Stephanie S. McCann, Partner, McDermott Will & Emery06.01.22
Despite challenges from virtually every direction, 2021 was a banner year for investment activity in the healthcare sector—and early indications suggest that 2022 will be equally busy.
Even as geopolitical uncertainty (including U.S. and global sanctions on Russia), ongoing COVID-19 disruptions, and other macro pressures have contributed to rising costs of capital and increasing prices for energy and other goods and services, several healthcare and healthcare services companies are garnering investment dollars. Overall, the market remains resilient, lending activity appears equally robust, and deal terms are still relatively borrower-friendly.
This favorable environment, however, should not give rise to overconfidence. Several issues may create roadblocks for financing certain deals, and borrowers and lenders must identify creative solutions to help transactions reach the finish line.
Higher energy costs, for example, are likely to have a significant impact on industry subsectors that rely on the transportation of products or people, such as home healthcare services. Given the fact that reimbursement increases are typically set at the beginning of the calendar year, it is likely the size and duration of the gap between transportation and distribution costs and payor reimbursements will depend greatly on whether federal energy policy can encourage a downward trend in fuel prices.
Similarly, the U.S. Federal Reserve announced in March it would increase its target for the federal funds rate this year as part of its effort to combat the effects of high inflation. Interest rate setting is a delicate dance, and its impact on inflation and economic growth is not always immediate. Fast-rising interest rates and slow growth could have a significant dampening effect on healthcare investment transactions.
Labor shortages are yet another concern, not only regarding higher turnover and greater difficulty recruiting and hiring qualified employees, but also regarding higher compensation. In certain subsectors, such as skilled nursing homes and autism services, wages are a major contributor to overall costs. Throughout the pandemic, increased subsidy payments from the government helped cover salaries and related expenses. Once the formal declarations of a public health emergency are lifted, such payments are likely to stop. Taken together, the difficulty recruiting and paying for skilled workers is likely to create a stiff headwind and dampen investor interest in these subsectors.
Other key risks in today’s healthcare market include identifying the permanent changes in healthcare consumer behavior versus those temporarily created by the pandemic. While telehealth is likely to remain an important feature of care delivery, for example, the expiration of federal and state public health emergency declarations and their associated regulatory waivers will impact exactly who can provide telemedicine, where these services should be provided, and the types of patients that can benefit from it.
Similarly, despite the high number of COVID-19-related admissions, hospitalizations and emergency room visits fell during the pandemic, while certain other outpatient services maintained pre-COVID-19 levels. Even if the rate of SARS-CoV-2 infections continues to level off over the next year, it is not entirely clear how that will affect patient demand.
Finally, many healthcare companies depended on pandemic-related government stimulus packages to stay profitable. But that federal or state largesse is unlikely to continue, at which point the “new normal” will look like the old normal: Healthcare companies will survive and/or thrive by providing excellent products and services, maintaining high standards of care, and achieving real results.
This is a trend against which lenders should push back. Regardless of the industry, underwriters must conduct thorough due diligence when making lending determinations. Issues to review include loan-to-value (i.e., purchase price), sponsor-backed versus non-sponsor-backed options, sector/industry differentiation, geographic density/concentration, and other macroeconomic concerns.
In a robust but challenging market, healthcare investors must also focus on the enterprise value of the target company, as well as its potential resilience and sustainability. This may entail seeking additional expertise to look beyond classic considerations and at complex issues such as reimbursement, the regulatory environment, the patient experience, etc.
Another area that warrants exploration is a company’s response to the opportunities and challenges that arose during the pandemic and the likelihood the conditions that led to success or distress will continue after COVID-19 finally fades. Management teams that claim the pandemic was the primary cause of all their challenges (or, conversely, push the idea that an entirely new normal has taken shape and that none of the old rules apply) should be viewed with a certain level of skepticism—perhaps they protest too much (or too little).
