Two weeks ago, my partner Perrin DesPortes and I spent most of the week in Chicago at the McGuireWoods Healthcare Private Equity Conference where we were honored to be a “Featured Company.” For those who might not be familiar, McGuireWoods is a 180 year-old, international law firm covering numerous sectors of the economy and are recognized as one of the preeminent firms in the DSO space. This conference was very well attended as it was their 14th time putting it on.
The conference covered almost all aspects of the healthcare field over two full days with 29 different panels and breakouts. Topics ranged from operational considerations like changing payer mix and maximizing organic growth to strategic levels dealing with valuation and pricing models. There were a variety of structural discussions based on debt and equity placement as well as sector-specific panels on veterinary, behavioral health, occupational therapy, hospital care, dermatology and…oh yeah – this little space called dentistry.
Perrin and I drank copious amounts of coffee and made every effort not to get distracted by the frequent discussions of “Repeal or Replacement of the Affordable Care Act.” As you can imagine, however, President Trump featured prominently in many of the discussions even after only 30 days in office. We were fortunate to get a chance to network with many people who were either active in or curious about the dental space in which we operate. I’ll try to summarize some of their comments as well as a few of the panel discussions in my remaining two big takeaways from the trip (please refer to Perrin DesPortes' prior blog post for the recap of the discussion on “Dental Services and What’s Next for the Sector” here).
Panel Discussion of Macro-Trends in Lending
The panel was comprised of four executives from two major banks and two Private Equity companies. I shudder to think how many billions of dollars these four guys are responsible for moving on an annual basis. Their perspectives were fascinating.
As a recap of what got us here, their key takeaways from 2016 were that it was a very
borrower-friendly environment overall that reached down into the lower middle-market, which is the space many established and emerging DSOs are in. Pricing and terms were and continue to be favorable for those looking to borrow, and there were many lenders providing senior debt. Overall, it was a very competitive year from a lending perspective. This was driven by the presidential election as well as the performance of healthcare industry. Private Equity was very active by as much as three times over prior years – part of which was due to more funds coming down stream. Currently, the lower middle-market has a LOT of activity with more lenders looking to come down stream. Some of this is macro and interest-rate driven (500-600 BPS above LIBOR).
As for the post-election outlook for 2017, the debate to repeal or replace the Affordable Care Act (changing payor systems) will have a significant effect. You will probably see lenders becoming more selective in their focus on sectors as some decline and others have greater upside. The election may be settled, but the impact on healthcare is not. Obviously, the impact on Medicaid-based businesses will feel an impact, so expect lenders to recalibrate accordingly. The bottom line here is that the valuations from lenders or Private Equity will take on a more conservative outlook. It’s not that they won’t lend in certain spaces, but they’ll stay conservative and only do it at a lower leverage point (for example: 2x EBITDA).
There will be certain segments facing headwinds into 2017 and beyond, such as radiology imaging or the home infusion space (due to drug costs increasing and reimbursement decreasing). Meanwhile, others will still benefit from tailwinds. A few examples they noted were: medical device companies; dermatology; behavioral health; dental; and veterinary (all fragmented industries where platforms can scale-up, acquire or go de novo and also incorporate multi-site specialties). Overall, healthcare spending is growing at a rate 30% faster than GDP, so it’s still an enviable space – and they don’t see that slowing down from an investment standpoint.
“Alternative” (Non-Bank) Lending Sources Discussion
While this panel didn’t have much exposure to the dental industry, the topic was very compelling. There are many emerging market DSOs that have traditionally been debt financed through banks; however, the departure of East West and Opus banks have created a great degree of uncertainty in this space. In short, if you’re the owner of a 5-20 site DSO, then how are you now planning on funding your continued growth? It may be time to ask an Advisor about the parameters around sources of “alternative” funding.
The panel led off with the fact that there aren’t many bank debt providers in the $2-$10MM in EBITDA space, which has given rise to non-bank lenders (investor funds).
Banks are basically capped at 3X EBITDA, but alternatives can often go above 4X leverage. Banks can only afford losses of .5% (50-75BPS), whereas alternative lenders can afford more in their portfolio. The regulatory environment has been helpful for these guys and the bankers enjoy not having to suffer through the wild cycles and taking the risk. In short, banks are getting away from true cash flow lending in the $2-$10MM EBITDA space.
Some of the positive aspects of alternative lending sources are that “speed to close” is typically faster for them and the overall sponsor-backed community has grown dramatically over the last few years. The capital requirements increase due to regulations that hit community banks especially hard, so loan availability to middle market is becoming less. Individuals are rated BBB or less and the banks are required to hold 25% on a balance sheet whereas lending to A/AA/AAA companies require far less at around 10%. Additionally, compliance and regulation is burdensome to everyone. Applied for a mortgage loan lately?...
So, looking forward into their crystal ball indicates that if regulations go down and capital requirements get relaxed on community and regional banks, then oversight and compliance may ease slightly – which would all be good for middle market. President Trump is focused on smaller banks because they are the ones that lend to small businesses – and that’s where the growth is.
Other trends to note are that family-owned and run businesses are more well-run than ever before and have better future objectives for partial buyout. People leaving large firms to start their own or buy and run a business, which is leading to bridge solutions for founder-owned businesses. There is a lot of growth of independent sponsors in the $2-10MM EBITDA space (lower middle-market), which is providing funding for acquisition with preferred equity and minimal dilution through different types of debt (senior, mezzanine, minority recap, majority sale, etc.).
In conclusion, I think the emerging market DSO space is going to get more complicated due to overall trends in healthcare, continued industry consolidation and confusion around appropriate lending sources and structure. Our two days in Chicago basically clarified that. At the same time, this emerging market space will be filled with opportunity for years to come. If you’re already in it and would like to talk further about your current situation contrasted against your future options, we hope you’ll reach out to us at TUSK.
Special thanks to Bart Walker and all of the great people at McGuireWoods for hosting us in Chicago. We look forward to seeing everyone at the conference again next year.
To continue discussion on these topics or any others related to trends in our industry, please feel free to contact me here.
TUSK is a practice brokerage, strategy and M&A advisory firm specializing in the dental market.