An untimely crack has formed in the foundation beneath recent health care deals, including the second largest LBO of all time.
To help balance the federal budget, President Bush in February proposed reductions to Medicare and Medicaid reimbursements over the next five years. If passed by Congress, the plan would cut reimbursements to the tune of $77 billion over five years, and $280 billion over the next 10 years.
Democrats, which control Congress, have signalled they’ll fight the proposal. But many observers still call the Medicare and Medicaid programs vulnerable–a situation that threatens the profitability of hospitals, nursing homes, and other health care providers recently acquired by buyout shops.
Health care has been an especially popular destination for buyout firms to invest. The industry is generally viewed as a recession-resistant safe-haven when times are bad. In good times it’s as appealing as any other growth story, especially with a baby-boomer customer base that’s growing every day. Buyouts tracked 70 health care LBOs last year, including a number of services deals, accounting for 7 percent of total LBO activity.
The other two largest health care deals last year, as tracked by Buyouts, were
It’s too early to say just how these companies will be impacted by any cuts to Medicare or Medicaid, if at all. But already, buyout firms say they are paying closer attention to the percentage of revenue that flows from these programs into potential targets, and steering clear of those that they deem are too heavily exposed.
Similar Cuts 10 Years Back
Medicare is a federal health insurance program reserved for people age 65 and older and for people with disabilities. Medicaid, a health insurance program for poor people, is sponsored by the federal government and administered by states. Both programs have seen cuts before.
The Balanced Budget Act of 1997, enacted by the Clinton Administration, created substantial changes in Medicare policy, including the largest reductions in reimbursement payments to service providers in the program’s history. Medicare-dependent providers, such as long-term acute care providers and nursing homes, were hit hard. Several filed for Chapter 11 Bankruptcy.
“It’s accepted that when the government gets serious about balancing the budget, the largest discretionary expenditure they have is the Medicare budget,” said
But the care that hospitals, nursing homes and care-givers provide is surely not a discretionary expense for the growing population of aging Americans. When providers continue to give that care while taking cuts in reimbursement, it’s the equity holders and the bond holders that take the hit.
Consider what happened to the long-term acute care market—which serves patients that require intense, special treatment for extended periods of time—and the nursing home industry after the Balanced Budget Act of 1997 was passed. In one five-month period between 1999 and 2000, three of the largest publicly-traded long-term care providers and nursing homes filed for Chapter 11 Bankruptcy protection. All blamed their misfortunes on cuts to Medicare reimbursements. These included Mariner Post-Acute Network, which filed in January 2000; Sun Healthcare Group, which filed in October,1999; and Vencor Inc., which filed in September 1999. In the case of Mariner, at the time the nation’s second-largest nursing home operator with 400 locations, the company said its Medicare reimbursement had been slashed by $115 per nursing home resident.
We’ve already seen shots across the bow in terms of cuts that Medicare made in the long-term acute care [hospital] sector and in the imaging sector, and some companies are already feeling the pressure.
Harris Hyman IV
Fear And Ratings
If the Bush proposal gets passed, general partners say that hospitals, long-term care providers and outpatient care centers—some of which receive 40 percent to 50 percent of their revenues from the combination of Medicare and Medicaid—would be the first to feel the pinch, followed by residual effects in the medical device manufacturing sector. Even with no cut backs yet, the fear is already growing.
“We’ve already seen shots across the bow in terms of cuts that Medicare made in the long-term acute care [hospital] sector and in the imaging sector, and some companies are already feeling the pressure,” said Harris Hyman IV, a general partner at
Indeed, last November, J.W. Childs portfolio company InSight Health Services, a provider of outsourced diagnostic imaging services, saw $550 million worth of its securities downgraded to a “Caa1; outlook negative” by Moody’s Investors Service. Moody’s listed reimbursement cuts in Medicare as among the reasons for the move.
Then last month, Moody’s put Select Medical Holdings Corp., a Welsh Carson Anderson & Stowe-owned operator of 96 specialty hospitals and approximately 544 outpatient rehabilitation clinics, under review for possible downgrade due to potential adverse affects stemming from “the proposed changes to Medicare reimbursement.”
“We’re very sensitive to” reimbursement changes, Carson said. “In new investments we’re looking at, our first choice would be to have a business that didn’t have a significant Medicare exposure.”
Case in point: United Surgical Partners, a short-term-stay surgical facilities operator that Welsh Carson Anderson & Stowe has agreed to acquire for about $1.8 billion. With only 10 percent to 15 percent of revenues coming from government reimbursements, “they’re not immune to Medicare, but they certainly aren’t nearly as dependent on it as others,” Carson said. “At most acute care hospitals, half your revenue would be coming from Medicare.”
The medical device market might offer some relief to buyout firms from the threat of government reimbursement cuts, but it’s certainly not exempt. Reimbursement pressure eventually filters through to the device companies indirectly. When service providers are faced with losing reimbursement dollars, they have to figure out which expenses they’re going to cut back on, “and a good place for that is on medical device costs,” said Grotech’s Hyman. A hospital’s efficiency comes from its workers, so that’s where most of the operating capital must go, Hyman said, adding that it’s easier for hospitals to cut costs on products than it is on people.
“You’re just bringing different risks to the table” when you invest in the device side of the market, said Jim Forbes, managing director and head of global health care investment banking at Merrill Lynch. “You might be somewhat insulated from reimbursement issues, but you’re susceptible to things like FDA approval requirements and technological obsolescence.” Pricing is also a risk. Since device companies are typically growing faster than service providers, Forbes added, they tend to be—on a multiple of EBITDA—more expensive by a factor of up to five turns. Purchase price multiples for product companies, he said, can run as high as 12x to 15x EBITDA, while service providers go for between 8x and 10x EBITDA.
Still, the prospect of buying a fast-growing health care company with little exposure to Medicare and Medicaid risk is proving tempting.
“One of the big growth areas is orthopedics,” said Lester Knight, founding and managing partner at
Another area of health care where buyout firms are looking for deals is in plastic surgery. “There seems to be an infatuation with looking good and staying young—so people are doing a tremendous amount of cosmetic procedures, which is very good business because a lot of it is paid for out-of-pocket, and not reimbursed,” Knight said.