ibankerblog

Why Deals Crater

I never tire of what I do as an investment banker: I sell companies; I help companies
buy other companies/assets; and, I raise money for companies. It was Lloyd Blankfein of Goldman Sachs who summed it up in a series of unforgettable comments in 2009:

"We're very important." "We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It's a virtuous cycle." "We have a social purpose." "I'm doing God's work." Business Insider 2009

Amen, brother.
What I'm not: a consultant (although I do offer advice about stuff); a financial planner -- I don't set up financial plans for you; a stock broker - I don't sell stock or bonds to widows and orphans; a lawyer; or, an accountant.

I've been asked what are the most common reasons that deals (M&A and private placements) become undone or are re-priced downward after a letter of intent (LOI) has been signed. I spoke to several of my colleagues and the answers haven't changed over time. The most common reason is first:

(1) Missed numbers (usually revenues, EBITDA, FCF, or net income). This really happened: a client was looking to raise money and an investor put in an acceptable LOI. Client had 12 months of consistent slightly growing monthly revenues of $250K. The month the non-binding LOI was signed monthly revenues dropped to $50K and client couldn't confirm that the revenues had simply slipped to the right and would be picked up the next month. My client's position: "no big deal, we're a great company." The investor's position: things came to a screeching halt. When revenues failed to ramp in the next two months, it was "see ya, stay in touch" time.

Another tale of the tape: after a LOI was signed, a sell-side client lowered the remainder of the year's revenue projections by $4mm. EBITDA went from positive to negative. The client expected no adjustment to price as future projections were so great. Uhhhh....it was one of these moments: "Those who cannot remember the past are condemned to repeat it"...Santayana.

The buyer came back with a lower offer; the client accepted it; and the deal got done. Word to the wise, if you know you're about to miss your numbers, let me and your other advisers know immediately. I can start to socialize the message and lessen the shock and impact. It's along the lines of telling me if due diligence will disclose that you killed your parents. Tell me ahead of time so that I can position you as a recent orphan. The goal is no downside surprises.

(2) Management team turns out to be incompatible with buyer's team or are too prickly/difficult for the investors to embrace. Sometimes this can result from a CEO who wants to cut the deal alone or lead negotiations on everything. Not a great idea. There are always times in negotiations when someone needs to be the bad cop. That should be the investment banker or attorney. CEOs, CFOs, CMOs, and other c-level management types think they're impressing their new bosses by being hard-nose guys/gals. Usually they come across as lacking self-awareness, ill-versed, parochial, and out-of-their element. My advice to clients is to run their company so number 1 above doesn't happen and prepare to come in at the last minute as the tie-breaking Solomon. Leave the plumbing to the plumbers. Being in the trenches is overrated.

(3) Due diligence hiccups. See my advice above about disclosing problems to me and your other advisers. Everything tends to come out during due diligence, so the goal is no negative surprises. Have an undisclosed CERCLA exposure at that old manufacturing plant? Uh oh. Have a growing number of disgruntled customers? Think they won't be found out? Uh oh. Took an aggressive stance on revenue recognition? Think it doesn't matter? Uh oh. Have some undisclosed off-balance sheet liabilities? Even ignoring fraud issues and the consequences thereof, these types of problems cause offers to be re-priced at best or pulled at worst. If a buyer or investor concludes that my client isn't honest or forthright, the usual remedy is "we're outta here" under the theory that life's too short and there are too many alternatives to have to do business with crooks or the ethically challenged.

(4) No leverage. I run into this when I'm pulled in at the last minute to close the buyer or investor at the table which is "almost about to wire the funds." Sometimes I get an assignment when a prospect comes in to tell me that that "sure thing" financing didn't close. I don't have to be CSI to figure out how this has gone: the buyer or investor realizes that the client is dealing only with them and no one else. The CEO and his/her team are doing all the work and there's not an investment banker in sight. The thought is corroborated by the fact that the client is using an inexperienced attorney. It's off to the races. The offer comes down; the pre-money comes down; the liquidation preferences go up; last-minute terms are added, indemnities mushroom, etc. If a deal does get done, it's suboptimal. These folks are penny wise and pound foolish, but are absolutely loathe to admit it. They saved a dime and lost a buck.

I also see another version of this when potential clients come to me with 6 months' worth of cash burn and no plan on how to fund the company after it runs out of money. Buyers and investors will realize this and won't tend to respond with the top dollar offer. They will take a "let's wait to see what we'll accept when we miss a payroll" approach or their offer will implicitly be discounted to value financial distress.

(5) Who really owns the intellectual property (IP)? I find that if the IP is key to the value proposition for a buyer or investor, the deal won't get done if IP rights are in question. When I was at IBM, IBM would walk every time if IP ownership wasn't clean. Indemnification isn't sufficient because damages can far exceed the consideration paid.

(6) Passage of time. When deals linger on with little to no apparent progress, they become untethered and float away. Without too much self aggrandizement, but in keeping with Blankfein's comments, my job is to make things happen. It's how I get paid. Left unattended, VCs or PEs will go on to the next shiny thing in the road. A strategic buyer's business development team will move on rather than report lack of progress. My client will look like Mrs. Havisham and I like Pip. Not a great ending after such great expectations.

I could go on, but the above 6 are a decent sample. I may re-visit this again and focus on reasons deals fold pre-LOI, but those are hard times when your baby is deemed to be too ugly to even get a smile, a wink, or even a nod.

