By: Jonathan Killion, Managing Director, Carl Marks Advisors
Date: January 22, 2019

Middle-market healthcare companies are experiencing extremely exciting, but also challenging times. Well-run organizations are seeing significant investor interest and rewarding valuations, however organizations displaced by the rapidly changing healthcare landscape are challenged to regain their footing and maintain valuations to support invested capital.

How is the health of the domestic healthcare market? The healthcare industry continues to be an exciting industry with robust investor appetite, active M&A environment, and an increasing list of non-traditional market competitors. Supporting the high valuation levels is a set of fundamentals that benefits from favorable demographics (the aging U.S. population) and a cultural willingness to demand the latest and greatest medical care (at higher costs) in exchange for incremental benefits to quality of life and life expectancy. Assuming no wholesale legal changes, the Centers for Medicare & Medicaid anticipate national health spending is to grow at an average rate of 5.5% per year through 2026, reaching a total of $5.7 trillion. Overall, health spending is projected to grow 1.0% faster than national GDP over the same time period and reach 19.7% of total GDP.

All of these trends would seem like good news for the industry, and as a whole it is. However, the challenge comes from the realization that the cost of care currently provided is putting stress on federal, state and individual resources. As a result, despite the positive trends, many healthcare organizations are grappling with intense pressures that are challenging their long-term viability.

We at Carl Marks Advisors recently completed a survey of healthcare professionals to find out what are the biggest challenges heading into 2019. Probably of little surprise, healthcare providers and service companies continue to struggle with a number of challenges, including reimbursement, staffing and technological implementation.

Why Should Asset-Based Lenders be Concerned About the Challenges Highlighted by Healthcare Professionals?

The first reason may be obvious; but anything that negatively impacts the health of their borrower is a concern. In our experience, monetizing the healthcare organization can be difficult, time consuming and expensive, and provide recoveries below exposure levels.

Furthermore, the value of hard assets for healthcare organizations are highly correlated with the going concern nature of the business. Should the business wind down, the risk to impairment to PP&E and receivables increases significantly. Depending on the nature of the receivables, maximizing recovery may require coordinating a soft landing that allows customers to transition work to alternative providers in an effort to mitigate offsets against outstanding AR, or the retaining of the revenue cycle team to bill, collect and re-process denied claims. The challenge in either a soft landing or a wind down where receivables are collected is agreeing on who will fund and for what benefit. To prevent these types of challenging and potentially costly situations, lenders of all types are well advised to understand the challenges faced by healthcare companies today and how they correlate to current or prospective borrowers.

This survey raised a couple issues that are particularly important to the asset-based lender. They focus on the nexus of pressures to financial performance and pressures to the key collateral (receivables) held by asset-based lenders.

What are the Key Issues Healthcare Asset-Based Lenders Need to Understand in 2019? 

Healthcare organizations find themselves dealing with a number of well-documented drivers of distress which have tangible impacts on the value of a lenders collateral. Our survey found the Revenue Cycle process was the biggest challenge identified, with 72% of respondents citing reimbursements and payments as the number one challenge for middle market healthcare companies.

The issue can be segmented into two areas:

• Downward pressure on pricing challenging profitability levels, and
• Challenges in being paid for services rendered.

The challenge of making healthcare cheaper, better and faster has led to three major ways the industry is trying to rationalize costs:

• By reducing reimbursement rates,
• By moving to alternative payment models (i.e. Fee for Value), and/or
• By increasing denial rates.

The revenue cycle process consists of coding, billing, and proper patient care decisions. Breakdowns in any of those three areas can have a significant negative impact on the quality of a lender’s collateral. Causes for the denials are varied but, in our experience, most are the result of front-end processes issues, such as eligibility verification. However, issues extend all through the process and can be for missing or incorrect claims data, insufficient or missing authorizations, or missing documentation. Couple the complexity of coding and billing with the burdensome processes created by many insurance companies, and the risk profile of collecting accounts receivable continues to increase. To the extent a lender is lending against outstanding accounts receivable, monitoring the denial rates for a borrower is a key financial metric.

Another important metric for asset-based lenders to monitor is the changing composition of healthcare receivables. Aside from an industry-wide focus on reducing costs of healthcare, the other large push has been to merge those who pay for care and those who receive care. As a result, the payor mix that has traditionally been concentrated to large commercial payors and/or government payors is changing over time toward increased exposure to private payors. Higher deductibles and the increase in patient responsibility are causing a decrease in payments to providers for patient care services rendered from traditional payors.

The implication is that a private-pay receivable is of significantly lesser quality than a commercial or government payor – even after the risks of denials are considered. The collection rate on private-pay bills is extremely low, and industry studies estimate that by 2020 the percentage of patients not paying their bills in full will rise to 95%. Meanwhile the percentage of patients that have made partial payments toward their hospital bills has gone down dramatically from 89-90% in 2015-2016 to 77% in 2016.

In addition to the pressure on receivables, real estate is not free from unfavorable trends and pressures. Traditionally healthcare services and providers have needed a brick-and-mortar location to provide care, services and products to individuals in need. Increasingly, the need for a physical location is diminishing in favor of a model that looks to increase efficiencies, decrease costs and improve patient conveniences. Technological improvements have allowed the increase in telehealth and mobile resources that are able to provide care in outpatient/mobile settings at cheaper costs and higher convenience levels to the patients.

The overall outpatient migration is fully expected to continue, and the obvious question will be what will come of healthcare facilities who no longer need the current levels of real estate assets. These trends have been particularly detrimental in LTAC’s and SNFs where patients increasingly prefer home care over onsite care. Real estate properties may need to be viewed within the prism as industry agnostic, and it should be considered what the requirements would be to transition it from a healthcare facility to another purpose facility. Lenders should look at the costs and demand factors as the overall need for healthcare-specific real estate diminishes over time.

What should Asset-Based Lenders Do To Best Protect Themselves Against These Challenges?

It is important to understand what borrowers are doing to protect lenders’ collateral against these trends which pose threats to their value.

Asset-based lenders should make sure to understand and stay current on the practices comprising revenue cycle management. The Chief Financial Officer is the critical leader of this function; make sure to have clear and frequent communication with him/her on the behavior of their payors. This can and should be done before issues arise, as it can serve as an early warning sign against stresses and pressures the company may face going forward.

Secondly, focus on the underlying financial performance of the organization. Depending on your investment objective, it may be prudent to be an early advocate of a transaction that refinances or repays your debt obligations. The risk is if liquidity becomes tight or enterprise value diminishes, the cost of recovering your collateral may be significant, result in reputational damage and not be shared by more junior participants in the capital structure. If the process is started early enough (i.e. when the company has sufficient liquidity), the current seller’s market may provide an opportunity for all stakeholders to get out at a salvageable level.

Should you find yourself in a situation where a more challenging financial turnaround be necessary, understand early on the challenges (both business & legal) to recovering your collateral and the cost associated and prepare for challenging discussions with junior creditors and equity stakeholders.

Jonathan Killion is a managing director at Carl Marks Advisors, an investment bank that provides financial and operational advisory services.  He is a healthcare industry expert with over 10 years of financial restructuring and investment banking experience. He works closely with healthcare companies, management teams, and boards of directors, lenders, and investors on hospital restructurings, strategic planning, and M&As.