Private equity firms are not slowing down on hospice investments as demographic tailwinds in a fragmented industry create a favorable environment for growth.
Private equity hospice deals occurred in record numbers last year, according to data from the M&A advisory firm The Braff Group. Of the estimated 60-plus transactions during 2021, at least 39, or 65%, were private-equity based, a rise from 56% in 2020.
Moreover, the proportion of hospice and home health transactions that involved private equity firms rose by 25% between 2011 and 2021, Braff reported. But as the presence of these investors grows throughout health care, more legislators and regulators are asking questions about their impact.
Hospice News sat down with Randal Schultz, a certified public accountant and health care lawyer with the Minneapolis-based firm Lathrop GPM, to discuss this regulatory landscape and the factors that can draw a PE firm towards acquiring a hospice company. Schultz is also a former adjunct professor of corporate law at Rockhurst University and has spoken nationally on health care business and law.
What are some of the provider characteristics that most attract private equity firms right now?
I’ll give you the direct answer: All the equity funds are really ever looking for is cash flow.
If you had to synthesize all the motivations of all the equity funds across the spectrum of health care, they’re looking for cash flow. Their idea is: They want to pay a multiple today, aggregate entities, and increase cash flow. Once their cash flow hits a certain level, they believe they can resell that entity for yet a higher multiple. That’s their game right there.
There are two main types of equity funds. There’s the equity fund, that’s just pure money. It’s a pure financing transaction where they pay a multiple now hoping to aggregate and then sell it at a bigger multiple two to three years down the road. The spread is the margin they make, and that’s as far as their thought process goes. And then due diligence looks at whether we are acquiring something that will sustain or increase cash flow so that we can hit that increased-multiple goal.
Then you get the second type of equity fund, which believes they know more than the next guy about how to operate whatever the health care sub-specialty would be, whether it’s hospice, long term care, or whether it’s orthopedics, you name it.
They believe that they’ve come up with a business strategy and financial model that allows them to provide the service more cost-effectively, and therefore, hopefully, at a higher quality level than somebody else.
I did an equity deal with a urology group. There are all kinds of ancillaries you can have to generate money for a urology practice, facility fees, certain types of imaging, and all kinds of stuff you can do. They’re all separate revenue sources.
The equity fund salivates when they can find a urology group that’s got young good doctors in it, who have never developed any of these ancillaries and is in a demographic area in a growing community.
What makes that kind of scenario so appealing?
Why does the equity fund love its situation? Because they can turn around and then they can use whatever business you may have, get the physicians into all these ancillaries, and greatly increase cash flow over what existed before.
Now, where they may have paid a 9x multiple for a cash flow of X, they can turn that cash flow into X plus Y plus Z overnight. They’re instantly positioned to sell the equity to a bigger fund at a higher multiple.
If there’s a very poorly run hospice, long term care facility, whatever it may be, and people who understand the business can come in and spot why it’s not performing the way it should, then that’s a target-rich environment for these business guys. They try to then recreate the business model that they’ve worked successfully in the past, and fix all the issues with what they’re acquiring.
The whole point is to get the lower-producing facility producing at a more profitable higher rate, which then again creates the position for yet a bigger roll-up. I’ve never been in a discussion where the equity fund hasn’t talked about the secondary roll-up as the ultimate cherry for people who are selling. They say we will buy your facility for X dollars; 80% of that will be cash and 20% of the equity in our future roll-up company.
Obviously, the buyer wants as low cash numbers as possible and the highest, rollover equity. They can make the argument for investing with our new roll-up company, and when we hit it big then you’ll win.
Now, the issue with all these things is sustainability. In order for there to be a future equity sale years down the road, there’s got to be a continuing and expanding profit margin that can be taken out by the equity fund. That is the mathematics of the game. An equity fund is not going to want to buy a company where the capital contribution is so big that they can’t generate profit off their multiple.
Now, if a company is doing something that’s obviously not financially as prudent as it could be — and the equity fund can instantly see that and make a change than having to invest a bunch of capital — the equity fund will jump over that.
If it isn’t broken too much, let’s fix it, and then we make a bunch of money. But if it’s too broken, it’ll cost so much to fix it that it doesn’t make sense to buy it.
Where does regulatory compliance come into play during that process?
They always look at the regulatory issues out there. Are you a company that has all kinds of regulatory issues and just hasn’t hit the light yet? Or do you engage in practices that are just ripe for regulatory issues?
That’s the other side of it, because nobody wants to spend their money on litigation.
There has been more discussion among lawmakers and some regulators about private equity activity in health care. What are some of the legal risks that could potentially come with investing in a hospice?
I think from an ivory tower perspective we’d all like to think that health care providers are the best people to provide care, design care, and decide how care should be provided. The last thing you want is some banker out there pulling strings, telling people how to operate when that banker doesn’t have a clue what they’re doing.
There’s a little bit of Pollyanna in that though, because who really understands how health care is being delivered? One of the problems we’ve got in health care right now is we’re getting so segmented, and the organizations are so big.
Who are the best people to run a health care organization? It’s the delivery of health care services, but it’s also finance. And a lot of people who are really good at providing health care services don’t know anything about finance and can’t begin to utilize economies of scale, investigate new technologies, and determine where there are cost efficiencies. Those terms are just totally foreign to a lot of people who are educated from a science or health care perspective.
Similarly, a lot of the MBA types can’t spell “health care.” Most people can’t buy a health care business from an informed-judgment perspective There are no checks and balances necessarily on the cost.
People are automatically condemning equity funds because they don’t understand health care. They need to take a look at the broader scope of how health care is being delivered in this country.
Technology is enabling us to do things with a lower cost-intensive basis than we were able ever able to do before, but it all takes a lot of money. If you’re a mom-and-pop shop out there, and you don’t have any equity investment and can’t get the technology, are you serving patients better?
Some of the lawmakers that are asking questions about these firms allege that they adversely impact quality. What’s your take on that?
I’m not here to defend equity funds, because I still believe that doctors should be more well-rounded. There should be more of a collective community feel with a lot of our health care providers. But that’s not what they’re being taught in the residency programs. They’re being taught to sub-specialize as much as they possibly can.
So I don’t think it’s fair necessarily to automatically say that the equity funds that are owning and acquiring facilities are decreasing the quality. Because you do have some of the equity funds that are focused on technology. Can they provide more services with better outcomes on a more cost-effective basis? If they can, and reimbursement is appropriate, then they can make a better margin. That allows them to sell at their multiple earlier.
So this is a complex issue, and it can’t be solved just by someone saying that equity funds shouldn’t be in health care, or that we’re going to regulate equity funds more. At the end of the day, equity funds are an economic driver. The clients of mine that get involved with equity funds for the most part are doing it because they’re getting some money out of it, but also because they’re getting new technologies that they need.
By getting new technologies, they’re able to provide a broader base of care, and better and faster care for their patients. So there’s a positive attribute to the equity fund as well.
The delivery of health care is such a complex dynamic that you can’t just roll up your sleeves and say equity funds are good or equity funds are bad, or health care is good or health care is bad.
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