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What’s Ailing the Healthcare Industry?

A Carl Marks Advisors Healthcare Podcast

Welcome to our podcast focused on current issues impacting the healthcare industry. I’m Jeanine Krattiger, director of marketing with Carl Marks Advisors, and with me are two members of the leadership team of the firm’s heathcare group, Marc Pfefferle, partner, and Jonathan Killion, managing director. We invited Marc and Jonathan to speak specifically about some of the issues the firm has dealt with in the healthcare industry and how they helped companies manage through those issues.

Marc, are there any major trends in particular the firm is seeing in the industry?

PFEFFERLE: We have seen a meaningful amount of deal flow in the healthcare industry. Broadly speaking, the largest disruption has been the intersection of highly leveraged businesses and specific healthcare-related regulatory, reimbursement, and supply chain pressures which have negatively impacted free cash flow of the operating businesses. We have also seen particular sectors, such as senior living and community hospitals, undergoing broad levels of distress, with several other sectors, like durable medical equipment, proton radiation treatment centers, and pharmacies, undergoing more market- or situational-based levels of stress.

Looking forward, we see other sectors that will be subject to consolidation, such as medical transcription; disintermediation, such as GPOs (group purchasing organizations); overexpansion/health system competition—for example, urgent care; rising minimum wages—for example, home healthcare; and increased regulation—for example, pain management due to actions to curb the opioid crisis, that will create varying levels of stress. We’ll talk more specifically about some of these issues and some of the strategies we have employed to help management teams, sponsors, and lenders deal with them.

But as a starting point, I’d first like to talk about the increasing purchase multiples we are seeing in the market for healthcare assets. High purchase multiples are being rationalized by a handful of key factors:

  1. The aging population and significant forecast market growth offer attractive return opportunities to financial and strategic investors, particularly with regard to sectors with perceived low reimbursement and regulatory risk, such as IT (information technology), drugs, staffing, and services geared to improving provider efficiencies or lowering costs.

  2. Significant interest and participation in the M&A market by strategic buyers that are pressured to grow revenue to gain market leverage or risk losing their competitive edge.

  3. An investment thesis focused on roll-up of highly fragmented subsectors to gain market leverage through increased scale.

As a result, we have seen healthcare assets routinely trade in the 10x to 20x EBITDA range and, in certain cases for strategic buyers, even higher. For financial buyers, these valuations create highly leveraged capital structures and require aggressive levels of growth to meet investment hurdles.

While there are tremendous opportunities available to capitalize on the growth of healthcare markets, there are also pressures and disruptive forces stemming from efforts by public and private stakeholders to make healthcare better, safer, more cost-effective, and increasingly convenient, and with high levels of accountability. Invariably, a portion of these highly leveraged deals will fail, especially as interest rates continue to rise.

KRATTIGER: You mention this tension and the effort to make healthcare better, cheaper, and more convenient. How do you break that down into specific issues affecting healthcare organizations?

KILLION: Setting aside the leveraged capital structures, we typically notice some combination of four different factors that are challenging management teams:

  • Reimbursement/Pricing Pressures. When speaking to C-level executives at leading healthcare organizations, we find their biggest concerns are revenue growth and the ability to get paid for services performed. In most subsectors, revenue growth is required to gain scale to stay competitive in consolidating markets and to gain maximum leverage over payers and above thin profit margins. Revenue is being pressured, first and foremost, both by reimbursement rate reductions or increases which lag increased costs—that is, rate or coverage changes by CMS (Centers for Medicare and Medicaid Services), which are then followed by commercial payers. The second major way revenue is being pressured is through denials and authorization restrictions, which place increased burdens on providers to bill and collect. This downward pressure on revenue has created downward pressure throughout the supply chain, compressing margins and free cash flow and negatively impacting a company’s ability to service debt and invest in the business.

  • Supply Chain Pressures and Increased Efficiency. Major health systems and provider groups are becoming larger and more sophisticated with regard to supply chain management—for example, tighter inventory management—allowing them to pressure their suppliers in terms of increased competitive bidding leverage and to require higher services levels, such as just-in-time deliveries and return privileges, to generate efficiency improvements at the expense of their suppliers. Suppliers without strong negotiating leverage, such as those who control proprietary drugs or critical medical devices, are most affected.

  • Regulatory Pressures and Scrutiny. Providers are faced with extremely high levels of scrutiny and audits at both the federal and state levels from multiple agencies. CMS also audits billing practices looking for fraud but also can reject claims which lack proper documentation. The government under the Trump administration has not let up on pursuing companies for False Claims Act and other whistleblower complaints. In addition, the FTC (Federal Trade Commission) has taken a particularly close look at healthcare transactions as they relate to competitive dynamics and the possibility for price increases. Disruption caused by audits, government investigations, and/or related to noncompliance can be costly and disruptive to business operations.

