National health spending is expected to reach nearly $6.0 trillion by 2027, according to the Centers for Medicare & Medicaid Services. The aging American population is the industry’s primary growth driver.
In the lower middle market in particular, there’s significant fragmentation in a number of sub-sectors providing the opportunity for repeatable roll-up programs. Home health services is one of those categories. Home health services deals made up nearly 10% of healthcare deals on Axial in 2019, the largest share of any subsector in the space. We talked to Bradley Smith, Managing Director of Texas-based healthcare-focused M&A advisory firm VERTESS; Cory Mertz, co-founder of Mertz Taggert, a healthcare M&A advisory firm focused on home and behavioral health; and Neil Johnson, managing director at healthcare advisory firm Lawrence Evans & Co., about trends they’re seeing in the space.
This article is an excerpt from Axial’s 2019 Lower Middle Market Periodic Table of Healthcare — check out the full report for more on the top LMM investors and acquirers and healthcare investment bankers and advisors, as well as other in-demand healthcare categories.
In home health services, “PDGM [Patient Driven Groupings Model] is going to be big,” says VERTESS’s Bradley Smith.
PDGM is a new case-mix classification model used to structure healthcare payment categories and reimbursement thresholds. Come January 1, 2020, there will be a change in the unit of home health payment from a 60-day period to a 30-day period, forcing smaller providers to make substantial adjustments to their operating models.
“It will be similar to what happened in home health in 2000, and it will cause a massive consolidation. Similar to competitive bids that the DME [Durable Medical Equipment] market went through in 2009 and 2010, we are going to see a consolidation of a significant portion of the marketplace, creating opportunity for existing players and generating more PE interest. PDGM is a disruptive opportunity for them to execute a rollup strategy and capture a substantial part of the market,” says Smith.
“Home care will certainly come out of this PDGM issue with fewer operators in the market,” notes Mertz Taggart’s Cory Mertz. “I’m not sure how many, but I’ve heard estimates that as many as 30 percent of companies will come to market as a result of the cash flow shortage.”
For investors seeking new platform investments as well as entrepreneurs, it seems that the new threshold created by PDGM will determine whether they are above or below the minimum economies of scale. “Operators will realize they can’t make money doing the same thing over the last 10 years. They’ll be forced to adapt by either selling, merging, or raising capital, with the only other option being to go out of business or declare bankruptcy. And that puts acquisition activity and the market as a whole on steroids,” says Vertess’ Smith.
No one seems to disagree about PDGM’s ultimate impact on the category. However, perspectives diverge substantially more on when and to what extent activity will intensify. Many think that it will take at least one or two quarters for M&A activity to increase by forcing businesses to go to market, and an additional few quarters until we see the majority of buyers and investors becoming comfortable with deploying capital.
Activity in the near-term could also be stalled by the uncertainty of the future regulatory environment, which could create misaligned expectations between buyers and sellers. Even if more deals will come to market, given the expected declines in revenues and increased urgency of sale, we can expect to see a decline in valuations. The kind of structural shift represented by PDGM often results in a temporary freeze on activity, as business owners typically agree that consolidation is due, yet linger in denial about who should be consolidated or play a tug-of-war with buyers on valuation.
Says Neil Johnson, managing director at Lawrence Evans & Co., “The unknown revenue reduction is causing buyers to restructure and reprice, which sellers don’t want to see. So we are in a bit of a holding pattern on those deals until after Q1 2020 due to that uncertainty.”
“Right now, it’s hard enough for a PE firm to get a handle on the [healthcare] industry in general, but then to figure out how PDGM might impact a target is very difficult,” notes Mertz’s Q3 Home Health report. “They have other opportunities they can look at for now until the dust settles in home health. I would look for private equity to jump back into the mix in the second half of 2020, barring any other unforeseen regulatory announcements.”
As for sellers, pressure is likely to grow on the weakest players to jump to the front of the queue, and take buyout offers at lower valuations for fear of missing out completely. The most savvy financial and strategic buyers will likely be rewarded with lower valuations for early takeouts, while tolerating more risky investments.
Read Axial’s 2019 Lower Middle Market Periodic Table of Healthcare for more LMM healthcare data and trends.