As inflation ravages the American consumer, the Federal Reserve has embarked upon a series of interest rate hikes that will have an impact on asset values. How much of an impact it will have on care at home valuations, and when that impact will be felt, is yet to be determined.
In the face of decades-high inflation, the Fed raised interest rates this June by 0.75 percent, the largest increase since 2000. While difficult to predict precisely what the Fed will do going forward, experts predict they will raise rates again in July.
”As the cost of capital increases for business and buyers in particular, the result is lower asset values,” said Mertz Taggart Managing Partner, Cory Mertz, “We are not ringing the alarm bells here by any means, as the demand for quality home care, home health, and hospice agencies remains extremely strong, but you can’t enjoy historically high values forever. There ultimately will be some softening.”
There are a few commonly accepted methods to quantify an agency’s value. However, the two most common in healthcare services transactions are the Market Approach (multiple of EBITDA) and the Discounted Cash Flow, or DCF. Let’s walk through each of these techniques to illustrate the impact of rising interest rates.
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 in the home health and hospice space: 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.
In general, if the acquiring company has a higher EBITDA multiple than it’s acquisition target, the transaction will be accretive to the acquiring company. 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? When interest rates rise, stock market values tend to drop, as the public company business costs increase, the consumer enjoys less disposable income and wealth to spend on goods and services, 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 rise, buyers’ cost of capital increases. This ultimately increases the discount rate buyers will be forced to use in evaluating at-home care acquisition opportunities. The end result is a lower present value, which is, effectively, a lower purchase price,” Mertz said, "The good news is, a 2-3% difference on interest rates isn't really going to make much of a difference with private equity groups interested in healthcare services."