  • Competitive Environment. As mentioned earlier, healthcare organizations are increasingly large, more sophisticated, and looking to be disruptive to legacy business models. New competitors, such as Amazon and CVS, are looking to disrupt the market and capitalize on the enormous market potential. The bottom line is that competitive conditions can and will change over time.

KRATTIGER: The topic of reimbursement rates and pricing pressures comes up a lot when we think about issues affecting healthcare companies. Can you elaborate about what you are seeing in the market?

KILLION: Reimbursement levels are the right place to start because in many ways it’s the tip of spear for the other issues. The healthcare industry is infamous for what has been a prolonged period of rising costs, and for most of this time payers have been footing the bill with little regard for the effectiveness and cost of care. That is changing as the national conversation has turned to healthcare’s lack of affordability for many, if not most, Americans.

We see revenue/rates being compressed in three major ways.

The first stems from payers insisting on—or dictating, in the case of CMS—lower rates. A client of ours recently suffered a 20 percent-plus decline in Medicare rates on a key product line. Another example is that beginning January 1, CMS will pay for drugs acquired through the 340B program at the average sales price (ASP) minus 22.5 percent, which is a significant change from the ASP plus 6 percent rate it was paying before. Overall, this represents a $1.6 billion annual reduction in spending on drugs.

The second way revenue is being compressed is through increasing denials. Payers are trying to control their expenses by increasing the denials back to the care providers. While not specifically reducing the reimbursement rate, payers, through increased denials, are reducing payments to providers and slowing the payment cycle, allowing them to keep more money for longer periods of time. Care providers must fully and properly document all charges and are put in the position of hiring additional staff to work the denials for eventual payment. Large health organizations now have a small army of staff whose sole focus is fighting to get paid.

The third way is a bit less obvious but no less real. Payers, both commercial and governmental, are looking to reign in their costs by shifting risk from themselves to those that can control costs and reduce waste. The ACA (Affordable Care Act) helped support a paradigm shift toward alternative payment models, which are more fee-for-value (FFV) based care versus fee-for-service (FFS), with the goal of improving outcomes relative to cost. This is being achieved through new types of payment models which reward efficient and cost-effective care by considering outcomes and penalize inefficient or more costly care. This shift has been slow but is nevertheless inevitable.

In a lot of ways this makes sense, as providers are closest to the patient and have the most power to impact the level and quality of care. This change, however, is large, and it’s not just impacting providers but also all companies that operate in and around the healthcare industry. To maximize value in this new reimbursement environment, providers are rethinking business models and looking toward their supply chains to preserve already thin margins.


This downward pressure on revenue has created downward pressure throughout the supply chain, compressing margins and free cash flow and negatively impacting a company’s ability to service debt and invest in the business.


KRATTIGER: You mentioned the collateral impact on the healthcare supply chain from the compressed reimbursement rates. Could you help us all understand that a little better?

PFEFFERLE: Reimbursement pressures are having a cascading impact on the entire industry. Organizations with direct payer exposure are getting pressured by rate reductions or rate increases that are lower than their cost increases. As this relates to commercial payers, companies can agree to accept lower rates, successfully defend their rates, or lose/not retain the payers’ business. We are seeing management teams, fearing the last outcome, agree to lower rates, perhaps not as low as those initially requested by the payers but still lower than current rates.

Providers understand that unless they implement their own cost reductions, any payer price concessions will be a dollar-for-dollar hit to their own EBITDA/free cash flow. One of the areas they look at to mitigate lost profits is vendor price concessions. This trickledown effect eventually ripples throughout the healthcare supply chain, having varying effects on different subsectors of the industry.

Large health systems and GPOs, which leverage buying power of a broad range of provider members, use multiple rounds of competitive bidding to drive not only low pricing but also generally very favorable terms. Specific examples include limiting price increases; lowering inventory levels of products, such as supplies, drugs, devices, etc.; reducing the number of suppliers and SKUs; holding suppliers to higher service standards; and requiring just-in-time deliveries.

Companies most susceptible to these pricing pressures are those that operate in highly competitive, fragmented, and commoditized products and services. As a result, those organizations most exposed to these pressures are the ones least positioned to defend against them. The trend of rate compression filtering through the supply chain is expected to persist as increasing demand and technology advancements challenge the limited financial resources of patients and payers.

