After attending the recent annual conference of the National Association for Home Care & Hospice (“NAHC”) in St. Louis, Missouri, and speaking with numerous clients, consultants, and vendors, AGG Healthcare partner, co-chair of the firm’s Post-Acute and Long-Term Care team, and NAHC board member Jason Bring has compiled the issues and trends driving home health and hospice deals. To round this out, Jason sat down with Matt Brohm, co-chair of AGG’s Healthcare Private Equity team who is also ranked by MergerMarket League Tables on a global and national level for private equity transactions closed in 2021, to compare AGG’s recent mergers and acquisitions (“M&A”) activity and gain his insights. Here’s what Jason learned.
2022 Market Faces Headwinds
First off, it is no secret that 2021 was a record year for M&A deals in the home health and hospice segment of the healthcare industry, both in terms of volume and valuations. In 2022, however, both volume and valuations seem to have declined to pre-pandemic levels. We are currently seeing a more troubled operating environment with staffing challenges and tight credit. Rising interest rates have also put downward pressure on valuations. That said, premium assets are still demanding strong multiples, although still not as strong as 2021. Private markets tend to lag the public markets. Initially, the lag between private and public markets with respect to headwinds in the market was somewhat slower. But the two markets are now harmonizing. Though one obstacle remains — owners in the private markets are still imagining the dollar signs of 2021 and have been slow to realize that those multiples are no longer achievable. This imbalance can pose a rude wake-up call for owners who missed the peak market in 2021.
The silver lining in today’s market is that buyers are still looking for deals in the home health and hospice spaces. In fact, we are still seeing quite a bit of private equity activity in the space. Interestingly, private equity activity has especially shown some resiliency to the economic headwinds. In fact, private equity has outpaced strategic (public, etc.) deals in 2020 and 2021. Many private equity funds still have significant “dry powder” available and need acquisitions to continue to grow their platforms (versus slower organic growth that is often inconsistent with the private equity model).
Factors Driving Valuations
As touched on above, a myriad of factors drive valuations, often turning on the buyer’s existing platform, its need for continued growth through acquisitions, and scarcity of other assets in the market. When zeroing in on a particular target, however, buyers are looking for a strong management team, access to talent, strong (and compatible) IT infrastructure, and the absence of significant legal/regulatory issues. Other ancillary factors include licensure, certificates of need, staff, and sometimes payor contracts. When going to market, sellers should be prepared to tell prospective buyers a compelling story about the organization, its future growth opportunity, and the reason for the owner’s exit. Also, engaging legal counsel early in this process can often add significant value at closing. For example, legal counsel can conduct preliminary due diligence on the seller to identify weak points and areas for improvement prior to going to market. Preparing an executive summary (or engaging a broker, investment bank, etc.) in advance of going to market can help refine and tell that story and better prepare the seller to handle buyer’s questions.
Presale Prep Work
Even before preparing an executive summary for potential buyers, sellers should undertake several presale reviews and, if needed, tune-ups. First off, the seller must have credible financials and accurate cost reports. If there is any doubt, bring in a consultant to review and help tighten the financials. Next, consider preparing an internal quality of earnings (“QoE”) report (an evaluation of a company’s financial performance to identify nonrecurring transactions, revenue sources, customer concentrations, unusual or cyclical trends, significant estimates, consistency in application of accounting policies, and other key metrics). Buyers will perform or commission their own QoE report as part of due diligence, but it is a sign of strength and a good negotiation tool to have an internal QoE report for potential bidders to evaluate when preparing offers.
In addition to the financials and QoE, the seller must be able to explain its key referral sources and its relationships. If the marketing team utilizes a strong customer relationship management (“CRM”) software, this helps ensure continuity of contacts for the purchaser, making it less dependent on the seller’s key marketing staff, who may choose not to transition to the buyer.
Of course, beyond the business drivers, the seller must also objectively examine its risk profile. During due diligence, a buyer will exhaustively review the seller’s legal, reimbursement, and compliance history. So, the buyer should do the same in advance, correcting things where possible and preparing explanations for past challenges. A strong track record of solid reimbursement with few audit denials helps assure prospective buyers that they are not inheriting a ticking time bomb. If there has been recent audit activity, the buyer can show how it prevailed on appeals or, if not, how it learned from the audits and implemented improvements to combat the prospect of future denials. Finally, overall compliance is important, ranging from solid survey histories, to billing, employment, and other areas. For more sophisticated sellers with established compliance teams, this should be integral to the organization. For smaller organizations with compliance officers who wear many other hats, consider bringing in consultants (often retained through counsel) to undertake with a compliance review; then work with counsel to address any troublesome findings.
With the presale prep work complete, the buyer can then paint a more fulsome and compelling story with the executive summary. But don’t stop with just a written summary. The buyer will need to road test communicating that story to prospects, including answering practice questions buyers are likely to pose.
Due Diligence and Pitfalls
After going to market, the buyer and seller will enter into a non-binding letter of intent, providing the buyer with a period of exclusivity (trending around 60 to 90 days) for the buyer to do a deeper dive on the seller through comprehensive due diligence, with the target of closing within 90 to 120 days. A common pitfall by sellers is to not engage legal counsel to provide advice and negotiate the letter of intent. It is also important for sellers to bring in legal counsel assist with the due diligence production efforts. Due diligence has become exponentially more difficult in recent years, focusing on the usuals, such as financials, quality of earnings, and compliance, but now extending into less conventional areas, such as technology security risks and cyber preparedness.
Due diligence often uncovers issues that can kill a deal altogether, trigger renegotiation (i.e., lowering) of the purchase price, or require significant escrowing (holdbacks) of the purchase price. Common issues include a checkered past of the founder or key employees, legal issues, compliance issues, and negative audit history, such as repeated denials or high denial rates. Again, this reinforces the need for buyers to undertake significant pre-market efforts to ensure a strong compliance and billing profile.
Conclusion
The future of healthcare is in the home, so we expect to see continued consolidation within the home health and hospice markets, albeit with 2022 and potentially the beyond seeing a slower pace and lower valuations than the peak we enjoyed in 2021. Interestingly, home health and hospice M&A tend to move in opposite directions with two-to-four-year trends. This was especially true as home health digested PDGM. CMS’s recently finalized home health rate cuts do not help the home health M&A outlook, but with the cuts delayed and then spread over several years, it provides some predictability for investors. Predictability is healthy for private equity, whereas uncertainty creates a chasm between valuations of buyer and seller, with the buyer unable to predict and therefore lowering the valuation. Of course, NAHC and others are working diligently to reverse CMS’s cuts, whether through legislation or otherwise, which would serve as a net benefit to the M&A environment and to home health providers everywhere.