Jack Langworthy is a Managing Director at Covington Associates. He can be reached at 617-314-3950 or ibankerblog@covllc.com.

What is Digital Media, anyway?

This is the first Blog entry from the new Digital Media Team at Covington Associates.
Learn more about us here.

The term "digital media" has evolved significantly since 1999, when I joined the senior management team at one of the early pioneers in digital media, Avid Technology [NASDAQ-AVID].

Until the mid-nineties, and before the proliferation of the public Internet, the digital media industry was focused on the systems for creating, editing, enhancing, recording, and playing back visual or audio media, most often for use in the media and entertainment industries. Avid led the way with Oscar®-winning products like the Avid Media Composer for editing film and video and Digidesign ProTools for editing, mixing and mastering audio as well as products for shared storage and media asset management. Other important companies in digital media in that period were Apple with its media friendly computers and software, Adobe with PhotoShop and After Effects, AutoDesk/Discreet Logic with the Flint/Flame/Inferno composting and effects line, and Dolby with 5.1 surround sound.

With the growth of the Internet and the explosion of new digital products and services came a new category within digital media, often called "new media," which reflected the transition from analog to digital forms of both media creation and consumption, and use of new technologies for distribution of content. Large bandwidth "pipes" were deployed across the world with the help of Cisco, and it became feasible and affordable for companies like Akamai to move "rich media" over the internet through increasingly powerful streaming video solutions. In audio, through the use of MP3 files and P2P networks (led by companies like Apple and iTunes, and the more controversial BitTorrent, Napster and Grokster), music distribution (legal and illegal) exploded, and decimated the music industry. The film and television industries have intelligently reduced their commercial risk by partnering with companies like Comcast, Netflix, and Hulu for new digital distribution models for their content, but the outcome is far from clear as broadly successful revenue models do not yet exist.

As Web 2.0 infrastructure took root, and driven by companies like Facebook and Twitter, yet another digital media category evolved called "social media." This drove the growth of social networks and other means for large scale internet-based collaboration, communication, and commentary. The media types included in social media are exceptionally diverse: text, photos, video, audio, digital art, games, virtual goods and "mash ups" of a variety of sources. Other centuries-old media staples like books and newspapers are evolving into digital form as a result of e-books and other tablet reading devices, through the efforts of companies like Amazon and Apple.

Now with the advent (and competing definitions) of Web 3.0, one can speculate about the new contours of the term “digital media.” I would love to hear Marshall McLuhan’s suggestion.

So here is my try: Digital Media is central to the increasingly data-driven, collaborative and frictionless worldwide consumption of all types of information. It is comprised of technologies, platforms, data and knowledge for the creation, management, distribution and monetization of existing or newly created digital forms of communication, art and performance.

John Bowen and I are focused on the current evolution of Digital Media, from a perspective of more than two decades of experience within the industry. Our Digital Media Team looks forward to working with companies in all aspects of digital media in regard to their corporate finance and M&A needs.

Ethan Jacks is a Managing Director at Covington Associates. He can be reached at 617-314-3950 or ethan@covllc.com.

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In Healthcare, It’s All About the Data!

In this fast-changing healthcare environment, better outcomes and improving financial
performance hinge on the ability to gain insight from data. Any organization, regardless of current capabilities can benefit from becoming more analytical over time. Healthcare analytics is rapidly evolving by making extensive use of data (statistical & qualitative) and predictive modeling. There is an overwhelming amount of digital data available through point-of-care encounters, medical claims, pharmacy claims, lab values, biometrics, financial reporting, and others. The insight from this data combined with medical guidelines reveal (i) gaps-in-care & care-alerts, (ii) opportunities for cost savings, (iii) best practices, and (iv) ability to mitigate operational risk.

Many financial/business-oriented systems are now concentrating on solutions dealing with clinical data. The emerging integrated clinical/financial analytical systems combine traditional sources (e.g., general ledger, HR, cost accounting, and claims/revenue data) with rich clinical data from providers. The appeal to integrate detailed data sets into an analytics system is triggered by healthcare reform requiring public report cards and pay-for-performance initiatives, which includes health platforms’ focus on performance metrics and management. Data is also the catalyst for payment reform. The fee-for-service payment model is shifting to outcome-based payment that is linked to provider and member performance and satisfaction ratings.

Gartner predicts that many care delivery organizations, particularly larger ones, will self-develop their own data warehouse systems, with some external support from solution architects, professional services firms, and/or application vendors. This large and eclectic vendor landscape includes consulting, product, and platform vendors. The growing demand for healthcare analytics is attracting many vendors in the following categories:

Payer / Provider Performance Measures: Active Health/Aetna, DocSite/Compuware, IBM, IMS Health, Ingenix, Resolution Health/Wellpoint, MedVantage, Thompson Healthcare, etc.

Decision Support / Risk Mitigation: Cerner, ChoicePoint/Reed Elsevier, DocSite/Compuware, Fair Isaac, iSoft, LTC Risk Management/American Safety, McKesson, PointRight, Verisk, etc.

Wellness Management: Alere, Celera, Health Dialog/Bupa, Healthways, InforTech, Portavita, Thompson Healthcare, WebMD, etc.

Healthcare Marketing: Cegedim, comScore, Thompson Healthcare, IMS Health, inventive Health, SDI Health, TNS Group, Wolters Kluwer, etc.

