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Leveraged Finance: Private Equity-Backed Investor Interest In Health Care Has Taken A Toll On Ratings

The Health Care Industry Remains Popular For Private Equity Investors

Private equity activity in health care rose globally to record levels in 2018, a trend that continued into 2019. Total disclosed deal value in 2018 reached $63.1 billion, the highest since 2006, and deal count grew to 316 from 265 in 2017. North America remains the most active region, with health care services companies the fastest-growing subsector for new issuers.

Concurrently, in the health care companies we rate, we've seen an influx of private equity-owned issuers. We rate the overwhelming majority of these companies in the 'B' category, especially at the lower end of the category ('B' and 'B-'). The number of 'B' and 'B-' ratings has increased to 57% of the entire health care rated portfolio from about 45% in 2014. The proportion of 'B-' rated companies in the group has doubled--22% in 2019 compared to only 11% in 2014.

Over the years 2014-2019, we rated about 130 new transactions and among these, the percentage of new issuers we rated 'B' or 'B-' increased to 100% in 2019 from 75% in 2014. These ratios directly correlate to an increase in private equity-backed companies: the proportion of private equity-backed new issuers increased to 100% in 2019 from 63% in 2014.

Chart 1


Chart 2


A Steady Increase In Acquisition Multiples And Leverage Leads to Rating Deterioration

Over the past three years we've seen an increase in acquisition multiples (see table 1). These high multiples paid in acquisitions typically correlate with higher leverage.

Table 1

New Issuers--Acquisition EBITDA Multiples, By Year Of Transaction Origination
Average multiple
Transactions originated in 2017 12.7
Transactions originated in 2018 13.2
Transactions originated in 2019 15.0
Multiples are based on pro forma EBITDA, as presented to us, excluding estimated future synergies in transactions involving merger. Source: S&P Global Ratings.

We note that the multiples cited in the table are based on the companies' presentations of the last 12 months of pro forma EBITDA (excluding future synergies in transactions that involve a merger of two or more entities). However, as our research has shown (see "When The Credit Cycle Turns: The EBITDA Add-Back Fallacy" and "When The Cycle Turns: The Continued Attack Of The EBITDA Add-Back"), some pro forma EBITDA measures might be overestimated, and the multiples might be even higher than we've indicated here.

Along with higher acquisition multiples, we've witnessed an increase in leverage, because the two factors are highly correlated. Based on the transactions originated in 2017-2018 and the leverage metrics in the year of origination we found positive correlation between the acquisition multiples and leverage.

Chart 3


Material Downside Risk And No Rating Upside For Private Equity-Backed Issuers Over 2014-2019

We've noted that private equity-backed companies are exposed to downside rating risk and no upside. The deterioration in credit quality correlates not only to the higher leverage levels at the deals' origination, but also stems from the increasing number of underperforming companies within the private equity-backed cohort. We found that among the transactions we rated over 2014-2019 all rating upgrades were on publically traded companies. No upgrades of private equity-backed companies occurred, and we downgraded 21% of these companies. About 30% of the downgrades on the private equity-backed issuers we rated over 2014-2019 were associated with the transactions originated in 2018, reflecting material underperformance of the most recent cohort only a short time after the origination of the deal. In contrast, we saw material upside potential among publically traded companies, with 23% upgraded over the same period.

Table 2

Changes In Ratings Of Private Equity-Backed Issuers, For Transactions Originated In Years 2014-2019
New private equity-backed issuers No rating change Downgrade Upgrade Total
Transactions originated in 2014 3 2 0 5
Transactions originated in 2015 7 2 0 9
Transactions originated in 2016 11 5 0 16
Transactions originated in 2017 18 5 0 23
Transactions originated in 2018 22 6 0 28
Transactions originated in 2019 17 1 0 18
Total 78 21 0 99
No change/downgrade/upgrade ratio 79% 21% 0% 100%
Source: S&P Global Ratings.

In looking at the various reasons behind the downgrades of the private equity-backed companies, we found that a combination of factors typically led to a lower rating (in 18 out of 21 cases two or more reasons supported the downgrade). We grouped these into several key categories--three relate to revenue performance, another three to the costs, one to the working capital, and another group representing other factors that do not fall within the previous categories (see chart 4).

Chart 4


We based about 45% of the downgrades, among other factors, on lower-than-expected demand or pricing pressures that led to lower-than-forecast revenues. An additional 15% of the negative rating action rationales cited the loss of a significant contract as a factor behind the company's underperformance. In about 30% of the downgrades, a negative reimbursement change led to weaker-than-expected results, reflecting the vulnerability of the health care service providers.

A combination of revenue-related factors with higher-than-expected operating costs resulted in materially lower-than-projected cash flow generation occurred in 6 out of 21 examples. For about a third of the companies, integration challenges, along with either working capital management issues or disruption stemming from a transition of the enterprise resource planning (ERP) system, prompted the negative rating action.

We think these factors will continue to be relevant in the coming years. As the economy slows down, competition and pricing pressures may intensify and the reimbursement environment will continue to evolve. At the same time, companies will continue to complement organic growth strategies with M&A activity, which will increase integration risk.

