The Distressed Debt of Healthcare Private Equity

I’m guessing it doesn’t feel great for Radiology Partners to once again be one of a handful of named companies in another “distressed debt” article. From last month’s “Health-Care Debt Gets Harder Look as Distress Builds” in Bloomberg:

The companies face legal and regulatory pressures too. The No Surprises Act, which makes it harder for medical providers to charge patients large amounts of money for work done outside their health insurance network, has weighed on some companies.

Loans to Radiology Partners, a group of radiology practices, have deteriorated since the end of 2021 in part due to the law, according to Moody’s Investors Service, which downgraded the company to Caa1 in November. The company’s $1.6 billion first-lien loan due 2025 is currently quoted at about 86.8 cents on the dollar, Bloomberg-compiled data show, down from nearly par a year ago.

Note the ungenerous implication that the inability to squeeze patients through surprise billing is a mention-worthy driver of its worsening financial outlook. Please note, non-radiologists, that the RP story isn’t much different from other highly-leveraged companies operating in this space. Recall that behemoth Envision just finished with its round of financial machinations aimed at screwing over its creditors.

In their December 2022 healthcare sector report, Moody’s gave this cozy summary:

The healthcare sector’s credit default risk is rising. So far this year, the ratings of 25 North American healthcare companies have been downgraded to B3 negative or lower, representing a material deterioration in the sector’s credit quality. Healthcare now accounts for approximately 16% of the companies on our B3 Negative and Lower List, compared to less than 4% at 31 December 2015.

Nearly 90% of healthcare companies rated B3 negative or below are owned by private equity. Attracted by healthcare’s historical stability and buoyed by accommodative debt markets, financial sponsors have aggressively consolidated fragmented subsectors, including physician practices, emergency medicine and anesthesiology, to name a few. The resulting roll-ups carry high levels of debt, which will pressure their cash flow and limit their ability to adapt to the changing macroeconomic environment, as well as to increasing social risk, new legislation and litigation.

Capital structures will become unsustainable.

90%!

For those who usually ignore market gibberish, here’s some context about credit agency ratings and corporate bonds:

Moody’s is an independent firm that grades the quality/riskiness of investments. When Moody’s downgraded Radiology Partners to Caa1 from B3 last fall, that grade reflected a move from “speculative” and “high-risk” to “poor quality” and “very high credit risk.”

From Bloomberg’s analysis, “86.8 cents on the dollar” and “down from nearly par” are talking about the current value of RP corporate bonds on the secondary market. Unlike a mortgage or car that gets amortized over a specific term, bonds are issued with a par (face) value and a coupon rate. The par value is what the bondholder gets at the end of the term (i.e. the loaned money that you get back at the end). The coupon rate is the interest rate paid during the life of the bond.

When a bond trades below par, it’s discounted. In this case, the discount is likely a reflection of both the decreased credit rating (possible default/increased uncertainty regarding being paid back when the bond reaches maturity) and rising interest rates (the fixed rate of the old bonds are not competitive with higher current market rates).

Back in 2020, RP raised $800 million at 5.25% for 5 years to buy vRad from Mednax. So, for example, if you bought that $100 bond in 2020 at 5.25%, you would have earned $5.25 in interest every year before getting $100 back in 2025. But if you bought that bond today at $86.8, that same $5.25 is an effective interest rate of 6% (you still get the original $100 at the end as well). That relative increase reflects the extra return investors currently require given current bond yields and the risk of default. RP’s cashflows in the short term are presumably fine. The question is what the market will be willing to provide in terms of letting them raise more money to pay off or roll over that $1.6 billion in 2025 and another $1.6 billion by 2028.

Back to Bloomberg:

Healthcare companies used to be some of the safest to lend to during economic downturns, until private equity firms bought them out and larded them with debt. Now they’re some of the riskiest borrowers in the world of leveraged loans. Five companies in the healthcare space defaulted last year, compared with a historical average of roughly one default a year for an industry that often has stable demand, according to S&P Global Ratings.

The article points out that many of these PE-owned healthcare companies are leveraged at around 7:1 debt to earnings. That figure was apparently around 5:1 back in 2014. In their downgrade release, Moody’s stated RP’s debt to EBITDA was 10:1.

The outlook for healthcare companies, especially service providers, looks bleak. They face labor shortages as medical professionals retire en masse, and regulatory changes are weighing on how much they can charge government payers and insurers. And as leveraged loan investors pare back their exposure to riskier healthcare borrowers, the companies face higher refinancing costs. The industry’s financial difficulties may hit not just investors, but also patients seeking treatment or care.

I don’t think the collapse of SVB last week is going to help. One driver of its spectacularly rapid fall was unrealized bond losses.

Unless inflationary pressures subside and the economy improves, there’ll likely be fewer loan sales coming to the market, money managers said. Companies with bloated debt and projected weaker cash flow will probably pursue transactions such as debt swaps and capital raises to create more breathing room.

Let’s go back to Moody’s again for some more about that:

Distressed exchanges will remain the most common form of default. Saddled with unsustainable capital structures, many healthcare companies rated B3 negative or lower will likely pursue transactions that we consider to be distressed exchanges (DEs). DEs have always been popular among private equity sponsors when the companies they own get into financial difficulties and we expect their popularity to continue. We consider a transaction to be a distressed exchange if it allows a company to avoid default or bankruptcy and results in an economic loss for creditors.

For companies with deteriorating operating performance, lenders will likely be unwilling to refinance upcoming debt maturities unless they believe their economic loss would be less than it would be if the borrower filed for bankruptcy. Companies that are unable to meet greatly increased cash interest expense may seek to convert their debt to payment-in-kind (PIK) obligations, pursue debt-to-equity conversions, or even enter bankruptcy, in order to shed debt and revise their capital structures to make them more sustainable. Here too, lenders will often agree to such transactions because they represent less economic loss than their alternatives…Completing a distressed exchange is often less expensive than undergoing a formal bankruptcy process, and often enable financial sponsors to retain control of a company, which may well not occur in a bankruptcy.

This is future I think we’re likely to see, which is why people who are hoping that somehow these companies will cease to exist in a couple of years are in for disappointment. There are real and potentially irreversible changes in how medicine is practiced that may even worsen as these companies struggle.

Let’s finish with a practical consideration: distressed exchanges, if they occur, will almost certainly decrease the values of the stock owned by “shareholder” radiologists. The bondholders always get paid first. So yes, take the shares of stock when you work for one of these companies, but I wouldn’t consider them as a real investment opportunity, as many radiologists did during the early buyout days. And never take the IOU in lieu of real money.