Flux Market: Understanding and Responding

Volume 10, Issue 15, August 1, 2023

by Dave Turgeon, Managing Director, and Jack Turgeon, Senior Consultant

In today's ever-changing market, businesses must remain keenly aware of emerging trends and swiftly adapt their strategies. As we enter the midway point of 2023, it is evident that the market is undergoing significant fluctuations driven by macroeconomic forces and evolving financing dynamics. This article aims to illuminate these transformative shifts and provide valuable insights into how healthcare businesses can successfully navigate this dynamic landscape. By gaining a comprehensive understanding of the current market conditions and taking proactive measures to prepare for the future, businesses can position themselves for resilience and growth amidst the uncertainties that lie ahead.

Let us provide some points of reference to help you better understand where we sit today. Since 2008, our government and central bank have been promoting highly accommodative policies intended to stimulate economic growth. They were installed after the 2008 financial crisis. Interest rates have been kept low, we’ve been printing records amounts of money, and the federal government has spent aggressively. When COVID-19 hit, stimulus ramped up even greater, as the chart below of money supply from the American Institute for Economic Research shows. Asset prices increased dramatically. None of this, by the way, is political or depends on your personal opinion of large vs. small government.  Following record inflation in 2022, the Federal Reserve has pivoted. In the past 15 months, we’ve had 10 interest rate hikes and at least one more is likely.

In March 2023, Public Television and Frontline released a documentary titled "The Age of Easy Money." The episode clearly explains how we got to this moment and what it means for our future. It can be viewed on YouTube. We reference it because business owners should consider watching it. The program provides valuable insight with historical perspectives and the opinions of experts.

What's transpired during this "age of easy money" is that banks allowed buyers to borrow much more to finance acquisitions than was the historic norm. In 2022, for example, the leverage on the private equity-backed purchases in the United States reached an all-time high of 5.9x EBITDA, according to PitchBook. This unprecedented amount of leverage helped finance one year after another of record numbers of M+A transactions. As the Frontline documentary points out, such free flow of money is coming to an end.

We are now seeing two changes in the market. First, we’re seeing interest rate increases. Everyone sees those, and they’re easy to measure and understand. The cost of debt is more expensive. That means today's asset prices are getting depressed because the future value of discounted cash flows is less. The second change, which is equally important and less well understood, is that the leverage offered by commercial banks is getting more restrictive.

Changes in Financing Deals

We are seeing the impact of these two dynamics on deals today. We are in daily dialogue with buyers about how these issues are affecting valuations. In the table below, we provide two cases to show the impact of the change in leverage ratio and valuations. For simplicity, we'll use one line item to represent "profit," and we'll ignore taxes.

Case #1 is a view of a transaction that's been fairly common. A buyer pays 11x EBITDA and finances it with a combination of debt and equity.  Case #2 shows the impact of a change in bank financing on overall valuation. You'll note that the overall valuation drops from $35.2 million to $28.8M (almost 20%). The multiple of profits drops from 11.0x to 9.0x, driven by the decline in the amount of debt available to finance the deal. While a buyer may need to come up with more cash at close (as percentage of overall deal), they are not making up for the drop of the bank's portion of the financing.

What Does This All Mean to Buyers?

A more restrictive policy of banks is playing out with buyers, including larger companies consolidating businesses. If you've been acquiring businesses based on an assumption of sustained low interest rates and strong leverage ratios, these changes pose a challenge. You're likely carrying too much debt, and your interest expense is rising. You're reviewing all your options. Do you invest more equity in existing companies? Lower valuations on new deals? Look for different deals? Push for more rollover equity on new deals to de-lever your own balance sheet? Seek mergers where the combined entity can save costs and get an even higher valuation? It's fair to say that everything is on the table but paying high multiples for new deals is unlikely.

Outlook and Steps for Business Owners

While it's undeniable what's happening in today's market, one can speculate on what's likely to come next. It would be understandable for sellers to think, "If values are low now, I'll just wait for a later time to sell my business. I'll wait for leverage ratios to go back to where they were." In our view, this would be a mistake. If we are truly at the end of the age of easy money, then we are returning to a more normal period of asset prices and valuations.

It’s unlikely the decline in asset prices will be immediate. Stanley Drunkenmiller, the highly regarded investor, recently talked about how the stock market is likely to trade with very small returns for 5 to 10 years. His view is that asset prices are overvalued and will need years to correct. We'll likely revert to historic norms in all asset classes. The valuations paid for small and medium-sized businesses in the coming years will revert to the norms that have existed for decades.

There are steps business owners should take now to prepare their business for an eventual sale, which include the following:

• Start with a valuation of your business as of today. As VERTESS, we provide free business valuations based on your financial performance and other metrics.
• Understand the market for your business. This is an area where it's more important than ever for business owners to work with quality M+A Advisors. We can share with you how buyers are approaching businesses like yours and what successful transactions have in common. We can talk with you about comparable transactions and buyers.
• Put together a plan for how to increase the value of your business. A good M+A advisor will provide you with a list of questions buyers will ask and the metrics most important for your valuation.
• Learn what's needed to stand out among other businesses going to market. This includes highlighting qualities that might be hard to quantity but drive value. Buyers are generally reviewing many opportunities simultaneously. We want work with you to clearly define what makes your business uniquely valuable. It can include your culture, brand, management team, market position, competitive dynamics, the repeat nature of your revenue, or many other factors.

Positioning Your Healthcare Business for Success

To summarize, the healthcare industry is experiencing significant changes in the market, driven bymacroeconomic trends and shifts in financing deals. The age of easy money, characterized by historically low interest rates and high leverage ratios, is coming to an end. It is important for healthcare business owners to understand the evolving market conditions and take proactive steps to prepare for a future sale. While waiting for leverage ratios to return to previous levels may seem tempting, it is crucial to recognize that we are entering a period of normalization in asset prices and valuations. Business owners should work with quality M+A advisors to conduct valuations, develop strategies to increase business value, and highlight unique selling points to stand out in a competitive market. By understanding buyer expectations, focusing on key metrics, and differentiating their businesses, owners can position themselves for successful transactions in an evolving market landscape.

VERTESS is an M+A advisory firm that works exclusively in the healthcare industry. Our focus is on helping our clients achieve their goals, including those discussed above. A large portion of our business is "sellside" work, meaning we help business owners prepare and sell their business. We were recently recognized as one of the top investment banks serving the lower middle market, generally defined as deals with valuations below $250 million. To learn more about VERTESS, our services, and how we can help you better prepare for a sale, please reach out to us through our contact information provided below.