Investment Considerations for Medtech Mergers and Acquisitions

The medical technology sector has a steady cadence of acquisition announcements as large companies seek to boost their growth rates by buying fast growing smaller companies. Those small company franchises command attention as major players often pay a premium to add the new product line to their own portfolios. Borna Health has benefited as Boston Scientific acquired Apollo Endosurgery, Silk Road Medical, Axonics and others. We do not invest based on the idea of an impending acquisition, however great, growing, defendable medtech franchises naturally attract larger company interest.

The ‘Borna M&A Framework’ (BMAF) compares acquisition strategy and execution to a management team holding a gun with two bullets. Each acquisition uses up a bullet. If the bullet is well utilized management gets another bullet. On the other hand, a bullet wasted on a poor target is gone. And a terribly wasted bullet may cost company management the used bullet, plus the remaining one. The setbacks resulting from a bad acquisition can last for years.

The implications of BMAF are relevant to medtech executives considering acquisitions and investors evaluating the surviving companies. We evaluate these transactions by considering four factors.

1) Customer and channel overlap: The easiest acquisition is one that adds a product used by the acquirors’ customer base allowing sales through their existing sales force. This low-risk pattern played out well in cardiology when electrophysiology and interventional catheter companies (created by VC backed entrepreneurs) provided a stream of effective specialized products to flow through the majors’ existing sales channels.

As a counter example, medical sensor company Masimo, which ruled pulse oximetry, strayed a bit too far from home when it acquired a consumer audio company with the intention of applying its sensor and signal processing technology to sport watches. The customer, channel, and competitive environment were all dramatically different from its medical sensor business. It did not go well.

Business overlap is not always essential. In the 1990’s cardiovascular giant, Medtronic expanded into the white spaces of orthopedics and diabetes. The company successfully acquired market leading franchises in Sofamor-Danek’s spinal implants and Minimed’s insulin pumps. These businesses operated profitably as independent entities within the Corporation, adding significant shareholder value.

2) Later stage is easier: As a company grows it becomes smarter, mastering the art of selling to its customers. As a venture capitalist, I observed two huge knowledge inflection points in the life cycle of a medtech start-up company. The first bolus of learning came with moving the technology into the clinic as physician users could give feedback on the appropriateness of the device and its effectiveness relative to other approaches. The second educational opportunity is commercial, occurring when a company makes its first sale. While landing customer number one, management learns exactly who makes the purchase decision, what motivates the buy and the details of the sales cycle. (The time required to land that order was always longer than expected!) Closing that first sale provides  an education.

Early-stage acquisitions of companies that do not yet generate revenues are particularly risky as corporate business development teams exploring companies for purchase often do not realize the limits of their knowledge. The selling management may not be aware of those potential ‘bumps in the road’ either. Those surprises usually push back the timelines and increase costs. Additionally, the losses generated by an early-stage company can be a significant financial drag.

3) The relative size conundrum: When a huge company acquires a smaller company, there is less integration and income statement risk. If things go badly (as they often do) the issues may not crush the earnings of the larger acquiror. As the acquired target companies become more substantial the integration/execution risk grows. The Massimo-Sound United and Baxter-HillRom transactions  illustrated that eating an appetizer can be easier than consuming a whole steak. When the issues with these transactions arose, they overshadowed the performance of the healthy portions of the acquiror’s business. Subsequently, their stocks underperformed for years.

4) The growth rate matters: For a publicly traded acquiror to create value through acquisition, the process should add top-line growth and not just mass. The JPMorgan analyst, Robbie Marcus pointed this out in a call discussing a Baxter acquisition and he described the situation perfectly. Simply buying mass does not make for a better combined company or a better stock.

The medtech sector has a few great acquirors. Boston Scientific leadership has built a behemoth through acquisitions. The management team has consistently bought companies that boost the growth rate and generate attractive margins. To augment their M&A effort, they have built a first-class venture effort that provides a stream of potential targets. Stryker also has a fine track record and more than once I have scratched my head in puzzlement when reading their latest acquisition announcement. But the team in Kalamazoo understands operations and they seamlessly integrated those additions into the organization.

We also consider the historic patterns. Great medtech franchises can be acquired at any stage, but there are moments when lightning is more likely to strike. If a company is on a perfect growth roll, there is little incentive for the board and management to consider a sale. But when great companies trip up and the stock price struggles, the situation changes. In those trying times, management envisions the value of their equity and options package collapsing. It is not just the CEO that feels that phantom pain because the stock usually is widely held across the organization. The paper-loss can lead a management team to appreciate the illusory nature of paper gains and drive the decision to regain those losses through a sale.

We also like businesses with large markets, high margins, and few competitors. Ophthalmology, cardiology, and orthopedic hardware are attractive spaces. On the other hand, certain companies are unlikely acquisition candidates due to the nature of their businesses. For example, we avoid orthopedic bracing as there are few barriers to entry and many competitors. These negatives can, in turn, make those players marginally less attractive investments.

While Borna Health does not invest based on the hope of an acquisition, we do factor it into our thinking for two reasons. An acquisition of a portfolio company at a premium can favorably impact fund performance. And second, the situation at the acquiror changes, either for the better or sometimes the worse.