Behavioral health M&A will likely be down in 2023 compared to a string of red-hot years that peaked in 2021.
That’s not necessarily a bad thing, some believe. The industry is on the downswing of a dealmaking cycle that includes booms and cooling periods.
Still, the interest in behavioral health by investors and strategic acquirers won’t be diminished, Dexter Braff, president of M&A advisory firm The Braff Group, said at Behavioral Health Business’ VALUE conference.
“We are in a transitionary phase, which is code for an M&A guy [saying], ‘It’s not as good as it was last year,'” he added. “So what’s the outlook? Strong, it’s still good. The demand for behavioral health still far outweighs the supply. What we also see, though, is a more disciplined approach towards determining what’s going to be bought and how much is going to be paid.”
Growing interest by investors for the last several years has driven up multiples for investing in or acquiring behavioral health businesses, Braff said. The Braff Group tracked 201 deals in 2022, down 24% compared to 2021.
However, Braff considers 2021 an anomaly with several factors at play limited to that year, such as changes to capital gains taxes. Compared to 2020, a less anomalous year, deal volume was up a modest 4% in 2022.
In 2023, several forces will depress dealmaking in behavioral health. These will likely include inflation, workforce pressures, interest-rate hikes, high-profile company stumbles, more sober approaches to valuations, reconciling previously high multiples and the war in Ukraine, Braff said.
“Those of you who may have enjoyed some of the valuations that happened in the past two or three years can thank your private equity friends for bidding up the valuations,” Braff said. “They’re not necessarily delighted about that. … But that competition for deals pushes things up a lot.”
Low interest rates from the Federal Reserve made debt affordable as a tag along for private equity investments. However, rising interest rates as an attempt by the fed to tamp down consumer prices has made debt more costly. This impacts how investors think about returns on their behavioral health investments.
The average multiple for equity financing in 2022 was 5.9 times EBITDA and 5.6 times for debt financing, according to Braff.
“If the amount of debt they can deploy is less because it’s more expensive, if they don’t backfill it with equity, then the valuation is going to drop,” Braff said.
Braff said his firm has seen investors opt for temporary all-equity deals or lower deal amounts because of debt costs. All equity teams are temporary, he said, adding that investors will likely seek to recapitalize when debt is more affordable.
Behavioral health private equity investment shifted to more follow-on deals in 2022. It also reflected a drop in platform deals. In total, 2022 saw 132 private equity deals, while 2021 and 2020 saw 172 and 130, respectively.
The count of platform deals in 2022 decreased by 40% compared to 2021 and 24% compared to 2020. Yet the number of follow-on deals in 2022 was up 10% compared to 2020.
Private equity deals made up 65% of all deals in 2022, Braff said. Private equity’s presence is largest in behavioral health compared to all other health care services segments that the Braff Group tracks. That 65% share held by private equity deals has held firm since 2018.
“The fact that [platform deals] are down from 2020 has me a little bit anxious,” Braff said. “We will have to see if it’s just an anomaly because it’s also a very good indicator of what we might expect in the future.”
Historic trends by behavioral health subsector
Mental health and addiction treatment deal volume was down by 26% in 2022 compared to 2021. Even so, mental health saw a 9% increase and addiction treatment sent an 18% increase compared to 2020.
Over the last five years, addiction treatment and mental health have seen the highest deal volumes and the highest rate of increase in deal volumes. Mental health has seen about 300 deals while addiction treatment has seen about 350 deals from 2018 to 2022, according to Braff Group data.
So what’s the outlook? Strong, it’s still good. The demand for behavioral health still far outweighs the supply.Dexter Braff, president of The Braff Group
Within addiction treatment, medication-assisted treatment (MAT) services and value- to mid-range residential addiction treatment services are far and away of the most interest to investors by deal volume.
In 2023, MAT faces a major regulatory hurdle. The Drug Enforcement Administration proposed rules would effectively end pure-play virtual telehealth MAT.
The highest rate of deal volume shrinkage is in high-end residential addiction treatment.
“You’re talking about programs that are costing $60,000 to $70,000 a month because lobster tails are expensive,” Braff said. “What we’re seeing now is a much more movement towards what we call value- to mid-range providers. This is something we expected but it’s taking a little longer than we thought. The reality of it is, with affordable substance use disorder treatment, that’s where the people are.”
In 2022, autism therapy deal volumes had a slight downward trend, with total deals at about 200. This made it the third most active sector in behavioral health transactions for the trailing five years ending in 2022.
Mental health services benefit from a recognition across the board that the need for it has never been higher, reimbursement increases, reductions in stigma and increases in telehealth use.
Braff sees telehealth utilization in mental health as a systemic boon because it eases access to care and it creates more opportunities for new mental health patients to engage in services.
“I know that a lot of people think that [telehealth] is taking away from face-to-face services,” Braff said. “I can prove this, I don’t have the data. But I don’t think that’s happening. I think what’s happening is it’s an entry point for people to have face-to-face care.”
Coming down from highs
Valuations and multiples have come down from what Braff identified as a fever dream that reached a high in 2021 and ended entirely in 2022.
While underlying demand trends remain, as reflected in staffing shortages and long waiting lists for several behavioral health services, investors are redefining what they use as the basis of a multiple and what forms of earnings they will assess.
“This happens every time we wind up in a post-explosion marketplace,” Braff said. “Last year and the year before, the definition of EBITDA was the go-forward for 20 months. Everything you think is going to go good happens, nothing goes wrong and that was the EBITDA you get for your valuation. Not bad if you can get it.”
Investors now would rather assess actual results for a period of time. Even with multiples remaining the same, shifting from actual earnings results to pro forma and estimated earnings will lower total valuations.
“Buyers have gotten more disciplined,” Braff said.
On top of the economic pressures, high-profile stumbles have garnered a lot of attention, making investors more dubious.
Braff specifically mentioned the troubles of the Centers for Autism and Related Disorders, potentially the largest autism provider in the U.S.; the digital mental health provider Cerebral; and the soon-to-be-defunct addiction treatment provider Delphi Behavioral Health Group.
The Centers for Autism and Related Disorders pulled out of several markets during the summer. It and a handful of other autism therapy providers struggled to maintain staffing levels and many rolled out layoffs to cope with wage pressures and stagnant payer rates.
Former high flyers in the venture capital-backed startup world like Cerebral and Elemy have suffered bad press and scrutiny over several public missteps. Cerebral’s data-sharing practices and allegations of inappropriate prescribing of controlled substances generated scrutiny from several government stakeholders. Elemy laid off staff as part of a sharp pullback on direct care services and a pivot to a platform strategy for providers and patients.
Buyers have gotten more disciplined.Dexter Braff, president of The Braff Group
The trend for deal multiple expectations moves in cycles. Barring any negative macroeconomic trends, Braff estimates that behavioral health might be five years off from seeing sky-high valuations again.
However, investors that put money into companies now and in the near term will likely have to “arbitrage down” from high-valuation investments. Investors will have to make tough decisions on whether or not to extend hold periods, take losses on investments or otherwise make moves to pump up a multiple in an exit.
In behavioral health and other sectors that the Braff Group works in, this has translated to investors and their portfolio companies making “a flight to quality,” meaning that companies will scrutinize the quality of their acquisition targets.
Still, behavioral health is exceptional in terms of expected multiples. Services businesses generally see multiple ranges of 4 to 6 times EBITDA because they often have little to no assets outside of accounts receivable.
On top of that, many behavioral health providers are tied to government payers, adding a layer of risk to the investment, Braff said.
“So there still is opportunity, but it’s not as easy to access,” Braff said. “When you’re above 4 to 6, you’re in premium land.”