Inflation, deteriorating financing conditions and intensive legislative reform efforts are leading to a reluctance to transfer capital on the part of healthcare providers and their owners as well as potential investors. At the same time, we assume that the current transaction-inhibiting aspects will become less important again and that M&A activities involving healthcare providers will increase. However, the framework conditions for M&A transactions are becoming more complex.
Taking stock: current lethargy in M&A transactions
The number of M&A transactions in traditional bidding processes has recently collapsed for inpatient healthcare providers. As advisors on the seller and buyer side, we are currently only able to observe consolidations within a sponsor group or isolated transactions in the context of special situations such as insolvencies.
In addition, the age-related succession problem in the outpatient sector remains unresolved for many medical practices as a result of demographic change; nevertheless, only a few practices change owners.
The reasons for the lethargy in the M&A market are increased operating costs and poorer financing conditions coupled with regulatory uncertainty.
We can identify three main obstacles to M&A transactions involving healthcare providers:
1. Pressure on the operating result due to inflation
Not only have material costs – and here in particular the costs for electricity, gas and heating1 – risen massively in the last two years, but also personnel costs2 as a result of the wage-price spiral. The increase in personnel costs was further fueled by the shortage of skilled workers, which has to be compensated for by the increased use of external personnel.
The pressure on returns due to the increase in operating costs is offset by a higher return requirement due to the likewise increased investment payments3.
This is because inflation does not stop at construction and other investment measures, meaning that higher investment volumes have to be earned by the company.
2. Worse conditions for refinancing investment projects
The pincer grip of yield erosion and growing yield requirement could be loosened by lowering the yield requirement. If investments in the hospital sector were to be funded 100% – as has been the ideal assumption of dual hospital financing since 1972 – investments would not have to be cross-subsidized by the operating result before depreciation, interest and income taxes (EBITDA).
Only when the funding ratio is less than 100% – on average across all clinics – is it necessary to refinance the own share of investments through positive EBITDA.
If it is not possible to close the financing gap with an adequate profit margin, the remaining equity share usually has to be covered by borrowed capital. However, interest rates for borrowed capital have also risen as a result of higher inflation expectations. The observed interest rate increases, in conjunction with the increased financing share of investments, therefore increased the need for returns.
3. Reform uncertainty in legislation
On the other hand, the pressure on returns due to cost inflation could be countered by raising the prices for healthcare services provided in line with inflation. There are currently major uncertainties in both the inpatient sector (due to the Hospital Reform Act) and the outpatient sector (due to the MVZ reform).
For hospitals, marginal revenues would fall sharply in the future following the introduction of a retention fee, which would make it no longer economically viable to expand volumes in order to increase overall revenues. In addition, the prime rates are only adjusted to inflation with a time lag, so that the cost increase must be financed in advance
MVZs can counter rising fixed costs (for personnel, rent, IT) by optimizing their service portfolio. However, it is to be feared that the MVZ reform will lead to a restriction of regional expansion opportunities. There is also uncertainty as to whether the business model for the establishment of supra-regional MVZ chains will be sustainable in the future.
Consequence: Different values among market participants
The M&A lethargy in healthcare provider transactions described above creates a dilemma:
- On the one hand, there are institutions whose current liquidity situation requires an injection of external capital.
- On the other hand, there are potential investors who have high liquidity positions or would have to consider investing in a healthcare facility due to a lack of investment alternatives.
So why capital-seeking healthcare companies and strategic or financial investors are not currently coming together seems incomprehensible at first glance, as capital could be transferred if the contractual conditions were structured accordingly.
Obviously, the dried-up M&A market for healthcare providers is based on different value perceptions and assessments regarding the development of value-determining factors. Many sponsors or owners are still clinging to their corporate values from the pre-corona era with barely perceptible inflation and low or zero interest rates at the same time. On the other hand, investors have already adjusted the company values downwards in line with the lower margin expectations and higher revenue risks.
As there are currently different valuation concepts, the originally planned or necessary capital transfer is simply not taking place. As a result, it is often not possible to make the necessary investments; services have to be restricted due to investment freezes, which is why returns continue to dwindle.
Although the “defensive” healthcare sector is fundamentally attractive, some potential investors will wait for the feared market shakeout in order to avoid a premature entry with a supposed bad investment.
Expected future development
The time series chart from 01.01.2020 to 30.09.2023 shows the monthly development of short-term and long-term interest rates for German government bonds and the consumer price index compared to the same month of the previous year. The time series provide an indication of how interest rates and inflation rates may change in the future.
