Crisis highlights debt structure in health care and its effects

The COVID-19 health-care crisis and the recession are highlighting how debt, a necessary ingredient for a buyout, can negatively affect patient care, affordability and investor returns.

To be sure, private equity firms are as interested in the sector as ever. Despite transaction volumes slowing to a trickle in the spring as a result of the pandemic and consequent recession, $19.3 billion was invested in 231 health-care transactions worldwide year-to-date as of June 4, according to data from London-based alternative investments research firm Preqin. By comparison, $62.3 billion was invested in 724 deals in all of 2019.

Health care has also outperformed other private equity sectors over the majority of time periods and also had the lowest likelihood of losing capital, said Morgan Holzaepfel, Boston-based partner who leads the health-care primary investment team at Adams Street Partners LLC, an alternative investments firm.

An Adams Street Partners analysis shows that private equity investments in health-care companies made between 2013 and 2016 earned multiples on invested cash flows of 2.62 times compared with 2.25 times for all other private equity-backed companies as of Dec. 31. (Adams Street analyzed 11,614 portfolio companies in funds in which it had invested.)

Over the last two or three years, Adams Street has seen manager interest in health-care companies increase, and it will continue to be an attractive place to invest capital, Ms. Holzaepfel said. However, in the short term a number of sectors in that industry are feeling the pain of the pandemic and recession.

"Within sectors we've seen a divergence of performance," Ms. Holzaepfel said.

"Hospitals are being squeezed" because they are primarily treating COVID-19 patients and halting more profitable activities such as elective surgery and non-emergency health services, she added. Also negatively impacted are health-care providers, especially those offering elective services such as dermatology, dental and gastrointestinal because they have been shut down during the crisis; companies running clinical trials, which also have been halted or slowed because of lack of access to patients and hospitals; and drug companies reliant on global supply chains, according to an Adams Street white paper Ms. Holzaepfel co-authored.

But other areas, such as home health care and medical devices, could benefit, she said.

"Generally, the U.S. was not prepared for a pandemic like this. That is fairly obvious to most people. We're behind the eight ball for (personal protective equipment) and ventilators," Ms. Holzaepfel said.

Adams Street's theme in health care is to invest in companies that are improving the quality but decreasing the cost of health care, she said. The managers that Adams Street executives are focused on are often health-care specialists that are investing in growth businesses and using modest amounts of leverage, Ms. Holzaepfel added.

In the past, managers and investors had considered health care to be a defensive industry, resilient in downturns, said Samuel Porat, New York-based managing director, head of alternative yield strategies at Neuberger Berman, in an email. Before the pandemic, private equity firms invested in companies involved in the shift to values-based care and to fee-for-outcomes from fee-for-service payment models, he said.

"With the tide going out now, the risks in some of these (health-care company) business models is being exposed, and debt and equity markets probably hadn't fully priced in all these risks adequately," Mr. Porat said. "But health care is a massive industry, typically (about) 15% of GDP in most developed economies so perhaps it was crude to look at health care as a single industry driven by the same factors."

In the future, Mr. Porat expects that health-care companies will be financed differently, depending on sector and business model.

"We will likely see costs of capital range more widely and different levels of indebtedness across the various health-care segments — and that's probably a good thing," he said. The sectors most in need of a change to their business models and lower debt levels include health-care companies that have "retail-like" business models such as physician staffing and location-based models like surgery centers, he said.

These businesses "have been hard hit by stay-at-home orders and patients deferring doctor visits and elective procedures," Mr. Porat said.

Many industry watchers and some members of Congress say that private equity should do more to make sure their health-care portfolio companies do more to lower costs for patients and improve the quality of care, including adopting metrics and standards to provide a consistent definition of quality of care, as well as basing payment on outcomes.

The U.S. spends double the amount on health care per capita than any of the other Organization for Economic Cooperation and Development countries, and health-care outcomes in the U.S. rank in the bottom half of all OECD countries including life expectancy at birth, infant mortality and quality of primary care, the Adams Street report noted.

Members of Congress point to private equity managers and their portfolio companies as a prime source of surprise medical bills. They say that companies backed by private equity firms use out-of-network billing as a strategy to drive up their pay rates. In September, House Committee on Energy and Commerce Chairman Frank Pallone, D-N.J., and ranking member Greg Walden, R-Ore., sent letters to the CEOs of KKR & Co Inc., Blackstone Group Inc., and Welsh, Carson, Anderson & Stowe seeking details of physician staffing compensation.

KKR executives "have been cooperating with the committee's request," company spokeswoman Kristi Huller said in an email.

Legislation sponsored by Messrs. Pallone and Walden as well as one backed by the private equity industry supporting an independent dispute resolution model to prevent surprise billing are stalled in Congress.

Should President Donald Trump lose in the upcoming election, there is a chance that a new administration will push to eliminate surprise billing, said Neil Olderman, Chicago-based partner in the health-care group of law firm Faegre Drinker Biddle & Reath LLP.

When private equity invests in service companies that provide such medical professionals as emergency doctors, primary care doctors and anesthesiologists to hospitals, "they do benefit from the surprise bills," said Mr. Olderman, who is also president of the Faegre Drinker-owned consultant Innovative Health Strategies. "As outside network providers, they are able to charge full rates."

Should a new administration force companies to change these business practices going forward, private equity firms would need to search for a new way to reduce costs or be more productive to compensate for the loss, Mr. Olderman said.

Nursing homes is another sector that is being pushed over the financial brink by the pandemic. Several have already tipped into bankruptcy and receivership by thin margins, mainly outsourced operation and a heavy debt load, Mr. Olderman said.

"In my view, it's set up to be very fragile and more likely than not to come crashing down," Mr. Olderman said.

Nursing homes have been hard hit by the pandemic. There were 95,515 confirmed cases of COVID-19 and 31,782 deaths caused by the virus in nursing homes as of May 21, according to the Centers for Medicare and Medicaid Services.

Recent research has shown that nursing homes owned by private equity firms offer poorer standards of care than non-private equity-backed nursing homes.

A March academic paper found that between 2000 and 2017, private equity ownership of nursing homes led to declines in patient health and compliance care standards. The researchers — Atul Gupta, assistant professor at the Wharton School, University of Pennsylvania; Sabrina T. Howell, assistant professor of finance at Leonard N. Stern School of Business, New York University; Constantine Yannelis, assistant professor, University of Chicago Booth School of Business; and Abhinav Gupta, department of finance, New York University — did not find the same level of quality decline after acquisitions by non-private equity corporations and chains.

These issues laid bare by the COVID-19 crisis is making investors more aware of the importance of environmental, social and governance issues, said Sanjay R. Mansukhani, director, private equity in the New York office of Willis Towers Watson PLC.

"There will be a lot more due diligence done on ESG in health care and LPs will want reporting, monitoring of their investments," Mr. Mansukhani said.

ESG is becoming a critical part of risk management, and much more central to risk and return, he added. "GPs will have to stress test their playbook for more outlier events. What services do their companies have to keep up with in times of stress?" Mr. Mansukhani said. "Returns will have to be calibrated with that in mind."

Going forward, private equity firms will be under pressure to demonstrate that when they buy a health-care business, they don't negatively impact the company, Neuberger Berman's Mr. Porat said.

"I hope PE (private equity) firms learn the lessons of overleveraging certain industries like retailers," he said. "It would be bad for health care, society and especially the private equity industry if the pressures of servicing an overly high debt load led to an erosion of quality patient outcomes."