When you hear the word drone, you might think of the military uses, the proposed Amazon.com delivery drones, or those jokers who shut down airports by flying drones around runways.
But drones are serious business, says Gretchen West of Hogan Lovells in Silicon Valley.
There are little-known commercial uses of drones that save time, money, and lives that will only expand in the near future… as long as government regulations can keep pace with development of new technology.
The industry is maturing quickly, as is M&A activity in this space. We talk about that, as well as…
Mentioned in This Episode: www.hoganlovells.com
Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters where I speak with the leading experts in merges and acquisitions. We’re all about one thing here. That’s a clean exit for owners, founders and their investors. Today, I’m joined by Gretchen West, senior director at the Law Firm Hogan Lovells in Silicon Valley. Years before the commercial drone industry was taking off, no pun intended, Gretchen was already at the forefront of the Unmanned Systems Industry advocating on behalf of the global community to reduce the barriers to enable operations and use. Now, Gretchen has been a key speaker and authority on all things drone for the past couple years and was recently featured at most current Silicon Valley M&A forum. Gretchen, welcome to M&A Masters and thanks for joining me today.
Gretchen West: Thanks for having me, Patrick.
Patrick Stroth: Now, the reason why I asked to come along today and talk to our audience is, when we think about drones, I want to go back and compare it to the evolution of the airline industry, which didn’t exist until 1914. That’s actually 11 years after the Wright brothers had their first flight ever. We compared it with the drone industry which didn’t really come to our public attention until 2001. That’s when we knew about military drones. It took more than 10 years later. The next time the public really heard about drones is when Jeff Bezos was featured on 60 Minutes talking about using drones for delivery. That was done in 2013. It just seems like yesterday. The reason why you were featured on the recent Silicon Valley forum and the purpose of our conversation is to highlight just how in the blue an industry we take for granted today just didn’t exist not very long ago and in a very short period of time became a wide part of everybody’s daily lives just like the airline industry.
If you’re an entrepreneur out there, how can you take advantage of a trend that you see it coming? Because there are a lot of opportunities out there for things that didn’t exist beforehand. We look at the drone situation here and that’s just our latest example of something from nothing. Before we get into talking about all things drone with Gretchen, Gretchen, why don’t you give our listeners a little bit of context and tell us how you got to this point of your career and with drones in particular?
Gretchen West: Sure. Well, I’ve been working in the drone and unmanned system space for about 15 years. Back when I first started, I was working for a non-profit, which my experience is in non-profit management, I worked for an association that focused on air, ground and maritime vehicles that were unmanned and so remotely piloted or autonomously piloted. Back then, it was really all military. Quite honestly, this technology dates back to the Vietnam war. Some would even say World War II. A lot of this technology was developed decades ago. It obviously evolved over the years into more sophisticated military equipment, but like you said, Jeff Bezos put us on the map from a commercial perspective but even a lot of the commercial applications were developing a few years before that. I really focused my work now.
You said that this is a newer industry. There’s lots of challenges. My work is really focused on helping enable this technology because I’ve seen a lot of the benefits, the commercial drone technology can bring to the public and to various industries. The work that I focused on is really reducing those barriers so that we can see more meaningful expansion of this industry because there’s mostly a lot more benefits to all these different various companies and industries.
Patrick Stroth: You mentioned barriers. I can imagine they’re the logical barriers of technology coming in, but there are other barriers out there. Why don’t you talk about those?
Gretchen West: Well, I think anyone that’s involved with technology understands that policy does not match the pace of technological development. It’s certainly the case where we’re talking about commercial drones. The FAA is the regulatory authority that manages our air space. This is a new entrance into our air space. Obviously, we’ve been flying on commercial aircraft for years and general aviation has been around for decades, but this is a new entrance. It is much smaller. In the future, they will be flown autonomously. For the FAA, to create rules around the brand new type of vehicle, it’s then very challenging. The rules that are on the books already really relate to commercial aviation. It doesn’t make sense to have the same rules for a commercial airline to be implied on a very small five-pound drone. Over the last 10 years, actually, longer than that, we’ve been trying to work with the government agencies to help them understand what this technology is.
Where we are today, we still have a lot of regulatory hurdles, but the FAA and the other government agencies have come a very long way in helping enable this technology, but there’s still a lot of challenges around public perception, there’s challenges around privacy. There’s just a lot of different challenges, but they are all things that we can achieve if we work together as an industry and these are all things that we’re working very hard to overcome. With any other technology in an industry, the policy making doesn’t match the speed of technology. We’re seeing that very, very clearly in the commercial drone space.
Patrick Stroth: I get a sense when we talk about some of the regulatory considerations and how it’s trying to keep pace. There are a lot of examples where, particularly with the FDA and other regulatory bodies that the regulators work very hard to slow down approval. That’s the opposite, at least, from what we read in periodicals when we’re talking about regulatory issues and autonomous cars. Do you get a sense, the FDA and the Feds are doing what they can to accelerate or facilitate? Are they working with the industry to try to come up with some good rules?
Gretchen West: They are and they have been for many years. I think, sometimes, the FAA gets a bad rep because they are moving slowly, but their whole mission is to protect the safety of the air space. No one wants to be flying on a commercial airplane and have an incursion with a commercial drone. I think we’ve all seen enough new stories about how drones have been flying around airports. That’s the number one priority of the FAA. I think we all agree that something we all have vested interest in. It’s not deliberately a slow process, but some of it is just the way rules are written in the government, that it takes time to go through an inner agency process with so many different agencies weighing in. That said, the FAA has said repeatedly, so has the Department of Transportation, that they are very interested in working with industry. They’ve made a lot of great stride. Their congress has passed, now, two re-authorization bills that has language around unmanned aircraft systems to enable broader commercial operations.
Now, it’s just a matter of getting the rules in place to really enable that. It takes time, but I think we all know that we’ve all seen some of the benefits of commercial drones as has the FAA. I think they all know enforcement is the very difficult challenge. Rules have to come at a place because people aren’t going to stop flying drones. They understand the value of them. The rules need to be in place. The FAA, I think, is moving as quickly as they can as an under-resourced agency, in my opinion.
Patrick Stroth: Well, it is peril, I would say, with the autonomous driving because I had never seen regulators more excited than the concept of getting drivers off the road and so forth and doing everything they can on that. It’s encouraging to see that government is actually working with that. When we look at the public perception of this and a lot of people have what limited views they’ve seen on using drones for taking pictures or if they’ve seen them on TV shows being used in brighter ways. There’s a perception out there. I would also think with commercial airlines, it took a lot of bravery in the early days for somebody to actually think to get on an airplane and fly across the country. Now, there’s got to be some courage and some knowledge of uses for the drone beyond what people can think right off the top of their mind. You had just referenced the commercial benefits of drone usage. Give us a couple of examples on how they’re being deployed and what benefits they’re bringing to companies or to the public at large.
Gretchen West: Sure. There are so many benefits. We could spend several hours on this call, on this podcast just talking about the various benefits, but just to highlight a few. There’s the benefit of saving money. For example, in the oil and gas industry, when a human have to inspect a flares deck, that flares deck has to be shut down, which can cost a company up to a million dollars a day. If you’re able to use a drone, you don’t have to shut down the flares deck. You can use a drone with various sensors to monitor and inspect that flares deck. That’s just one example. There’s other examples of how, for example, saving lives and improving safety.
