Sujan Rajbhandary

Medical Devices OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems.Medical devices range from simple tongue depressors and bandages to complex programmable pacemakers and sophisticated imaging systems.Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices.The U.S. elderly population (persons aged 65 and above) totaled 60 million in 2023 (18% of the population).The U.S. Census Bureau estimates that the elderly will number 92.7 million by 2065, representing more than 25% of the total population.U.S. Population Distribution by Age GroupThe elderly account for nearly one third of total.Personal healthcare spending for the population segment was approximately $22,000 per person in 2020, 5.5 times the spending per child (about $4,000) and more than double the spending per working-age person (about $9,000).U.S. Population Distribution by AgeU.S. Healthcare Expenditure by AgeSource: U.S. Census Bureau, Centers for Medicare and Medicaid Services, Office of the Actuary, National Health Statistics GroupAccording to United Nations projections, the global elderly population will rise from approximately 808 million (10% of world population) in 2022 to 2.0 billion (19.4% of world population) in 2065.Europe’s elderly made up 20% of the total population in 2022, and the proportion is projected to reach 31% by 2065, making it the world’s oldest region.Latin American and the Caribbean is currently one of the youngest regions in the world, with its elderly at 9% of the total population in 2022, but this region is expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand to 25% of the total population by 2065.North America has an above-average elderly population as of 2022 (17%) and is projected to expand to 27% by 2065.World Population 65 and Over (% of Total)Click here to expand the image above2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $4.4 trillion in 2022 to $7.2 trillion in 2031, an average annual growth rate of 5.5%.This projected average annual growth rate is slightly higher than the observed rate of 5.1% between 2013 and 2021, suggesting some acceleration in expected spending. Projected growth in annual spending for Medicare (7.5%) and Medicaid (5.0%) is expected to contribute substantially to the increase in national health expenditure over the coming decade.Growth in national healthcare spending, after significant growth in 2020 of 10.2%, slowed to 2.7% in 2021. Healthcare spending as a percentage of GDP is expected to increase from 18.3% in 2021 to 19.6% by 2031.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures.Medicare currently provides healthcare benefits for an estimated 65 million elderly and disabled people, constituting approximately 10% of the federal budget in 2021.Spending growth is expected to average 7.8% from 2025 to 2031.The program represents the largest portion of total healthcare costs, constituting 21% of total health spending in 2021 and 10% of the federal budget.Medicare accounts for 26% of spending on hospital care, 26% of physician and clinical services, and 32% of retail prescription drugs sales.U.S. Healthcare Consumption Payor Mix and as % of GDPAverage Spending Growth Rates, Medicare and Private Health InsuranceDue to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Medicare spending totaled $944.3 billion in 2022 and is expected to reach $1.8 trillion by 2031.The Inflation Reduction Act (“IRA”) was signed into law on August 16, 2022 by the Biden administration.Among other items, the IRA aims to lower prescription drug costs and improve access to prescription drugs for Medicare enrollees.Two healthcare spending-related items in the IRA include out-of-pocket caps for insulin products (capped at $35 for each monthly subscription under Part D and Part B) and a $2,000 out-of-pocket annual spending cap for drugs under Medicare Part D.These provisions could have significant effects on the growth rates for out-of-pocket spending for prescription drugs, which are projected to decline by 5.9% and 4.2% in 2024 and 2025, respectively.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients).In most developed economies, the consumers themselves are one step (or more) removed from interactions with manufacturers, and, therefore, pricing of medical devices.Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used).Accordingly, medical device purchasing decisions tend to be largely disconnected from price. Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs.Hospitals are the largest market for medical devices.Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting 1) higher standards to evaluate the benefits of new procedures and devices, and 2) a more disciplined price bargaining stance.The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency.In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively.A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 48.9% of (traditional) Medicare payments were tied to Category 3 and 4 APMs in 2022, compared to 40% in 2021 and 35.8% in 2018.In 2020, CMS released guidance for states on how to advance value-based care across their healthcare systems, emphasizing Medicaid populations, and to share pathways for adoption of such approaches.CMS states that value-based care advances health equity by putting focus on health outcomes of every person, encouraging health providers to screen for social needs, requiring health professionals to monitor and track outcomes across populations, and engaging with providers who have historically worked in underserved communities. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face similar increasing healthcare costs.A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices.Industry participants are required to report manufacturing costs, and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil.Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth of medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients.Successful product development usually requires significant R&D outlays and a measure of luck.If viable, new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments.First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period.Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations.Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization.For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S.The 510(k) clearance process may occasionally require clinical data and generally takes between 90 days and one year for completion.In November 2018, the FDA announced plans to change elements of the 510(k) clearance process.Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 10 years.In early 2019, the FDA announced an alternative 510(k) program to allow medical devices an easier approval process for manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria. In February 2020, the FDA launched its voluntary pilot program: electronic Submission Template and Resource (eSTAR) as an interactive submission template that may be used by the medical device submitters to prepare certain pre-market submissions for a device.Starting in October 2023, all 510(k) submissions were required to be submitted using eSTAR unless exempted.The premarket approval (“PMA”) process is more stringent, time-consuming, and expensive.A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical, and manufacturing data.Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days.However, the process typically takes significantly longer and may require several years to complete.Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval.The current iteration of the Medical Device User Fee Act (MDUFA V) came into effect in October 2022.Under MDUFA V, the FDA is authorized to collect $1.8 billion in user fee revenue for the five-year cycle, an increase from the approximately $1 billion in user fees under MDUFA IV, between 2017 and 2022.A significant change from MDUFA IV to MDUFA V relates to performance goals for De Novo Classification requests (requests for novel medical devices for which general controls alone provide reasonable assurance of safety and effectiveness for the intended use). There has also been updated PMA guidance, with the FDA conducting substantive reviews within 90 calendar days for all original PMAs, panel-track supplements, and 180-day supplements.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations.Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the European Union: Regulation (EU 2017/745), also known as the European Union Medical Device Regulation (EU MDR).The regulation was published in 2017, replacing the medical device directives regulation that was in place since the 1990s.The requirements of the MDR became applicable to all medical devices sold in the EU as of May 26, 2021.The EU is the second largest market for medical devices in the world with approximately €150 billion in sales in 2022, only behind the United States. The EU MDR has introduced stricter requirements for medical device manufacturers, including increased clinical evidence and post-market surveillance. Consequently, there is an increased risk for longer approval processes and delays in manufacturing of these devices.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations.According to the WHO, middle income countries, such as China, Turkey, and Peru, among others, are rapidly converging towards outsized levels of spending as their income scales.When countries grow richer, the demand for health care increases along with people’s expectation for government-financed healthcare.Upper-middle income countries accounted for 16.6% of total global healthcare spending in 2021, up from 8.2% in 2000.As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies.According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.World Health Expenditure as a % of GDPGlobal medical device sales are estimated to increase 5.9% annually from 2023 to 2030, reaching nearly $800 billion according to data from Fortune Business Insights.While the Americas are projected to remain the world’s largest medical device market, the Asia Pacific market is expected to expand at a relatively quicker pace over the next several years.SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers.While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base.Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy.However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.Post-Script – 2024 OutlookThe medical device industry looked to have put the effects of COVID-19 behind by 2023.A large number of elective procedures were deferred in the early part of the pandemic and a measure of catch-up in procedure volumes was reported in subsequent periods.Back to focusing on the longer-term demographic and other trends?Well, maybe not quite so fast.It was always likely that the pandemic-induced disruptions would linger just a bit longer, creating some uncertainty around consumers’ needs and preferences.But the industry awakened to a different type of potential disruption in mid-2023.Would GLP-1 drugs alter long-term demographic trends by reducing massive obesity rates?And would the industry face widespread lower demand for bariatric surgery devices, glucose monitors, cardiovascular devices, orthopedic implants and other equiptment?A mid-year swoon in medtech stock prices was attributed, at least by some, to the wonder drugs.As 2023 came to a close, however, many appear to have reversed course from that early response.We may or may not get more clarity on the longer-term effects of these treatments in 2024 but, surely, they will also bring opportunities to go along with potential challenges for device makers.Taking a broader view, some trends from recent periods will likely persist in 2024.Companies will continue to focus on profitability and profitable growth in a (relatively) higher-interest rate environment.Some observers suggest that an expected but measured decline in rates over 2024 (if it materializes) may not do much for medtech stock prices, further underscoring the need to shore up margins.On the flip side, since the period of rapid interest rate increases appears to be behind us, transaction volume should pick up from the low levels of the past two years.Finally, innovation, as always, will continue to be part of the conversation as novel treatments that serve unmet needs will help to unlock new markets.2024 Outlook reading list:What To Expect From Medtech In 2024 (McKinsey & Company)5 Medtech Trends To Watch In 2024 (MedtechDive)2024 Outlook For Life Sciences: GenAI, Drug Prices, Economy Likely To Influence Strategy (Deloitte)

FEATURE ARTICLE | Five Trends to Watch in the Medical Device IndustryEXECUTIVE SUMMARYThis quarterly update includes a broad outlook that divides the healthcare industry into four sectors:Biotechnology & Life SciencesMedical DevicesHealthcare TechnologyLarge, Diversified Healthcare CompaniesWe include a review of market performance, valuation multiple trends, operating metrics, and other market data. This issue also includes a review of M&A and IPO activity

Executive SummaryOver the past decade stock-based compensation (SBC) gained widespread popularity as a way to reward employees while conserving cash.Turmoil in the stock market during 2022 resulted in employees seeing diminishing value in SBC and investors questioning its aggressive use.In this article, we discuss how market volatility can affect employee, management, and investor perspectives on SBC.

