The Triple Helix @ UChicago

Winter 2014

"The Influence of Financial Institutions on Healthcare Companies" by Matthew Yeung

 

 The involvement of different financial institutions in different sectors of businesses has been often criticized by the general public as a corrupting influence on the companies involved, due to the institutions perceived desire to make profits at all costs. So what influence would a financial institution have on healthcare, the sector believed to be the most altruistic and least profit-driven? One potential glance into the consequences of the involvement of financial institutions lies in Madison Dearborn Partners (MDP)’s $1.6 billion acquisition of a controlling stake in Ikaria, a firm known for providing hospital therapies focused on critical care. A close analysis of the private equity firm’s goals and their effect on Ikaria’s decisions as a healthcare firm would foreshadow how financial institutions may affect healthcare companies in the long run. 
     We have to first understand how private equity companies make profits. The process is as follows:

1) Private equity companies raise capital from partners
2) They select certain companies that are either undervalued, or have profit potential, and acquire them with the raised capital. 
3) Operational changes are made to the company over time in an attempt to make the company under acquisition more valuable
4) The private equity firm would then try to sell the portfolio company, either by selling it to another private buyer or by conducting an initial public offering (IPO) 
5) After returning the funds to the partners of the acquired company, the private equity firm earns a proportion of the funds as fees, which varies based on the growth and return of the company while under the firm’s acquisition.

The above process describes a buyout fund, which is the most well-known type of private equity firm strategy. In most cases, in order to achieve greater potential returns on their investments, the firms partake in leveraged buyouts, or LBOs, in which they use a high proportion of debt to buy the business. In the case of Ikaria, only 25% of the money used to purchase the company was from the partners and shareholders of Ikaria and MDP. 

So what would this all mean for the healthcare company Ikaria? A common practice for firms acquired through LBOs is that assets of the company, such as cash (and its equivalents), would be used in order to pay down some of the debt, which may leave the company without adequate capital in case of any unexpected expenses. The additional debt on the balance sheet will deteriorate Ikaria’s liquidity and solvency ratios, which would make the cost of debt on the markets more expensive should the firm seek more financing for operational activities. 

With MDP as a majority stakeholder in Ikaria, a shift in the company’s direction is probable and to be expected. An agreement was already made so that some non-commercial products currently developed by Ikaria would be separated to another company. The agreement implies that Ikaria believes that these products may not be able to generate enough income in order to justify their continued research and development expenses. This hand-off may not be in the best interest of the public as further stages in the development of these non-commercial products may render them beneficial for the public and the development itself would have likely benefited from Ikaria’s resources. 

On the other hand, as private equity firms are mainly interested in increasing the value of their portfolio companies, there will likely be more operational improvements while under the acquisition of a private equity firm than if the portfolio company remained a private company. Therefore, managerial improvements might be expected for Ikaria. An optimistic view is that the managerial improvements will speed up the development of therapeutic devices currently in the pipeline and benefit potential clients, provided that the development increases the value of the firm. Ikaria may also be able to expand, as the acquisition will provide some capital to the firm, which can be used to extend the reach of its services, thereby allowing Ikaria to help more people. 

However, a worrying aspect of the acquisition of Ikaria concerns the various techniques that private equity firms use in order to extract more value from the company. One recent controversial technique that private equity firms have used is called the supercharged IPO, wherein the portfolio firm and the private equity company make an agreement in an IPO.[1] The private equity company will then receive payments from the tax reductions claims due to Ikaria’s IPO[1]. This arrangement means Ikaria may be paying MDP for years after the IPO, depriving them of cash needed for further development of medical treatments once it is offered to the public.

The longer term implications of Ikaria under MDP’s management may be further complicated by the nature of the business, as Ikaria’s business model relies significantly on proprietary treatments and patents. Any current product will thus have a limited profit stream before the patent expires. Therefore, it is imperative that Ikaria continue to develop new patents in order to sustain its income stream for the long run. However, development of new patents may contradict MDP’s objective for extracting the highest possible equity value out of the firm, leaving Ikaria, in the worst case scenario, facing a profit “cliff”, where patents expire without being replaced by newer patents. 

So what might be the overall effect on Ikaria under MDP’s control? It is likely that while Ikaria would be able to expand its operations and subsequently benefit more people under MDP’s management, this expansion may come at a cost to Ikaria’s long-term operations as a business. It is likely that its existing shareholders would have to contest many of MDP’s operational decisions to ensure that the company is at its best going forward. 

References

[1] Beltran, Luisa. 2014, "Madison Dearborn, expected to fundraise, invests $244 mln in Ikaria."peHUB, Accessed March 1, 2014. http://www.pehub.com/2014/01/madison-dearborn-expected-to-fundraise-invests-244-mln-in-ikaria/ 
[2] Garza, Joe. Garza & Harris. 2012, "Supercharged IPOs Draw Attention." Garzaharris, Accessed March 1, 2014. http://garzaharris.com/supercharged-ipos-draw-attention/

 
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