The cell tower industry, you have climbers that carry about 80 pounds of gear and they can climb up to or higher than 1,000 feet in the air. You don’t know what changes in weather there will be. There are climbers that die every year from climbing these towers. It’s a very dangerous job. Why not use a done? You could get it up to inspect the tower in about 20 minutes. If there’s a problem with the tower, then you send the climber up to repair whatever needs to be repaired, but otherwise, you just potentially saved some time and saved lives by doing that. There’s so many other industries that are using this technology. For example, in the construction world, they have to measure stockpiles. The way you do that is, you have a human walking around the pile of whatever it is measuring manually.
Well, there’s technology out there now, a sensor that you can put on a drone and it can map that stockpile and give you those measurements in real-time. It’s a time-saving. It’s a cost-saving. It’s not replacing the human worker because there are other jobs that have to be done within all of these industries. The drone is more of a … it’s a tool to help. You mentioned Jeff Bezos in delivery and I think a lot of people nicker a little bit when they hear about delivery, but I think one of the most important aspects of drone delivery is in the humanitarian area. Lots of companies are developing technology where you can deliver blood from blood banks to hospitals or organs from hospital to hospital for organ transplant. There is this testing and there are actual trials going on overseas, outside the United States, where the regulatory environment might be a little bit easier where aid is being brought to people in need. There’s countries, third world countries, where drones have flown after natural disaster, delivering water or medicine or whatever it might be.
I think some of those use cases really open up the door for delivery whether it’s consumer delivery, business to business delivery or humanitarian. I think being able to get something to you quickly especially after a natural disaster is incredibly important. I could go on and on about all the different benefits and all these different industries. You’ve got news gathering and mining and inspecting railroads, inspecting bridges, any kind of infrastructure, farmers using drones in their field to instead of walking a field to look for damage after a hailstorm or looking for areas of irrigation, maybe, or they can put a drone up in the air and have NDVI sensory imagery, all sorts of different types of mapping where they can immediately see what’s going on in their field.
Public safety has been using this technology for a long time. They’re good for traffic monitoring from a security perspective, using a drone to monitor a facility such as a prison or pharmaceutical plant or a nuclear facility. There’s so many different great use cases where drones … Really, they’re a tool that can create efficiencies and they can reduce cost, and they can save money and save lives.
Patrick Stroth: It’s whatever the limits of the imagination are. This isn’t just some funky little happy gadget. This is a real flexible, viable tool that’s going to be sustainable, I can imagine. Again, I keep going in the parallel to when they would think about the first airplanes where they were used. Before they’re carrying passengers, they’re carrying letters. They’re probably limited to about 30 or 40 pounds worth of letters that they could carry at a time. Now, you think about what FedEx delivers in a single day. I think that this is just amazing. Now, there’s going to need to be a couple of breakthroughs both on a regulatory and a developmental stage to really get this a little bit more mainstream. There were a couple areas that they may not be on the cusp of that, but what are the things that we should look out for that if these things changed or these thing gets solved regulatory or otherwise, then we’re going to see things open up wide.
Gretchen West: Yeah. There’s a handful of really near-term pending things that are going to help. There’s obviously some other longer term challenges that we need to overcome, but last year, the FAA re-authorization bill was passed. I don’t remember how many pages, but there were pages of provisions for the FAA around integrating and enabling UAF technology, drone technology. DFA has now have their handful with all these task that they need to complete, but the first and probably most important thing that the industry needs to see now is remote identification. A couple years ago, the security agencies, DOJ, DHS and others were very concerned about the clueless, the careless and the criminal actors of flying, and how do you identify the difference between the three?
You’re talking about a sports stadium where somebody is flying near a sports stadium or an airport where somebody is flying near an airport to Gatwick, for example. We’ve all read those new stories about drone flying around Gatwick and the millions of dollars that were lost because the airport had to shut down. Was that the person that was flying, which is just a kid that’s out flying with his dad just for fun as a hobbyist. Maybe, maybe not. Is it something that’s clueless that’s out there that doesn’t understand the rules or somebody that’s criminal? As of today, there’s not really a good way to identify any of the drones that are in the sky. Yes, there are some apps and some things that are baked into some of these drones, but it’s not a formal process.
To be able to move forward with any of the other expanded operations that our industry needs to see, those remote ID, whatever remote ID is going to look like, whatever the rule is that the FAA comes up with, that has to happen first. That is a critical piece to satisfy the US security agencies and the FAA. That is the number one thing that we’re waiting for. Secondary to that is, I’ve mentioned expanded operations a few times. The law, now, permits commercial operations of drones, but it’s very limited. You cannot fly beyond visual line of sight of the drones. You have to have your eyes on the drone at all times. You can’t fly over people. You can’t fly at night. Now, some of these, you can get a special permission from the FAA to do, but it’s much harder. For a lot of the operations, the industries that I just mentioned, if you’re a real estate agent and you’re just flying over a house, you can stay within visual line of sight, not fly over people and not fly at night. You’re probably fine.
If you want to monitor a big pipeline or a railroad, then you need to fly beyond visual line of sight. We’re waiting on some rules now to enable those expanded operations. One was just opened for comment which closed this past Monday and would be operating over people and operating over people in a moving vehicle. The way that the rule is crafted by the FAA, it’s going to hamper the commercial drone industry if it passes as it is. Not being able to operate a drone over a person and a moving vehicle is a non-starter for this industry and operate the restrictions around operating over people is, there needs to be more research and testing that’s done because it’s still very restrictive. Those are some rules that we’re waiting to see how they change in order to enable this community.
I mentioned a security concern, that’s a big issue for the federal government, but it’s not just about remote identification. It’s also about this new industry that sprouted up. It’s called, Counter-drone Technology or Counter-UAS Technology. Think about a baseball stadium or a football stadium. They like to use drones to film practices and eventually, maybe even film games, but they don’t want drones flying into their stadium when there’s a map gathering, when there’s a game going on. A drone was just flown into Fenway Park the other day. This counter-drone technology, potentially, could help curve some of the careless, clueless criminal, but the authorities are very, very limited in the industry to use that technology. That’s something we really need to see develop with the FAA and with congress to figure out, how do we let more than just a few federal agencies utilize this technology, how do we allow private companies to be able to use it.
I think, remote idea is the most important, but the fourth one is called, The UTM, the Unmanned Aircraft Traffic Management system. It’s basically virtual highways in the skies for drones to fly. It’s like air traffic control for commercial aircraft but at low altitude and it’s all automated. Now, the FAA have been developing this for years with a couple hundred industry partners. I think we’re getting closer to see some implementation of the UTM, but this is what is going to help our industry have all this operation. It’s going to enable delivery. It’s going to enable beyond visual line of sight and operations over people. It will be this automated system that will help all of this. It’s meant to be designed in a way that if you’re flying from point A to point B, you get your coordinates. If a medevac flies into your route at some point in time, you’re automatically diverted. It’s meant to be this automated system that’s very safe. It’s really going to enable the technology and this industry to grow. We’re still waiting for that to be implemented.
Patrick Stroth: Yeah. Not only do you not have pilots in the vehicle, but then it sounds like you’re not going to help people in the air traffic control system or the automated, which you’d have to do with the volume of vehicles out there under this UTM.
Gretchen West: Exactly. The current air traffic control system that the FAA uses is one of the safest in the world for man deviation, but think about adding millions of aircraft to that system. It will be impossible for the FAA to be able to monitor all of that in addition to man deviation.
