Troubled behavioral health assets are more likely to come to market in 2024, according to several deal specialists.
This is bad news for buyers who acquired assets at the peak of the market three to five years ago. Odds are coming down from atmospheric highs, leaving investors unlikely to get out at the prices they want. However, more assets coming to market at a bad time to sell could break the behavioral health logjam.
“It’s been a bit of a perfect storm with aggressive wage inflation, increases in benefit costs and rapidly rising interest costs,” John Heneghan, founding partner of Shore Capital Partners, told Behavioral Health Business. “Some private equity firms and, importantly, some executives, will say, ‘It’s a really long way from here to get to an outcome that we’re all excited about. . . . Let’s lick our wounds and get out the market right now.”
Why would this happen? In short, everything is more expensive.
Inflation has exploded since the start of the pandemic. Some figures show that the average inflation rate in 2022 was about eight times higher than in 2019. In recent months, inflation has slowed to an annual increase of 3.2%. Still, significant spending increases leading up to 2023 have fundamentally changed the financial demands companies face.
“Inflation affects every line item in earnings and expenses: it’s not just wages,” Matt Rubin, senior managing director of distressed asset restructuring and support services for Solic Capital, told BHB. “It also affects insurance. Our insurance tripled in one year.
The most powerful troubling force, however, may be rising interest rates. The Federal Reserve’s effective interest rate has been near zero since the Great Recession of 2008. The Fed rate is now 5.33, three times higher than it was in 2019, just before the start of the COVID pandemic.
Volatile increases in debt interest rates led to significant financial problems for companies that engaged in leveraged buyouts, a preferred practice for acquiring private equity firms. In part, that was the driving force behind financial and investment giant Blackstone Inc. (NYSE: BX ) to sell the Center for Autism and Related Disorders (CARD) back to its founder at a loss due to bankruptcy.
“I’ve seen balance sheets of larger strategic buyers where interest payments have doubled from ’21 to ’22,” Kevin Taggart, managing partner and co-founder of M&A firm Mertz Taggart, told BHB. “If you’re talking about $20 million going toward $40 million, that’s substantial.”
While interest rates rose, deal-making fell to a recent all-time low. And financial buyers held onto their assets.
“Private equity has been busy with deals in 2021 and 2022 like we’ve never seen before in the United States,” said Dexter Braff, founder and president of M&A firm The Braff Group, at BHB’s INVEST 2023. “Here’s the problem: I’m not selling them anything. The number of exits has now reached a multi-year low.”
But as pressure on balance sheets mounts, many companies and investors will need to reassess their strategy.
Who will sell?
Troubled assets will be marketed based on a variety of factors, depending on their size and specialty.
Larger, more mature organizations seeking to accelerate growth through debt are likely to be the best candidates to become distressed assets for sale. This is very common among previously highly acquisitive addiction treatment and autism therapy platforms.
In turn, large, market-leading companies can change hands at a discount compared to their previous transaction. This will largely be a function of unusually high multipliers in the past rather than depressed current multipliers.
Smaller behavioral health organizations face a different path, and the outlook is much more mixed.
Often, smaller organizations that aren’t heavily invested in growth don’t have relatively high debt burdens compared to their larger counterparts, which suffer from high interest rates, Taggart said. But high interest rates can still mean that small behavioral health organizations struggle even more with cash flow issues and access to capital to bridge the gap between higher costs. This will lead to some difficult questions for the owners of these organizations.
“Am I selling? Do I invest more capital? Shall I double?” Rubin said. “Or should I just close the doors? I don’t think companies at this level have the ability to file for bankruptcy because it’s too expensive.”
Bankruptcy is often reserved for organizations that have the liquidity to afford the process in the first place, Rubin added.
Even if some smaller organizations become distressed assets, there is a chance that they will become an attractive acquisition target. Smaller and newer companies can be compelling targets if they have a unique service, significant footprint or regional access, Robert Miller, partner and co-head of the business department at healthcare law firm Hooper Lundy, told BHB.
“I think that would be a key place to look for distressed asset transactions if I were a behavioral health buyer,” Miller said.
The multiples change who will buy distressed assets
Miller maintains that healthcare companies, primarily behavioral health companies, will dominate the M&A market in 2024. There are two main reasons: the ratios are high but below record levels, and combined with the high interest rates, behavioral health deals may not meet the return on investment objectives of most private equity funds.
For example, the autism therapy space has seen the average high-end multiple shrink by a few percentage points over the past few years, but the average low-end multiple remains flat.
Still, the odds are higher now than they were a few years ago, “stubbornly so,” according to Miller.
“When interest rates went up, there was still an appetite to do deals because the assumption was that purchase prices would come down and that expectations of EBITDA multiples would come down,” Miller said. “That didn’t happen in my opinion, or anyone I’ve talked to about it.”
However, if enough deals take place with ratios that are significantly lower than previous years, the sector’s ratios could be lowered, Braff said. A key driver for this could include time-bound agreements that investors have with their financial partners and the so-called “maturity wall” of debt obligations that are due to come due, he added.
“[The private equity firms’] the portfolio they have to sell is getting old and they have to sell it. But they don’t want to sell it right now because the market is not as attractive as it was,” Braff said. “As we age, the pressure to sell at lower valuations will happen. If they start coming out at lower ratings, that could lower ratings across the board.”
High-quality organizations will be able to command premium valuations because of the relative scarcity of companies that have not yet been acquired by a PE firm or strategic buyer, Braff said.
Furthermore, the factors fueling the demand that keeps odds high today are unlikely to abate anytime soon. Demand for care is huge and much of the industry remains highly fragmented and underdeveloped from a business perspective.
“Buyers will change – it will happen – but [behavioral health] it’s still a very attractive segment to have in your portfolio,” Braff said. “Buyers need to get back in the game because the reality is if you want to get the growth you’re looking for and get from $100 million to $300 million, you don’t do that to startups.” You have to make acquisitions.”