Private Equity Groups Take an Interest in Home Health

By Dexter W. Braff

Over the past 18 months, there has been a marked increase in investor interest in the home health care sector from private equity groups. In fact, two groups - Crescent Capital and Charterhouse Group International - emerged as the leading bidders for Tender Loving Care (at $245 million), with Crescent's offer ultimately being approved by the U.S. Bankruptcy Court. So, why this sudden interest in relatively small health care service sector that heretofore was at best an investment afterthought?

First, a quick primer on private equity. Essentially, private equity groups, or PEGs, raise money from high-net worth individuals, pension funds, foundations, and others that they invest on their behalf according to the groups' stated objectives. Often these investments are in the form of equity "buyouts", where PEGs acquire some or all of the equity possessed by an initial "platform" company, invest additional dollars to increase the value of that company, and ultimately exit - in the hopes of making a substantial profit-via a sale or initial public offering. Typically, PEGs seek overall fund returns of 25 percent to 40 percent, and operate on a relatively short investment horizon of three to seven years. To capture such substantial returns, they rely on three basic strategies:

1) Acquire companies when values are relatively low to increase the likelihood of generating gains upon exit;

2) Aggregate multiple acquisitions and build enough critical mass to garner the valuation premiums bestowed on larger companies; and

3) Invest additional resources to integrate acquisitions, cut costs, increase market penetration, and heighten the profits that drive value.

Bearing these basic investment tenets in mind, it becomes clear why private equity is targeting home health:

• The home health sector is relatively undervalued. PEGs often talk about investing in a sector ahead of the market - that is, before other buyers recognize its opportunities, swarm in, and drive up prices. This is certainly the case with home health. Although the sector's opportunities for sustained growth and profitability are extraordinary, and its risk profile is arguably more attractive than that of any other home care sector, with the exception of hospice, home health valuation multiples continue to lag - a residual effect of the industry's volatility that peaked with BBA 1997. However, multiples are now predictably improving, although they have a way to go before reaching levels consistent with other home care sectors that have reasonably similar risk/return profiles. As such, home health care is a prime target for "buying low, selling high"- PEG strategy No. 1.

• The home health sector is extremely fragmented. There are an estimated 7,100 [1] home health agencies nationwide. Yet, all publicly traded home health care providers combined account for only 4 percent of the total market. Accordingly, the market is relatively wide open for newcomers to build substantial size - and capture attendant valuation premiums - PEG strategy No. 2.

• Efficiencies and revenue enhancement can be captured in home health. Although the overall home health care industry has become vastly more efficient in the post-BBA environment, there is still room for improvement. First, there continues to be pockets of the industry where some continue to struggle-most notably, hospital based providers that typically have substantially higher cost structures than free standing independent and not-for-profit providers. The latter agencies sometimes find it difficult to strike a comfortable balance between meeting community needs and remaining financially viable. That explains why these providers have recently become the focal point of consolidation activity.

Second, home health has generally been slow to invest in the technology that can drive down costs. And third, the sector has been similarly slow to adopt sophisticated marketing strategies and assemble professional salespeople essential for achieving top-line growth. There are, thus, substantial opportunities in home health to create value-enhancing efficiencies and market penetration through selective acquisition, re-engineering, investment in technology, and marketing - PEG strategy No. 3.

• Viable exit strategies exist. Over the past 18 months, there has been an extraordinary increase in the stock value of many home health and hospice providers. [2] Accordingly, an exit via an initial public offering (which we haven't seen in years) is becoming more viable. In a somewhat self-fulfilling prophecy, as private equity groups consolidate such a fragmented, "immature" industry into sizeable, fully integrated companies, they become extremely attractive platforms themselves for the next wave of buyers looking to create even larger, national providers. So the near term opportunity for liquidity - crucial to meeting equity funds' investment objective - looks promising.

1 Source: National Association for Home Care & Hospice

2 In the 18 months ending June 30, 2004, The Braff Group Index of publicly traded home health and hospice providers rose 85.6%