Patrick Stroth: That’s amazing. The ID of all the different uses for the drone brings up the idea because for an M&A conversation we’re having today, drone is a very interesting topic and people might be thinking … Yeah, but how does that apply to us in M&A because we’re not necessarily in the aerospace industry or the flying industry? How is this going to be applicable? I just think that there are a variety of different technologies that drones are using right now. They open up opportunities for all kinds of innovators. You’re talking about the UTM and the counter-drone technology. You could probably flush that a little bit, but what are the types of technologies that are necessary for this industry to grow?
Gretchen West: Well, I think when a lot of people think of drones, they just think of this little, small toy aircraft that’s flying around in the sky. Really, that’s the shell of it. There’s plenty of companies that are developing the hardware, but it’s really the brains in the drone that’s the most important thing. You’ve got the sensors. There’s a variety of different sensors depending on what your application is, whether it’s agriculture, construction, mining, whatever it might be. There’s mapping technology that’s being developed. Communications, infrastructure technology. The software that comes a navigation software to be able to automate how you get drones from point A to point B. I mentioned remote ID. There’s lots of different companies that are developing technologies to satisfy what remote ID might look like.
Obviously talking about UTM, I mentioned there’s about 200 partners that are working with NASA and the FAA to develop this. A lot of it is software. It is multiple layers of software that are going into what this UTM structure will look like. We’re at step one through a program, now that several companies have developed an app where you can get notifications and authorizations to find certain air spaces, but that’s step one. There’s all these layers of software and technology that need to go into a UTM system. Insurance companies are automating drone insurance for how operators are able to obtain insurance. Again, counter-drone technology which is similar but different but a lot of different technologies that are being built into how counter-drone technology is going to work. Basically, it’s air space security is what counter-drone technology really is.
There’s so many different areas within this commercial drone space where innovators can develop different software layers to fit into whatever these different applications are. They’re all very different. There’s so much opportunity. We see startups that are developing these types of technologies every day. There’s a lot of opportunity to get into this space and start helping craft what the feature of commercial drone integration is going to look like.
Patrick Stroth: Well, I think, also, if there’s the creation, again, from nothing comes something, lots and lots of new applications and new developers on that. We got to figure down the road and again, that focus on us is looking how it applies to M&A is that there are going to be a lot of M&A opportunities. Give us, from your perspective, what you’re seeing on the M&A front within the drone sector.
Gretchen West: Sure. I think we’re going to continue to see increased activity in M&A including in this year. Back 15 years ago or even 10 years ago when these commercial companies were just starting to get into the space, there weren’t that many companies and they were mostly startups. Now, you’re seeing big named companies like Amazon, Intel, IBM, Goggle, Cisco, AT&T, Verizon, Ford, Mercedes Benz and all these companies that you wouldn’t think of as being in the drone space. All of them are starting to develop something around commercial drone. Intel, for example, has acquired a couple companies to help with what their drone solution is going to be. Goggle has done the same. Verizon has done the same. They’ve acquired a company called, Skyward, which is going to help them be a player in the UTM space.
I think we’ll continue to see more companies interested in commercial drone technology. Some that you may not even think of today that will be interested in developing some drone program. Instead of going out and building your own hardware and software, which hardware is hard in a software, there’s a lot of companies out there that have been very, very successful in what they have been able to develop. I think we’ll see a lot of strategic M&A coming. Unfortunately, we’ve seen some companies that have failed in this space. I think we’ll continue to see that. I mentioned counter-drone technology. That’s a newer part of this industry. Two years ago, there were probably a dozen counter-drone technology companies. Now, there’s over 200. There’s over 200 systems that have been developed around counter-drone technology.
It’s just not sustainable to have 200 types of technology out there in the counter-drone space. I think we’ll see a lot of consolidation in that space as well and probably, eventually, see more consolidation in UTM as we get closer to private industry being a supplier of this technology with the federal government and with the users of that air traffic management system. I think we’ll see more consolidation there to just build in all those layers under one company. I think that industry is very right for just an increase, a large increase in M&A activity. It’s been one of those industries for so long where it’s just … People are developing. There wasn’t a good roadmap from a regulatory perspective. Some people were developing technologies that may not fit.
Now, we have a pretty clear roadmap. Even though it’s moving slowly and that has its own challenges, I think we are at a stage where the industry is becoming more mature and so we will be seeing a lot more M&A activity.
Patrick Stroth: It’s early mature and it will continue to go. I think the biggest beneficiaries throughout all of this is going to be the public, the consumers, because we’ll get finer working finished products here that are both safe and reliable and less and less expensive to operate as time goes on. That’s why American business does as well as it does. Do you have any predictions for just what’s around the corner for the industry or any trends that you see coming that we should keep an eye out for?
Gretchen West: Well, I think the counter-drone space is really interesting. Like I said before, there’s limited authority. A couple agencies within the federal government are allowed to actually use the technology, but there are things in play to create some new rules to allow for private companies to hopefully get approval to become a user of that technology. I think that’s very important. I mentioned before from a security standpoint using counter-drone technology around … anywhere there’s a map gathering or an amusement park or some critical infrastructure. I think counter-drone technology is an area that we’re going to see a lot more development and something to watch. I think the commercial drone industry as a whole and all these different amazing use cases that we can find benefit and save money, save lives, create efficiencies, I think … The industry is moving slowly because of the regulatory environment. I know sometimes that is a concern to investors. This is not an industry with quick returns at this stage, but we know that it’s coming. We’ve seen the value that this technology provides.
I think if people just hold on a few more years, we will see more commercial operations and those returns will come back in. There will be a lot more M&A. A lot of startups, I know, were developing technologies simply to be acquired by a customer or strategic partner or something like that. I think this is coming. Even though there’s a lot of challenges, our team and the work we do are … We’re in Washington, D.C. all the time talking to the regulators and the federal government to help reduce these barriers. We’re going to get there. We are going to get there. I think it’s really important to keep an eye on this space from commercial operations of drones, to counter-drone technology. Even urban air mobility, the air taxi industry which is similar but different to commercial operations of drone, but all of these areas, I think, are fascinating areas and they are coming. It’s going to be a place where I think investors, investment thinkers really need to pay attention to.
Patrick Stroth: Well, as you mentioned, we’re just scratching the surface of this topic. We didn’t even get in to talking about the types of investor’s funds, fund managers, opportunities and things like that. I think we’re going to leave that to our listeners that if they’ve got a particular question like that, I think they can direct that to you directly. Gretchen, how can people find you?
Gretchen West: Well, they can find me via email at firstname.lastname@example.org. That’s H-O-G-A-N-L-O-V-E-L-L-S.com.
Patrick Stroth: Thank you very much, Gretchen. Again, it’s a catchy topic, but it’s also right on point with what we want to do. Thank you, again, for joining us and have a good afternoon.
Gretchen West: Thank you. You too.
The typical insurance broker wants to serve all their clients’ needs, especially if it’s a large client that requires various types of insurance to cover its operations.
The motivation is to be there for the client, who you know well. And the extra commission doesn’t hurt either.
But although a broker may have the best intentions, if the insurance required is out of the broker’s area of expertise (and no broker is master of all), this practice is actually not good for clients. They’re just not going to get the best value out of their policy.
When it comes to Representations and Warranty (R&W) insurance, a highly specialized variety that covers M&A deals, this is definitely the case.
