The US economy is hobbled by weak employment growth, extreme fiscal dysfunction and an unprecedented Federal Reserve monetary easing policy. Yet this gloomy scenario has created new opportunities in healthcare for savvy institutional investors in the distressed and special situations private equity mid-market. Since 2011, approximately $1.4 trillion in institutional high yield debt has been issued. In the first three-quarters of 2013, companies have issued institutional leveraged debt at the fastest rate in history: a staggering annualised $1 trillion level.
Over the last 20 years or so, about 14 percent of below-investment-grade loans and bonds have defaulted within four years of issuance. The percentage is even higher in the mid-market. The combination of record levels of debt issuance, unsustainable economic trends, and discord in D.C. has created a promising environment for distressed-for-control investors.
Clearly, given the size and scope of defaults, savvy investors could position themselves well to capitalise on opportunities in the distressed private equity mid-market in healthcare, while staying focused on their risk and return objectives. However, to maximise returns, they also need to be receptive to new strategies developed by asset managers with deep experience in value-oriented investment, and expertise in finding the hidden gems missed by others.
Conventional market wisdom dictates that timing is critical for tapping into opportunities in distressed markets that go through boom-and-bust cycles. Based on our 13-year track record in mid-market distressed and special situations private equity investments, however, we believe in just the opposite. It is not about timing, but knowledge of where and how to look for the most compelling opportunities.
Right now, healthcare is a particularly promising sector for distressed mid-market private equity investments, driven primarily by three key factors.
The Federal government (via Medicare) is the largest buyer of healthcare services. Thus, government policy rather than macroeconomic factors drives the distressed cycle in healthcare services. With healthcare consuming 18 percent of annual federal spending, the government has zeroed in on ways to curb the spiraling cost via reimbursements, rate reductions (i.e., price cuts) and competitive bidding. Many healthcare companies have grown accustomed to a “cost-plus” operating mentality. Their management teams are unlikely to identify and implement efficiency measures and cost containment programs, thereby effectively weakening their competitive positions.
Affordable Care Act
The aim of the Affordable Care Act, now plagued by malfunctioning technology and Congressional resistance to funding – is to provide federally-funded health insurance to 34 million uninsured Americans who can join health exchanges that will serve as a marketplace for individuals to access and enroll in health insurance plans. In addition, Medicaid will expand eligibility to households that are within 138 percent of the federal poverty limit. We estimate that 60 percent of the newly insured will be covered by Medicaid and the rest by health exchanges. For providers, however, each option delivers inferior pricing relative to employer-sponsored insurance rates. This, in turn, will heighten the degree of business exposure of healthcare companies from government rate pressure.
Additional spending cuts
Implementing the ACA will severely strain the US federal budget and prompt additional spending cuts. The federal government will have to find offsets to match the cost of expansion. In its February 2013 analysis, the bipartisan Congressional Budget Office estimated the total cost of Obamacare to be $1.8 trillion, up from the $944 billion it had projected in 2010. Not only would this punch an even bigger hole in the Federal deficit over a 10-year period, but also, going by precedent, the $1.8 trillion estimate will still be wildly below the actual cost.
All three factors clearly point to heightened consolidations in the healthcare sector. With spending cuts and policy changes, the universe of healthcare companies will be ripe for restructuring and operational overhauls. These developments, coupled with the stable and attractive long-term attributes of the healthcare sector, promise an attractive environment for institutional investors in distressed private equity.
Patrick Boyce is a partner and the head of private equity at Highland Capital Management.