Revenue Cycle Management: athenahealth, Capario, Emdeon, GatewayEDI, GHN-Online, Ingenix, MedAssets, MED3000, MedeAnalytics, Navicure, Origin Healthcare, Passport Health, etc.

Fraud Prevention: ChoicePoint/Reed Elsevier, HealthDataInsights, IMS Health, Ingenix, TC3, SCIOinspire, Thompson Healthcare, Verisk

Compliance Decision Management: InfoStrength, MediRegs/Wolters Kluwer, Quantros, TractManager, Verge Solutions, etc.

Consulting Services: Accenture, ACS, CSC, Dell Services, Deloitte, IBM, InfoSys, SAP Business Objects, Teradata, etc.

Healthcare analytics improve the competitive market position, profitability, resource use, cost-effectiveness, quality and customer stickiness. Given that this industry landscape provides leading key performance indicators, they trade, relatively speaking, at healthy multiples. Public companies trade at median revenue and EBITDA multiples of 3.9x and 14x, respectively; while precedent M&A transactions have been sold at median revenue and EBITDA multiples of 3.7x and 15x, respectively (sources: Capital IQ and 451 Group). The application of analytical tools is expanding within the healthcare marketplace, as more data is available digitally, resulting in solutions that benefit the clinical and financial aspect of healthcare constituents. As a final note, it’s difficult to triage the problem if you can’t see the problem.

Zeke Navar is a Principal at Covington Associates. He can be reached at 617-314-3950 or znavar@covllc.com.

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Holidays are creeping up. I hate to come across like Scrooge, but I like Thanksgiving
better than Christmas: the pace isn’t as frenetic; expectations are lower; and the drama potential is less. A dry turkey causes less angst than a child or adult blubbering about some imagined slight attendant to getting anything less than the “perfect” gift. Plus Christmas is on Saturday and I’m not sure if I’ll get Friday off. Then again I spent the Friday after Thanksgiving waiting for Godot, so who knows.

I write a weekly column about HIT, investment banking, HIT services, or anything else that I think about. I’ve been doing it for 21/2 years and it helps keep me current as I scramble for topics or stop to examine the next bright, shiny thing in the road.

One recent continuing theme is how lightweight the Meaningful Use Stage 1 criteria are.

As a way of background, the American Recovery and Reinvestment Act of 2009 (ARRA) economic stimulus package aims at incenting more physicians (aka Eligible Providers - EP) to adopt electronic health records (EHR) in their practices. For office-based physicians, as a general rule, the Health Information Technology For Economic & Clinical Health Act (HITECH) portion of ARRA provides up to $44,000 in funding under Medicare and up to $65,000 in funding under Medicaid per EP over a five-year period for adopters of “certified” EHR products used in a “meaningful way.” Incentive payments begin in May, 2011. About 70% of the 5 year HITECH incentive payments will be disbursed (e.g., $30k of $44k) in the first 2 years, As an added stimulus for a physician to invest in a “certified” EHR, the HITECH provides that the Center for Medicare and Medicaid Services (CMS) will reduce its reimbursements to non-participating physicians by an amount of up to 5% of reimbursements otherwise due to a physician beginning in 2015. The Congressional Budget Office estimates that 90% of U.S. physicians will adopt EHRs by 2019 compared to less than the 10% current meaningful use adoption in the physician office setting if all goes as planned. Not so fast.

The original plans for features and functions of a “certified” EHR, and what constitutes “meaningful use” were gutted by the various lobbying groups. Virtually all of these lobbyists were interested only in trying to get HITECH incentive payments to their members as quickly as possible while ensuring that their members only needed to deliver the least amount of features and functionality possible for the most amount of money. Fair disclosure: I am a member of one of those groups, HIMMS. While it makes me almost tear up with pride to reflect on what HIMMS and others have done, I eventually remember that as taxpayer I am going to be paying for this so my chest-thumping stops, at least briefly.

We thought it might be useful to paste in Stage 1 (of 3) criteria and not just link to the Healthcare IT article. The "measure" part is what constitutes "meaningful use." Meeting the simple Stage 1 criteria could result in 70% of the incentive payments flowing to the EP before Phase 2 comes up. Stage 1 is the easy stuff: the hard parts (Stages 2 and 3) are theoretically more valuable to patients and are a risk of being inadequately funded and poorly serviced if EPs pick only a vendor proclaiming that its product is Stage 1 MU certified. That vendor may not be around for future stages and EPs will have no easy answer (see below as to one tried and true solution****)

From: “Meaningful use objectives: eligible professionals, hospitals”, July 13, 2010 | Healthcare IT News Staff