The third category of deal activity, which in some instances is very fruitful and interesting, involves independent sponsors. Several institutional investors are spinning off funds run by smart people experienced in buying growing companies and who can spot a good, if non-traditional, fit. In any event, cash flow matters, as funds must be available to service the debt.
Much depends on the sponsor. Looking beyond the hard numbers, lenders are also focusing on the behavior and non-financial performance of potential deal partners and borrowers. Meaningful data to support the borrower’s request is a “necessary cause” to close a deal, but it is not a sufficient cause. There must be a certain synergy between all parts of the team that is further supported by trust and intellectual honesty.
Healthcare information governance, revenue-cycle management, staffing, and value-based care are also likely to see an influx of capital and an uptick in transactions in addition to already high activity levels. But businesses that are primarily provider-based may provide more complex opportunities because reimbursement rates have not kept pace with cost increases.
Stephanie S. McCann is a partner at McDermott Will & Emery. McCann focuses her practice on corporate finance. She represents private equity groups, commercial lending institutions, and major public and private companies in connection with the structuring, negotiation, and documentation of secured and unsecured financing transactions, including senior, mezzanine and subordinated debt transactions, acquisition financings, loan workouts, and restructurings. McCann is a current member of McDermott’s Executive and Management committees.
Even as geopolitical uncertainty (including U.S. and global sanctions on Russia), ongoing COVID-19 disruptions, and other macro pressures have contributed to rising costs of capital and increasing prices for energy and other goods and services, several healthcare and healthcare services companies are garnering investment dollars. Overall, the market remains resilient, lending activity appears equally robust, and deal terms are still relatively borrower-friendly.
This favorable environment, however, should not give rise to overconfidence. Several issues may create roadblocks for financing certain deals, and borrowers and lenders must identify creative solutions to help transactions reach the finish line.
A Trifecta of Challenges (and Then Some)
Rising prices, higher interest rates, and labor shortages are among the top issues that will surely create downward pressure on deals.Higher energy costs, for example, are likely to have a significant impact on industry subsectors that rely on the transportation of products or people, such as home healthcare services. Given the fact that reimbursement increases are typically set at the beginning of the calendar year, it is likely the size and duration of the gap between transportation and distribution costs and payor reimbursements will depend greatly on whether federal energy policy can encourage a downward trend in fuel prices.
Similarly, the U.S. Federal Reserve announced in March it would increase its target for the federal funds rate this year as part of its effort to combat the effects of high inflation. Interest rate setting is a delicate dance, and its impact on inflation and economic growth is not always immediate. Fast-rising interest rates and slow growth could have a significant dampening effect on healthcare investment transactions.
Labor shortages are yet another concern, not only regarding higher turnover and greater difficulty recruiting and hiring qualified employees, but also regarding higher compensation. In certain subsectors, such as skilled nursing homes and autism services, wages are a major contributor to overall costs. Throughout the pandemic, increased subsidy payments from the government helped cover salaries and related expenses. Once the formal declarations of a public health emergency are lifted, such payments are likely to stop. Taken together, the difficulty recruiting and paying for skilled workers is likely to create a stiff headwind and dampen investor interest in these subsectors.
Other key risks in today’s healthcare market include identifying the permanent changes in healthcare consumer behavior versus those temporarily created by the pandemic. While telehealth is likely to remain an important feature of care delivery, for example, the expiration of federal and state public health emergency declarations and their associated regulatory waivers will impact exactly who can provide telemedicine, where these services should be provided, and the types of patients that can benefit from it.
Similarly, despite the high number of COVID-19-related admissions, hospitalizations and emergency room visits fell during the pandemic, while certain other outpatient services maintained pre-COVID-19 levels. Even if the rate of SARS-CoV-2 infections continues to level off over the next year, it is not entirely clear how that will affect patient demand.
Finally, many healthcare companies depended on pandemic-related government stimulus packages to stay profitable. But that federal or state largesse is unlikely to continue, at which point the “new normal” will look like the old normal: Healthcare companies will survive and/or thrive by providing excellent products and services, maintaining high standards of care, and achieving real results.
