Volume 9, Issue 17, August 16, 2022
The information covered in the following column is derived from two sources. First, VERTESS recently conducted a survey of more than 20 buyers of substance use disorder (SUD) treatment providers on a variety of topics, including acquisition strategy and market trends. Second, I engaged in extensive discussions with fellow VERTESS team members who collectively are heavily involved in the private capital markets and witness the cycles in the verticals we represent.
My intentions in this column are to articulate broad concepts in current trends and developments within the broader healthcare M+A markets. While I am writing for owners of all healthcare businesses, there is a special emphasis on owners of SUD treatment businesses since the survey conducted was with SUD buyers and SUD is an area in which I specialize. SalientValue also has articles on general recommendations for healthcare business owners and vertical/segment specific articles outside of SUD.
For owners interested in selling their businesses within the next 12 months — or anticipate a longer horizon before selling — my hope is this column helps you make sense of the motivations for investors, understand how to develop expectations, and identify areas of your practices that can be sustained or improved to achieve higher valuations.
Note: If you are a SUD buyer reading this, please reach out to me (firstname.lastname@example.org). Not only do I welcome your feedback and opinions on this column, but we are also in the process of building on the survey's results and conducting a more robust study tied more closely to pricing guidance for SUD assets. We are looking for additional participants and perspectives.
I think an effective way to get right into the meat of this column is to start with explaining how investors in the lower middle market are thinking about current market conditions. Investors tend to be sophisticated and data driven, attempting to look ahead of the curve of industry directions. They often make decisions according to a group conscious. They have advisors if they lack experience going through market cycles. They make wise investment decisions. They're shrewd negotiators and engage in buying much more frequently than an owner does selling. Finally, they are seasoned negotiators who know when to pass, when to wait, and when to buy.
What does this all mean to healthcare business owners in today's economic climate? With the stock market making significant movements on seemingly weekly new economic data, be careful not to attribute public market behaviors to the lower middle market. Even investors in the public markets live by the words of investor Bill Miller: "It's time, not timing, that produces great results." The primary job of investors is to realize the long-term benefit of economies, recognizing that economies typically improve even in the face of (shorter-term) volatility. If your healthcare segment is poised for long-term growth, investors in privately held businesses would typically maintain that it is far worse to sell at the bottom of the market — but miss getting back in to enjoy the recovery and long-term trend — than it is to buy at the peak of the market, which only causes short-term heartburn. Most investors will agree that accurate market timing is merely embroidering along the edges.
Another way to understand the current buyer psychology is to look at recent real estate market trends. Consider that just a year ago, a pretty nice home but one with a very unappealing kitchen would have no problem selling quickly — and usually for a pretty penny. Today, that home would likely still sell. There may be fewer interested buyers and the price paid might have declined, but a home — like a healthcare business — that is average or above average is still very appealing, particularly to those who are upgrading/downgrading or moving geographies.
Getting back to healthcare, investors have money to spend and are looking for those businesses with clear potential and, of course, those already in great shape. For an average business, do what you can to "clean up your kitchen" and move into the next tier. For a below average business, identify your messy kitchen(s) and get to work on fixing and updating it.
Investors are naturally more defensive, but that doesn't mean you should believe a lowball offer is likely to be representative of typical offers for your business. Why? From a purely theoretical perspective, investors know that even though they may be more defensive now than a year ago, they'll need to become more offensive at some point (likely in the not-so-distant future). For most investors, changing their investment thesis today, only to change it back again in a year, is more difficult and uncomfortable than staying the course of a well-thought, deliberate investment thesis. This is true in the public markets and exacerbated in the private lower middle market where equity is more difficult to sell.
While investors often respond similarly to market trends and adjust their strategy accordingly, one investor generally does not know much about other investors. They keep their details private. An investor may be more or less defensive based on their resources, adequacy of resources relative to needs, lifecycle of inflows and outflows, aspirations, and the ability to withstand volatility.
The economy undoubtedly influences investing. Consider the current economy. After a long period of Fed rate cutting, bond buying, and government deficit spending, there was a tsunami of liquidity around the world. We're now in a de-stimulating environment. With the Fed's behavior suggesting further tightening of liquidity — which is less salutary for markets —combined with geopolitical instability, there are reasons for investors to take a more defensive posture.
The great thing about investing is there is always another side of the story. Even as the Fed raises rates, these will still be among the lowest in history, and we're not likely to go back to 20-plus percent interest rates. The Fed will likely remain biased to easy money conditions because governments like them so much. Such conditions have become the norm, so a return to historic interest rates would be too much a shock.
Also, some experts speculate that inflation will soon subside, bringing back the "transitory" term that led to significant market struggles. Factories were shut down, supply chains faltered, and there was more money chasing fewer goods. That's a great way to create inflation. As the supply machine gets back to normal, it could bring back down inflation. But the problem with inflation is that expectations — once they're imbedded into consumer psychology — are difficult to change. "I'll buy now because prices are going up" makes prices go up further. The bottom line here: It's difficult to get timing right, and it's less important than enjoying long-term trends.
