Distressed assets in the behavioral health space are more likely to hit the market in 2024, several deal professionals said.
This is bad news for buyers who purchased assets at the top of the market three to five years ago. P/E ratios have fallen from their highs and investors are unlikely to exit at the desired price. However, the behavioral health deal logjam could be broken by more assets coming to the market at a time when they are not suitable for sale.
“It’s kind of a perfect storm with wages rising dramatically, benefit costs increasing, interest expenses rising rapidly,” John Hennegan, founding partner at Shore Capital Partners, told Behavioral Health Business. “Some private equity Equity firms, and just as importantly some executives, will say, ‘There’s a long way to go to get to the results we’re all excited about…let’s lick our wounds and get in the market now.'”
Why does this happen? In short, everything is more expensive.
Inflation has risen sharply since the onset of the pandemic. Some data show that the average inflation rate in 2022 will be about eight times that of 2019. In recent months, annual inflation has slowed to 3.2%. Nonetheless, the significant increase in costs through 2023 has fundamentally changed the financial needs faced by the company.
“Inflation affects every line on the income statement: not just payroll,” Matt Rubin, senior managing director of restructuring and distressed asset support services at Solic Capital, told BHB. “It affects insurance as well. Ours Insurance tripled in one year.”
The most distressing force, however, may be rising interest rates. Since the Great Recession of 2008, the Fed’s real interest rate has been close to zero. The Fed’s interest rate is now at 5.33, three times what it was before the COVID-19 outbreak in 2019.
Rising interest rates on variable debt have created serious financial problems for companies participating in leveraged buyouts, a takeover practice favored by private equity firms. In part, this was the impetus for financial and investment giant Blackstone (NYSE: BX) to sell the Center for Autism and Related Disorders (CARD) at a loss to its founders through bankruptcy.
Kevin Taggart, managing partner and co-founder of mergers and acquisitions firm Mertz Taggart, told BHB: “I’m seeing balance sheets of large strategic buyers whose interest expense doubled from ’21 to ’22. “If you’re talking $20 million to $40 million, that’s significant.”
Despite rising interest rates, transaction volumes have fallen to recent historical lows. Financial buyers retain their assets.
“The volume of private equity deals in 2021 and ’22 is unprecedented in the U.S.,” Dexter Braff, founder and president of buyout firm The Braff Group, said at BHB’s INVEST 2023. Not selling any thing. Exit numbers are now at their lowest point in a long time. “
But as pressure on balance sheets mounts, many companies and investors will have to reassess their strategies.
Who will sell it?
Distressed assets will be brought to market based on different factors, depending on their size and specialization.
Larger, more mature organizations seeking to accelerate growth through debt may be the first choice for distressed assets for sale. This is very common among previously highly acquired addiction treatment and autism treatment platforms.
In turn, large, market-leading companies may change hands at a discount to previous transactions. This is largely the result of unusually high P/E ratios in the past, rather than the current depressed P/E ratio.
Smaller behavioral health organizations face a different path and a more complex outlook.
Typically, Taggart said, smaller organizations that haven’t invested heavily in growth don’t have as high a debt load relative to their larger peers that bear high interest rates. But high interest rates can still mean smaller behavioral health organizations have a harder time dealing with cash flow issues and accessing capital to make up the difference between higher fees. This will create some difficult questions for the owners of these organizations.
“Do I sell? Do I invest more money? Do I double it?” Rubin said. “Or do I just close the door? I don’t think companies at this level can afford to file for bankruptcy because the cost of bankruptcy is too high.”
Typically, bankruptcy is reserved for organizations that have enough liquidity to undertake bankruptcy proceedings in the first place, Rubin added.
Even if some smaller organizations become distressed assets, they may become attractive takeover targets. Robert Miller, partner and practice group co-chairman at health care law firm Hooper Lundy, told BHB that smaller and newer firms may be better off if they have unique services, broad practice areas or regional access. will become an eye-catching target.
“I think if I were a behavioral health buyer, this would be a key place to look for distressed deals,” Miller said.
Multiple Changes Who Will Buy Distressed Assets?
Miller believes healthcare companies, primarily behavioral health companies, will dominate the M&A market in 2024. There are two key reasons: P/E ratios are high but below record levels, and combined with high interest rates, behavioral health companies will have an advantage in the M&A market. Healthcare deals may not meet the ROI objectives of most private equity funds.
For example, the autism treatment space’s average high-end multiple has shrunk by a few percentage points over the past few years, but its average low-end multiple has remained flat.
However, Miller said P/E ratios are now “consistently higher than they were a few years ago.”
“When interest rates rise, there is still interest in doing deals because people assume purchase prices will fall and expectations for EBITDA multiples will fall,” Miller said. “In my opinion, that’s not happening, In the opinion of anyone I’ve spoken to about this, that’s not happening.”
However, Brough said if a large number of deals trade at significantly lower P/E ratios than in previous years, industry-wide P/E ratios could be weighed down. He added that a key driver of this phenomenon may include time-bound covenants that investors enter into with their financial partners, as well as the so-called “maturity wall” of upcoming debt maturities.
“[The private equity firms’] The portfolio they have to sell is outdated and they need to sell it. But they don’t want to sell now because the market isn’t as attractive as it once was,” Brough said. “As you get older, the pressure to sell at a lower valuation is going to happen. If they start exiting at lower valuations, it could drive down valuations across the board. “
Brough said high-quality organizations will be able to command premium valuations due to the relative scarcity of companies that have not yet been acquired by private equity firms or strategic buyers.
Furthermore, the factors currently driving demand to maintain high multiples are unlikely to be resolved anytime soon. The demand for care is very high and much of the industry remains highly fragmented and underdeveloped from a business perspective.
“Buyers are going to change – that’s going to happen – but [behavioral health] is still a very attractive part of your portfolio,” Brough said. “Buyers have to get back in the game because the reality is that if you want to achieve the growth that you’re looking for and go from $100 million to $3 Billion dollars, you just can’t do that to a startup. You have to make acquisitions. “