Underwriters, Borrowers Must Broaden Their Considerations
In recent years, underwriting processes have accelerated and deals are also being negotiated relatively quickly. When timeframes are compressed, it can be difficult to conduct appropriate due diligence.This is a trend against which lenders should push back. Regardless of the industry, underwriters must conduct thorough due diligence when making lending determinations. Issues to review include loan-to-value (i.e., purchase price), sponsor-backed versus non-sponsor-backed options, sector/industry differentiation, geographic density/concentration, and other macroeconomic concerns.
In a robust but challenging market, healthcare investors must also focus on the enterprise value of the target company, as well as its potential resilience and sustainability. This may entail seeking additional expertise to look beyond classic considerations and at complex issues such as reimbursement, the regulatory environment, the patient experience, etc.
Another area that warrants exploration is a company’s response to the opportunities and challenges that arose during the pandemic and the likelihood the conditions that led to success or distress will continue after COVID-19 finally fades. Management teams that claim the pandemic was the primary cause of all their challenges (or, conversely, push the idea that an entirely new normal has taken shape and that none of the old rules apply) should be viewed with a certain level of skepticism—perhaps they protest too much (or too little).
Independent Sponsors Join Sponsor-Backed and Non-Sponsor-Backed Firms
Deals involving sponsor-backed and non-sponsor-backed companies play a predominant role in today’s healthcare investment market. From that perspective, sponsor-backed companies generally benefit from slightly better deal terms (often in the range of approximately 100 basis points). For non-sponsor-backed companies, the use of proceeds is often more focused on growth, which requires underwriters to lean—to a greater extent—on capital-budgeting analyses as compared to traditional credit analyses.The third category of deal activity, which in some instances is very fruitful and interesting, involves independent sponsors. Several institutional investors are spinning off funds run by smart people experienced in buying growing companies and who can spot a good, if non-traditional, fit. In any event, cash flow matters, as funds must be available to service the debt.
EBITDA Adjustments, Addbacks Emerging as Favored Term
Over the past few years, EBITDA adjustments and addbacks have become one of the most valuable borrower-friendly deal terms; other popular deal terms include add-on acquisitions flexibility, delayed-draw term loans, incremental loan features, and builder baskets. Investment firms, however, are often competing with banks. As first-lien secured lenders, these firms are often more concerned about asset-stripping and leakage than about add-on flexibility.Much depends on the sponsor. Looking beyond the hard numbers, lenders are also focusing on the behavior and non-financial performance of potential deal partners and borrowers. Meaningful data to support the borrower’s request is a “necessary cause” to close a deal, but it is not a sufficient cause. There must be a certain synergy between all parts of the team that is further supported by trust and intellectual honesty.
Healthcare May Change (or Revert), but Will Remain Hot
Among other specialties, primary care and risk-bearing practices, behavioral health, and pharmaceutical and medical device services are likely to present strong investment opportunities in the next year. Several solid companies in these sectors are between five and seven years into their current models and have a demonstrable record of profitability.Healthcare information governance, revenue-cycle management, staffing, and value-based care are also likely to see an influx of capital and an uptick in transactions in addition to already high activity levels. But businesses that are primarily provider-based may provide more complex opportunities because reimbursement rates have not kept pace with cost increases.
Prepare an Exit Strategy Before Investing
Ultimately, the best entrance strategy is a solid exit strategy. Lenders—whether investment firms or traditional bankers—must be clear on their goals for the transaction and understand exactly how and when they want to end the relationship with the healthcare company. Plans should be made that account for success beyond the business’s wildest dreams, a failure to realize full potential, or something in between.Stephanie S. McCann is a partner at McDermott Will & Emery. McCann focuses her practice on corporate finance. She represents private equity groups, commercial lending institutions, and major public and private companies in connection with the structuring, negotiation, and documentation of secured and unsecured financing transactions, including senior, mezzanine and subordinated debt transactions, acquisition financings, loan workouts, and restructurings. McCann is a current member of McDermott’s Executive and Management committees.