One example of this is a pharmacy client that suffered significant proprietary drug cost increases that could only be partially passed through to key customers, which were major hospital systems, causing EBITDA to fall from $15 million to $2 million in a single year, strictly by virtue of a squeeze between drug costs and sell prices.

KRATTIGER: How are companies dealing with what seems like pretty foundational changes to the way they’ve been doing business?

PFEFFERLE: Some are doing well and some not so well. There is no one-size-fits-all solution to operating in this reduced-rate/outcome-based care model, and many companies have achieved varying results with a range of different approaches.

As is always the case, the best-run companies try to stay ahead of the curve by anticipating change, challenging legacy business models, investing heavily in IT infrastructure, continually striving to be cost-efficient, and working hard to effectively integrate bolt-on or service line expansion acquisitions.

As discussed, we are seeing healthcare companies implement growth strategies to increase scale and efficiency and also to gain more leverage over payers, customers, and suppliers, which brings both opportunity and risk in terms of high purchase multiples and potentially high debt service levels, requiring effective integration and realization of synergies.

For providers, no longer is quality care enough to be a differentiator—those are table stakes to compete. Patient experience is often the differentiator. Many industry competitors pursue the same fundamental strategies; the successful ones are better at execution.

In the case of hospital systems, this includes building large feeder networks of primary care doctor practices, urgent care clinics, and outpatient treatment facilities and surgical centers to capture and keep patients and fill hospital beds. Also, you are seeing new organizations, such as Amazon, CVS, etc., see the disruption as a massive opportunity, given the overall size of the healthcare market.

Clearly, there will be winners and losers. For example, some companies have been slow to react and limited in their approach. In helping these healthcare companies, in many respects the approaches and solutions are no different from helping non-healthcare companies that encounter financial difficulty—mainly restructure around the most profitable segments and customers, and maximize organizational and cost efficiency.

These companies first need to gain a thorough understanding of how changes in the healthcare market, including impacts from reimbursement rate cuts or supply chain pricing pressures, affect them and what options exist to restructure operations, adjust service levels, or cut SG&A costs. Change is difficult, and throughout this process it is critical to continually challenge the status quo.

The still evolving switch from fee-for-service to value-based reimbursement also may require companies to invest in data analytics tools to monitor quality improvements, more robust population healthcare management techniques, and upfront patient billing strategies.

One final point is that healthcare providers need to ensure proper focus and procedures are in place to ensure medical billing compliance. Implementation of the ACA brought a whole new level of focus to medical billing practices and compliance. Payers are now on the offensive against billing improprieties, overutilization, and potential fraud, and proper documentation is critical to ensure payment for services is received on a timely basis. For example, it is difficult to get Medicare and Medicaid to pay deficient claims that are more than 120 days or 90 days, respectively, unless fault for the delay is clearly shown to be on the part of the government.

You could make the argument that the regulations are working as they were intended—the healthcare industry is being forced to eliminate questionable practices and rationalize cost structure for players in the market. Can you give more specific examples of how you are helping companies deal with these?

KRATTIGER: The goals of reducing costs on the overall healthcare system while improving outcomes for patients are good ones. However, it is also important to note that these changes are not being implemented equally or even fairly, and significant change creates both dislocation and opportunity.

First, to accomplish positive change, it is critical for companies to evaluate and understand the profitability of each significant component of the business, such as discrete business segments, service offerings, customers—by class and individually—payers, region or state, etc., and to also take a hard look at service levels, sales and marketing, IT, SG&A, overall staff compensation levels, outsourcing opportunities, and contractual arrangements involving both vendors and customers. In the case of falling reimbursement or pricing levels, vendor price renegotiation is also a key opportunity. The focus should always be on growing profitable areas of the business while reducing exposure to, or even shedding, less profitable areas of the business as well.

In this regard, we recently helped a client exit from a state entirely in what will be a two-year process because reimbursements had fallen to a level where it was impossible to operate without incurring significant EBITDA losses. By exiting the market, redeploying existing assets, and focusing future capital on value-accretive opportunities, the company was much better positioned for growth going forward.

In another example, we helped a client sell a good business segment at 15 times EBITDA. The segment could be easily leveraged into a larger competitor to pay down debt and support the restructuring of and investment into the core business unit.

As another example, a former client was a specialty pharmaceutical distributor that experienced a material reduction in procedure volumes related to its products. In addition to the decline in volumes, this specific industry experienced severe price compression that put pressure on margins.

Given these dynamics, the company had to get laser-focused on efficiency to preserve declining margins as well as strategically retain and gain market share to remain competitive without pricing itself below costs. There were a number of nuances to this industry. However, this company was able to outperform its much larger competitors on a performance KPI (key performance indicator) basis and was ultimately purchased by a strategic buyer as part of a vertical integration play that served to further highlight the contraction the industry was experiencing.