R&W insurance protects both Buyer and Seller if there is a financial loss resulting from a breach of the Seller’s representations that were outlined in a purchase-sale agreement.
If there is a breach, the insurer covers the losses because the coverage transfers the indemnity obligation from the Seller.
Buyers and Sellers entering into deals who are interested in one of these policies need a broker who specializes in R&W insurance and does it routinely. Not to mention that the broker must understand how M&A works.
In R&W insurance, it’s not what you know, it’s what you don’t know that will come back to bite you.
Here’s why: On the surface, the coverages from one R&W policy to another are very similar. It’s rare when R&W insurance policy verbiage diverges greatly and have material coverage missing, which often happens with other types of business insurance. Within various business insurance programs, many coverages considered “essential” by some are deemed “optional” by others and therefore omitted to save costs (i.e. Uninsured/Underinsured Motorists coverage).
The scope of coverage for an R&W policy is determined by two elements: The Seller’s reps and the degree to which the Buyer performed diligence on those reps.
The key difference between R&W policies comes from decisions Underwriters make as to what degree they’re willing to cover all or most of the Seller’s warranties. This decision is based on two elements: The Underwriters’ appetite for risk in a certain business sector and the amount of diligence performed by the Buyer. It’s essential for the insurance broker to determine to what extent each insurer is willing to cover the majority of warranties, and where there may be flexibility.
Unlike other instances when business insurance is considered, R&W is brought to bear in M&A transactions where 100’s of millions are at stake. That’s both exhilarating and terrifying for the parties. Often times, Buyers and Sellers haven’t used R&W before, so they have no idea what to expect from the process. They need a “steady hand” to guide them, manage their expectations and inform them as to what they can expect.
Brokers who lack experience in placing R&W will struggle to navigate the underwriting process. Ultimately, this can put their clients through unnecessary stress due to delays and “surprises” that an experienced player can anticipate and prepare for.
An example would be to prepare Buyers for the time and access Underwriters will need with the Buyer’s team to review the diligence performed and which outside parties participated. Brokers unfamiliar with R&W might fail to prepare their clients for this, which can result in a huge burden on the Buyer.
A broker’s relationships with Underwriters at different insurance companies is essential. Different insurers have different appetites for risk. A qualified broker, who are also experienced with M&A, knows who does what.
Some insurers are comfortable with healthcare deals and the added regulatory scrutiny they bring.
Some insurers are comfortable in the up-and-coming cannabis market. (Actually, there’s only one insurer in this market so far, but more will ultimately follow.)
Some insurers will cover certain deals but only with so many strings attached that the client won’t actually qualify, or the cost will be too high.
Insurance companies’ appetite for certain risks can change over time, and a savvy broker will keep track of these trends.
R&W policies cover complex business deals – and the Underwriters typically don’t know every industry well. That’s where the broker comes in to match the right Underwriter with experience – and interest – in a certain space for the deal.
A good broker/Underwriter relationship has other benefits.
First, a good broker sends information the Underwriters need without waiting for them to ask. That means coverage is obtained that much more quickly.
Just like anything in life, when you know someone, things just go smoother. This is particularly true on smaller deals, in which Underwriters have to deal with less due diligence provided by the Buyer.
Some insurers will penalize the Buyer for having less comprehensive due diligence. But a good broker can be a go-between and mediate in that case.
For example, say the financial statements were reviewed but not officially audited. The broker can explain why that was the case and why it’s okay. A trusted relationship makes it possible.
Typically, both Buyers and Sellers have their own brokers handling their respective insurance programs. When those brokers see the premium sizes (and the resulting commission) from R&W policies for big deals they say, “Sign me up.” They’re not qualified, but they’re certainly not leaving that money on the table and are willing to dabble if given the chance. This creates unnecessary friction between the parties as they argue on behalf of their “guy” or “gal”.
The best approach is to select an independent specialist who will only handle the R&W placement. There would be “zero conflict” with the incumbent brokers as R&W is a one-time deal that doesn’t touch any other policy.
That neutral broker will have a fiduciary responsibility to the Buyer (R&W policyholder) to provide the broadest level of protection, while committed to delivering a variety of options that are budget appropriate in the interests of the Seller (who often shares in the cost of R&W).
That’s why a neutral broker who knows R&W best practices and has the clients’ best interest at heart will get the ideal outcome for both sides.
There’s no shortcut for a broker who has experience and has had working relationships with Underwriters for years. With that comes mutual respect. If there are disagreements or contentious points, they are easier to work through.
In an M&A deal, Buyers and Sellers should not rely on a broker who does their other insurance to secure their R&W policy. Get a specialist.
A number of Underwriters have already “trained” me. I know the inside track. They know I’ll run the process the way they need to provide the best policy in a timely manner.
I’d be happy to discuss with you how Representations and Warranty insurance could benefit your next M&A deal, as well as the costs. Please contact me, Patrick Stroth, at email@example.com or 415-806-2356.
It’s a tight talent market out there in the technology industry. And that’s especially for all C-suite positions right now, says Stephen Kuhn, partner at Advantary. Yet companies, especially startups, are facing pressure from their boards to hire senior executives.
And that means they’re sometimes rushed into bad hiring decisions.
Stephen talks about a short-term solution to this issue that can have long-term positive impact on companies facing these challenges, as well as…
Mentioned in This Episode: www.advantary.com
Patrick Stroth: Hello there. I’m Patrick Stroth. Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisitions. We’re all about one thing here. That’s a clean exit for owners, founders, and their investors. Today I’m joined by Stephen Kuhn, partner of Advantary. Advantary provides interim CXO services across the entire C-suite, including CEO, COO, CTO, CMO, CSO, and wait for it, CPO. That’s a lot of Cs. Advantary augments a company’s management team long-term or short-term, full-time or part-time. Stephen, thanks for joining me. Welcome to M&A Masters.
Stephen Kuhn: Patrick, thanks very much for having me.
Patrick Stroth: Now before we get into all things Advantary and C-Suite, tell us what led you to this point in your career?
Stephen Kuhn: I’ve been in the technology industry in Silicon Valley for the last 40 years. I was born and raised in San Francisco. Started programming professionally when I was 16 in 1978, and got the entrepreneurial bug. Sold my first company while I was at UC Berkeley. Went onto study Managerial Finance at Harvard, and have in total started nine companies. I’ve been CEO at seven. Seven companies were pure tech. One was a boutique tech M&A Investment Bank, and I subsequently ran M&A Core Public Software Company. And the last company, the ninth company was a PE firm focused on the wine industry, so decidedly not tech.
Patrick Stroth: Well I’ve got to ask you, and this isn’t something that you and I prepared for, but coming from one native San Franciscan to another native San Franciscan, we’ve got quite a few in our audience. There’s a question we always ask each other is where’d you go to high school?
Stephen Kuhn: I went to San Francisco University High School.
Patrick Stroth: How about that? Okay, congratulations for you. I went to SI. That’s for our listeners who probably don’t care about that. Tell me about Advantary.
Stephen Kuhn: Advantary is a partnership of 11 and counting. We’re adding new partners. Highly experienced entrepreneurs who have started dozens of companies, raised hundreds of millions in debt and equity capital, and had many exits. We provide interim CXO services across the entire C-suite with the exception of CFO. We engage full-time or fractional, long-term or short-term, but it is an interim engagement. We’re not a placement agency. We help companies prepare for and go through transitions, including capital raises, the loss or hiring of key executives, technology issues, stagnation, accelerated growth, and international expansion, which is a major focus of our group this year.
