Are High Prices Testing Private Equity's Ability to Close Healthcare Deals?
By David H. Fater

Now that healthcare consumerism is replacing traditional retail storefronts with dental and urgent-care clinics, the sector has drawn ravenous interest from private equity funds. But are would-be buyers getting discouraged by increasingly high prices? In a recent survey of private equity funds and strategic buyers, the top challenge identified in completing healthcare mergers and acquisitions is a shortage of attractive targets. The biggest reason? The deals are getting too expensive.
Of the 579 deals for U.S. healthcare targets last year the median transaction value has increased substantially since 2015. It is what appears to be a perfect storm and the number of transactions was the second highest on record. The specific targets included healthcare providers like physician practices and health systems as well as healthcare IT companies and life sciences companies. This is a diverse mix of targets with each of them having their own unique valuation issues.

Health system deals tend to catch a lot of headlines primarily because of their size, but they actually represent a small proportion of overall healthcare acquisition transactions.  Midmarket transactions, especially among relatively small specialty practices, make up most of the deals taking place.
The problem is investment banks are overpricing the companies looking to sell, valuing them in some cases two or three points higher than just two years ago without much justification for it. It is an old story where companies that are essentially average in terms of their financial performance or operational capabilities are looking to demand a price that is in line with companies operating in the top quartile. Put differently, the sellers believe their streets are paved with gold rather than high class bricks.

Prices have risen on the provider side in a herd mentality because their peers are selling at premiums. Dental groups, for example, are attractive to private equity firms because insurers tend to reimburse them without much pushback, their patients return at regular intervals and their industry is fragmented, inviting firms to create services organizations to support them. It is the reason that physician practice management companies flourished in the late 1990���¯���¿���½s and we all know where that ended up. However, it has not deterred private equity groups from looking at other specialty groups that have similar criteria such as dermatology, ophthalmology, plastic surgery and behavioral health.

Private equity's strong appetite for healthcare acquisitions was on full display in a recent regulatory filing that revealed nine such firms submitted offers to buy Nashville-based physician staffing company Envision Healthcare in February. In June, Envision announced private equity firm KKR would buy the company for $9.9 billion in cash and assumed debt. KKR submitted a bid for up to $46 per share, which came in less than other offers of up to $60 per share. We recently valued a specialty practice at $155 million and when the transaction closed it fetched very near that price.

As the acquisition trend plays out, a new difficulty for private equity is finding companies with the infrastructure to support the kind of growth they are targeting. Outside of hospitals and health insurers, the healthcare market is highly fragmented with many early stage companies. The targets tend to be one or two dominant players of size and then there is a significant drop-off in terms of size and sophistication.

Interestingly enough, 73% of respondents in a recent survey had walked away from a potential healthcare acquisition. The principal reason was what was discovered in extensive due diligence. Would-be acquirers walked away because of anticipated problems with reimbursement, technology integration and security and compliance. We have preached for years about the necessity of integrating the due diligence with the post-merger integration plan as the best way to determine if the deal is worth doing and at the target price.

A different firm���¯���¿���½s view through the lens sees that 75% of what is out there still represent attractive targets. This is most evident in physical therapy, urgent care, dentistry and even veterinary practices. Bringing consumerism into the equation makes a transaction more attractive AND that is one of the things that is inherently wrong with our current healthcare system. The consumer is not really involved because of the way the system works. So, the more like a retail play the more attractive the business is.

Despite all of private equity's investment in specialty practices, several industry experts said firms haven't shown the same appetite for hospitals and health systems. Brick and mortar assets like hospitals are expensive, and the high degree of consolidation that has already taken place in the sector has made them even more so, not to mention buying health systems means improving patient care, paying for building upkeep and adding new technology. Also, the rapidly growing trend is to push more services out of the hospital and into free standing facilities which can help drive down cost to the system.

To explore ways in which we can provide assistance in assisting with your merger and acquisition activity, including valuation, in this evolving health care environment, please contact David H. Fater at dfater@alda-associates.com or Richard M. Cohen at rcohen@alda-associates.com.

