Healthcare has always been an attractive market for private equity (PE), and over the years, PE firms have poured money into various healthcare provider entities, including home health, hospice and physician surgery centers, to name a few. But getting into the healthcare provider space isn't easy, and PE firms face particular challenges.
Private equity firms need to generate a high rate of return on their investment over a relatively short period of time. Healthcare providers are not immune to economic stressors like higher costs, supply chain issues, workforce challenges and now higher interest rates. Each of those elements puts a strain on earnings and reduces leverage, which creates a challenge for PE firms looking to invest in provider entities.
In recent years, competition among PE firms investing in healthcare providers has driven up valuations to extremely high multiples, which means there's a smaller margin for error in achieving earnings projections. Since the onset of COVID-19 in early 2020, many PE firms are working with lenders to renegotiate leverage ratios because they have failed their covenants. Some PE investors are obtaining waivers and are also re-forecasting projections going forward due to the economic challenges they are facing.
The ever-changing regulatory environment and payer models within healthcare, on top of strong economic headwinds, also create challenges to accurately predict growth, and predicting growth for PE entities is an extremely important factor when they invest in healthcare providers.
This is particularly true regarding behavioral health providers. Because there is such fragmentation in the behavioral health market, it is an attractive area for PE firms to invest. But, because of the combination of increasing demand for services and persistent staffing shortages, providers are having a difficult time meeting demand, which puts a strain on earnings and meeting projections.
Still, there’s a significant opportunity to improve healthcare delivery through innovation and PE can help provide the fuel that's needed for innovation, which could lead to reduced costs and improved outcomes. Healthcare is a stable industry and it’s considered a stable investment as the demand for healthcare services is consistent.
Although the number of healthcare deals in 2022 slowed when compared to 2021, PE firms have continued to invest at a high rate in healthcare companies, a trend that's expected to continue in 2023.
In addition, because of the significant amount of market fragmentation among smaller outpatient ancillary providers, a real opportunity exists for efficiency and consolidation in various sub-sectors. Many of these smaller outpatient ancillary providers are not operating as efficiently as they could, so there are many opportunities for investment, with solid return prospects, by making these organizations more efficient and innovative.
Because of these factors deal activity will remain strong in 2023. Due to higher interest rates, buyers will be more selective when deciding where to allocate resources due to the impact on leverage and the cost of capital. While it’s impossible to predict which health sub-sectors will attract the most deal flow, with innovation being so critical in healthcare, health technology deal level will likely be high. The most fragmented provider sub-sectors, like behavioral health, home care and veterinary care, will continue to be attractive to PE.
For more information on this topic or to learn how Baker Tilly’s healthcare specialists can help, contact our team.