Healthcare roll-ups, which feature private equity firms combining individual practices into larger groups, have become a popular area of private credit lending. Some say the exuberance has led to poor outcomes for patients and direct lenders alike.
The timing of when these investment platforms were financed — from 2018, to the late-2021 heyday of peak private credit deal activity, through today — is key, market participants say.
As for other sectors, in the higher-for-longer inflationary environment, some healthcare companies are struggling under the heavy debt burden. The problems of some of these borrower companies are laid bare in BDC portfolios, where they languish as non-accrual investments. A lack of exit opportunities, with M&A activity muted, is weighing on this sector.
Adding to woes, private equity transactions in healthcare have drawn regulatory scrutiny.
The Federal Trade Commission, the DOJ’s Antitrust Division, and the US Department of Health and Human Services launched a cross-government public inquiry in March into private equity healthcare deals, arguing that sponsors have maximized profits at the expense of quality care.
The request for public comment includes a focus on private credit funds and their impact in the healthcare space.
Vital signs
Healthcare valuations started to rapidly increase in 2018, when debt was cheap and widely available. An investment thesis that healthcare is a non-cyclical, recession-resistant sector helped generate demand for these businesses.
“For several years prior to interest rates rising, a majority of deal activity in the healthcare space that we reviewed was driven by physician practice management roll-ups, or PPM,” said Garrett Stephen, senior managing director and co-head of origination at First Eagle Alternative Credit.
According to data from PitchBook, in 2019, healthcare services accounted for 59% of all healthcare buyout deals. In 2021, which saw the greatest number of healthcare related LBOs, the percentage increased to 63%.
A private equity sponsor would acquire a specialty practice, such as dermatology or anesthesia, and grow the platform through add-on acquisitions of smaller practices at lower multiples.
Typical deals involved an initial acquisition with an EBITDA multiple of around 12x, followed by subsequent acquisitions with buyout multiples of 6-8x. Debt to finance the acquisitions was typically priced between S+550 and S+650, depending on the company. Leverage could be around 6x.
“It felt like every other week there was a new PPM roll-up. The only question was, what’s the specialty this time?” said Carolyn Hastings, a partner in Bain Capital’s private credit group.
In many ways, the deals appeared to be a win-win-win situation. Sponsors were drawn by the attractive equation of the roll-up strategy and the exit potential. A key feature of deals is the multiple arbitrage potential, where sponsors increase a platform’s value through acquisitions alone, managing to sell the combined platform for more than the individual parts are worth.
Lenders were happy to deploy capital — and were expected to be well compensated for their risk. Many deals of this type were done before a fundraising wave for private credit led to spread compression and deteriorating protections for lenders.
An ostensible benefit of chaining up small practices was that doctors and other professionals were able to focus on patient care and reduce the administrative burden of running a practice. Many also received a sizable payout via the transaction.
Beyond multiple arbitrage, roll-ups can reduce costs through shared services and medical supplies.
“Private equity or other institutional investments can improve the operational environment for these practices. In many cases, individual practices are not run as efficiently as they can be, and a centralized platform can provide administrative and billing support that allows physicians and dentists to focus more on the care and outcome of patients,” said Kunal Shah, a managing director at Brightwood Capital.
While true, the ultimate goal of these deals, as all transactions, is to net a profit for investors.
And in many cases, the best-quality deals did end up being winners for investors and patients alike. However, a variety of factors converged that led to some losers as well.
For example, excitement over these types of deals resulted in non-healthcare sponsors entering the space, ones who didn’t have the expertise necessary to make these roll-ups successful, market sources say. One complexity for these businesses is revenue cycle management, due to dependencies on insurance payors and Medicare, according to market participants.
Competition from lenders may also have led to looser underwriting standards. EBITDA add-backs on syndicated and private credit deals alike were abundant. Many of the pro forma EBITDA revenue or billing adjustments took longer to realize than lenders accounted for, and companies had leverage based off cash flows that never materialized.
Typically, buy-and-build structures mimic the original capital structure of the loan. In the case of these healthcare roll-ups, many add-on acquisitions were financed 100% by debt, according to market participants.
Underwriters also assumed volume, meaning the number of patients the office was seeing, would remain constant. However, after an acquisition, some professionals simply took their agreed-upon payout and retired or reduced their workloads. In the worst case-scenario, patients whose doctors or other healthcare professionals left would also then leave the practice.
