Federal Reserve Chair Jerome Powell signaled Friday from Jackson Hole that the US central bank is likely to keep raising interest rates and pushed back on the idea that the Fed would reverse course anytime soon. “Restoring price stability will likely require maintaining a restrictive policy stance for some time,” Powell said Friday in remarks at the Kansas City Fed’s annual policy forum in Jackson Hole, Wyoming. “The historical record cautions strongly against prematurely loosening policy.”
”Interest rate increases result in lower asset values,” said Mertz Taggart Managing Partner, Cory Mertz, “We saw this in the equity markets on Friday. Chairman Powell's words signaled more aggressive future rate hikes than Wall Street analysts had built into their models. The result was a broad market sell-off, resulting in lower values, with the Dow losing over 1,000 points."
That begs the question: if the Fed is intent on raising rates, in an effort to restore pricing stability, i.e. lower asset values, what impact will rising rates have on the value of your home health agency or hospice?
To illustrate, let's walk through two of the more common approaches to business valuation: The Market Approach (multiple of EBITDA) and the Discounted Cash Flow, or DCF.
Market Approach (or EBITDA Multiple)
In short, the EBITDA multiple method is analogous to how residential real estate is valued. To value residential property, stakeholders find the most appropriate, recent “market” comparable transactions to get a range of values, which are driven by, among other things, size, location, and construction. Similarly, with at-home care agencies, we look at market “multiples”, which can vary significantly from one transaction to another depending on, among other variables, size, geography and payor mix.
Under the EBITDA multiple method, a risk-driven multiple is applied to the agency's EBITDA during a recent time frame. EBITDA is a proxy for normalized 12-month cash flow. The multiple is determined by the multiples used in recently closed comparable transactions and then adjusted for risk associated with the post-closing cash flow of the agency. EBITDA is then multiplied by the chosen multiple to arrive at the enterprise value for the agency.
How the rate hike can affect agency values under EBITDA multiple
Let’s examine the two most active types of acquirers for private home health, home care and hospice companies -- private equity groups and public companies.
Private equity groups implement various strategies to create value for their investors, but acquiring an agency using debt leverage is one of the more commonly used methods for stoking returns. Historically around 30-60% of funding for platform acquisitions has come from debt.
When rates rise, the borrowing costs for private equity firms increase, lowering returns, if all else remains static. Since lower ROI is not in the private equity playbook, something has to give, and it’s usually purchase price.
Public companies, meanwhile, are under the market's microscope, with many parties publicly judging their acquisitions for the investment community. When an acquisition is completed, Wall Street analysts determine if the transaction is accretive or dilutive. An accretive transaction will increase the acquiring company's earnings per share, while a dilutive company will decrease the acquiring company's earnings per share.
Broadly speaking, if the acquiring company has a higher EBITDA multiple than its acquisition target, the transaction will be considered accretive to earnings to the acquiring company. This means the increased value of the buyer will exceed what they paid for the target. If the target agency’s EBITDA is higher than that of the acquiring company, the transaction will be dilutive, and not typically looked at favorably by the analysts.
Now, how do interest rates influence all of this? As illustrated above, when interest rates rise, stock market values tend to drop as the public company business costs increase. Consumers enjoy less disposable income and wealth to spend on goods and services these Companies provide, and investors shed equities in favor of safer investments. The resulting lower multiples of public companies (considered the ultimate consolidators) trickle downstream to private equity investors seeking their respective exits. For example, a publicly traded home care company trading at 12x EBITDA will have a difficult time justifying paying 16x for a large PE portfolio company without a significant strategic angle or synergies, especially under the microscope of Wall Street.
Discounted Cash Flow (DCF) method
In the DCF method, when an investor analyzes a business investment opportunity, an agency’s future cash flows are forecasted for a period of time (typically three to five years) after which a terminal value, the agency’s expected value at that future date, is estimated. The final step in determining the agency's present value is to discount those future cash flows, including the terminal value, back the present day. Buyers will discount those future cash flows using a discount rate, which is their minimum required rate of return given their cost of capital and the risk of the investment. As interest rates go up, discount rates increase, thereby lowering present values.
”As interest rates rise, buyers’ cost of capital increases. This ultimately increases the discount rate buyers will be forced to use in evaluating home care and hospice acquisition opportunities. The end result, according to the math, is a lower present value, which is, effectively, a lower purchase price,” Mertz said, "The good news is, a 3-4% difference on interest rates isn't really going to make much of a difference with private equity groups interested in healthcare services, especially care-at-home opportunities. It's still very much a seller's market, with too much money chasing too few quality M&A opportunities."