CASH AND WORKING CAPITAL MANAGEMENT (PART 1)

by David H. Fater

(This is the first part of a two-part feature on cash and working capital management. This first part examines the cash flow cycle. The second segment will focus on the individual components of working capital management.)
 
CASH MANAGEMENT
It is August 2018 and the economy is storming down the tracks, the stock market is delivering significant gains and banks are starting to lend again. So why should a company worry about its cash position? The answer to that is one of Fater���¯���¿���½s Golden Rules ���¯���¿���½Always raise money when you don���¯���¿���½t need it-because when you do need it, the capital raise will be more difficult and much more expensive���¯���¿���½.

While borrowed money is obtainable and interest rates are low, interest rates will be going up. Consequently, more attention should be focused on what might be called the very best way to raise capital and cash and is the cheapest method available. That method is doing a better job of managing your company's cash. In this article, we will examine the impact of managing working capital in general which will also include managing cash better and more effectively.

It is often neglected because entrepreneurs underestimate how valuable it can be. They tell themselves that the company has been getting along quite well with a rather easygoing attitude toward cash management, and that it would be unnecessary and difficult to impose tighter controls. And management, busy at producing and selling a line of products or services, does not find it easy to pay attention to cash management.

There is another reason for neglect. Management believes that while large corporations might realize substantial savings, the benefits for small to mid-sized companies are probably too insignificant to bother with. The facts suggest just the opposite.

Better cash management may be even more important for a growth company in its early stages than for the large, mature organization. The young, emerging company, bursting with ideas and energy though it may be, nevertheless has a limited track record, and sources of outside funds may be limited and expensive. With aggressive management of the company's cash flow, you can accumulate working capital and therefore place less reliance on outside funds and focus on increasing profitability.

An extra benefit is that sound cash management practices will earn respect from banks, suppliers, and customers that will pay off in countless ways. While various bank services can be useful in managing a company's cash, the greatest opportunities for improvement are typically internal. Common sense procedures such as controlling the level of raw materials and inventory, dispatching bills on a timely basis, and paying bills no earlier than necessary can significantly improve both liquidity and profitability.

THE CASH-FLOW CYCLE
Most business managers are familiar with the revenue and cost cycles of their businesses. This information is typically presented in the income statement, which describes the economic performance/profitability of the business during the reporting period. While important to the long-term health of the business, profitability is not the primary contributor to liquidity. The key ingredient in managing business liquidity is the cash-flow cycle.

Simply stated, the cash-flow cycle is (1) the investment of cash in raw materials and product, (2) the sale of the product, and (3) the receipt of cash payment for the sale. Because of the order in which these business activities occur, the liquidity of the company is directly affected by the timing differences in cash transactions for each activity. Cash disbursements, inventory overhead expenses, and cash receipts occur at disconcertingly different times, resulting in the need for greater cash flow or other sources of funds (capital or borrowings) to support liquidity. This is especially true in high-growth companies who can grow themselves right into bankruptcy because they did not focus on liquidity but rather only on sales and profitability.

The relationship between your income statement and your actual flow of cash is accounted for on the balance sheet in the various elements of working capital. Increases in working capital must be financed by your business, and if not properly controlled may result in serious liquidity problems. Generally, business managers cannot pay raw-material suppliers, personnel, lessors, mortgagors, or service vendors without using working capital or borrowing unless they first collect funds for the products they sell. However, if everybody tried to collect for sales before paying vendors, nobody would get paid. Thus, business managers must focus on control of the cash-flow cycle.

Cash-Flow Cycle Example
The business purchases raw materials, which are held for an average of 30 days before conversion to finished goods. In this example, finished goods are considered held in inventory for 30 days prior to shipment to customers and conversion into accounts receivable.
The company's customers typically pay 40 days after shipment. The company also keeps a cash balance equal to approximately 10 days of sales, for bank compensation and operating purposes. In the liability cycle, accounts payable are deferred for 30 days. As a result, this business has 80 days (30 plus 30 plus 40 plus 10 minus 30) of sales value invested in net working capital. Therefore, 80 day���¯���¿���½s worth of sales must be financed through loans, infusions of capital, or the retention of earnings.