Core Set **
1) Objective: Record patient demographics (sex, race, ethnicity, date of birth, preferred language, and in the case of hospitals, date and preliminary cause of death in the event of mortality)
Measure: More than 50 percent of patients' demographic data recorded as structured data.
2) Objective: Record vital signs and chart changes (height, weight, blood pressure, body mass index, growth charts for children)
Measure: More than 50 percent of patients two years of age or older have height, weight and blood pressure recorded as structured data
3) Objective: Maintain up-to-date problem list of current and active diagnoses
Measure: More than 80 percent of patients have at least one entry as structured data
4) Objective: Maintain active medication allergy list
Measure: More than 80 percent of patients have at least one entry recorded as structured data.
5) Objective: Record smoking status for patients 13 years of age of older
Measure: More than 50 percent of patients 13 years if age of older have smoking status recorded as structured data
6) Objective: For individual professionals, provide patients with clinical summaries for each office visit; for hospitals, provide an electronic copy of hospital discharge instructions on request
Measure: Clinical summaries provided to patients for more than 50 percent of all office visits within three business days; more than 50 percent of all patients who are discharged from the inpatient department or emergency department of an eligible hospital or critical access hospital and who request an electronic copy of their discharge instructions are provided with it
7) Objective: On request, provide patients with an electronic copy of their health information (including diagnostic test results, problem list, medication list, medication allergies, and for hospitals, discharge summary and procedures)
Measure: More than 50 percent of requesting patients receive electronic copy within three business days
8) Objective: Generate and transmit permissible prescriptions electronically (does not apply to hospitals)
Measure: More than 40 percent are transmitted electronically using certified EHR technology
9) Objective: Computer provider order entry (CPOE) for medication orders
Measure: More than 30 percent of patients with at least one medication in their medication ordered through CPOE
10) Objective: Implement drug-drug and drug-allergy interaction checks
Measure: Functionality is enabled for these checks for the entire reporting period
11) Objective: Implement capability to electronically exchange key clinical information among providers and patient-authorized entities
Measure: Perform at least one test of EHR's capacity to electronically exchange information
12) Objective: Implement one clinical decision support rule and ability to track compliance with the rule
Measure: One clinical decision support rule implemented
13) Objective: Implement systems to protect privacy and security of patient data in the EHR
Measure: Conduct or review a security risk analysis, implement security updates as necessary and correct identified security deficiencies.
14) Objective: Report clinical quality measure to CMS or states
Measure: For 2011, provide aggregate numerator and denominator through attestation; for 2012, electronically submit measures

Menu Set ***
1) Objective: Implement drug formulary checks
Measure: Drug formulary check system is implemented and has access to at least one internal or external drug formulary for the entire reporting period
2) Objective: Incorporate clinical laboratory test results into EHRs as structured data
Measure: More than 40 percent of clinical laboratory test results whose results are in positive/negative or numerical format are incorporated into EHRs as structured data
3) Objective: Generate lists of patients by specific conditions to use for quality improvement, reduction of disparities, research or outreach
Measure: Generate at least one listing of patients with specific condition
4) Objective: Use EHR technology to identify patient-specific education resources and provide to the patient as appropriate
Measure: More than 10 percent of patients are provided patient-specific education resources
5) Objective: Perform medical reconciliation between care settings
Measure: Medication reconciliation is performed for more than 50 percent of transitions of care
6) Objective: Provide summary of care record for patients referred or transitioned to another provider or setting
Measure: Summary of care record is provided for more than 50 percent of patient transitions or referrals
7) Objective: Submit electronic immunization data to immunization registries or immunization information systems
Measure: Perform at least one test of data submission and follow-up submission (where registries can accept electronic submission
8) Objective: Submit electronic syndromic surveillance data to public health agencies
Measure: Perform at least one test of data submission and follow-up submission (where public health agencies can accept electronic submission)
Additional choices for hospitals and critical access hospitals
9) Objective: Record advance directives for patients 65 years of age or older
Measure: More than 50 percent of patients 65 years of age or older gave an indication of an advance directive status record
10) Objective: Submit of electronic data on reportable laboratory results to public health agencies
Measure: Perform at least one test of data submission and follow-up submission (where public health agencies can accept electronic data)

Additional choices for eligible professionals
11) Objective: Send reminders to patients (per patient preference) for preventative and follow-up care.
Measure: More than 20 percent of patients 65 years of age or older or five years if age or younger are sent appropriate reminders
12) Objective: Provide patients with timely electronic access to their health information (including laboratory results, problem list, medication lists, medication allergies)
Measure: More than 10 percent of patients are provided electronic access to information within four days of it being updated in the EHR.

*This overview is meant to provide a reference tool indicating the key elements of meaningful use of health information technology. It does not provide sufficient information for providers to document and demonstrate meaningful use in order to obtain financial incentives from the Centers for Medicare and Medicaid Services. The regulations and filing requirements that must be fulfilled to qualify for the Health IT financial incentive program are detailed at www.cms.gov

** These objectives are to be achieved by all eligible professionals, hospitals, and critical access hospitals in order to qualify for incentive payments.

*** Eligible professionals, hospitals, and critical access hospitals may select any five choices from the menu set.

So the bulk of the HITECH incentives payments may be out the door before the value of fully certified EHRs to patients or EPs is realized.

**** Then we’ll have to have another incentive program for the lobbyists to gut to “realize the EHR dream.” Only in America, Land of Opportunity: Just like the Jets and the Sharks.

Jack Langworthy is a Managing Director at Covington Associates. He can be reached at 617-314-3950 or ibankerblog@covllc.com.

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Mountain Climbing, Visibility, and the M&A Market

A few weeks ago, my family and I ventured north to New Hampshire to enjoy some hiking
and take in the fall foliage on a beautiful, clear New England October morning. Having successfully reached the peak of Mount Monadnock (elevation 3165 ft, no small feat for my intrepid six year old daughter), we enjoyed incredible visibility with clear views of the White Mountains to the north and the outline of the Boston skyline visible in the distance to the east, nearly 70 miles away. This was the third time I’ve dragged my family up that mountain in what has unofficially become an annual tradition, but never have we enjoyed the visibility that we enjoyed that day. And while I could pen an article about the merits of New England hiking in the fall, I’ll stick to my day job in middle-market M&A and give a short note about the value of visibility.