Fortunately, inflation — if it in fact does spark or has sparked a recession — generally wouldn't result in a long-term recession (agnostic of the definition of a recession, which is certainly making the headlines lately). Data from the Bureau of Labor Statistics and National Bureau of Economic Research suggest that if a recession were to begin next month (September 2022), which appears reasonably unlikely under academic definitions, it would peak in October and return to the long-term trend one year from inception (September 2023).
With that said, we are probably approaching — or have reached — the end of the most recent business cycle. Sharp rises in consumer prices have triggered recessions since 1956, with higher prices and/or the Fed's interest rates reducing demand. But the SUD sector likely only has one thing that's going to hurt it, aside from an increasing cost of debt: wages increasing before reimbursement rates go up. Remember that investors have varying projections of each industry. In SUD, some believe that value-based contracts will not become mainstream, despite indications suggesting otherwise. Others believe payors will eventually shift more significantly toward medication-assisted treatment (MAT) and are buying and building outpatient facilities to insulate themselves if payors push providers that direction. Not every buyer may believe your business is positioned well for the long-term trends, which is why working with an M+A advisor will give you the opportunity to meet a wide variety of investors and find the buyer who most believes in your business and its model.
A final note here concerning credit. Since most transactions are financed in part by debt, investor returns will decrease unless investors can acquire businesses at lower multiples. However, the real issue is not the cost of debt; it is the availability of debt. Banks often lend on a multiple of EBITDA, similarly to how investors communicate valuation. Not long ago, investors would likely receive a loan for around 2.5x EBITDA for a healthy SUD business. The average coverage ratio appears to be dropping to the 2x-2.5x range, which has a material effect on valuation. Leveraging someone else's money entitles the investor to higher returns on their equity, thus lower leverage means lower returns. I wish I could say that investors will split the difference in leveraged-based valuation with sellers, but in the lower middle market, the result will be lower valuations unless you can attract multiple investors and entice one or more to split the difference.
There were fewer SUD transactions last quarter (Q2 2022) than the previous three quarters (Q1 2022, Q4 2021, and Q3 2021). That's not surprising, but it's also not alarming. For one, the SUD industry recently went through its best M+A cycle ever recorded. Moreover, in uncertain economic times, like the one we're in, some buyers will acquire a handful of businesses in a particular state to gain licenses and local branding and then pursue a de novo campaign. Buyers are burnt out from the extremely high multiples from the past year, but they can't complete deals at lower multiples (unless they convince you to sell without representation and try to get away with off-market pricing). Thus, they're turning more to de novo strategies. To do that effectively, many of the prolific investors in the space are buying 1–3 businesses in a particular state, then growing organically and/or with smaller "bolt-on" investments to their platform.
Payor mix, referral sources, levels of care, and census continue to be important drivers of value, but the top of the list is becoming geography, and by that I mean state selection. This translates to fewer buyers going after deals. But then again, we're comparing our current numbers to historic highs. A decrease in transactions does not mean there are low numbers of transactions. It just means the numbers aren't as high as they were when they were at their highest.
Transformative combinations, strategic rationale (e.g., residential treatment providers acquiring outpatient facilities to improve reimbursements, acquisitions of full continuum programs in new geographies, acquisitions of locally branded providers), and heightened selectivity will only grow. That's not the best news for smaller companies, but great news for those with more than $2 million in EBITDA. We anticipate a greater willingness of buyers to engage with specialty providers as well.
Below are some early findings from our pilot research concerning how investors perceive attributes of SUD treatment providers. These are areas where your facility can stand out, which is particularly important at a time when investors are taking a more defensive posture. If you're not strong in these areas, it may not be an optimal time to move forward with bringing your business to the market.
Providers focused on one level of care. Overall, we're not seeing buyers avoiding providers who offer a single level of care, but these businesses historically trade on lower valuations. Two major exceptions are MAT and outpatient care, which have become central to many investment theses. If you operate in multiple states and have a clear strategy to sell to other parts of the care continuum, you will be perceived as valuable. Do you own a network of MAT clinics? If so, you may want to consider how that will fold into full-continuum programs. Do you own intensive outpatient programs (IOPs)? Hopefully they're near detox and residential facilities. Ensure you have strong relationships with those providers and be able to demonstrate referrals.
