Distressed assets in behavioral health are more likely to come to market in 2024, according to several dealmaking professionals.
This is bad news for buyers who acquired assets at the top of the market three to five years ago. Multiples are down from atmospheric highs, leaving it unlikely that investors will make exits at their desired prices. However, more assets coming to market at a bad time to sell may dislodge the behavioral health dealmaking logjam.
“It’s been a bit of a perfect storm with aggressive wage inflation, increases in costs of benefits, and a rapid rise in interest expenses,” John Hennegan, founding partner of Shore Capital Partners, told Behavioral Health Business. “Some private equity firms, and as importantly, some executives, will say, ‘It’s a really long road from here to get to an outcome that we’re all excited about … Let’s lick our wounds and go to market right now.'”
Why would this happen? In short, everything is more expensive.
Inflation has exploded since the onset of the pandemic. Some data show the average inflation rate in 2022 was about eight times higher than in 2019. In recent months, inflation has slowed to a 3.2% annual increase. Still, substantial cost increases leading into 2023 have fundamentally changed the financial demands companies face.
“Inflation impacts every single line on the P&L: It’s not just salaries,” Matt Rubin, senior managing director of restructuring and distressed asset support services for Solic Capital, told BHB. “It also impacts insurance. Our insurance tripled in one year.”
The most potent distressing force, however, may be elevated interest rates. The Federal Reserve’s effective interest rate has been near zero since the Great Recession of 2008. Now, the Fed’s rate is 5.33, three times higher than it was in 2019, right before the onset of the COVID pandemic.
Variable debt rate increases have led to substantial financial problems for companies that participated in leverage buyouts, a favored acquisition practice of private equity firms. In part, this was a driving impetus for the financial and investment giant Blackstone Inc. (NYSE:BX) to sell the Center for Autism and Related Disorders (CARD) back to its founder at a loss through bankruptcy.
“I’ve seen balance sheets of larger strategic buyers where interest payments doubled from ’21 to ’22,” Kevin Taggart, managing partner and co-founder of the M&A firm Mertz Taggart, told BHB. “If you’re talking about $20 million going to $40 million, that’s material.”
While rates increased, dealmaking fell to a recent historic low. And financial buyers have held onto their assets.
“Private equity loaded up on deals in 2021 and ’22 like we’ve never seen before in the United States,” Dexter Braff, founder and president of M&A firm The Braff Group, said at BHB’s INVEST 2023. “Here’s the problem: They’re not selling anything. The amount of exits right now has hit a long-time low.”
But as pressure builds on balance sheets, many companies and investors are going to have to reevaluate their strategy.
Who will sell?
Distressed assets will be driven to market based on different factors, depending on their size and specialty.
Larger, more mature organizations that have sought to accelerate growth via debt will likely be top candidates to become distressed assets for sale. This is very common among previously highly acquisitive addiction treatment and autism therapy platforms.
In turn, large, market-leading companies may change hands at a discount compared to their previous transaction. This will be largely a function of unusually high multiples in the past rather than the depression of present multiples.
Smaller behavioral health organizations face a different road, and the outlook is much more mixed.
Often, smaller organizations not heavily invested in growth don’t have comparably high debt burdens relative to their larger peers, who are suffering under high interest rates, Taggart said. But high interest rates could still mean small behavioral health organizations struggle even more with cash flow issues and accessing capital to bridge the gap between higher expenses. This will lead to some tough questions for the owners of those organizations.
“Do I sell? Do I invest more capital? Do I double down?” Rubin said. “Or do I just shut the doors? I don’t think companies at this level have the ability to file bankruptcy because it’s too expensive.”
Often, bankruptcy is reserved for organizations that have the liquidity to afford the process in the first place, Rubin added.
Even if some smaller organizations become distressed assets, there is a chance that they will make an appealing acquisition target. Smaller and newer companies may be compelling targets if they have a unique service, substantial footprint or regional access, Robert Miller, a partner and co-chair of the business department at the health care law firm Hooper Lundy, told BHB.
“I think that would be a key place to look for distressed asset transactions if I were a behavioral health buyer,” Miller said.
Multiples shift who will buy distressed assets
Miller maintains that health care companies, mostly behavioral health companies, will have an advantage in the M&A market going into 2024. There are two key reasons: Multiples are high but down from record-setting levels, and, combined with high interest rates, behavioral health dealmaking might not meet most private equity fund’s ROI objectives.
For example, the autism therapy space has seen the average high-end multiple shrink by several percentage points over the last few years, though, the average low-end multiples remain flat.
Yet, multiples are higher now than several years ago, “stubbornly so,” according to Miller.
“When interest rates went up, there was still an appetite for doing deals because the assumption was that purchase prices would fall and that expectations for multiples of EBITDA would fall,” Miller said. “That has not happened in my view, nor in the view of anyone with whom I’ve talked about this.”
However, if enough deals come through at multiples that are substantially lower than in previous years, multiples across the sector could be dragged down, Braff said. A key driver for this could include time-bound covenants that investors have with their financial partners and the so-called “maturity wall” of debt obligations coming due, he added.
“[The private equity firms’] portfolio that they have to sell is getting old, and they need to sell it. But they don’t want to sell it right now because the market isn’t as attractive as it was,” Braff said. “As it gets older, the pressure to sell at lower valuations is going to happen. If they start exiting at lower valuations, it could pull valuations down across the board.”
High-quality organizations will be able to command premium valuations due to the relative scarcity of companies that aren’t already acquired by a PE firm or strategic buyer, Braff said.
Further, the factors fueling the demand that is keeping multiples high today won’t likely resolve any time soon. Demand for care is sky high and much of the industry remains highly fragmented and underdeveloped from a business perspective.
“The buyers are going to change — that’s going to happen — but [behavioral health] is still a very attractive segment to have in your portfolio,” Braff said. “Buyers have to get back in the game because the reality of it is if you want to achieve the growth that you’re looking for and get from $100 million to $300 million, you’re not doing that to startups. You have to do acquisitions.”
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