October 29, 2007

HIT Industry Consolidation: The Impact on Vendors
By David Kauppi, MBA, CBI
For The Record
Vol. 19 No. 22 P. 6

The health technology industry is undergoing an unprecedented wave of consolidation. According to MidMarket Capital’s analysis of industry financial reports, there were 471 merger and/or acquisition deals in the sector in 2006 compared with 443 deals in 2005. Meanwhile, 2007 is on track to be another record-setting year.

For healthcare executives, two questions may arise. First, will consolidation help or hinder the drive toward industry standardization? Second, does this mean I should avoid smaller best-of-breed vendors in favor of large companies? To answer these questions, we need to step back and take a look at the evolution of other technology-based industries.

Consolidation is a natural, positive development in most new, fast-growing industries. In the early 20th century, for example, there was rapid growth and then consolidation in the railroad, automobile, and aviation industries. In nearly every case, consolidation brought large-scale production and lower consumer prices, while industry innovation continued at a rapid rate. The same progression will occur in the HIT sector, eventually leading to bigger companies and lower prices for end users.

More Vendors, Less Adoption?
Let’s take a quick look at the industry today. The 2007 HIMSS conference in New Orleans boasted a record 915 vendors. Looking more narrowly at clinical information system, health information system, and electronic health record (EHR) vendors, the 2007 Healthcare Informatics Resource Guide lists 180 companies in these categories alone.

Many industry analysts agree that in the long term, the U.S. market cannot support this many vendors. In the last year, more than one dozen small HIT vendors quietly went out of business. For other emerging companies—especially those with limited capital resources—survival may require acquisition by a larger company.

The plethora of HIT vendors has worked against widespread adoption of specific standards. In fact, the wide array of operating systems and features makes comparison difficult and interoperability often impossible. This is one main reason why physicians and hospitals have been reluctant to purchase electronic medical records and other information technologies. However, the current wave of consolidation will likely spur more standardization of data standards and operating systems.

To promulgate standards and boost physician adoption, the federal government created the Certification Commission for Healthcare Information Technology, which has developed minimum standards for EHR functionality and certified 80 products thus far.

While one goal of the certification effort was to create a level playing field among IT vendors, some analysts believe it will lead to further consolidation as many small companies struggle to pay the review fees: a $28,000 registration fee and up to $40,000 in additional fees for updates and new products.

Large Vendor Preference
In the hospital industry, there is a widespread preference for large vendors, which brings to mind the old adage, “Nobody got fired for buying IBM.” You may well say the same thing about any of the six major software vendors.

Should hospital executives shy away from independent companies or small vendors that may be acquired? No. Many HIT users fear that when a large company acquires a small vendor, the latter’s technology is likely to disappear, but that is no longer the case. Now, more acquisitions are structured as “hybrid” or equity participation agreements.

In a hybrid mergers and acquisitions (M&A) deal, a large public corporation takes a stake (typically 10% to 50%) in a smaller public or private company. Generally, this equity infusion comes with a right to purchase the entire company at a later date if certain conditions are met.

One leader of the hybrid M&A model has been Cisco Systems, which began using it more than one decade ago. Between 1993 and 2007, Cisco made 119 acquisitions, many of which were start-ups or small companies with limited track records. Larger companies use hybrid acquisitions to gain access to new technologies at minimal cost. In most cases, their intention is to add the new technologies to their current product lineup. For example, a corporation willing to spend $250 million could invest it in an outright purchase of one established company or take a dozen $5 million to $25 million stakes in start-up companies.

A hybrid acquisition holds unique benefits for the seller. For the smaller company, it provides welcome capital, access to new markets and, in many cases, enables the company founders to maintain a high degree of control.

Despite these advantages, hybrid mergers have faced two points of resistance. On the seller side, entrepreneurs are attracted by the glamour of venture capital. Many first-time entrepreneurs believe that obtaining venture capital money signifies they have made it to the big leagues. What they often overlook are the long odds.

According to The Venture Alliance, the odds of a first-time entrepreneur obtaining venture funding are less than 3%. For example, in 2005, out of 125,000 interested parties making pitches to venture capital firms, only 2,939 received funding, with an average of $7.4 million being paid out.

And when an entrepreneur does catch the eye of a venture capital firm, it may face punishing valuations, high expenses, and time-consuming reviews by multiple parties.

On the buyer side, resistance to hybrid mergers comes from the traditional culture found in many corporations that equates ownership with 100% control and a centralized, top-down decision-making process.

However, more corporations understand that in the accelerated world of 21st-century business competition, it is critical to diversify product development by investing in multiple projects. They are also seeing the advantage of fostering an entrepreneurial spirit within the larger corporate structure to improve motivation and boost creative thinking.

A hybrid acquisition can provide a corporation with an efficient vehicle for learning about new products, and technologies can also serve as a platform for additional acquisitions.

The 2017 Marketplace
What will the HIT marketplace look like one decade from now? Will the industry have consolidated down to just a handful of large companies? It’s unlikely. The industry is currently highly fragmented and extremely competitive, and small companies can quickly obtain market dominance. Consolidation will somewhat reduce the overall number of vendors, but scores of companies—large and small—will remain active innovators and sellers.

Smaller vendors will retain many advantages. Because of their narrow focus, they often excel in their use of technology, response to market needs, and focus on deeper departmental workflow solutions.

From a purchaser’s perspective, big is not necessarily better. Many hospital IT executives have had the unfortunate experience of having a large vendor unexpectedly drop a product or business unit, leaving them to scramble for a new solution.

In the next decade, we can expect similar struggles as the industry consolidates. Overall, the trend will be toward products with more functionality and greater reliability. These are the benefits of a competitive, free enterprise marketplace.

— David Kauppi, MBA, CBI, is the managing director of Chicago-based MidMarket Capital Inc. and may be reached at davekauppi@midmarkcap.com.