Considering the desired effects of controlling the cash-flow cycle results in the following. Raw-material and finished-goods inventories have been reduced to 15 days each, and accounts receivable have been reduced to 30 days. Cash is controlled to eliminate idle balances. Accounts payable are deferred for an average of 40 days. Net working capital is reduced from a total of 80 days to 20 days, or a 75 percent reduction in the working-capital requirements.

Consider the actual financial effect of this working-capital restructuring on a company with annual sales of $5 million. Before restructuring, the required net working capital for 80 days of sales would equal approximately $1,096,000 ([$5,000,000/365] x 80). Through restructuring, the working capital required is reduced to 20 days of sales, or approximately $274,000 ([$5,000,000/365] X 20). Where has the remaining $822,000 gone? The improvement does not typically show up in the balance of cash. Instead, good business people will take this opportunity to reduce expensive debt or reinvest in assets that support increased sales levels and propel profitable growth. We had one client that was not focused on this issue until we pointed out that for every additional day���¯���¿���½s sales outstanding in accounts receivable, they would need an additional $1,000,000 of financing.

The economic benefit of a reduction in net working capital may be most dramatically seen in the example of debt reduction. To the entrepreneur or the manager of a high-growth company, external financing may be very expensive. An entrepreneur, whose only alternative funding source is often venture capital, may in fact have an effective annual financing cost of 20 percent or more. When this is applied to our example, the $822,000 reduction in working capital would reduce annual interest by up to $98,640 per year. Examined more directly, at $5 million in annual sales and 20 percent financing rates, each day's sales squeezed out of net working capital is worth up to $2,740 ([$5,000,000/365] x .20. This quantification methodology can help the business manager determine whether changes in operating methods or procedures are beneficial when compared with the cost of making those changes.

Fluctuating Sales: Cash-Flow Effects

This cash-flow approach to cash management is particularly important in understanding the effects on your business of rapid expansion or contraction of the sales level. Let���¯���¿���½s consider the effects on a company with rapidly increasing sales for five months, followed by three months of significant contraction. Despite continuous profits through the entire period, this company has experienced significant demands for additional working capital during the expansion cycle, but generated significant extra, unallocated cash ("throwoff ") during the contraction cycle. Consequently, a business may require large injections of additional capital to fuel rapid growth. Conversely, cash throw-off during sales decreases can be illusory because cash will be required later during the next expansion in business.

These cash-flow effects are particularly important for companies in seasonal markets, such as toys or construction. Reducing the net number of days of working capital can significantly reduce the size of your cash requirements or cash throw-offs in fluctuating sales situations. However, it cannot change the fact that additional working capital will be required for growth, and that cash throw-off will frequently occur during contraction.

Now that we have examined the cash flow cycle and ways in which cash can be maximized, we will examine the individual elements of working capital management in Part Two. Together, cash and working capital management need to be working together in unison to maximize liquidity.

To explore ways in which we can provide assistance in analyzing your working capital issues and strategies to improve your liquidity, please contact David H. Fater at dfater@alda-associates.com or Richard M. Cohen at rcohen@alda-associates.com