In M&A, as in mountain climbing, visibility is your friend. Corporate dealmakers need to act on informed views of future prospects, risks and opportunities. Uncertainty breeds inaction, and while domestic M&A activity has increased of late, it is still recovering from the uncertainty and depths of the Great Recession, when crippled credit markets and a collapse in business and consumer demand led to a sharp downturn in M&A. Until CEOs and boards gain conviction in their own businesses, and until they gain visibility into the future impact of government reform, tax policy and regulatory changes, dealmaking volumes will remain in recovery mode. Throw in an unemployment rate still near 10% and lowered end-market demand, and you can soon see that corporate dealmakers have to climb a mountain of uncertainty. In fact, domestic M&A activity continues to lag behind 2009 figures, with US $481.9 bn worth of deals announced year to date, down slightly (1.6%) from the same period last year.

However, the cloud of uncertainty may soon begin to dissipate. As I write this post, the critical mid-term elections are less than a week away (and have likely occurred by the time you’re reading this). No matter which way the election results tilt, the outcome should go a long way towards increasing certainty about the future direction of regulation, taxes and healthcare reform. The results of the election will give U.S. taxpayers, business owners, corporate managers and their advisors new visibility about their future prospects, as well as changes in their corporate expenses and tax obligations. They may or may not like the direction post-election, but at least they will be in a position to make more informed decisions about their future. Expect the M&A markets to react accordingly.

Still, entrepreneurial markets continue to enable risk taking—for those able to afford it. In the third quarter, several large and cash-rich corporate buyers in healthy sectors took advantage of their capital to make strategic acquisitions. While recovering companies across industries have been socking away cash in the aftermath of the financial crisis, technology companies in particular have been lining their coffers. It’s no accident that a number of the headline deals in the third quarter were in the technology sector, where balance sheets are especially flush.

Like everyone else who makes a living in the M&A business, I enjoyed following the recent duel between tech stalwarts Dell and HP as they sought to top one another in their bid to capture cloud-computing company 3Par. Other recent headline deals included IBM paying a 120 percent premium for Unica Corporation and Intel buying McAfee at a 60 percent premium. If the market will not pay for growth opportunities, acquirers clearly will. Those same dynamics hold true with emerging growth and mid-market businesses which I serve, as large strategic buyers seek to ramp up M&A efforts to acquire needed technology, fill solution gaps and enter new, higher growth areas. A healthcare technology client of mine recently rebuffed a large-cap strategic’s takeover bid at a 10x multiple of its trailing revenue--choosing instead to partner with a different strategic player in a commercial relationship, and pursue a more lucrative payday in the future. They weren’t making the decision lightly, and obviously didn’t have perfect visibility into the future, but growth demands a premium in any M&A market.

Interestingly, while total domestic, year to date $ volume of M&A deals is down slightly from the same period last year, total deal count is up by 25.4% , indicating smaller deals are increasingly getting done. With improvements in the financing market, an increase in private equity activity, and a seemingly more stable economy, the pieces are in place for more robust M&A activity going forward. The mid-term elections should lead to increased visibility in taxes and the regulatory environment, setting the stage for an increase in corporate dealmaking. Like the view I enjoyed from the top of Mount Monadnock on a clear October day, there is hope that the corporate dealmaker’s visibility will soon improve.

Grant Grava is a Director at Covington Associates. He can be reached at 617-314-3950 or ibankerblog@covllc.com.

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A Vital Signs Excerpt: MU and certified EMRs

Managing Director Jack Langworthy writes weekly commentary on the HCIT and related
sectors in his email, Vital Signs. The following is an excerpt from one of his July emails. To be added to the distribution list, email him at ibankerblog@covllc.com.

“It was the best of times, it was the worst of times” – Tale of Two Cities

We’re happy that the federal government issued meaningful use criteria for hospitals and doctors on July 13. We were a little taken aback that the criteria had been so scaled back primarily by industry/trade group lobbying. The driver for lobbying is to optimize the chance for incentive payments available under the Health Information Technology for Economic and Clinical Health Act (HITECH) provisions of the American Recovery and Reinvestment Act of 2009 (ARRA) signed into law in 2009.

Source: 1/09 Chilmark Research

The calculations for HITECH Medicaid and Medicare incentive payments to hospitals are complicated. Here’s a good article to wade through describing the methodology:

HITECH incentive payments to hospitals
We don’t think regression analysis capabilities are required to crack the code, but it requires some ciphering along with an ability to add, subtract, multiply, and divide.

There is still the open issue of what it means for an EMR to be “certified” which is the second part of the process toward the promised land of the incentive payment mother lode. Right now we think only Certification Commission for Health Information Technology (CCHIT) has stepped up to apply to be a certifying body, but the Drummond Group was making noises and sending out press releases that they were applying, too. The more the merrier and we expect there to be more.