[Sources: Interest rates – yield curve of listed German government securities/monthly values, Deutsche Bundesbank, query 02.10.2023, inflation rates – development of consumer price index/comparison with the same month of the previous year, Destatis Federal Statistical Office, query 02.10.2023].
We assume that the market for controlled, self-initiated M&A processes involving healthcare providers will pick up again.
The following points seem to speak in favor of this:
Declining inflation
We assume that inflation rates have peaked and will fall back to a long-term average level. The Federal Statistical Office has calculated an inflation rate of just 4.5% for September 2023 compared to the same month in the previous year – after 8.8% in November 2022. In its forecast from September 7, 2023, the ifo Institute estimates an increase in consumer prices of just 2.6% for 2024 and 1.9% for 20254.
An economic slowdown could also ease the problem of the shortage of skilled workers, as employees increasingly turn to the cyclically resistant healthcare sector. A poorer order situation for tradesmen and construction companies may reduce the pressure on construction costs. Finally, it is hoped that digitalization and the elimination of bureaucracy will increase productivity.
Improved refinancing conditions
The inverse interest rate structure indicates falling interest rates for longer-term debt financing in the future. Since January 2023, German government bonds with a remaining term of 25 years have had a lower yield than German government bonds with a remaining term of 0.5 years. This indicates that interest rates will soon peak and that banks will once again be extending more loans.
To secure the hospital infrastructure, the federal states would have to grant higher funding quotas or subsidies. More rapid approval and granting of public funds would be necessary, as the liquidity-related planning freezes are currently further increasing the investment backlog. Following the expiry of the coronavirus aid, the hospitals and federal states are calling for liquidity to be secured promptly5)5.
Resolving the reform backlog
The current reluctance of investors is certainly largely due to planning uncertainties. However, it can be assumed that the reform measures for hospitals and MVZs will not be as restrictive as currently feared. After all, German healthcare providers are chronically underfunded, in particular due to a lack of equity.
In order to make the healthcare sector more attractive for urgently needed investors, the framework conditions must therefore offer the prospect of a high level of costing certainty with adequate margins. If it is the will of society that profit margins should be limited in the future (incorrectly referred to as “de-economization”), the risks involved in generating these margins must be reduced accordingly in return. Otherwise, (equity) capital would not be made available to the extent required in future and the service base of healthcare providers would probably continue to decline.
The past has shown impressively that a constant stream of new requirements – such as minimum volumes, minimum staffing levels, quality requirements or documentation obligations – can jeopardize area-based care. If the general will here is also to maintain healthcare provision in the area through solitary and small facilities, the requirements should be matched by adequate remuneration.
Our forecast: Increased interest from investors in the future
The market for inpatient healthcare providers has always been a challenge for both strategic and financial investors.
In the past, it was possible to compensate for the high capital commitment, the large investment requirements, a high proportion of fixed costs with weak margins, the demanding regulatory framework and the regionally limited market through planning security and de facto restrictions on competition. In addition, the demographic trend appeared to at least stabilize the forecast income.
This planning security is currently not given due to the reform measures. However, it is to be expected that the framework conditions for investors will improve in terms of costing certainty. Furthermore, in anticipation of the concrete form of the hospital reform, it can already be observed in some cases that a merger is intended to achieve a higher level of care and thus secure the future of the facilities concerned.
Capital providers in the outpatient sector, especially financial investors who were active in the past, were deterred by the legislative process initiated to regulate MVZs, despite the trend towards outpatient care. The impending restriction of expansion opportunities in the vicinity of a planned hospital or in a KV district may currently impair the planning security and scope for action for the business model sought by such prospective buyers. However, if there is clarity here again, investors in the outpatient sector will have a reliable basis for calculation and can drive forward networking in the highly fragmented market.
Talk to our experts
The regulatory environment for M&A transactions with healthcare providers will remain challenging in the future and is likely to become even more complex. In this respect, a structured M&A process tailored to the special features of the institution and a professional, market-experienced due diligence of the transaction object are becoming increasingly important.
As an integrated consulting company in the healthcare sector, Oberender AG has many years of comprehensive expertise in supporting service providers in improving their refinancing capability, increasing their attractiveness for equity and debt capital providers and finally accompanying the entire process for raising debt and equity capital – if desired, also for individual consulting modules. Find out more here.