We relieve pressure on companies as they look for CXO’s in this very tight talent market. We serve the small to mid-sized technology market, including SASS, Syntax, AR, AI, IOT, Blockchain, Cyber Security, Digital Health, and with the addition of our newest partner, Consumer Package Goods and Supply Chain Management. There’s a lot going on on the technology side of that these days.
In terms of size, there’s no company that’s too small. It’s frankly only an issue of budget. And there’s no company too large. We have a billion dollar plus revenue public client. But our sweet spot is clients with revenues between 5 and 75 million. But we go lower including pre-revenue companies of course, and obviously higher revenues as well.
Patrick Stroth: Well that’s one thing that is striking is that when we were kids dreaming about going into business or being successful, the idea of success was build a company, sell it, and then at a young age in your 30s and then go buy an island somewhere. And one thing that’s just more and more common in Silicon Valley, it’s not just here, it’s just concentrated, is people like you who are extremely successful, could have bought several islands out there. But instead of shopping for hammocks and boats and stuff, you’re going out and finding more challenges, more companies to help. It’s striking how this is what you live for and just being able to provide great services and add value to other startups. Back when you were starting up you’d get them moving on, it’s really a fantastic resource that’s out there.
What’s the type of value that Advantary brings because I can tell you right now, finding talent, if that’s tough, finding management is even more so. What do you bring to bear for owners and founders that is not otherwise out there?
Stephen Kuhn: Unlike a traditional consulting firm, think of McKinsey or Bain or PWC, we actually provide hands on operational services. It’s the highest, best value we can provide to our clients, given the length of experience, the breath of our experience in the technology market.
So you mentioned talent at such a premium, it’s hard to come by, that’s absolutely right. And a lot of companies are forced into a high pressure situation where they need to find, locate, recruit, and retain senior management. And in this market, it’s extremely difficult. And making a bad hire is sometimes existentially costly. I’ve certainly seen examples of firms that have made bad hires in C-suite, and I can think of some in particular in the chief revenue officer role that have been unqualified, culturally not a fit, and culture is a really important aspect here as well. You need people who can really fit in.
And so if a company is compelled under pressure from the board, pressure from their performance in the KPI’s on their business plan, to get someone in, just anybody who’s breathing, to find a CXO who can fill the role, that can be very challenging. And so we can step in on an interim basis, provide some real support. During the time that they’re out recruiting, the company can make forward process. It can achieve its milestones while taking the time, having the breathing space to actually find the right person for that role.
Patrick Stroth: One of the things I was thinking of, is you’re bringing somebody in to a CXO position while your client company is out doing the longer term search for the longer term solution. Largely what you’re doing is shorter term. You can do the long-term, but I get the sense that more of your stuff is targeted, your service is targeted towards short-term, is that right? Because if it is, I think it removes a lot of conflict because you can get somebody who can plug and play and they’re not worried about preserving their job or their role. They’re into add value with the knowledge that this is not going to be forever, so you’re not playing defense. You’re just working forward, and you don’t have to worry about legacies or things to kind of build in as you take a position. I think that’s a nice, un-conflicted approach.
Stephen Kuhn: Yeah. That’s absolutely true. And we work with firms, I think our shortest engagement has been probably six weeks or a couple of months and we’ve had, have a client for well over a year now. But we typically work from a quarter to a few quarters in length of the engagement.
So sure, we can come in and solve a particular problem, work with the company through a challenge or a transition and stay on for a bit longer to see through the onboarding of our replacement frankly.
The value we can bring is yes, the experience, yes, the understanding, we’ve made lots of mistakes ourselves. We can load balance as well. A lot of firms don’t need a full-time CXO. A classic example that most people are familiar with is a CFO. A lot of early stage companies don’t need a CFO. Similarly, they may not need a full-time Chief Product Officer, Chief Technology Officer. You’ve got a small firm that’s got a founder who’s a great engineer, who perhaps hasn’t been an entrepreneur before. Hasn’t run a team of engineers, doesn’t mean they’re not smart, they’re usually brilliant. But they just lack some experience and we can provide that mentorship, that guidance, and actual hands on architecture, scaling issues, security issues, so on and so forth, on the technology side, experience on the product side, the marketing side or revenue or business development.
So coming in on an interim basis to provide support when support is needed, to step back when it’s not. It actually, and because we’re consultants we’re not employees so there isn’t the tax issue there as well, we can be very cost effective for our clients.
Patrick Stroth: What does it look like to work with Advantary? I mean, describe types of engagements that you have available.
Stephen Kuhn: So we, in addition to the interim CXO positions that we’ve talked about, we actually have five package services if you will, that we provide and they are briefly, pre-transaction preparation and execution, getting ready for a debt or equity transaction, whether that’s a capital raise or M&A event. A lot of companies aren’t properly prepared, and so deals don’t get done, they get done more slowly, or on sub-optimal terms. And here’s the situation with the old adage, an ounce of prevention is worth lots of pounds of cure here. They can really drive a lot of value out of Pre-Transaction Preparation, proper preparation.
Second is around growth, strategy, marketing, sales, business development and cross border expansion. Cross border is a particular process as I mentioned earlier, for us because those firms outside the U.S. looking to enter the U.S. Market, are effectively doing a startup within a startup. It’s very risky, it’s very time consuming. It’s a real distraction from the core business.
As a team of entrepreneurs who’ve started lots of companies here in the states, we can provide a tremendous amount of value there.
Third practice is around technology and patent management, best practices, and implementation.
Fourth is around designed thinking. Designed thinking methodology is a terrific problem solving framework. And we help solve companies strategic issues leading them through a design thinking process. It’s extremely powerful. And the fourth is really focused at investors or buyers. So perhaps some of your clients for example, or your audience on the M&A side, we work with investment banks, but also the principles, PD firms, family offices, and corporate buyers on their pre-transaction diligence. So we can go in and look at a company’s team, the technology and their pipeline, their product market bid, their strategy and so on, to help the buyer if that fits with their objectives.
Patrick Stroth: That’s pretty comprehensive. You mentioned with the cross border so I don’t want to sound redundant here, but the services for Advantary are available not just California but what’s your service territory range? Entire U.S.?
Stephen Kuhn: It’s global in fact. We’ve got clients, certainly across the U.S., but also in Australia. We have a French client we acquired last month. And we are working in Mexico and Latin America as well. So really it’s global. We have a natural center of gravity if you will in the Bay Area. If you looked at a heat map of the globe, there would be a bright red spot around the Bay Area. But you’d see hotspots around the globe as well.
Patrick Stroth: Gotcha. Well now the biggest questions people have when they hear about services like this, well is it a fit for me, yes or no? And they can make that decision based on what you said.
The next thing, and this is just true of life, is timing is everything. At what point if there are people in our audience or there are questions, at what point should they start thinking about someone like an Advantary?
Stephen Kuhn: That’s a great question and it really depends on the nature of their needs. For example, if they’re thinking, even contemplating an exit in the next year or two, that’s a great time to be thinking about us to help in that pre-transaction preparation. A lot of things can be fixed relatively quickly, but there are a lot of things that take time. It takes effort to steer the big tanker in the ocean, to move in a new direction or to find the right person to fill that role. So we can be very helpful long in advance of those types of transactions, but then there are other things that are much more immediate. You need to hit your numbers this quarter, right. So you’re going to need some strategy, marketing, sales, and business development efforts.