For this quarterly update, we bring together a couple of strands of our medtech and device industry practice.First, as long-term observers, public market developments in 2022 were interesting and perhaps marked an inflection point for the short to medium term.Second, in October, we attended a medtech industry conference, where we were able to gather a rich set of perspectives.The implications for some of the larger companies in the space are probably clear-cut.The downstream reverberations to private, development stage companies may be less straightforward.Nevertheless, since development stage companies are typically constrained by currently available funds and continually contemplating the next funding round, these developments are of critical importance.2022: A Brief ReviewA tumultuous year in the public markets is coming to a close.By the end of the third quarter 2022, the S&P 500 was down nearly 25%, marking a near-bottom for the year.The broader medtech and devices industry largely followed suit.On the brighter side, established large, diversified companies, while lagging their own previous benchmarks, outperformed the broader market.As a group, some biotech and life sciences companies (see next section) also seemed to fare relatively well.A closer look reveals that within the group some of the larger companies with more diversified revenue bases and, perhaps more importantly, profitable operations performed much better than smaller companies promising higher growth but deferred profits.Current profitability also appeared to differentiate better stock price performers among the medical device and healthcare technology companies.At the same time, negative sentiment was more apparent for wide swathes of these two groups compared to the broader industry.It is obvious in hindsight but over the course of 2022, as interest rates rose and remained high, markets seemed to prefer existing earnings and nearer-term cash flows over future (rosier) prospects.The shift towards more caution also manifested in other measures of market sentiment and activity.Wholesale downward revisions of earnings (growth) estimates have not occurred so far (this may yet come to pass), so much of the price decline reflects compressing valuation multiples.The pace of M&A transactions, which had gone from strength to strength during 2020 and 2021 despite myriad disruptions and distractions, decelerated significantly in 2022.By our measure, total transactions volume in the industry through the first three quarters of 2022 was roughly equal to that of just the fourth quarter of 2021.The number of IPOs also slowed to a trickle.Looking Ahead to 2023 and Beyond: A Few Notes for Development Stage CompaniesNo industry is an island but as we and others have pointed out, several long-term trends, demographic and otherwise, suggest a favorable overall outlook for the medtech and device space. Even against the seemingly dour recent market backdrop, a multitude of attendees at the medtech conference agreed on the relative merits of the industry compared to the broader economy and market. We work with a number of development stage medtech and device companies over the course of a typical year. From that perspective, we find the long-term trends interesting because of the structural emphasis on continual innovation that improve outcomes for patients and clinicians.A defining feature of medtech innovation funding is that it occurs over multiple tranches as the technologies and companies achieve various developmental milestones.In this context, some observations for development stage companies:An obvious first order effect of the recent public market developments over the past year is that development stage companies should expect generally lower valuations for funding rounds (at least) over the next couple of years.Lackluster exit activity, via either M&A or IPO, delays and/or reduces deployable capital for venture capital funds, which will make them more cautious in considering investment decisions.The sentiment shift towards more caution is shared by all investors, although the degrees will differ.Accordingly, in addition to valuation compression, some types of companies (for example, those at the pre-clinical stage) will find fundraising to be extremely difficult.As a corollary, investors are likely to prize clean clinical data. Companies focused on demonstrating good clinical outcomes will be better prepared for future funding rounds.Similarly, companies that can stretch their existing funds until they can achieve a good (clinical) milestone will be better rewarded in the next funding round.Commercial traction after hurdling regulatory approval remains an important structural consideration, especially for the non-corporate investors.Wrap-upBeyond the near-term market dynamics, a key conference takeaway for us was that the medtech funding eco-system is deep and diverse.We met and heard from traditional venture capital investors, corporate investors, and folks who operate in the continuum between them.The goals for the various investors differ to some degree, with some focused on financial attributes while others (like corporate VCs) include strategic considerations in the mix.Investors with broader goals and considerations are, to an extent, less sensitive to the prevailing market conditions and can afford to take a longer-term view.Even among these investors, financial terms and preferred deal structures vary considerably.For development stage companies contemplating fundraising efforts, a deep and diverse investor eco-system can provide plenty of optionality.In keeping with a recurring theme of this update, a note of caution – evaluating a potential funding round requires both an examination of the financial terms and an understanding of the structural features and their longer-term implications.Mercer Capital has broad experience in providing valuation services to medtech and device start-ups, larger public and private companies, and private equity and venture capital funds involved in the sector.Please contact us to discuss how we may be of help.For a more in-depth review of the industry, take a look at our most recent newsletter.

Medical Devices OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems.Medical devices range from simple tongue depressors and bandages to complex programmable pacemakers and sophisticated imaging systems.Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices.The U.S. elderly population (persons aged 65 and above) totaled 40.3 million in 2021 (13% of the population). The U.S. Census Bureau estimates that the elderly will more than double by 2060 to 95 million, representing 23% of the total population.The elderly account for nearly one third of total healthcare consumption in the U.S.Personal healthcare spending for the population segment was approximately $19,000 per person in 2014, five times the spending per child (about $3,700) and almost triple the spending per working-age person (about $7,200).According to United Nations projections, the global elderly population will rise from approximately 608 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060.Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region.While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from approximately 8% in 2015 to more than 21% of the total population by 2060.2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $4.1 trillion in 2020 to $6.2 trillion in 2028, an average annual growth rate of 5.4%.This projected average annual growth rate is faster than the observed rate of 3.9% between 2009 and 2018. Projected growth in annual spending for Medicare (4.3%) and Medicaid (5.6%) is expected to contribute substantially to the increase in national health expenditure over the coming decade.However, growth in national healthcare spendinghas slowed in 2021 to 4.2%, down from 9.7% in 2020. Healthcare spending as a percentage of GDP is expected to remain virtually unchanged from 19.7% in 2020 to 19.6% by 2030.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures.Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018 and is expected to rise to 18% by 2028.Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2020.Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services.Due to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services.Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $776 billion in 2020 and are expected to reach $1.5 trillion by 2030.The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs.While political debate centered around altering the ACA has been a continuous fixture in American politics since its passing, it is unlikely that material reform to the ACA occurs in the near future under the Biden Administration.Total Medicare spending is projected to grow at 5.6% annually between 2025 and 2030, compared to year over year growth of 11.3% in 2021 and 3.5% in 2020.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients).In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices.Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used).Accordingly, medical device purchasing decisions tend to be largely disconnected from price. Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs.Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices.Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency.In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively.A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 35.8% of payments were tied to Category 3 and 4 APMs in 2018, compared to 32.8% in 2017.In 2020, CMS released guidance for states on how to advance value-based care across their healthcare systems, emphasizing Medicaid populations, and to share pathways for adoption of such approaches. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face similar increasing healthcare costs.A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices.Industry participants are required to report manufacturing costs, and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil.Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth of medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients.Successful product development usually requires significant R&D outlays and a measure of luck.If viable, new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments.First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period.Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations.Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the US without prior authorization.For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S.The 510(k) clearance process may occasionally require clinical data and generally takes between 90 days and one year for completion.In November 2018, the FDA announced plans to change elements of the 510(k) clearance process.Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 10 years.In early 2019, the FDA announced an alternative 510(k) program to allow medical devices an easier approval process for manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria. The plans materialized as the Abbreviated 510(k) Program later in the year.The premarket approval (“PMA”) process is more stringent, time-consuming, and expensive.A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical, and manufacturing data.Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days.However, the process typically takes significantly longer and may require several years to complete.Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval.The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022. Intended to begin in 2020, negotiations for MDUFA V were delayed due to the COVID-19 pandemic. The FDA and industry groups reached a deal for MDUFA V, slated to go into effect beginning fiscal 2023, which would generate up to $1.9 billion in fees to the agency over five years. The U.S. House of Representatives passed MDUFA V in June 2022 and the Senate is expected to follow suit by September 2022.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations.Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive.Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market.This CE marking verifies that a device meets all regulatory requirements, including EU safety standards.A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. According to the WHO, middle income countries, such as Russia, China, Turkey, and Peru, among others, are rapidly converging towards outsized levels of spending as their incomes increase.When countries grow richer, the demand for health care increases along with people’s expectation for government financed healthcare.Middle income country share, the fastest growing economic sector, increased from 15% to 19% of global spending between 2000 and 2017.As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies.According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades.Global medical device sales are estimated to increase 5.4% annually from 2021 to 2028, reaching nearly $658 billion according to data from Fortune Business Insights.While the Americas are projected to remain the world’s largest medical device market, the Asia Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers.While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base.Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy.However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.

