M&A Market Faces Choppy Period in Face of Changed Risk Perceptions

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Talking points have changed. The fervor has cooled. The due diligence has intensified. Health care organizations active in the mergers-and-acquisitions market are facing a number of notable changes as they enter the second half of 2022.

Yes, investors of all stripes still have billions of dollars of capital to put to work, many healthcare ventures are generally less affected by financial market swings, and, in the words of Venable law firm partner Ari Markenson, “I don’t know of advisors who are twiddling their thumbs.” Good deals for good companies will still get done.

But the aftermath of COVID-19 and the changing climate in financial markets are throwing up roadblocks that are hampering deal activity even though longer-term fundamental tailwinds such as the shift to outpatient settings and technology enablement remain in place.

“Our world is changing and I think the next 12 months are going to be very different than the past 12 months. I’m not bearish […] but I do think everyone is adjusting their risk tolerance and valuations are going to plateau and begin coming down,” said Burk Lindsey, who leads Raymond James Financial Inc.’s roughly 50-banker healthcare services team. “A+ deals are still going to get done but the Bs and B-minuses and C-pluses, some of those are not going to get done. And the ones that do get done will take longer. And it’s going to hurt. It’s just going to be more challenging.”

One important point to note about tracking consolidation in healthcare is that megadeal activity, which can mask much of the action among small and midsized companies, already has cooled. Research firm Kaufman Hall & Associates noted this spring that the average size of healthcare firms sold in the first quarter of 2022 was $246 million. That was less than half 2021’s record number but also more than 30 percent smaller than the average seller’s size from 2016 to 2020.

The market’s most prominent and expensive transactions now also have to deal with more aggressive stances at the Federal Trade Commission and U.S. Department of Justice, which have both challenged a number of planned healthcare mergers in recent months. But middle-market firms who hire Lindsey and his peers don’t have to concern themselves with antitrust matters and activity is on the whole still at a solid level – especially after the market digested a rather manic end to 2021 deal-making because of expected tax law changes.

“I’m not to the point of hysteria,” said Mike Moran, co-founder of M&A Healthcare Advisors in Los Angeles. “I think we’ll be back in a good place by the third quarter or fourth quarter.”

Still, buyers and sellers in the middle market today face various red flags they didn’t have to consider six months or a year ago. Among them:

• Some buyers have become more wary of committing to purchases because COVID and its fallout have clouded the financial pictures of the businesses they’re eyeing. A typical dental practice, Markenson said, would have seen next to no patients the first six months of the pandemic but then put up a gangbusters 2021. Halfway through 2022, he said, many a buyer and seller still can’t judge the true profitability and viability of such ventures.

Lisa Nix, leader of the transaction advisory services practice at Top 40 accounting and advisory firm LBMC, said big increases in labor and supplies costs also are mucking up a lot of initial valuations and contributing to “some really tough headwinds” on a number of deals.

“We’re seeing more and more clients wanting to wait and see for another month, another quarter [and] time is usually not your friend in a deal,” Nix said. “We’re seeing more deals die, put on pause and being retraded.”

• Those growing deal risks and rising cost of financing are pushing to the sidelines some investors, lenders as well as representations and warranty insurers. Yes, those retreats are taking away some of the froth in the market but they also remove some of the oil that makes the deal ecosystem run efficiently. That means sellers might have to go about their process more discreetly than in recent years, reaching out to a small number of possible buyers and avoiding a public auction.

“We’re moving into an environment where the perception is that the risk of a process is much higher,” Lindsey said. “Buyer valuation expectations tend to adjust much faster” than those of sellers.

• The due diligence of coding, compliance and other traditional business functions has become more detailed – and has grown to include a key new area of operations.

“Recruiting and retention was not a top 10 diligence item 18 months ago. It is now the No. 1, 2 and 3 most important,” Lindsey said.

Nix said potential buyers now need to be very mindful of the staff lists they’re provided early on in talks and go back for updated versions several times as negotiations progress to make sure key employees are sticking around in a market desperate for top talent. Similarly, recruiting costs that in the past were seen as non-recurring items are now increasingly being incorporated as a regular cost of doing business, lowering targets’ margins.

Moran said some buyers are using acquisitions as a primary tool to add talented workers, particularly in the behavioral health, addiction care and autism treatment spaces. There’s never been a greater emphasis, he said, on the human capital at target firms. At the same time, he added, rising compensation costs are crushing already-thin profit margins at some companies who as a result may have a hard time pulling off a sale.

• Some of the so-called dry powder investors have raised or secured commitments for is scouting areas of the market it hasn’t been in before.

Markenson said some potential purchasers are walking away from auctions relatively early because of the time and money they expect to spend only to be handily outbid by more muscular peers still willing to see past potential issues and put to work some of their capital.

“COVID threw a lot of insanity into the market” from a pricing standpoint, Markenson said. “But there already was a lot of insanity in the middle market pre-pandemic. I think a lot of folks went downmarket because valuations for larger deals had become unsustainable.”

• A knock-on effect of some investors stepping away from big deals is that strategic buyers could be gaining an edge over private equity and other investors. Compounding that dynamic are rising interest rates and general financial market uncertainty, which Walgreens Boots Alliance executives noted in late June led to them calling off a sale of their Boots division in the United Kingdom. In short, the health care PE winds are turning.

“Solvency issues may prompt sponsors to sell to another sponsor and de-stabilize partnerships, alliances, and operating assumptions,” veteran industry watcher Paul Keckley wrote in his The Keckley Report newsletter June 20. “And the long game being played by strategics will accelerate as lower valuations present opportunities.”

It’s worth reiterating that the dealmaking market still has a lot going for it when it comes to potential buyers and interest in a number of trends that have long-term legs. But those on both sides of potential deals will need to be more discerning of the risks they face, more realistic about what’s still possible/realistic and more careful with the money they’re spending. The relatively quiet seas for M&A in recent years have gotten choppy in a hurry and look to stay that way for a while.

“I’d love some calm waters but I don’t know that we’re going to get them,” LBMC’s Nix said. “It’s just not out there. Hang on and take your Dramamine; we’re in for some seasickness here.”



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