You are looking to raise capital. And we can help prepare the company for that capital transaction. And those usually aren’t done a year or two in advance, that’s usually the next few months we need to get that done. So it really depends on the nature of the engagement.
Ranges from today, oh we need your help today. In fact I met with a client, a prospect yesterday who is launching here in the U.S., they’re a Mexican firm. And they’re looking to get launched in May. And they’ve got a tremendous amount of work to do before they can do that. So they needed immediate. So you can see it really depends on the circumstance, the context, and the nature of the services that they require.
Patrick Stroth: Yeah. Stephen, of the services and the types of engagements you talked about, the majority of them revolve around or have an aspect of the practice of M&A and we do try to focus on M&A. You’ve been around companies and helped companies that are both scaling and exiting. And so you’ve got a great perspective with regard to M&A. What do you see in the trends going forward here in 2019 going forward for M&A? Just at any level from what you have seen.
Stephen Kuhn: On the M&A side, clearly, historically, M&A has been roughly 90% of the exits. When companies exit, M&A is the exit of choice verses IPO about 90% of the time. I don’t see any change in that. If anything, despite some very large, very successful IPOs, I think the trend is definitely continuing on the M&A track.
And I pause there only because several examples came to mind of firms that are providing, think of co-location spaces, and other accelerator programs that are creating essentially a marketplace of technology and entrepreneurs. On the one had they’ve got small entrepreneurial companies with brilliant technology. And those companies are really good at innovating, creating new technology, and getting from zero to one, from nothing to something.
And on the other side of that market, you’ve got large firms, typically Fortune 500 firms, that are really good at scaling, but maybe not always so good at innovating. And so there are a number of incubators, an increasing number of incubators out there that are positioning themselves, as they say, a marketplace for large corporates to come in and get access and visibility to the startup world providing a key for them, which is innovation.
And on the other side you’ve got these young firms that are really good at innovating, and are challenged with scaling and are looking for opportunities to partner, in the short-term, partner with the larger corporates, but really looking to those corporates as their exit path. And so with the lives of these incubators, these marketplaces if you will as I tend to think of them, there is I think increasing amount of M&A activity. And as I speak to my investment banking friends around the country, both boutique and larger firms, they are absolutely saying trends up and to the right on M&A.
Patrick Stroth: This is a very good perspective to have. I appreciate that.
Stephen, how can our listeners find you to learn more about Advantary for themselves, for their own entities, or for their clients?
Stephen Kuhn: Yeah, thanks for asking. Of course there’s our website www.advantary.co. And you bring up a really important point which is that while we do work for the companies themselves, we’re often brought in and referred to those companies by, there’s other service providers. It could be one of our partners in the Fractional CFO space, it can be VC or PD or Family Offices as well. It could be an investment bank that needs help with one of their clients or prospective clients as they are going through or contemplating going through an M&A transaction.
So encourage all of your listeners if they think they have a need, or suspect they might have a need for some of our services, just go to the website. Pick up your keyboard and send an email over to me or to firstname.lastname@example.org and we’ll certainly get right back to you.
I’m also available of course on LinkedIn, easily findable there. Yeah, looking forward to hearing from your clients and seeing if we can be of help.
Patrick Stroth: Well it was a pleasure speaking with you today Stephen. Thanks very much. And if anybody needs to find out other ways to get ahold of Stephen, go take a look at our show notes at www.rubiconins.com. Hit the insights tab and you’ll find our interview there as well and you’ll have the show notes as well.
Patrick Stroth: Thanks for joining us today Stephen, and have a good day.
Stephen Kuhn: Thank you very much Patrick.
The pool of Buyers of technology companies is getting wider. Tech companies, as well as Private Equity firms, are now facing significant competition for quality acquisition targets from an unlikely source – non-tech strategics.
In fact, traditionally non-tech companies have become the most active acquirers of tech companies.
The most recent example is the $300M purchase of Dynamic Yield, an artificial intelligence (AI) company, by McDonald’s. It’s the fast food giant’s largest acquisition in 20 years. They plan to use Dynamic’s tech in order to improve drive-thru ordering, as well as digital products like self-serve kiosks and a mobile app.
“With this acquisition, we’re expanding both our ability to increase the role technology and data will play in our future and the speed with which we’ll be able to implement our vision of creating more personalized experiences for our customers,” says McDonald’s president and CEO, Steve Easterbrook in a statement.
But this practice isn’t new. Newspaper company Gannett purchased the remaining shares of online site Cars.com for $1.8B in 2014.
Brick-and-mortar businesses have good reasons to go on a tech buying spree. There are several drivers that explain this trend.
In the case of Gannett, the acquisition of Cars.com filled Gannett’s shrinking advertising revenue it and other traditional media outlets were losing to online advertising. Cars.com is a leading site for online research and shopping for new and used cars, which, before the internet, was the bread and butter of newspapers. It’s the perfect fit.
Other drivers for the acquisition of tech companies by non-tech strategic corporate acquirers include:
I believe the most important driver is the concept that today, every company is a technology company, no matter what the industry. Technology saturates the day-to-day operations of every business.
Quoting from Wired magazine, “The essence of the value of technology companies is – people. It isn’t just the intellectual property that a technology company creates, owns, and sells; it is the people who create that intellectual property and who bring fresh thinking and fresh ideas about how to solve problems, particularly problems that relate to the customer. Ultimately, every industry will become a technology industry and every company will have to become a technology company.”
This bodes well for owners and investors of emerging tech companies.
More Buyers increases competition for desirable targets. Add to that, non-tech strategics are willing to spend more than Financial Buyers such as Private Equity.
According to 451 Research, Strategic Buyers have paid 20% more for target companies than Financial Buyers. To avoid losing opportunities, look for Buyers from all sides to provide more aggressive terms to preempt auctions.
One way savvy Buyers compete is to deploy Representations and Warranty Insurance (R&W) to enhance their offers.
R&W coverage insures Buyers and Sellers from financial loss resulting from a breach of the Seller’s representations and warranties outlined in the purchase agreement.
R&W transfers the indemnity obligation away from the Seller over to an insurance company. With the indemnity risk removed, Sellers can reduce or eliminate escrow or hold-back provisions and collect more cash as closing.
Buyers benefit by enjoying the protection from a post-closing loss that can result in both a financial hit as well as the fallout from having to claw-back money from the newly added tech company principals.
In most cases, the Sellers are willing, if not eager, to cover the cost of the insurance in exchange for securing a clean exit from the deal, so Buyers benefit even further.
R&W coverage has been used routinely by Private Equity. However, Strategic Buyers are slow to engage in this useful tool.
If you’re working with a Strategic Buyer, there’s an above average chance they’ve never used R&W, so introducing the concept of transferring risk out of a deal at a modest cost would add tremendous value.
A great guide to promote an understanding of the benefits is a free report I’ve put together about how you apply for R&W coverage, the costs involved, when the topic of R&W should first be discussed, and more.
You can download it here: 8 Things You Need to Know About Representations and Warranty Insurance
The politics of healthcare is a mess in this country, as you know.
But Matthew Hanis, executive producer and host of the Business of Healthcare, is more interested in practical measures for incrementally improving a system that is the most expensive in the world and doesn’t offer a great quality of care in exchange.