Drummond Group: we're in it to win it
Back to our concern about the watered down meaningful use criteria. Initially, hospitals and doctors would have had to meet all criteria to qualify for HITECH incentive payment. After “improvements” supported by the respective lobby groups, hospitals and doctors will have to meet a core criteria group and 5 from a list of 10. I expect they’ll all be able to record patient smoking status, record demographic information, list patient medications, and list medication allergies. And these are among the Phase 1 lay-up criteria for hospitals and doctors.

MU - No one said it would be hard
What’s going to happen when the criteria gets tougher as in Phases 2 and 3? Are the vendors which supplied the Phase 1 solutions going to be around when the going gets tougher? Are they going to offer the same relatively meaningless (excuse the pun) “guarantees” as they are doing with Phase 1 when it comes to Phase 2 and Phase 3? If “meaningful use” (MU) criteria drive what it means to be a “certified” EMR, there will be more risk that vendors which provide initial MU functionality won’t be around for the next rounds.

Should anyone care?

We think there’s a good chance that HITECH incentive payments will be paid to docs/hospitals/EPs complying only with the limited stripped down MU Phase 1 criteria. Because almost 70% of the incentive payments for doctors are made in the first 2 of the 5 years ($30K out of $44K), incentive payments may be made to docs/EPs using an EMR system that won’t qualify for Phase 2 or Phase 3 criteria coming in 2013 and 2015, respectively. And once the money’s gone, docs may be looking a spending net dollars to replace their EMR.

It there a safe harbor? Safer, maybe, if not shelter from the storm. But nothing is perfect.

We have spoken to several senior operating executives of 2008 and/or 2011 CCHIT-certified ambulatory EMR companies and they have said that their EMRs already have the functionality in current versions for what they expect to be the Phase 2 MU standards. Further, they don’t think it will be a stretch to meet Phase 3 MU criteria. We expect Phases 2 and 3 MU criteria to be daunting. And we expect that some number of doctors buying EMRs from vendors selling non-2008 or 2011 CCHIT-certified products will be disappointed when their vendors can’t hit Phase 2 or Phase 3 MU criteria and they have to replace systems.

Why do we at Covington care?

We’re investment bankers and don’t really have a dog in this fight. But we specialize in HIT software companies and those companies will have been treated poorly if the time and investment they’ve spent to get CCHIT-certification doesn’t count for anything meaningful (that pun again) under ARRA/HITECH. We think that docs and hospitals should give value to the greater comfort level they should feel in buying the generally more robust and functionally-advanced CCHIT-certified solutions.

As taxpayers (not to get into too much flag-waving), we’ll be sorely irritated if the first 70% of these HITECH payments are out the door and the public doesn’t have much to show for it.

But as bankers there’ll always be opportunities to provide services to both the winners and losers.

We love comments, so don’t be shy.

Jack Langworthy is a Managing Director at Covington Associates. He can be reached at 617-314-3950 or ibankerblog@covllc.com.

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Health Care Reform and the Quest for $1 billion in R&D Funding

Hooray to healthcare reform legislation. I recently attended an Ernst & Young webinar
that discussed the newly announced $1 billion therapeutic discovery project program. If ever there was a must see (and must do) source of non-dilutive financing for our biotech and pharma clients, this is it.

In one of the more inspiring exhibitions of the Federal Government’s might to do right, as envisioned by the Obama Administration’s overhaul of US Healthcare, the IRS and the Department of Health
and Human Services are promoting the $1 billion program, which will offer cash to pay for 50% of "qualifying therapeutic discovery projects” incurred in either 2009 or 2010. The credit can either be a reduction of the taxpayer’s Federal tax liability or a straight grant for the same amount tax free.

In an effort to encourage development of new and innovative therapeutic technologies here in the States, this broad-based program is targeted to taxpayers with 250 employees or less that are engaged in a wide range of therapeutic discovery projects.

So who should be doing this? Any qualifying companies that are in the midst of or are planning to undergo R&D projects to treat, prevent or diagnose disease. And if you’ve got programs in the pipeline that can be accelerated, don’t hesitate. These can include pre-clinical or clinical programs, or ongoing research. According to the IRS/HHS, programs that show the most potential to develop new therapeutics in areas of unmet medical need, including those that prevent, detect or treat chronic or acute diseases and conditions – even companion diagnostics – will be eligible.

The government’s overarching goal here is to improve treatment regimens while, at the same time, reducing long-term health care costs. Given our out-of-control spending, that’s a good start. It’s a good bet, as well, that oncology programs are likely to be seen as favorites of the agencies, given the clear unmet need exhibited by the market.

Not surprisingly, those programs/companies that exhibit a greater likelihood of creating high-paying jobs here in the US, while advancing our competitiveness in the life sciences, will be favored by HHS (and critics of healthcare reform on either side of the aisle).

What costs are covered? It seems like anything and everything from direct labor to clinical and/or research supplies… even royalties.

There’s no time to waste, as applications are due by the end of May. The IRS has indicated that it hopes to reply to applicants within one month, though that may be as challenging as it was for the recent oversubscribed Challenge Grant program.

With $1 billion at stake, there’s no question that this will be a competitive process as well. Key to receiving consideration will, for sure, be a timely application that is compelling and easily understood. Those companies that have ever (successfully) pitched the VC community will know what needs to go into this, i.e., strong data, a well thought out and convincing story, and a realistic and achievable business plan. That being said, the good news is that HHS may be a bit more “community” focused than the typical institutional investor and likely will be more geared towards positively impacting society, whether by improving treatment or expanding jobs. Funding well run and well managed programs will be key, though they’re likely not to be as focused on years to profitability or generating the 3 to 5x as the typical VCs will be. Kudos to the Great Society.