The idea that I want to convey is that for companies to avoid pitfalls and truly capitalize on the opportunities that these market shifts have availed, they need to be willing to completely rethink the business they have built and rebuild a business that caters to its newly redefined core competencies.

KRATTIGER: Regarding regulatory issues, what type of trends are you seeing?

PFEFFERLE: The risk of state or federal audits, inspections, or investigations has never been higher, and the cost of deficiency related corrective actions or the risk that a company cannot collect billings is higher than ever. These could include CMS, the FDA (U.S. Food and Drug Administration), state boards and other regulators, etc.

The OIG (Office of Inspector General) and DOJ (U.S. Department of Justice) have been very aggressive in their investigations of whistleblower complaints, which can lead to years of defense efforts and millions of dollars of costs, as well as significant distraction for members of the management team. Marketing activities that are customary in most other industries can have devastating consequence for healthcare companies.

For example, one relatively small client incurred a $13 million DOJ settlement largely for marketing practices that would be routine in most other industries. PE firms that are engaged in roll-up strategies may acquire an entity and be unaware of certain practices that as part of a larger organization could lead to regulatory issues. Even for the innocent, investigations can be both costly and disruptive.

Providers must develop and maintain extremely strong compliance departments, culture, and oversight to mitigate the risk of an audit/investigation and any negative outcomes.

KRATTIGER: Are there any specific sectors being hit hardest by these trends and changes?

PFEFFERLE: I’ll go through a few, but by no means is it an exhaustive list of healthcare segments under pressure. The poster child for healthcare stress is skilled nursing facilities (SNFs), many of which have opco/propco (operating company/property company) or REIT-owned (real estate investment trust) real estate structures, where among a host of issues, rent levels are often no longer supportable due to declines in operating performance. Examples include large SNF operators, such as Genesis, Manor Care, Orianna, and Sava, as well as many small operations.

Factors impacting facility performance include a shift in patient mix toward higher acuity and lower reimbursed Medicaid patients as healthier patients are increasingly treated elsewhere, such as in their homes. In fact, in many states Medicaid rates do not even cover the cost of care.

In addition, despite the aging population, occupancy rates have in general remained flat at best, and relatively low pay levels for physically and emotionally taxing clinical and nursing positions have created issues with staffing. Success typically requires high levels of operational efficiency; strong focus on tracking, billing, and collecting for all procedures performed; vendor negotiation of such services as pharmacy, food, supplies, and temporary staffing; and restructuring of lease payments.

Other segments under pressure include:

Community Hospitals. In most markets, community hospitals cannot remain viable in their current form, other than as affiliates of larger health systems providing basic levels versus any meaningful level of specialized care.

Electronic Healthcare Transcription Companies. Today there are more than 100 electronic healthcare transcription companies in a sector that is consolidating and will continue to do so, in our view, into at most a dozen providers over the next five to 10 years. Allscripts in the Northeast is an example of a company that has the scale and technology to survive. Many smaller competitors will not.

Urgent Care. While urgent care is a booming retail-oriented business, certain markets are becoming oversaturated with urgent care clinics. In some markets, newer units with enhanced facilities are taking share from older clinics, as well as increasing competition for large health systems that view urgent care as a patient feeder system for their networks. For example, in Phoenix, Banner Health System is expanding the number of its urgent care clinics from an originally acquired 32 to 50.

High-Technology-Dependent Businesses. For facilities such as radiology practices, technology obsolescence is a risk, and costs for equipment replacement, training, and competition are high.

Home Healthcare. While there is a huge demand for home healthcare services, increasing minimum wages are pressuring and will continue to pressure the economics of home healthcare companies, which compete in an inherently low-margin business. Some will inevitably run into financial difficulty.

However, it is certainly not all doom and gloom. There are many subsectors that are highly attractive—for example, surgical centers, especially those with a core group of doctors focused on outcomes and who have strong health system alliances.

Marc Pfefferle

Marc Pfefferle

Carl Marks Advisors

Marc Pfefferle is a partner at Carl Marks Advisors.

Jonathan Killion

Jonathan Killion

Carl Marks Advisors

Jonathan Killion is a managing director with Carl Marks Advisors. He has more than 10 years of financial services experience, working closely with owners, management, boards, and other key stakeholders to identify and execute upon performance improvement initiatives, restructuring, strategic planning, and M&A transactions. Killion has been especially focused on the challenges facing the healthcare industry, developing solutions to complex problems, sustaining clients’ viability, and enhancing enterprise value.

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