We also talk about the M&A landscape in healthcare, including the trend towards increasing vertical integration, as well as…
Mentioned in This Episode: www.bohseries.com
Patrick Stroth: Hello there, I’m Patrick Stroth. Welcome to M&A Masters, where I speak with the leading experts in mergers and acquisition. We’re all about one thing here, that’s a clean exit for owners, founders, and their investors. Healthcare is literally a force of nature in our economy. It’s been in the news quite a bit lately and like it or not, as time goes on, everyone will be consuming more, not less of it.
Today we’ll discuss the future of healthcare from a business perspective, and how mergers and acquisitions will factor into the inevitable changes coming to healthcare. I’m pleased to be joined by Matthew Hanis, Executive Producer and host of Business of Healthcare. Now in his 13th season, BOH is an online platform where Matt interviews senior leaders in healthcare. BOH estimates that 118,000 decision-makers are responsible of 80% or more of the buy and sell sides of US healthcare. Just about 20,000 of these very decision-makers participate in BOH’s audience. That’s about one in six, which is a respectable share of any market. It is for this audience that BOH was purpose-built to identify and help propagate proven innovations, elevating mission and margin more rapidly. Wow, one in six, that’s nothing to sneeze at. Matt, thanks for joining me, and welcome to the program.
Matthew Hanis: Patrick, thank you so much for inviting me on.
Patrick Stroth: Now, we’ll get into Business of Health in a moment. First, tell us how’d you get to this point in your career?
Matthew Hanis: Well, I tried to make as many mistakes as possible, and this is the culmination. I’d spent about 25 years in healthcare, most of that time I’ve either worked on the vendor side, selling data solutions to health systems, larger payers of health plans, or working within a health system, Mercy in St. Louis, to have the experience of actually doing the work of healthcare. Ultimately, all of those experiences culminated in a passion for entrepreneurship and for finding the innovations that I felt could really transform our healthcare delivery system in the United States.
Patrick Stroth: When we see BOH’s core statement, which is mission and margin, with mission, we get that because healthcare and doing good and providing care to people, there’s a passion, the mission. It’s the margin that people start looking at real quick. Why don’t you explain what you mean by mission and margin in the Business of Healthcare.
Matthew Hanis: Healthcare makes up about a fifth of the US economy, and every sector of the economy is important, but healthcare one of our challenges though is the cost of healthcare has continued to rise at a rate faster than pretty much any other aspect of our economy. But when you look at the quality of healthcare as measured by access, patient satisfaction, survival, life expectancy, all the broad measures of healthcare, we don’t do very well in this country. We have a major portion of our economy, which is getting progressively more expensive, and on most measures of quality, it’s not very good.
I believe that this is unsustainable. Now, the laws of physics tell us that all systems come back into balance. There’s a couple of different ways that we can see the US healthcare system coming back into a healthy balance in terms of cost and quality. One of the ways though, which tends to be the primary focus right now is trying to cut payments to physicians, and try to manage healthcare by managing how consumers consume it and managing how it’s provided. Our belief is that these approaches are unsustainable and that there are at the same time, very, very sustainable ways to improve the effectiveness and efficiency of our healthcare system. That’s what we try to bring to bear.
Mission is really about all the things you and I can agree on, quality, access, patient satisfaction, physician and other provider satisfaction. Margin is recognizing that like any other part of the economy, the providers who deliver healthcare must be able to make a profit in order to make it a sustainable business. We just need to figure out how to balance that with the cost to the consumer.
Patrick Stroth: The problem that you mention out there which is making a challenge for us is that cost of healthcare continues to go up, quality continues to go down. I would think that a lot of people would think well, the more it’s intuitive almost that if you spend more you should get better quality. Are there any specific reasons why the cost goes up and yet we’re not getting the value, the benefit?
Matthew Hanis: Yes. There’s a couple of different reasons. One issue which is very microeconomics, is pricing. We know that one of the biggest drivers of the cost of healthcare is the price that’s charged for healthcare. There’s an enormous set of problems around understanding price. God forbid you should have to go to the hospital for surgery. It’s extremely difficult to understand what that’s going to cost you, and what the costs would be for you to go get that exact same procedure in other settings.
Why is it so complicated to understand price and the cost of healthcare? Well, I believe that a big part of that is we’ve got a lot of intermediaries in our delivery system. Too many intermediaries can cause such a separation between the consumer of healthcare, the provider of healthcare and the payer of healthcare, that we create a whole myriad of complexity. I think a big aspect that we can look at is, why do we have so many intermediaries, so many people that handle healthcare transactions multiple times? Why is it so hard to get that data to be meaningful to the consumer?
I think another cause that we face in our system is regulatory constraints. I’m not suggesting that healthcare should become an unregulated industry. I think we can all agree that just about any industry in the US, we want to have good regulation over healthcare to protect the consumer and protect the providers of healthcare. The problem that we face today though is that the regulatory environment that healthcare providers face is so confusing and so complex that it’s almost impossible to comply. I’ll give you a concrete example. A typical health system reports somewhere in the order of 4,000 different quality metrics each year. Most of those quality metrics, most of those 4,000 are actually redundant metrics that are being reported to different organizations in slightly different ways.
Another issue in the regulatory side are the constraints of the Stark Laws. The Stark Laws were created to prevent or to discourage physicians from referring patients to treatment from which the physician would profit. The problem with that is if we ask a physician to take accountability for a patient’s total spend, and for that patient’s quality of care and their overall quality of life, which is the concept of fee-for-value, if we were to ask physicians to do that, unlock their ability to make those decisions and to be able to refer patients to the providers that they most want to work with and potentially refer them to themselves, for things like imaging, and other services that are adjacent or ancillary to the primary purpose of care, these issues of so many intermediaries and the regulatory constraints that are so confusing, create an enormous part of the enormous waste of our delivery system. Today we spend about a third of our healthcare dollar on waste, things that do not provide value. A decent chunk of that waste is directly related to too many intermediaries and enormous regulatory constraints.
Patrick Stroth: Wow. I think when people look at healthcare, the only way you address this is, either you have the universal care, care for all, unlimited, which a lot of people would say, well that means care for nobody because the system would be overrun. Or, the other extreme is fear there would be extreme rationing out there, where some arbitrary person will dole out allocation healthcare by some abstract basis. You’ve got fear on both sides, but it’s really a false choice. It’s not all of one, all this or nothing. There are models that are being set up and there are ways that are being tried to go forward. Why don’t you talk about those types of models.
Matthew Hanis: One of the fundamental trends in healthcare is the shift from fee-for-service to fee-for-value. The basic idea is that today, when a physician bills for a service they provide, or a hospital bills for a surgery that was performed in one of their operating rooms, they essentially are billing for units of work performed. They’re not charging for a knee replacement, they’re charging for all of the components that go into a knee replacement. The concept of fee-for-value is that you charge, or pay provider for the outcome that they’re delivering. The knee was replaced, no infection occurred, the patient came out of the procedure with a responsible period of recovery. Those concepts around fee-for-value create far better aligned incentives between the providers of healthcare and the payers of healthcare.
I just want to touch on your point about, I think you touched on the Medicare for all concept. It’s important to recognize three things about our current US delivery system. First, we cost per capita somewhere between 30% more and 200% more than the rest of the delivery systems in the world, like that in Britain, Canada, Sweden or Switzerland. Before we toss those systems out as being un-American, or undesirable, consider the fact that they generally provide much better access to care. More people can get to care faster. They cost on a per capita basis, far less than our system does, and in general their consumers of healthcare report being better satisfied with the care that they received.