EXECUTIVE SUMMARYThis quarterly update includes a broad outlook that divides the healthcare industry into four sectors:Biotechnology & Life SciencesMedical DevicesHealthcare TechnologyLarge, Diversified Healthcare CompaniesWe include a review of market performance, valuation multiple trends, operating metrics, and other market data. This issue also includes a review of M&A and IPO activity.

The medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons aged 65 and above) totaled 49 million in 2016 (15% of the population). The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 95 million, representing 23% of the total population. The elderly account for nearly one third of total healthcare consumption. Personal healthcare spending for the population segment was $19,000 per person in 2014, five times the spending per child ($3,700) and almost triple the spending per working-age person ($7,200). According to United Nations projections, the global elderly population will rise from approximately 607 million (8.2% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060. Europe’s elderly are projected to reach approximately 29% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from less than 8% in 2015 to more than 21% of the total population by 2060. 2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.5 trillion in 2017 to $6.0 trillion in 2027, an average annual growth rate of 5.5%. While this projected average annual growth rate is more modest than that of 7.0% observed from 1990 through 2007, it is more rapid than the observed rate of 4.3% between 2008 and 2017. Projected growth in annual spending for Medicare (7.9%) is expected to contribute substantially to the increase in national health expenditure over the coming decade. Healthcare spending as a percentage of GDP is expected to expand from 17.9% in 2017 to 19.4% by 2027.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 60 million elderly and disabled people, constituting approximately 15% of the federal budget in 2018. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2017. Medicare also accounts for 25% of hospital spending, 30% of retail prescription drugs sales, and 23% of physician services. Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $591 billion in 2017, and are expected to reach $1.3 trillion by 2028. The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs. On a per person basis, Medicare spending is projected to grow at 4.6% annually between 2017 and 2027, compared to 1.5% average annualized growth realized between 2010 and 2017, and 7.3% during the 2000s. As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers. The tax had become effective on December 31, 2012, but met resistance from industry participants and policy makers. In late 2015, Congress passed legislation promulgating a two-year moratorium on the tax beginning January 2016. In January 2018, the moratorium suspending the medical device excise tax was extended through 2019.3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance. The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively. A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 34% of payments were tied to APMs, a 5% increase from 2016 to 2017. Some expressed concern that the shift toward value-based care would encounter difficulties with the current administration. In November 2017, the CMS partially canceled bundled payment programs for certain joint replacement and cardiac rehabilitation procedures. However, indications are that the CMS supports value-based care and wants pilot programs to accelerate. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment. The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face increasing healthcare costs, as well. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices. Industry participants are required to report manufacturing costs and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China, and Brazil. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.4. Competitive Factors and Regulatory RegimeHistorically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. However, viable new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device (“predicate device”) that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data, and generally takes between 90 days and one year for completion. In November 2018, the FDA announced plans to change elements of the 510(k) clearance process. Specifically, the FDA plan includes measures to encourage device manufacturers to use predicate devices that have been on the market for no more than 1o years. The FDA also announced in its statements plans to finalize guidance establishing an alternative 510(k) pathway in early 2019. This alternative pathway would allow manufacturers of certain “well-understood device types” to demonstrate substantial equivalence through objective safety and performance criteria.The premarket approval (“PMA”) process is more stringent, time-consuming and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical and manufacturing data. Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days. However, the process typically takes significantly longer, and may require several years to complete. Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval. The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022.Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market. This CE marking verifies that a device meets all regulatory requirements, including EU safety standards. A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa and South Asia) have seen an increase in healthcare spending as a percentage of total output over the last two decades. Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia/Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years. SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.