Full-continuum providers. This continues to be the most valuable asset in SUD, although some investors are betting that inpatient/residential levels of care (typically the residential treatment center (RTC) and partial hospitalization program (PHP) billing codes) will be marginalized in the future. To be clear, it's only a handful of the prolific buyers in the space who feel this way. Adding in-house MAT services, expanding to mental health primary services, and demonstrating efficiencies — particularly as they relate to your information technology and workflows — are longer-term plays if you have the horizon. Near-term solutions to improve the value of your business include increased outreach to alumni, focusing on moving patients through your continuum (in particular, the utilization of outpatient services after facility-based services), internet presence (which is admittedly difficult to quickly improve if you're not already ranking high for searches), and tight compliance. In fact, we're seeing more HIPAA, billing, and other compliance-related audits than ever before. We do not see a general slowing in M+A activity for most full-continuum providers.
Out of network (OON). Our research suggests most investors are not willing to pay more than 7x OON earnings, with several investors only willing to pay between 5.5x and 6.5x on OON earnings. Admittedly, we recognize that these observations are based on a small data set which was not intended to include valuation guidance and are working to extrapolate more information from investors of OON providers in our upcoming research project. We heard more than once that Blue Cross Blue Shield (BCBS), for example, is signaling a cycle shift on the West Coast to further drop OON approvals, with even more approved charges tied to the patient's deductible or co-insurance. Whether or not this shift comes to fruition, it's already baked into the mind of some institutional investors.
If BCBS proceeds with the strategy, it will move through to BCBS companies throughout the country. Other OON payors are not yet indicating whether they intend to follow suit. Most investors think these payors will do so.
High deductibles may further motivate individuals to gravitate toward in-network (INN) providers, particularly in the current economic environment where household incomes have declined against inflation.
Overall, there is consensus that the long-term trend is a movement away from OON, but we disagree with those who expect OON will completely go away. There will always be a place for it, but it won't see the OON trends of 2015 ever again. In our initial survey and constant interactions with the capital markets, we hear plenty of investors who believe OON can still be valuable in a healthy payor mix and is especially valuable in secondary markets (the middle of the country) where reimbursements may remain high until more providers enter their geographies.
In-network contracts (INN). Those SUD treatment facilities with above national INN average rates will be worth incrementally more than ever. For example, if a claim to a provider for digital therapeutics (DTx) had a national INN average of $700 but a facility received $800, the incremental $100 would likely contribute to a higher multiple.
If you lack good contracted rates, consider hiring a consultant to help renegotiate your contracts. Understand that this a long-term issue. You're not likely to move to above-average rates in just a year or two. However, you can take steps now to get moving in that direction, including the development of a full continuum of services if you do not already offer it.
In addition, expanding into three or more states may lead to a more rapid rates increase. Ultimately, if your contract rates are average or even below average, your business may still have interested investors, but you may experience some sticker shock on the multiple they are willing to pay.
Bundled payments. We're seeing contracts where a group of services ("bundle") are covered under a single payment being piloted. There's heavier payor emphasis here in detox and MAT, where the goal is to get individuals into residential and outpatient care programs. Since an objective of bundled payments is to reduce reutilization, and SUD facility use increases during recessions, those with pilot contracts are going to provide a lot of insights into how payors view this payment model going forward.
Like any other lower middle market M+A advisory firm, we have not yet represented a SUD provider with value-based pilot contracts, so it's appropriate for us to avoid speculating too much on the valuation of these businesses until either more data exists or we have represented such a business.
Finally, I want to share a few quick tips on what SUD owners should be doing in response to the changes and trends we're seeing in the market.
I hope you found this column helpful. If you're a SUD owner and want to be notified when we publish the results of the more robust SUD market study, please reach out (email@example.com). And to repeat my request from earlier: SUD buyers, I'd love to hear from you as well.
If you're an owner thinking about selling — regardless of whether you're in the SUD market or another sector — contact the M+A team at VERTESS. We're specialized advisors who don't just look at healthcare; we look at specific segments in healthcare and are consistently engaged with those markets. Exit planning and executing that plan can be difficult, especially for owners engaged in the daily operations of their businesses. We'll help you determine the right path forward for the sale of your business and then do much of the heavy lifting that typically ends with a successful transaction.
After working in M+A advisory and corporate financial consulting, David co-founded Spero Recovery, a provider of drug and alcohol recovery services with over 100 beds in its continuum of residential, outpatient, and sober living care. As its CFO he led the company to significant revenue and margin growth while ensuring it adhered to the strictest principles of integrity and client care. After selling Spero he remained in leadership with the buyer as its CFO and quickly realized accretion and integration. Of the myriad lessons not learned while earning his MBA with Distinction in Finance from a Tier 1 university, the most profound was the importance of investing in his staff and clients. He learned that the numbers on a spreadsheet represent humans, families, and dreams, which was a radically different paradigm from investment banking.
At VERTESS David is a Managing Director providing M+A and consulting services to the Behavioral Health, Substance Use Disorder treatment, and other verticals, where he brings a foundation of financial expertise with the value-add of humanness and care for the business owners he is honored to represent.