This is a broad and well funded program. Anyone that meets the tax and employee qualifications and who is funding research programs or clinical trials, in any form, should be sitting down right now to draft. This is the American Way at its best, no? Just remember to get your applications in early!

Steve Mermelstein is a Managing Director at Covington Associates. He can be reached at 617-314-3950 or ibankerblog@covllc.com.

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Calling Joe Jackson – Reflections on an Unexpected Pairing in the Life Science Tools Sector

I read with great interest the recent news that Merck KGaA is going to acquire Millipore after reports that a fellow Massachusetts company, Thermo Fisher had made a bid. My initial (and admittedly weird) reaction was to start singing to myself that great Joe Jackson song, “Is She Really Going Out with Him?”. Let me try to explain why. For those of you not familiar with Millipore, the company is a leading provider of lab gear and supplies including filtration products (its legacy business), products for manufacturing of biological drugs, as well as reagents, kits and other consumables for life science/drug discovery research. At first glance, Thermo would be a logical acquirer of Millpore given that they sell products in many of the same markets; however, Thermo’s offering of products used in the manufacture of biologics drug (a rapidly growing segment of the drug market) is relatively small. So on the surface a marriage of Millipore and Thermo makes sense to me. In contrast, Merck KGaA is probably better known for its pharmaceutical business and the acquisition of Serono. Merck KGaA sells biological drugs, including Erbitux for colorectal cancer and Rebif for treatment of multiple sclerosis, but also has its Chemicals division that includes EMD Biosciences, a supplier of research reagents, kits and other consumables for life science research. So what drove Merck KGaA to make the decision to by Millipore? I think it’s fair to say that having products for biological drug manufacturing is a good thing considering the growth in such drugs is robust, not only in terms of new drugs but also in anticipation of generic biologics (so-called “biosimilars”). Some have speculated that it gives Merck KGaA access to this rapidly growing market while mitigating the risk of developing biologics themselves. Others that are more skeptical suggest that Merck KGaA must be seeing less than rosy growth prospects for its pharmaceutical business and therefore needed to find other business with healthier growth outlooks.

Regardless of the reason, what this transaction demonstrates is further consolidation in the research tools market. Over the past 18 months, we’ve seen some of the industry’s biggest players tie the knot, including: Invitrogen and ABI (to form Life Technologies) in a deal valued at $6.7 billion; and Agilent’s proposed acquisition of Varian, Inc. for $1.5 billion. In addition to these deals, Danaher has emerged as a major player in the life sciences tools space with recent acquisitions of AB SCIEX and Molecular Devices for an aggregate $1.1 billion. For those of us who work with emerging companies that possess life sciences tools and reagents, this consolidation could impact such companies in a number of ways. First, any wave of consolidation creates fewer buyers. Second, large transactions often take time to digest and therefore buyers that have just made such an acquisition may be on the sidelines during the integration process. Third, these transactions will probably push smaller and medium-sized players to be more aggressive in order to effectively compete with behemoths such as Life Tech. In my view, the latter will result in an active M&A market for smaller and medium sized life science tools and reagents companies especially if multiples remain attractive. If not, there’s always that hungry $20 billion market cap company in Waltham…

Dave Wood is a Vice President at Covington Associates. He can be reached at 617-314-3950 or ibankerblog@covllc.com.

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The Chicken or The Egg

Credit markets have existed in humanity since the beginning of time. Like the ongoing debate over the contested arrival of the chicken or the egg (I feel pretty strongly that it was the egg), which came first: The lender or the borrower? I’m less sure about this one but I suspect it was driven by an opportunistic farmer in ancient Mesopotamia who needed capital to expand his acreage or simply bridge the seasonality of his crop cycle. This discussion is relevant today because there is a general assumption that lenders aren’t currently lending money and if they are, the pricing and terms are not in the comfort zone of most borrowers. And without the injection of fresh debt capital into the markets and economy, it is unlikely that we will see a boost in the capital markets or economic activity.

When I speak to many of the lenders that we know, they tell me that they are very busy. “Doing what?” I ask. “Lending money?” They typically answer “Well, yes and no.” Much of what they are doing is rewriting their existing deals, refinancing the deals of other lenders, or, if they are putting out new money, it is to companies that fall on the larger end of the middle market spectrum. When asked directly about this lack of new money, they tell me that client demand is not there. In other words, borrowers are not borrowing.

When I speak to CFOs and the owners of privately held companies (either individuals or private equity groups) they seem resigned to the fact that credit (reasonably priced or not) is not available to them for expansion or acquisition. As a result, these initiatives have been put on hold (“why waste our time if we can’t get the financing”).

Stable and sustainable credit markets result from finding that equilibrium point between the Supply and Demand curves for credit. Regardless of the commodity in question, abundant supply will always (eventually) get soaked up by the market and increased demand will always (eventually) be met by existing providers or new entrants.

Whenever supply outpaces demand in the credit markets (such as when lenders thrust inexpensive, unwanted credit upon the market), we end up in a situation where borrowers have an abundance of credit at below market terms. History has proven that this credit dynamic always (eventually) leads to a bursting bubble with observers wondering how such an awful thing could happen (again). The healthier alternative for the market is for borrowers of the world to unite, rise up and revisit those growth plans or acquisitions. This action will create the loan demand that, in a truly competitive and capitalist system, will drive lenders forward to meet that demand on reasonable price and terms, raising the equilibrium point to a healthier and more sustainable level than it is today.