M&A Activity Will Stay High

Private equity sponsors tend to invest in areas that are highly fragmented and where they believe size and scale can bring operational leverage, by lowering costs or negotiating better terms with payors. The underlying investment thesis in many services-oriented transactions is based, inter alia, on consolidation and extracting synergies. For example, one of the largest transactions in 2018 involved a spin-off of one of the biggest players in the home health industry (Gentiva) and combined it with a large participant in the hospice segment (Curo) in an aggregate transaction valued about $5 billion. The merger model of one of the largest transactions of 2019 (between PharMerica Corp. and BrightSpring Health Services under a new entity--Phoenix Guarantor Inc.) outlined meaningful cost synergy opportunities as part of the deal. We expect the company, similar to its peers, to remain on an acquisitive path, seeking to bolster its presence in targeted post-acute-care clinical settings and the pharmacy segment.

The stiff competition among private equity investors leads not just to higher multiples paid for assets, but also to more aggressive strategies. One such strategy is an accelerated pace of acquisition activity, as the investors seek to earn a return on investment. We view integration risk as one of the key credit risks for many of these companies.

At the same time, many private equity-backed health care services companies remain narrowly focused. When they do expand, they stay within their niche, adding more within the same line of services (i.e., Radiology Partners, ScribeAmerica, US Anesthesia Partners). For the companies entirely focused in only one service line, the reimbursement risk has higher impact than for those with multiple lines of services. Others, like nThrive, have riskier business models that create more pressure on profitability and volatility of cash flows. Employing such strategies can make the companies more vulnerable to a negative change in economic conditions.

A Clear Downside Risk For Private Equity-Backed Health Care Companies In Coming Years

We forecast an increased downward risk within private equity-backed companies in the sector, stemming from their eroding credit quality. We believe private equity-owned companies will invest any access cash flow generation back toward expansion or distribute it through dividends. In numerous transactions involving private equity-owned companies in recent years, only a handful resulted in slight deleveraging or materialized into an initial public offering (IPO).

We expect high leverage in this cohort of companies to persist in coming years, leaving them with only a thin cushion against any unexpected negative developments. In 2019 we took an increasing number of negative rating actions in the health care sector, and we expect more of the same in 2020. Given the an elevated probability of recession in the coming year (assessed now at 25%-30% by the S&P Global Ratings' economists), we forecast that downward bias for private equity-backed companies will increase over the next few years, making the sector more vulnerable to downgrades and eventually to defaults.


Table 3

Key Factors In Rating Downgrades, For Transactions Originated In Years 2014-2018
Year of transaction Original rating Current rating Years between the transaction date and the downgrade Downgrade factors

Aegis Toxicology Sciences Corp.

2014 B B-/Stable/-- 5.4 Integration challenges, RCM/collection

CDRH Parent Inc.

2014 B CCC-/Negative/-- 3.1 Reimbursement

Albany Molecular Research Inc.

2015 B B-/Negative/-- 3.9 Contract losses, higher operating costs

Lanai Holdings III Inc.

2015 B CCC/Negative/-- 2.0 IT transition, Lower demand

Arbor Pharmaceuticals Inc.

2016 BB- B/Stable/-- 1.8 Lower demand

Medical Depot Holdings Inc.

2016 B CCC+/Negative/-- 0.7 Lower demand, higher WC and/or operating costs

Nathan Intermediate LLC/Netsmart LLC

2016 B B-/Stable/-- 1.0 Lower demand, higher operating costs

New Millennium Holdco Inc.

2016 B- CC/Negative/-- 0.4 Reimbursement

NMSC Holdings Inc./NAPA Management Services Corp.

2016 B B-/Negative/-- 3.9 Reimbursement, higher operating costs, RCM/Collection
Air Methods Corp. 2017 B B-/Stable/-- 1.6 Contract losses, reimbursement

Aveanna Healthcare LLC

2017 B B-/Negative/-- 1.0 Integration challenges, RCM/collection

PAREXEL International Corp.

2017 B B-/Stable/-- 1.8 Lower demand, higher operating costs

Spectrum Holdings III Corp.

2017 B B-/Stable/-- 2.2 Divestiture, lower expected EBITDA, lower demand

Team Health Holdings Inc.

2017 B B-/Stable/-- 2.9 Reimbursement, higher operating costs

Alcami Corp.

2018 B- CCC+/Negative/-- 1.0 Reimbursement, lower demand, higher operating costs

BW Homecare Holdings LLC

2018 B- CCC/Negative/-- 1.3 Integration challenges, RCM/collection

LifeScan Global Corp.

2018 B+ B/Negative/-- 1.4 Lower demand, higher operating costs

LSCS Holdings Inc.

2018 B B-/Stable/-- 1.1 Integration challenges, IT transition

Viant Medical Holdings Inc.

2018 B B-/Stable/-- 1.3 Integration challenges, IT transition

Vyaire Medical Inc.

2018 B- CCC+/Negative/-- 0.6 Contract loss, lower demand, IT transition, RCM/collection, higher operating costs

Femur Buyer Inc.

2019 B B-/Stable/-- 1.0 Higher operating costs, U.S. Food and Drug Administration (FDA) warning letter
Source: S&P Global Ratings.

Related Research

  • When The Cycle Turns: The Continued Attack Of The EBITDA Add-Back, Sept. 19, 2019
  • When The Credit Cycle Turns: The EBITDA Add-Back Fallacy, Sept. 24, 2018

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