. It wouldn’t work for, say, a company trying to get a new device through the regulatory process, as it’s likely not in a position to pay the coupon.
Medtech firms with promise
Example #1: Synaptive Medical
Synaptive is developing technologies supporting minimally invasive surgical procedures. Its main product line, BrightMatter, is focused on neurosurgery. The line includes 3D image guidance, planning tools, robotics and visualization.
“While the core focus at the moment is neurosurgery, we believe Synaptive’s product suite is applicable to many other surgical procedures. The company is planning expansion into other high-value areas where there is a large unmet need in surgical imaging, including spine, orthopedic, head and neck, and prostate cancer surgery,” an Epic brief says. Synaptive has a revenue target of $30 million to $50 million this year.
Example #2: Colibri Technologies
Colibri is a medical device company currently developing two catheters for minimally invasive surgical procedures. “[Its] technology came out of Sunnybrook Hospital in Toronto,” notes the Epic brief. “The company has an exclusive license for the core technology. In total, 50 international patent applications have been made, with five granted in the U.S.”
Clients should have at least $1 million in investable assets before considering private equity, says Mark Begg, director of wealth management at the Begg Cheng Wealth Management Group with Richardson GMP. In most cases, clients have $2 million, with 5% to 20% in private equity.
Ensure clients are educated on funds like Epic because the allocation is tied up for several years, he notes. And, because private equity is illiquid, “you only do it if you can expect outsized returns.” He looks for an average annual return of 20%.
One thing he likes about the Epic fund is that the companies it invests in aren’t generally start-ups. “Private clients don’t have the same longevity as a pension fund. So, I find it works better to have opportunities that are further along in their development and closer to the exit via a sale.” Begg says clients typically aren’t bothered when managers need to extend their funds’ terms to maximize returns. “My clients don’t need access to this money.”
His due diligence involves talking to Epic’s principals, people at hospitals, competitors and clients in the healthcare space. “[And] make sure managers have their own money invested.” He says Epic’s 20% stake is sufficient to align the interests of managers and investors.