When an exit event is not imminent, the appropriate models to measure the fair value of a company with a complex capital stack are the Probability Weighted Expected Return Method (PWERM), the Option Pricing Method (OPM), or some combination of the two.  While the choice of the model(s) is often dictated by facts and circumstances – for example, the company’s stage of development, visibility into exit avenues, etc. – using either the PWERM or the OPM requires a number of key assumptions that may be difficult to source or support for pre-public, often pre-profitable, companies.  In this context, primary or secondary transactions involving the company’s equity instruments, which may or may not be identical to common shares, can be useful in measuring fair value or evaluating overall reasonableness of valuation conclusions.For companies granting equity-based compensation, transactions are likely to take the form of either issuances of preferred shares as part of fundraising rounds or secondary transactions of equity instruments (preferred or common shares, as part of a fundraising round or on a standalone basis).  Fundraising rounds usually do not provide pricing indications for common shares (or options on common) directly.  However, a backsolve exercise that calibrates the PWERM and/or the OPM to the price of the new-issue preferred shares can provide value indications for the entire enterprise and common shares.  While standalone secondary transactions may involve common shares, facts and circumstances around those transactions may determine the usefulness of related pricing information for any calibration or reconciliation exercise.  Calibration, when viable, provides not only comfort around the overall soundness of valuation models and assumptions, but also a platform on which future value measurements can be based.This article presents a brief discussion on evaluating observed or prospective transactions.  Not all transactions are created equal – a fair value analysis should consider the facts and circumstances around the transactions to assess whether (and the degree to which) they are useful and relevant, or not.1Fair ValueASC 718 Compensation-Stock Compensation defines fair value as “the amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”  ASC 820 Fair Value Measurement defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”  While some of the finer nuances may differ slightly, both definitions make reference to the concepts of i) willing and informed buyers and sellers, and ii) orderly transactions.Notably, ASC 820 includes the directive that “valuation techniques used to measure fair value shall maximize the use of relevant observable inputsÉand minimize the use of unobservable inputs.”  We take this to mean that pricing information from transactions should be used in the measurement (valuation) process as long as they are relevant from a fair value perspective.Willing and Informed PartiesA fundraising round involving new investors, assuming the company is not in financial distress, tends to involve negotiations between sophisticated buyers (investors) and informed sellers (issuing companies).  As such, these transactions are relevant in measuring the fair value of equity instruments, including those granted as compensation.When a fundraising round does not involve new investors, the parties to the transaction are not necessarily independent of each other.  However, such a round may still be relevant from a fair value perspective if pricing resulted from robust negotiations or was otherwise reflective of market pricing.Secondary Transactions – Orderly Transactions?As they give rise to observable inputs, secondary transactions can be relevant in the measurement process if the pricing information is reflective of fair value.  Pricing from transactions in an active market for an identical equity instrument would generally reflect fair value.  In other cases, orderly transactions Ð those that have received adequate exposure to the appropriate market, allowed sufficient marketing activities, and were not forced or distressed Ð can give rise to transaction prices that are reconcilable with fair value.  Orderly secondary transactions that are relatively larger and those that involve equity instruments similar to the subject interests are more relevant.Strategic ElementsSome fundraising rounds involve strategic investors who may receive economic benefits beyond just the ownership interest in the company.  The strategic benefits could be codified in explicit contracts like a licensing arrangement.  Consideration paid for equity interests acquired in such transactions may exceed the price a market participant (with no strategic interests) would consider reasonable.  However, even as the pricing indication from such a transaction may not be directly relevant, it can be a useful reference or benchmark in measuring fair value.  For example, it may be possible to estimate the excess economic benefits accruing to the strategic investors.  Any fair value indication obtained separately could then be compared and reconciled to the price from the strategic fundraising rounds.In other instances, strategic rounds may result in the company and investors sharing equally in the excess economic benefits.  The transaction price could then be reflective of fair value, and a backsolve analysis to calibrate to the transaction price would be viable.More Complex StructuresA tranched preferred investment may segment the purchase of equity interests into multiple installments.  Pricing for such a round is usually set before the transaction and is identical across the installments, but future cash infusions may be contingent on specified milestones.  Value of a company usually increases upon achieving technical, regulatory, or financial milestones.  Even when future installments are not contingent on specified milestones, value may increase over time as the company makes progress on its business plan.  Pricing set before the first installment tends to reflect a premium to the value of the company at the initial transaction date as it likely includes some expectation of potential economic upside from future installments.  On the other hand, the same price may reflect a discount from the value of the company at future installment dates as the investments are (only) made once the economic upside is realized.  Accordingly, a reconciliation to pricing information from these fundraising rounds may require separate estimates of the expectation of future upside (for the initial transaction date) and future values implied by the initial terms of the transaction (for later installment dates).Some fundraising rounds involve purchases of a mix of equity instruments across the capital stack (i.e. different vintages of preferred and/or common) for the same or similar stated price per share.  Usually, common shares involved in mixed purchases represent secondary transactions.  From a fair value perspective, the transaction could be relevant in the aggregate and provide a basis to discern prices for each class of equity involved (considering the differences in rights and preferences among the classes).  In other instances, either the company or the investor may have entered into a transaction for additional strategic benefits beyond just the economics reflected in the share prices.  Depending on whether the buyer or the seller expects the additional strategic benefits, reported pricing may exceed the fair value of common shares or understate the value of the preferred shares.  In yet other instances, mixed purchases at the same or similar prices may indicate a high likelihood of an initial public offering (IPO) in the near future.  Typically, preferred shares convert into common at IPO and only one class of share exists subsequently.Timing of Transactions and Other EventsPerhaps obviously, for both secondary and primary transactions, more proximate pricing indications are generally more directly useful for fair value measurement.  Older, orderly transactions involving willing and informed parties would have been reflective of fair value at the time they occurred.  If a more recent pricing observation is not available, current value indications could still be reconciled with the older transactions by considering changes at the company (and general market conditions) since the transaction date.Planned future fundraising rounds could also provide useful information.  