Many of the same themes that have led private equity buyers to have strong interest in healthcare businesses have also driven significant interest in the sector from lenders. As shown in the chart below, loans to mid-market healthcare companies have increased dramatically since 2017.
Lenders are particularly attracted to the non-cyclical nature of healthcare services, favorable demographic trends for services targeting older patients, high-quality payors, and increasing ranks of insured patients.
Further, as interest among buyers in the sector has driven up enterprise values, the significant cash and/or implied equity in the bottom half of the capital structure enhance lenders’ view of the credit quality of healthcare transactions.
Historically, some generalist firms were more cautious about investing in the healthcare sector given a perceived need to have a strong understanding of the unique characteristics of the industry. However, given the large volume of deals in the sector, smaller credit shops now regularly pursue healthcare opportunities.
Given the complex intersection of ever-changing science, technology, and reimbursement, when performing due diligence on a potential borrower, lenders expand their underwriting to examine several healthcare specific topics.
The ongoing focus on escalating healthcare costs has led lenders to believe that virtually any service or product is at risk for a cut in reimbursement rates. And while a majority of Americans are covered by employer-provided health insurance, it’s the Center for Medicare and Medicaid Services (“CMS”) that heavily influences reimbursement rates for both commercial and government payors.
Each year, CMS revises its reimbursement rate schedule, often in an opaque manner. These “stroke-of-pen” changes can create a sudden and dramatic shift in the earnings of a practice or business. As a result, lenders will focus heavily on reimbursement trends over the prior several years and seek out reputable industry forecasts to shape their view of the future. It is not uncommon for lenders to apply a haircut to current reimbursement rates when modeling a transaction.
Another area lenders focus their due diligence on is understanding whether there are alternative therapies or products already in the market or coming to market that could disrupt demand for the potential borrower. These alternatives could take the form of 1) a new method of delivery like telemedicine or capitation or 2) a new pharmaceutical, procedure or device. Lenders view the risk as having two components as these alternatives could potentially reduce demand and/or reimbursement rates.
Revenue contribution by physician and physician compensation
When working with service-focused businesses, lenders want to understand whether there are “rainmakers” in the practice. Generally speaking, larger practices with patient encounters spread across more physicians receive stronger support. Specifically, we’ve seen instances where fewer than 10 physicians is considered by some lenders to be too small, while between 10 and 20 physicians is more favorable, and greater than 20 physicians is ideal.
A related theme is understanding compensation for physicians on a post-transaction basis. Traditionally, physicians who are partners in their practice receive distributions based on the profitability of the practice. In a levered environment, that compensation typically transitions to a more standard salary and bonus construct. Lenders want to feel comfortable that the new compensation levels are adequate to retain existing physicians and attract new ones.
Reliance on third-party diligence providers
Consistent with the trend of third-party service providers being used more frequently to perform due diligence on a target’s financial results, we also have experienced lenders expecting, and sometimes requiring, third-party reports on 1) reimbursement trends for the target’s service or product, and 2) regulatory and compliance matters. This is particularly true among lenders who are more “generalist” in nature and don’t have expertise in the healthcare sector. There are several third-party healthcare due diligence firms that carry significant weight among lenders and it is common for these firms to be referenced by name in due diligence lists or term sheets.
Ultimately, we expect lender interest in the healthcare sector to remain strong, supported in large part by continued interest from the private equity community. The inevitable aging of the patient base is going to continue for decades, driving demand for healthcare products and services. However, lenders fully expect advancements in science and technology across multiple fronts will require business models to evolve. We anticipate lenders will maintain discipline in their underwriting standards, but will also continue to provide aggressive terms for borrowers deemed to be well positioned.
This article was taken from the Livingstone Global Healthcare Report, which provides insights into the trends and activities driving the active healthcare sector worldwide.