Originally published in Business Insider

By Joanne Baginski

These are strange days for the healthcare industry.

In Washington, Congress continues to debate a major overhaul of the Affordable Care Act (ACA), President Trump is pushing large cuts to Medicaid funding, and many states are still waiting to see what becomes of their insurance exchanges due to rising premiums and waning insurer interest.

Amid all of this uncertainty, conventional wisdom suggests that the industry would pull back and take a wait-and-see approach to mergers and acquisitions (M&A) until the future becomes clearer.

But, in fact, the opposite is true. Not only does healthcare M&A activity remain high, but deals are also continuing to go through at valuations that seem completely unaffected by all of the regulatory uncertainty surrounding the industry.

On the face of it, this seems counterintuitive.

Given the changes the administration is considering for Medicaid and the ACA, reimbursement risk is a real possibility that could drastically reduce revenues industrywide. For M&A, this should mean lower valuations and reduced activity as buyers and sellers try to determine what their profits will look like during the coming years.

But these risks don’t change the fact that healthcare is a growth industry that is effectively recession proof. The population is aging, new treatments are emerging, and the industry is expanding to keep pace with this demand.

Even in the face of potential reimbursement rate risk, healthcare is simply too profitable to sit idly by amid the uncertainty coming out of Washington.

A new approach

So, while the pricing and valuations around healthcare M&A remain very strong, deal structures are changing to ensure that risk is borne by both the seller and the buyer.

For example, in the event of a reimbursement cut — and the administration’s plan could cut as much as $1.4 trillion from the federal Medicaid budget — a deal could be structured in such a way that both buyers and sellers share in the downside risk.

Consider a healthcare company with $5 million in net income that’s priced at $25 million, or five times earnings, in a sale. If reimbursements get cut in half, that $5 million of annual cash flow could potentially decrease by 50% as well. Overnight, the buyer has paid $25 million for a $2.5 million cash flow company, or 10 times earnings, which is an exorbitant multiple to pay for a company.

If both buyer and seller split that risk, say by tying 50% of the purchase price to future operations, the multiple would stay at a reasonable level, and the deal could still proceed.

In M&A, this type of arrangement is called an earn-out. A buyer pays a portion of the final price upfront for the transaction and then pays the rest over time on a set schedule.

In the case of that $25 million company, the buyer might have in the past paid $20 million upfront and the remaining $5 million over the subsequent three years as an earn-out. Today it would instead pay $12.5 million up front and spread the remaining $12.5 million out as long as cash flows for the acquired company stay consistent during the earn-out period.

This balances the economics of the deal so both parties can move forward.

Widespread activity

And that is good news because the opportunities in healthcare M&A remain significant.

The word “consolidation” is overused, but that is exactly what we’re seeing in the space today. More and more providers — from hospitals, to specialty groups, to private practitioners — are looking for ways to reach as many different communities as possible, particularly those that have high reimbursement rates, and they’re using M&A to do that.

This is investment for strategic reasons. Whether it’s because there is a service that is not currently being provided to a given community or just as a way to keep that market away from a potential competitor, expansion is the rule in today’s healthcare market.

You can see it all over the country in the urgent care clinics and emergency rooms that are popping up in strip malls and in the hospitals that are expanding from single-location towers to regional “systems,” all in an effort to reach the markets where they can get the most patients in the door at the best reimbursement rates.

That’s what I mean when I talk about healthcare as a recession-proof industry. The opportunities for growth are so large right now in so many different corners of the industry that there is very little that even regulatory risk can do to derail this M&A train. The risks are there, to be sure, but the industry has already priced them in.

And this will continue for the foreseeable future, no matter what happens in Washington.

Joanne Baginski leads the transaction advisory services practice at EKS&H.