In addition to the factors already addressed, a fair value analysis at the measurement date would need to consider the risk around the closing of the transaction.Besides the usual transactions, other events that occur subsequent to the measurement date could still have a bearing on fair value.  Future events that were known or knowable to market participants at the valuation date should be considered in measuring fair value.  Events that were not known or knowable, but were still quite significant, may require separate disclosures.Special Case – IPOsAn example of a special event on the horizon is an impending IPO.  An IPO is usually a complex process that is executed over a relatively long period.  At various points during the process, the company’s board or management, or the underwriter (investment banker) may project or estimate the IPO price.  These estimates may change frequently or significantly until the actual IPO price is finalized.  Even the actual IPO price may be subject to specific supply and demand conditions in the market at or near the date of final pricing.  Subsequent trading often occurs at prices that vary (sometimes drastically) from the IPO price.  For these reasons, estimates or actual IPO prices are unlikely to be reflective of fair value for pre-IPO companies.Setting aside the uncertainties and idiosyncrasies around the process, an IPO provides ready liquidity for investors and access to public capital markets for the company.  The act of going public ameliorates the risks associated with the lack of marketability of investments in a company.  Easier access to public markets generally lowers the cost of capital, which would engender higher enterprise values.  Accordingly, fair value of a minority equity interest prior to an IPO is generally perceived to be meaningfully different from (estimates of) the IPO price.ConclusionIncorporating information from observed or prospective transactions can help calibrate the PWERM or the OPM (or other valuation methods), along with the underlying assumptions.  However, a valuation analysis should evaluate the transactions to assess whether they are relevant.  Even when they are not directly relevant, transactions can help gauge the reasonableness of valuation conclusions.Valuation specialists are fond of thinking their craft involves a blend of technique and judgment.  The specific mechanics of models and methods, and related computations, represent the technical aspect.  There is certainly some judgment involved in developing or selecting the assumptions that feed into the models.  Judgment plays a bigger role, perhaps, in weaving together the models, assumptions, valuation conclusions, and other facts and circumstances, including transactions, into a coherent and compelling narrative.Contact Mercer Capital with your valuation needs. We combine technical knowledge and judgment developed over decades of practice to serve our clients.1   The discussion presented in this article is a summary of our reading of the relevant sections in the following:Valuation of Privately-Held-Company Equity Securities Issued as Compensation, AICPA Accounting & Valuation Guide, 2013Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies, Working Draft of AICPA Accounting & Valuation Guide, 2018 Originally published in the Financial Reporting Update: Equity Compensation, June 2019.

A logical fallacy occurs when one makes an error in reasoning.Causal fallacies occur when a conclusion about a cause is reached without enough evidence to do so.The cum hoc (“with this”) fallacy is committed when a causal relationship is assumed because two events occur together.When it comes to financial reporting, an example of this fallacy would be assuming that goodwill cannot be impaired unless the company’s shares are trading below book value.This is a tempting fallacy–especially as the U.S. economy is continuing a long expansion, companies are posting solid earnings, and valuations are reaching new highs.The S&P 500 increased 19% in 2017 and the Nasdaq was up 28%.In these market conditions, goodwill impairment probably does not seem like a pressing concern.After all, goodwill is considered impaired only when fair value drops below carrying value, right?While this is true, accounting standards require that goodwill be tested for impairment at the reporting unit level.Impairment relates to a reporting unit’s ability to generate cash flows.This means that a company’s goodwill can be impaired at the reporting unit level, even as its stock trades above book value.This was the case for multinational conglomerate General Electric last year.GE had a tumultuous 2017 as the company’s CEO and CFO departed, the dividend was cut, and a corporate restructuring was announced.The salient event for the purposes of this article is a $947 million impairment loss recorded in its Power Conversion Unit during the third quarter of 2017.This unit is what became of GE’s 2011 $3.2 billion acquisition of Converteam, an electrical engineering company.According to the company’s 2017 annual report, the causes for this impairment included downturns in marine and oil and gas markets, pricing and cost pressures, and increased competition.GE’s stock felt the turmoil, falling 42% in 2017.Shares traded at $17.25 at their lowest point, implying a market capitalization of $150.5 billion.But even at this point, GE’s stock was not trading below book value ($64.3 billion at the end of 2017).GE’s market value exceeded book value of equity by $86.2 billion.So while impairment and market value/share price are related, it is not safe to assume that there is no impairment if the stock trades above book value.Another notable example is CVS Health.The company made headlines with one of the largest mergers of the year when it announced the acquisition of insurer Aetna, Inc. for $69 billion in December 2017.A smaller, less widely reported transaction transpired in November when the company announced the sale of its RxCrossroads reporting unit to McKesson Corp. for $735 million.This unit was part of CVS’s 2015 acquisition of nursing home pharmacy Omnicare, Inc. and provided reimbursement assistance and sales operation support, among other services.In the second quarter of 2017, CVS recognized a $135 million impairmentcharge related to this reporting unit.As with GE, CVS never traded below book value.CVS stock declined approximately 8% in 2017 and hit a low of $66.45 on November 6.The market capitalization at this point was approximately $67.7 billion.The book value of CVS equity was $34.9 billion at September 30, 2017 and $37.7 billion at year-end.The above examples expose the fallacious idea that a company can avoid impairment charges simply because its stock trades above book value.That is not to say that there is no relationship between the two; an impairment charge can certainly signal the market and affect share price, or a decline in share price may foreshadow an impending impairment charge.Because goodwill must be tested for impairment at the reporting unit level, impairment may occur even when the company’s market cap exceeds book value. Originally appeared in Mercer Capital's Financial Reporting Update: Goodwill Impairment