“For these adjustments, there were a lot of assumptions made that may or may not have been well grounded. When interest rates started rising, and 100% debt-financed acquisitions were no longer possible, the equation stopped working,” said Bain’s Hastings.
“From 2019 to 2021, we did not do a lot of healthcare lending. We couldn’t agree to the amount of leverage or add-backs that sponsors wanted. We lost some deals and just had to accept that we had a little bit of a different view than the market,” said Hastings.
And then came Covid
The pandemic brought all these issues to a head. Healthcare demand, save emergency care, plummeted. Many practices closed their doors to comply with pandemic shutdowns.
In the aftermath of the pandemic, wage inflation and labor shortages added to problems. Many nurses and other medical professionals left their jobs altogether. When interest rates started rising in March 2022, healthcare platforms’ capital structures became further pressured.
In 2023, healthcare was one of the most distressed sectors in the Morningstar LSTA US Leveraged Loan Index.
Consumer healthcare demand still hasn’t reached pre-pandemic levels, and likely won’t during 2024, according to the January S&P Global Ratings’ report titled Industry Credit Outlook 2024: Healthcare. The report found that 2023 featured a record number of defaults for healthcare.
“This was partly because of the impact on EBITDA margins of inflationary pressures, particularly on labor, combined with the impact on cash flows from higher interest rates and the disruptions caused by No Surprise Act and Medicaid redeterminations,” S&P Global said.
“It was also partly due to the high level of private equity participation in healthcare, highlighted by the fact that over half of our rated universe is private equity owned and [has] above-average leverage.”
According to PitchBook research and the Morningstar LSTA US Leveraged Loan Index, healthcare services companies accounted for a disproportionate share of leveraged loan defaults in 2023: over 20% of default value despite the sector representing only 12.5% of issuers. The equivalent is not available for the private credit market.
In many cases, these assets aren’t trading hands, as sponsors have yet to become comfortable with assets that were trading at 16x and up now being sold at low 12x, say market sources.
Lenders say loans underwritten in 2019 to support healthcare roll-ups have fared the worst.
As healthcare companies have struggled, portfolio management treatment plans have included sponsors paying down debt, amend-and-extend transactions, partial PIK amendments, preferred equity, and in-court and out-of-court restructurings.
According to regulators, private credit providers aren’t the only ones feeling the pain.
“When private equity firms buy out healthcare facilities only to slash staffing and cut quality, patients lose out,” wrote FTC Chair Lina M. Khan in the FTC’s March 5 inquiry.
“Through this inquiry the FTC will continue scrutinizing private equity roll-ups, strip-and-flip tactics, and other financial plays that can enrich executives but leave the American public worse off,” said Khan.
Market conditions stabilize
Today, market participants say that some of the froth has dissipated from peak times. Some lenders and sponsors are more cautious. Deals are done with leverage almost a third lower, and EBITDA add-backs are scrutinized much more closely, market sources say.
Leverage is closer to 4-4.5x. Underwriting is more stringent. The aftermath of Covid has made it clearer which companies are actually recession-resistant and non-cyclical.
In the current market, many deals are structured so an existing team’s equity remains in the business, helping to ensure key individuals are invested in the company’s success even after a private equity buyout.
Deals done today tend to be stronger businesses, market participants say.
“We’ve seen 50 deals over the past 12 months and invested in three, since the quality of financials is so important,” said one private credit source speaking about healthcare roll-ups.
In February, dental partnership organization MB2 Dental secured $2.3 billion in unitranche debt financing from private credit lenders to support its acquisition strategy. A key feature of the deal is that dentists must continue to own the equity in their own practice, market sources say.
Arrangers have also found reception for healthcare deals in the syndicated loan market recently. For example, in April, radiology imaging company RadNet Inc. (Nasdaq: RDNT) completed an $875 million refinancing that priced tight to talk at S+250. Also in April, optometry practice management MyEyeDr completed a $1.4 billion refinancing, tight to talk at S+400. Notably, the deal included $425 million of new PIK preferred equity.
“We are in the fifth inning on a number of our healthcare investments. We still get calls frequently about new roll-up plays in the space,” said Kunal Shah.
Featured image: Rapeepong Puttakumwong/Getty Images