Representative Engagements

• Initiated and developed a de novo Accountable Care Organization to participate in the Medicare Shared Savings Program which grew to over 250 physicians over three years which successfully generated savings.
• Financial advisor to large physician practice in connection with a potential acquisition transaction where engagement includes determination of strategic and fair value and assisting in negotiations for closing the acquisition and in post acquisition integration.
• Review and in-depth analysis of new Medicare Reimbursement rules for subsidiary of Fortune 50 insurance company and assistance in developing a business model enabling the capture of a new revenue stream for both physician practices and affiliated providers.
• Acquisition due diligence and integration assistance for a public healthcare staffing company involved in numerous acquisitions. Retained by parent company to manage acquired company for 22 weeks through ALDA developed integration plan.
• Turnaround assistance for a near bankrupt client company, including tax and financial restructuring, and ultimate sale at a significant cash price.
• Leadership of development of client company's strategic plan for the next decade and assistance in repositioning the company.
• Determination of strategic value of a client company, packaging for sale and assisting in negotiations.
• Providing the entire management team for several life science and healthcare companies from early stage through obtaining additional patent protection, guiding clinical development plans, navigating the pathway through the FDA, establishing the manufacturing processes, initiating commercial sales and eventually transforming the Company into a publicly traded Company.
• Determination of strategic implications of a line of business with weak performance; development of strategies to maximize profitability contribution.
• Turnaround assistance for a troubled venture-backed company, including raising additional debt and equity capital.
• Acquisition and financing assistance for a public, international railroad in connection with a $300 million cross-border acquisition and refinancing.

Our experienced professionals are dedicated to helping clients unlock inherent value and create new value.

The ALDA Team includes, among others:

David H. Fater - Chief Executive Officer

Strategy, capital markets, restructuring, and mergers and acquisitions experience with public healthcare companies focused on physician management, rural healthcare, nursing homes, HMO's, diagnostic imaging and medical devices. Deeply involved in the implementation of the Affordable Care Act with Accountable Care Organizations, Independent Practice Associations and Management Services Organizations. 

Richard M. Cohen - Senior Operations and Business Development Executive

Healthcare operations and worldwide sourcing experience. Skilled in healthcare (physician management, clinical trials, medical and patient process flow, diagnostic imaging and life science) operations as well as in issues dealing with importing, exporting and manufacturing operations in South America, Far East and Europe. 

Thomas J. Bohannon - Senior Financial Executive

Accomplished, creative CPA, outstanding analytical and technical abilities. Has experience for over 40 years in public accounting and private industry including nursing homes, medical device companies,  hospitals, not-for-profits, retail, manufacturing, import/export and natural resources.

A. Ronald Turner - Senior Healthcare Executive

Senior healthcare industry executive with strong entrepreneurial focus including CEO and COO positions with start-up hospital companies and a publicly-traded hospital company. Extensive and successful operations experience for more than 50 hospitals and 9 nursing homes, and senior reimbursement experience for a major publicly-traded hospital company and a national accounting firm. Experienced in mergers and acquisitions, led operational turnarounds and debt restructurings that created significant value.

Mark W. Caton ���¯���¿���½ Senior Healthcare Executive

Senior hospital executive with over 30 years experience in operating not-for-profit and investor-owned rural/community hospitals as CEO or COO, and Regional COO with several national hospital companies.  Skilled in strategic planning and business development, operations management, revenue cycle management, medical staff development, and quality/resource management.

Daniel N. Weiss, M.D., F.A.C.C. - Chief Medical Officer

Medical devices and healthcare practice experience, engaged in a private medical electrophysiology practice where he performs numerous invasive cardiac procedures and has served as a consultant for several Fortune 500 Medical Device Companies including Philips, Boston Scientific/Guidant, St. Jude and Medtronic, as well as for several medical device and drug start-up companies. 

David Bott - Senior Information Technology Executive

Systems and network support solutions experience, proviedes analyis of strategic business needs and assessment of business models and their integration with technology.  

Santiago Guzman - International Executive

Experienced in new project development for companies in a variety of industries from start-up to Fortune 500. Client relations management, fluent in English and Spanish. Skilled facilitator for introductions with influential leaders in South America including those in the health care industry. 

With offices in:

• Delray Beach/Boca Raton, FL
• Atlanta
• New York
• Quito, Ecuador

For additional information, please contact:
David H. Fater, Chief Executive Officer
ALDA & Associates International, Inc.
751 Park of Commerce Drive; Suite 128
Boca Raton, FL 33487
(877) 845-4657
dfater@alda-associates.com