The Pandemic Created a Health Care Crisis. Can Investors Cure It?

The pandemic laid bare gaping holes in the reach and quality of health care services, research, and technology. Even though health care has long been fertile ground for investors, Covid-19 has created even more urgency. Allocators, hedge funds, private equity, and traditional managers are now hiring and investing in new resources to uncover a range of opportunities in the sector. 

This week alone, UBS O’Connor, the multi-strategy hedge fund manager that is part of UBS Asset Management, and Goldman Sachs Asset Management made big moves. O'Connor expanded its healthcare-focused investment team with the hiring of three medical doctors: Jason Bonodio is joining as a portfolio manager, while Robert Sweeney and Adam Sandler are signing on as research analysts.

GSAM has formed a new healthcare advisory council, a group of internal staffers and other resources that will provide expertise and insights for the firm’s private investing strategies. 

Over the past few years, GSAM and other private markets investors have gotten in on health care in a big way. In fact, last year, private equity deal activity in healthcare services reached a total value of $77.5 billion, topping previous records, according to PitchBook’s 2021 annual U.S. PE breakdown report.

David Solomon, the co-founder and managing partner of Hildred Capital Management, a healthcare-focused private equity firm, said the vaccines, the most visible innovations of the pandemic, weren’t the only driver of PE interest in the sector. Solomon stressed that the pandemic exposed unmet patient needs and structural inefficiencies in the U.S. healthcare system, which in turn, created opportunities for businesses. 

“Across the spectrum, you’re seeing real opportunities for interesting businesses that are able to improve the quality of care and the cost effectiveness of care,” Solomon told Institutional Investor. “And that creates a lot of really interesting investment opportunities.” 

In the near future, Kevin Russell, chief investment officer of UBS O’Connor, expects M&A activity to be a catalyst for strong investment returns. In fact, O’Connor estimates there’s approximately $1 trillion of M&A capacity in the healthcare market.

Russell said large pharmaceutical and healthcare companies have a “tremendous” amount of cash on their balance sheet. As fundamental research and data about smaller healthcare firms become more robust, he said these larger companies will look to acquire them. 

The decision to expand the firm’s healthcare team was driven by changes the manager observed in the sector in recent years. For example, the sector experienced “high correlation sell off” in the second half of 2021, meaning stocks moved in the same direction and at the same speed. Russell said this indicated that investors weren’t doing enough fundamental analysis and assessment of the prospects for individual portfolio companies. A high-correlation sell-off is the opposite of dispersion — when some stocks go up and some go down in a specific sector. In the healthcare sector, there is little dispersion. But hedge funds, especially those making relative value trades, want dispersion.

“Intra-sector dispersion is the fundamental thing that hedge fund investors like ourselves look for,” Russell told II. 

Dispersion reflects that some companies are better than others. 

“In biotech, that’s especially true,” Russell said. “Not every company has the same probability of their drug getting approved or their drug experiencing great sales. So when we see high correlation, that’s an indication that people are not spending enough time analyzing the fundamentals of individual companies and products.” 

UBS O’Connor saw this gap in fundamental analysis and expanded its team in response. Russell said he and his team think the healthcare sector is “almost definitionally subject to higher dispersion” compared to most other sectors, because some drugs work and others don’t. 

O’Connor’s three new doctors, Bonadio, Sweeney, and Sandler, will evaluate the prospects of different drugs and medical devices, analyze preliminary results of drug trials, and help the firm assess the companies that are likely to achieve approval from the U.S. Food and Drug Administration. 

“We very consciously went and found the highest scientific experience and intellectual capital that we could find, because that’s what we think is in the shortest supply in the market,” Russell said. 

The shortage of fundamental analysts in health care is intricately tied to the number of companies in the early stages or with promising but yet-to-be proved products, Russell said.

“A company that doesn’t have revenue yet and has some uncertainty about whether it’s ever going to have revenue is a very difficult investment proposition for many investors, particularly if they don’t have the scientific expertise to opine on that,” Russell said. 

Russell expects the opportunity in the sector to continue for several years, but he also anticipates “troubled flows” for health care investors who don’t focus on fundamental research. 

That’s because the healthcare sector has an “over-saturation problem,” Russell said: There are too many companies that are too early in their life cycle relative to the amount of people who can effectively analyze and conduct due diligence on these companies from a scientific perspective. In short, investment firms don’t have the capabilities or focus to hire analysts and portfolio managers who can provide the specific insights needed to succeed in healthcare investments. And, for those that do, there’s not a lot of capital backing them, Russell said.

“I just don’t think there’s going to be a flood of capital raised to offset that any time soon,” Russell said. “I don’t think there’s going to be a rush of people looking to come in and develop relative value strategies in the healthcare therapeutic space. Some will capitalize on it, but it’s going to still be outsized.”