Medical Device OverviewThe medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.1. DemographicsThe aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons 65 and above) totaled 48 million   in 2015 (15% of the population). The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 98 million, representing 24% of the total U.S. population.The elderly account for nearly one third of total healthcare consumption. Personal healthcare spendingfor the 65 and above population segment was $19,000 per person in 2012, five times the spending per child ($3,600) and almost triple the spending per working-age person ($6,600).According to United Nations projections, the global elderly population will rise from 608 million (8.3% of world population) in 2015 to 1.8 billion (18.1% of world population) in 2060. Europe’s elderly are projected to reach 28% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to experience drastic transformations over the next several decades, with the over 65 population segments expected to expand from 8% in 2015 to more than 23% of the total population by 2060.2. Healthcare Spending and the Legislative Landscape in the U.S.Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.2 trillion in 2015 to $5.6 trillion in 2025. Healthcare spending as a percentage of GDP is also expected to expand from 17% in 2015 to over 20% by 2025.Since inception, Medicare has accounted for an increasing proportion of total U.S. healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 57 million elderly and disabled Americans, constituting approximately 15% of the federal budget in 2015. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2014. Medicare also accounts for 26% of hospital spending, 29% of retail prescription drugs sales, and 23% of physician services. Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Netoutlays to the four parts of Medicare totaled $540 billion in 2015, and spending is expected to reach $709 billion by 2020. Between 2000 and 2010, growth in Medicare spending per capita was comparable or lower than private health insurance spending. The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected   to constrain annual growth in Medicare spending over the next several decades by curtailing increases in Medicare payments to healthcare providers, and establishing several new policies and programs designed to reduce costs. On a per person basis, Medicare spending is projected to grow at 4.3% annually from 2015 and 2025, compared to 5.7% average annualized growth realized from 2000 to 2014. As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers. The 2.3% levy was expected to net nearly $30 billion over a decade into the early 2020s. The tax became effective on December 31, 2012, but met resistance from industry participants and policy makers. In July of 2015, the U.S. House of Representatives voted to repeal the medical device tax. In late 2015, Congress passed legislation promulgatinga two-year moratorium on the tax beginning January 2016. 3. Third-Party Coverage and ReimbursementThe primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (the patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers typically receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance. The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models by the end of 2016 and 2018, respectively. In March 2016, the HHS estimated 30% of Medicare payments were tied to alternative, value-based models, nearly one yearahead of schedule. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment. The medical device industry faces similar reimbursement issues globally. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down industry product prices. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market. 4. Competitive Factors and Regulatory RegimeHistorically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. However, viable new devices can elevate average selling prices, market penetration, and market share.Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.Regulatory Overview in the U.S.In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data, and generally takes between 90 days and one year for completion.The premarket approval (“PMA”) process is more stringent, time-consuming and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical and manufacturing data. Once the PMA is submitted and found to be complete, the FDA begins an in-depth re- view, which is required by statute to take no longer than 180 days. However, the process typically takes significantly longer, and may require several years to complete. Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval, as well as establishment registration. The current iteration of the act, MDUFA III, was enacted in 2012 and expected to collect approximately $400 million in user fees over five years. The FDA and the medical device industry have reached a broad agreement on the outlines of the next iteration. The FDA is expected to collect nearly $1 billion in user fees over five years pursuant to MDUFA IV, which would go into effect in in October 2017. Regulatory Overview Outside the U.S.The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the U.S. FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.Medical device manufacturers face a single regulatory body across the EU, the Company’s second largest end market behind the U.S. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold on the market. This CE marking verifies that a device meets all regulatory requirements for the EU, and that they meet EU safety standards. A set of different directives apply to different types of devices, and the device must be compliant with the directive that purviews it.5. Emerging Global MarketsEmerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa) have seen an increase in healthcare spending as a percentage of total output over the last two decades. Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia and Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years. SummaryDemographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.

Concurrent with Madeleine Harrigan’s post last week about IPOs being the new private equity downround, the financial reporting group at Mercer Capital published an interview with the head of the group, Travis Harms, on the difficulties mutual funds face in valuing level 3 assets (think Square). The following is an excerpt from that interview.With respect to portfolio valuation, who are your clients and what services do you provide? In our portfolio valuation practice, clients cover the spectrum from debt-focused funds, to hedge funds, traditional private equity funds, venture funds, and sector-focused credit and equity funds. Despite the diversity of strategies, what they all have in common is the need to develop reliable, defensible fair value marks for hard-to-value assets in a real-time reporting cycle. That reporting cycle varies by client – we mark some assets on a monthly basis, while we look at others annually. The frequency with which we mark assets is generally a function of the fund manager’s ability to develop interim marks on their own – do they have the requisite expertise and staffing to develop and document reasonable interim marks? Now, of course, the fund manager has the expertise to value assets. However, the fund manager’s valuation objective is to determine “intrinsic” or “investment” value, which may well differ from the prevailing market consensus. That is not the objective of fair value reporting, though. Fair value is not the fund manager’s price target based on his investment thesis. It is a particularly defined standard: fair value is the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Developing and documenting the corresponding market participant inputs can be time-consuming and requires a different perspective than the fund manager is accustomed to using. Sometimes we are developing our own independent estimates of fair value from scratch; other times we are examining the fund manager’s own estimates for the purpose of providing positive assurance that the marks are reasonable. Regardless of the scope of our work, documenting, presenting, and defending our conclusions to auditors and, potentially, regulators is always part of our job. Looking to the VC markets a bit, you have commented on the Unicorn phenomenon and suggested that from a valuation perspective, “What’s obvious isn’t real, what’s real isn’t obvious.” What do you mean? What we mean by that is that – while the headline valuation ascribed to a company following a fundraising round is obvious (price x fully-diluted shares outstanding), that is not the real value of the company. What is less obvious, but considerably more real, is that the price per share in the most recent round reflects all of the rights and economic attributes of that share class. Those rights and attributes are not the same for all of the other shares included in the fully diluted share count. It’s like applying the per-pound price for filet mignon to the entire cow – you can’t do that because the cow includes a lot of other stuff that is not filet. In the same way, the “obvious” pxq calculation overstates the value of an early-stage company. Now, no doubt the values of many “unicorns” are substantial, even when calculated correctly – but the real values are not nearly as obvious as the often breathless headlines would suggest. Last week, a Wall Street Journal article elaborated on some of the difficulties that mutual funds face in valuing their investments in startups. Based on your experience with providing periodic fair value marks for VC funds, what are some of the elements that go into valuing such investments? What are some of the pain points? Valuing startup investments, including “unicorns” such as those mentioned in the Wall Street Journal article, requires developing a thorough understanding of the economics of the most recent funding round, which provides a market-based “anchor” for valuation at subsequent measurement dates. What we find most effective is to build our valuation model so that it corroborates the “anchor” value as of the date of the most recent external funding round. Once our model is appropriately calibrated, we can then develop appropriate market participant model inputs for the measurement date that take into account changes in markets, company performance, and prospects for future exit with regard to timing, amount, and form. Valuing these investments is particularly challenging given the illiquidity of the securities. When observable transactions occur only sporadically or at long intervals, it can be difficult to assess how changes in the market and company prospects will influence value. The longer the holding period – in other words, as you move from days to months to years – the greater the uncertainty regarding reasonable inputs and the wider the range of potential outcomes. Things become even more difficult when you layer in the unique features of many of these securities, such as liquidation preference, conversion, participation, and other rights and features. Finally, the WSJ article discusses the fact that there is variation, sometimes substantial, in the valuation marks provided by different investors in the same company. Is that troublesome? Is it troubling that different reasonably informed investment professionals come to different good faith estimates of the fair value of the securities we’ve been discussing? No. As we mentioned previously, illiquidity necessarily increases uncertainty. This is a phenomenon that you can observe even in securities that trade in markets – the less liquid and shallower the market, the wider the bid-ask spread will be. Even if you follow a rigorous calibration process like we outlined earlier, there is uncertainty about inputs. For example, you may know – on the basis of an observed market transaction – that a company’s value was $40 at a particular date, but what you still cannot directly observe is whether that was 8 times 5 or 10 times 4. Those unobservable inputs will necessarily breed good faith differences of opinion as the $40 value becomes stale with the passage of time. That is not to say that anything goes – there is a range of reasonable conclusions. But no, different estimates of fair value for these securities are not in themselves troubling. A different question, whether it is troubling – given this valuation uncertainty – that an open-end mutual fund owns such securities is for the regulators to decide. It may be that the fair value estimates are reasonable, and reasonably different, but those differences are simply not tolerable from a regulatory standpoint. That, however, is ultimately not a valuation question.Related LinksUnicorn Valuations: What’s Obvious Isn’t Real, and What’s Real Isn’t ObviousHow to Value Venture Capital Portfolio InvestmentsValuation Best Practices for Venture Capital FundsMutual Funds Flail at Valuing Hot Startups Like Uber (subscription required)Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

The following outlines our process when providing periodic fair value marks for venture capital fund investments in pre-public companies.Examine the most recent financing round economicsThe transaction underlying the initiation of an investment position can provide three critical pieces of information from a valuation perspective:Size of the aggregate investment and per share price.Rights and protections accorded to the newest round of securities.Usually, but not always, an indication of the underlying enterprise value from the investor’s perspective. Deal terms commonly reported in the press (example) focus on the size of the aggregate investment and per share price. The term "valuation" is usually a headline-shorthand for implied post-money value that assumes all equity securities in the company’s capital structure have identical rights and protections. While elegant, this approach glosses over the fact that for pre-public companies, securities with differing rights and protections should and do command different prices. The option pricing method (OPM) is an alternative that explicitly models the rights of each equity class and makes generalized assumptions about the future trajectory of the company to deduce values for the various securities. Valuation specialists can also use the probability-weighted expected return method (PWERM) to evaluate potential proceeds from, and the likelihood of, several exit scenarios for a company. Total proceeds from each scenario would then be allocated to the various classes of equity based on their relative rights. The use of PWERM is particularly viable if there is sufficient visibility into the future exit prospects for the company. The economics of the most recent financing round helps calibrate inputs used in both the OPM and PWERM.Under the OPM, a backsolve procedure provides indications of total equity and enterprise value based on the pricing and terms the most recent financing round. The indicated enterprise value and a set of future cash flow projections, taken together, imply a rate of return (discount rate) that may be reasonable for the company. Multiples implied by the indicated enterprise value, juxtaposed with information from publicly traded companies or related transactions, can yield valuation-useful inferences.Under the PWERM, in addition to informing discount rates and providing comparisons with market multiples, the most recent financing round can inform the relative likelihood of the various exit scenarios. When available, indications of enterprise value from the investor’s perspectives can further inform the inputs used in the various valuation methods. In addition to the quantitative inputs enumerated above, discussions and documentation around the recent financing round can provide critical qualitative information, as well.Adjust valuation inputs to measurement dateBetween a funding round and subsequent measurement dates, the performance of the company and changes in market conditions can provide context for any adjustments that may be warranted for the valuation inputs. Deterioration in actual financial projections may warrant revisiting the set of projected cash flows, while improvements in market multiples for similar companies may suggest better pricing may be available for the company at exit. Interest from potential acquirers (or withdrawal of prior interest) and general IPO trends can inform inputs related to the relative likelihood of the various exit scenarios.Measure fair valueMeasuring fair value of the subject security entails using the OPM and PWERM, as appropriate and viable, in conjunction with valuation inputs that are relevant at the measurement date. ASC 820 defines fair value as, "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."Reconciliation and tests of reasonablenessA sanity check to scrutinize fair value outputs is an important element of the measurement process. Specifically as it relates to venture capital investments in pre-public companies, such a check would reconcile a fair value indication at the current measurement date with a mark from the prior period in light of both changes in the subject company, and changes in market conditions.Mercer Capital assists a range of alternative investment funds, including venture capital firms, in periodically measuring the fair value of portfolio assets for financial reporting purposes to the satisfaction of the general partners and fund auditors. Call us – we would like to work with you to define appropriate fund valuation policies and procedures, and provide independent opinions of value.