Michael Papile is a Managing Director at Covington Associates. He can be reached at 617-314-3950 or ibankerblog@covllc.com.

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Feedback from InfoComm and NAB

The recent annual InfoComm (Pro Audio/Visual) and National Association of Broadcasters ("NAB") industry trade shows had some interesting, and perhaps surprising trends this year. Each are roughly $12 billion industries on the equipment side – double that amount with services added. Here are a few takeaways from the show:

1. Does lagging attendance matter?
No end-of-day lines at the Las Vegas Monorail and plenty of lunch seating in Orlando point to an estimated 15-30% drop in attendance from 2008. That said, almost every vendor we spoke to at both shows was pleasantly surprised with the quantity and quality of the business prospects that attended, with an equal amount of leads of higher quality from a year ago. The toadies appeared to have stayed home, but real buyers remain. The majority of vendors I spoke with point to at least flat-to-modestly growing revenues on a YTY basis, with very few experiencing declines. January and February 2009 appear to have been the nadir.

2. Revenue generation is taking a back seat to cost savings.
With television advertising shrinking and the broadband media business model unable to pick up the slack economically, I expect that cost savings measures will drive most decisions in the broadcast industry for the next 12 months. In both Broadcast and ProAV markets, technologies that produce strong ROI by reducing headcount, facilities and travel, and that improve workflows, control, collaboration, and the management of assets appear to be resonating.

3. Portfolio Management - diversity creates stability.
With many broadcast facilities having completed their conversion to digital and HD platforms, businesses that have focused on geographic diversity, in addition to alternative markets such as the enterprise (e.g., business, education, government) appear to be benefiting.

4. Will the “Cloud” change the game?
There is some evidence that cloud-based application environments (e.g., Software as a Service) may be an appealing alternative to equipment purchases. Advantages include the use of operational budgets (vs. capital budgets), variable usage rates, elimination of complexity and operational support, and the option to try it before buying it. Enterprise vendors are already embracing this paradigm, but it remains early days. I wonder whether Avid could utilize this strategy to change the game against Apple’s Final Cut Pro and other lower-cost competitors. Avid is well versed in end-to-end workflow environments, and a cloud-based initiative could give Avid’s customers the best of both worlds – world-class capabilities, operational efficiencies, and cost savings, and could be the game changer that nullifies Apple’s recent advances.

5. Bottoms-up technologies are experiencing strong growth.
Technology companies that enable powerful, but inexpensive, content production or take new approaches to old problems are experiencing strong growth. NAB and InfoComm are full of specialized vendors that service niche areas of the market. However, as customers continue to see advantage in buying from a single, well-capitalized vendor, best-of-breed will ultimately give way to end-to-end solutions from larger vendors. As such, I expect innovations to continue, leading to expansion, and ultimately acquisition by larger participants to bolster and add functionality to existing product lines.

6. Let’s get clear about proprietary versus open-source environments.
Traditional IT companies will play an increasingly disruptive, but not necessarily overriding role as IP-based solutions become pervasive in video markets. Will commodity-based, open-sourced solutions dominate? Well, it depends. While Apple has been lauded for its open application interface on the iPhone, it has been very careful about what it exposes. Professional broadcasters and audio/visual care deeply about perfection – a one-second glitch leads to a conniption. So while I do believe that closed proprietary solutions are bad business in the long term and that being “open” as far in the stack as possible is important (to play well with others in the network, for example), limiting one’s openness is smart and necessary in these industries.

7. It’s a multimedia, multi-platform world.
The ability to address multiple platforms – from traditional television distribution to wireless and LAN/WAN broadband distribution on multiple devices – is front and center. Investments are being made to address actual and expected demand. Will Richmond’s VideoNuze blog posted to this point this morning. Video and audio delivery over broadband connections for enterprise and entertainment use continues full steam ahead.

8. Onward and Upward – Automation and MAM (Media Asset Management).
Most businesses in this sector appear to be doing well with some discussions pointing to a joining of file-based MAM systems and automation functionality. MAM continues to be a fragmented market addressing ingest, production, marketing, distribution, and billing needs to name a few.

9. Enterprise Communications – increasing demand for video.
The use of video continues to expand its relevance in the enterprise, and vendors addressing this vertical market continue to grow at a fast and steady pace. The digital signage market continues to make strides, but continues to be very fragmented. I expect the trade winds to be favorable, with market dynamics flushing out the winners and losers.

10. Enterprise ProAV decision-makers are in transition.
The ProAV market continues its transition from its analog heritage toward IP-based solutions, with the compression of sometimes opposing decision-making groups (e.g., audio, visual, and information technology) accelerating. IT continues its mistrust of audio/visual departments on its networks. As integration companies are responsible for a majority of ProAV equipment installations, getting this group, in addition to industry sales professionals to break away from their comfort zone will be critical for the adoption of IP-based products to be truly embraced.

Like Broadcast and Cable markets, ProAV will evolve to use IP delivery in the network core, while adding value at each end of the network where human interaction occurs.

John Bowen is a  Director at Covington Associates.  He can be reached at 617-314-3950 or jbowen@covllc.com.  

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