The Credit Crunch, Private Equity, and Home Care

By Dexter W. Braff

Pick-up the business section of any newspaper today and you're almost guaranteed to see a story about the growing "credit-crunch". With the current practice of debt being originated, repackaged into various types of mortgage backed securities and collateralized debt obligations, which are in-turn sold - and resold - to the investment community, rising defaults in the sub-prime mortgage markets have rippled throughout Wall Street, not only taking out some major players including some well-heeled hedge funds, but creating a crisis of confidence that likely exceeds the real risk exposure. As a result, availability of new debt - including acquisition financing - is tightening, the cost is rising, and loan covenants designed to protect lenders are getting tighter. Moreover, private equity groups (PEGs), which have contributed mightily to the record setting boom in acquisition activity, may find it more difficult to finance these deals.

So how will this affect merger and acquisition activity in the broad home care arena?

First and foremost, we should point out that private equity has, in part, fueled the five year surge in home care related acquisition activity - first in hospice (2003-2006), then home health (2002 - present), and most recently, home infusion therapy (2006-present). As one example, according to Braff Group research, while there were 14 private equity sponsored home health acquisitions from 2001 through 2003, there were 28 such deals from 2004 through 2005, and 30 in 2006 alone. With private equity playing such a critical role in the home care community, any hindrance on their ability to finance a transaction and/or generate sufficient returns could meaningfully constrain acquisition demand and valuation.

The good news, however, is that generally speaking, with businesses that are light on assets and largely dependent on third party reimbursement, except perhaps for transactions in the $100 million range (which make up a fraction of industry deal flow), lenders have been far more conservative and disciplined with respect to financing acquisitions of health care service providers such as home health, hospice, and infusion then they have for more asset laden firms with less perceived risk. As such, unlike many private equity sponsored transactions that have fueled the M&A boom that have relied heavily on debt for financing, we have seen PEGs ante up substantially more equity to complete home care related deals. With PEGs targeting the home care space more accustomed to (a) less favorable debt availability, price, and terms, and (b) deploying more equity to close transactions, our view is the whatever negative impact the growing credit crunch will have on merger and acquisition activity in general, the impact will be far less problematic in the home health, hospice, and infusion therapy arena. Moreover, post-transaction, with less debt on the books, many PEG sponsored home health companies will be better able to weather inevitable reductions in reimbursement which, in turn, will foster market stability that is critical in sustaining a long run of M&A activity.

Unfortunately, something else besides the credit crunch looms ominously - a development that could significantly challenge private equity and all the investments it targets. In the wake of an M&A environment that has swelled the coffers of many PEGs and has bestowed riches and celebrity to its key players, congress has begun to scrutinize how private equity groups and hedge funds are taxed. Simply put, the bulk of the fees these firms receive are based on a percent of the profits generated by the funds they manage - profit that largely comes from the buy-out and subsequent resale of companies in their "portfolio". Conceptually then, the appreciation on these investments is capital gains, and has been taxed accordingly at 15 percent, far below the top end of the tax on earned income - 35% - to encourage investment. But critics argue that these profits are being earned largely on investments of other people's money such as wealthy individuals and pension funds - and not that of the PEGs themselves. As such, fees derived from them are arguably more akin to money management fees, which would be taxed at the higher earned income rate. Regardless of how you feel about the efficacy of this argument, if PEGs lose their capital gains tax treatment and take a hit to their profitability, we would anticipate changes in their behavior - changes we fear might curb their voracious acquisition appetites that have collectively spiked demand and valuation across many business sectors, including home care.