The Leveraged Buy-Out in the Healthcare Industry
An investment is the number one key driver for the growth of healthcare businesses. While The Ambulatory M&A Advisor has discussed various modes of investment, one that has not been covered is the process of the Leveraged Buy-Out (LBO) in the healthcare industry. The Ambulatory M&A Advisor examines the process of the LBO, benefits and risks, and who generally performs this model of investment.
“A leveraged buyout is really just a way to finance a transaction. When I try to teach associates about LBOs, I always say it’s like buying a house with a mortgage. You have to put some equity down, you then find a lender who will lend you the rest of the purchase price and then you secure the loan with the assets that you are buying. It is really just a way to finance the acquisition of an asset that has a value and it is used by private equity firms,” Jim Loss, partner at Morgan Lewis says.
“They go out and raise equity from other people and then they use that to provide the down payment of the purchase price for a business. The lender provides the debt, the lender then has a lien on the asset that they buy.”
Based on Loss’ definition of a LBO, the whole model is in place to increase the value of the asset, and reduce the debt if possible, and then sell the asset for a higher value. The real thought behind it all is that it is a way to supercharge returns, he says adding that by using the bank as a LBO you are able to get much better returns on your equity than you would if you had to pay 100 percent equity.
Adam Willis, director at Madison Capital Funding, and Group Head of Healthcare Leveraged Finance says there are two types of purchases in a LBO and these are the asset or stock sale of a company. Willis says that determination is based upon different attributes of a business.
“Whether it is a provider business where they need licenses transferred; and in an asset sale those licenses don’t transfer so you need to structure a stock sale or apply for new licenses. If there are potential liabilities of the business, you want to structure the LBO as an asset sale so that the liabilities don’t transfer,” Willis says.
“From a capital structure perspective, you have a traditional senior lender base of capital coming in, then you have a junior lender, whether it’s a first or second lien capital, or mezzanine capital coming in. Then you have the equity behind it, and that equity depends on the buyer. Sometimes they will take a preferred position relative to the sellers if the seller rolls over, or they will all be common.”
When talking taxes, Loss says that interest expense is tax deductible.
“So, if you buy a business that is making a net income of X dollars and you put a lot of debt on the business to buy it; now, all of a sudden you have lots of deductible interest. Your tax bill goes way down because you reduce your taxable income. Instead of paying the government you are paying the bank, and instead of paying taxes you are paying interest. Another benefit of all of this is that a business that is generating cash spends less money on taxes,” Loss says.
Loss says that the key term when thinking about a LBO is “debt capital.” In most instances, a LBO takes place when a private equity investor/fund invests in a business by buying into a majority stake of the desired business with very little cash, and with the aide of debt capital.
“In the 80s people would put less than 10 percent down. Nowadays, the ratios are getting quite different, and the private equity firms need to put up generally somewhere between 25 and 50 percent of the purchase price in equity. That’s a statistic that moves around depending on the debt market and purchase prices for businesses. Even at 25 or 35 percent down, there is still an opportunity to make a better return on your investment by using the bank as leverage,” Loss says.
According to Loss the banks involved with providing the debt for a LBO are protected because they can go after the assets.
“They have got the protection of the equity check. Before they lose any money, the buyer has to lose all of their equity. That’s why they want more equity in today’s market than like back in the 80s,” Loss says.
Willis explains that in healthcare the asset to equity ratio as being a huge driver.
“In the healthcare spectrum these are asset light business. They are really more human capital or intellectual property driven businesses. What you do see is a debt to equity ratio. It’s a requirement that lenders will want to see. What they will want to see is a minimum of 30 to 35 percent at its base, equity with the rest being debt. Those minimums, given where healthcare multiples are trading right now, you really are not often seeing those being tested because the valuations right now in the healthcare world are very high,” Willis says.
Loss explains that in the last couple of years businesses are selling 8,9,10 and more multiples of EBITDA.
“If the purchase price is very high, banks will generally not lend more than 3 ½ X EBITDA. The most that you could possibly borrow to buy a business is possibly 5-5 ½ X EBITDA. That would be a very rich debt package. So, if you are going to pay 10 X EBITDA, and you can only borrow 5 X EBITDA, then you have to put up 50 percent of the purchase price in equity because you are only able to borrow half of the purchase price from the lender,” Loss says.
Risks and Benefits
Rose Matricciani, partner with Whiteford, Taylor, Preston LLP says that the overall risk of a LBO depends on what type of entity that the buyer is purchasing or is investing in.
“From a healthcare perspective, we always look at whether or not the entities have abided by the government laws and authorities. Have there been violations or paybacks where they have a situation of a payback to a government entity due to improper billing. It’s a number of issues depending upon what your particular entity is covered by. There is quite a few issues depending upon the entities that are involved and what the regulations are,” Matricciani says.
According to Willis, there are a few benefits from a LBO; the first being the intent of a LBO which is for an investor to buy a business for the sake of growing it.
“Oftentimes you see an influx of new capital into the entity from an investor that is looking to grow. With that, they bring resources, energy, and new perspective to a business that may or may not need that. They can bring investment infrastructure, sales and marketing, provide new areas of growth, and often times will bring in new management teams and relationships. All of these resources that help what is probably a good business try to become a great business. With that investment comes a whole new perspective, a whole new approach, and oftentimes, additional acceleration towards that growth strategy. The benefits are really that new influx in capital coming in, and the resources it brings to bear for an enterprise,” Willis says.
“From the risk perspective, what I see is really just by definition, the leverage brings out a new risk, and also is oftentimes funny, because some of the benefits that come with that strategy or that influx of resources and investment provides some of the risks as well. What we have seen in some of our portfolio is once you put a company that is maybe not used to be operating in a levered environment to a levered environment, obviously the margin of error in terms of performance becomes smaller.”
Willis says that with leverage comes additional resources going towards paying that debt burden, and capital burden from an interest perspective. But more importantly, as you add infrastructure, with leverage comes financial covenants and different restrictions around what the business can and can’t do, whereas in an unlevered environment a business is really free to do whatever it wants because there is no one really monitoring performance and making sure performance continues to improve.
Willis says in a levered environment, if that growth or strategy doesn’t come to fruition right away, you could find yourself at odds with your bank group or in violation of covenants which could long-term hamper what you were trying to accomplish with that business, had the leverage otherwise not been on the business.
“We have seen new investors often change or try to augment the strategy of a business in a LBO in order to accelerate that growth. At times, that change in strategy can take management or employees attention off of that core business and what will be seen is that the core business suffers at the expense of trying to grow ancillary new products or new services. So, the core business suffers as the management team takes their eye off of the ball,” Willis says.
If you have an interest in learning more about the subject matter covered in this article, the M&A process or desire to discuss your current situation, please contact Blayne Rush, Investment Banker at 469-385-7792 or Blayne@AmbulatoryAlliances.com.