Now, I’m not arguing that those systems are perfect, and I’m certainly not arguing the idea that Medicare for all is a particularly good solution. But I would want to differentiate between the concept of a single payer system versus the concept of universal healthcare. A single payer system essential says, we’re all going to agree that one entity is going to pay for healthcare. Doesn’t say what the rules are about that. It’s just saying that each of us that pays money into healthcare is going to pay it to one place, and that entity is going to be the entity that pays the providers of healthcare. That’s how most of the delivery systems in the industrialized world operate.
In the United States we kind of have that, because 70% of healthcare provided in the United States is paid for by the government. Most people forget that it’s a relatively small portion of healthcare that’s paid for by the consumer and large employers. A single payer system does not necessarily mean universal healthcare. Universal healthcare takes it a step further and says, everybody gets healthcare and the government’s going to pay for it. Two really different ideas, but related.
Patrick Stroth: Well, let’s focus on M&A on the physician side of the industry, because we’ve got the large health systems, and we’ve got the large institutions and then you’ve got the pharmacy development, medical devices and everything like that. Let’s just look at the physician provider side of the industry. What do you see for the future of physicians in healthcare as we try to change into this fee-for-value emphasis?
Matthew Hanis: I think physician practices for the next 5 to 10 years are in a race for lives. What I mean by that is, if you take the concept of fee-for-value, which has generally pretty solid evidence to indicate that it produces better healthcare value for the consumer and the payer and the provider. If you agree with that premise, then that means that physicians are in a race to find ways to be in contractual arrangements where they have accountability. If I’m a primary care practice, it behooves me to try to enter into contracts where I take on the risk of a Medicaid population, a Medicare population, but I go directly to employers and contract with those employers to serve their employees and the employees families.
Those sorts of arrangements, manage care contracting if you will, are the strongest position for a physician to be in to get a market. If I as a physician practice hold contracts, either for the bundles of healthcare, like I’m a surgical practice, and the bundle for doing orthopedic surgery for a large employer, or I’m in the primary care space and I’m going to contract for the quality of care for an entire population, I’m guaranteed to be sitting at the bird’s eye view of how the money moves in healthcare. If I don’t have the contract for lives, that means that I’m going be subcontracted to somebody else.
I believe the essence of the M&A space for the physician world will be the race for lives. Those physician practices that have built the infrastructure and the capacity to take on population risk of various sorts, that can demonstrate their value in measurable ways, those organizations will continue to expand contractual relationships and exclusive network relationships with payers and ensure the flow of patients to their doors. That requires an enormous amount of work in infrastructure. Frankly, many physician practices are not spending those dollars. I think from an M&A perspective, I don’t think we’re going to see much more acquisition of physician practices by health systems. We’ve seen that market cool significantly. In fact, there’s signs of a number of physician practices unwinding their relationships with health systems.
What I do think we’ll see is acquisition and merger between physician practices, specialty groups merging into multi-specialty. I would expect that when you look at the 4,000 largest physician practices in the country, those organizations will likely consolidate. In 10 years from now I would predict that we’ll have half of those practices that occupy the largest group of physicians.
Patrick Stroth: You spoke awhile earlier about where we’ve got a big layer of intermediaries involved between provider and patient. If there was a way that if we had the physician practices moving toward this fee-for-value model than physician groups are going to be consolidating and one group will buy another, and so forth. Does that translate also to possibly them buying other facilities, imaging centers, surgery centers, physical therapy? Is there room for vertical integration and how would that look?
Matthew Hanis: Yeah. I think you’re spot-on. I feel like the trend there is a combination for the race for lives. If I’m a physician practice, I can provide a much better Population Health solution if I’ve got pretty good control over lab, pharmacy, imagining, rehab, physical therapy, those sets of services that are ancillary to the work of a physician, but are critical to achieving a particular outcome for a patient. That vertical integration trend, I think is very likely. I think that trend comes in two different flavors. One flavor is the vertical integration of healthcare service, like I just described. But the other is vertical integration in a manner to dis-intermediate many of the non-value producing participants in the healthcare ecosystem.
I’ll give you an example. If a physician practice had the ability to manage the total, all the healthcare transactions for one of their patients and they’re in a Population Health contractual arrangement, they probably are going have a much better understanding of the spend of that patient and be able to manage that spend more effectively. I can imagine, or I can see physician practices getting better at being able to do the data of Population Health and perhaps dis-intermediating stakeholders by directly contracting with employers, or contracting with employers in a manner that takes advantage of less brand name sorts of health plans, and more health plans that are designed to serve physician practice needs as much as they’re designed to serve large employer needs.
Patrick Stroth: Is there going to be need for some regulatory reform in order to do this?
Matthew Hanis: I think there is. We’ve already seen the Center for Medicare and Medicaid Services signaling that they want to soften or weaken the Stark regulations that prevent self-referral. We’re seeing several rulings that have come out of the Federal Trade Commission that solidify the ability for independent physician to contract together with health plans and other payers, without getting into anti-trust problems. I feel like from a regulatory perspective the three big things to be watch are Stark Laws, anti-trust law, and then a third area which is CON, certificate of need. Certificate of need constrains in about 20 states of the 50 states in the Union, about 20 states use CON laws to constrain the ability to create new imaging centers or add new surgery suites. Those constraints on the surface, make enormous amount of sense because they prevent the addition of unnecessary healthcare services, which often lead to an increase in utilization.
The problem with CON laws is they often get in the way of a physician practice being able to add imaging and other services to their capabilities of achieving that vertical integration. From an M&A perspective, the loosening of those laws would suggest an acceleration in the merger of physician practices and the expansion of practices to this vertical integration process.
Patrick Stroth: Could you see owners of medical facilities, I don’t know if they’re exclusively physicians as opposed to medical groups and physician practices by law, have to be owned by and run by a physician. But when you’ve got things like kidney dialysis centers, or labs, those don’t have to be owned by physicians. Could there be a situation in M&A where you could see a multi-state network of labs buying physician groups? Could that happen?
Matthew Hanis: I don’t know that I’m aware of that particular example occurring, but I’m 100% sure that there’s strange bedfellows in the outcome of these acquisitions. For example, United Healthcare acquiring DaVita, the largest dialysis business. Well, turns out United Healthcare is currently the largest employer of physicians in the United States. That’s kind of a surprising number because we all think of them as a health insurer, but in fact, they’re a provider of healthcare.
We also see retail pharmacy businesses moving aggressively into the providing of healthcare services. Being able to walk into a clinic at a Walgreens, to get your care taken care of. In those cases it’s not actually in most cases the entity, like the pharmacy is not necessarily employing the physician, but they’re contractually enabling the physician to practice care, and there’s movement of money. I would argue that, if it isn’t a merger on in fact, in many cases, it’s a merger in reality.
Patrick Stroth: The great interviews you have and they’re in HD quality videos and so forth, on Business of Healthcare. Matt, how can our listeners find you?
Matthew Hanis: Absolutely. They can find us on our website at BOHseries.com, or they can search for us on the web. Search on Business of Healthcare and our red logo, you’ll see us pop-up pretty high on the list, both our website, our podcast channels, or LinkedIn and our Twitter as well.
Patrick Stroth: Matt, thank you again for joining us, and we’ll talk again soon.
Matthew Hanis: Thanks so much Patrick. Thank you for having me.