💰Private Equity Own Yo Sh*t (Short Health. And Care)💰

Forget Toys R Us. Private Equity Now Owns Your Eyes and Teeth

It has been over a month since media reports that Bernie Sanders and certain other Congressman questioned KKR about its role in the demise of Toys R Us (and the loss of 30k jobs). At the time, in “💥KKR Effectively Tells Bernie Sanders to Pound Sand💥,” we argued that the uproar was pretty ridiculous — even if we do hope that, in the end, we are wrong and that there’s some resolution for all of those folks who relied upon promises of severance payments. Remember: KKR declared that it is back-channeling with interested parties to come to some sort of resolution that will assuage people’s hurt feelings (and pocketbooks). Since then: we’ve heard nothing but crickets.

This shouldn’t surprise anyone. What might, however, is the degree to which private equity money is in so many different places with such a large potential societal impact. It extends beyond just retail.

Last week Josh Brown of Ritholtz Wealth Management posted a blog post entitled, “If You’re a Seller, Sell Now. If you’re a Buyer, Wait.” Here are some choice bits (though we recommend you read the whole thing):

I’ve never seen a seller’s market quite like the one we’re in now for privately held companies. In almost any industry, especially if it’s white collar, professional services and has a recurring revenue stream. There are thirty buyers for every business and they’re paying record-breaking multiples. There are opportunities to sell and stay on to manage, or sell to cash out (and bro down). There are rollups rolling up all the things that can be rolled up.

In my own industry, private equity firms have come in to both make acquisitions as well as to back existing strategic acquirers. This isn’t brand new, but the pace is furious and the deal size is going up. I’m hearing and seeing similar things happening with medical practices and accounting firms and insurance agencies.

Anything that can be harvested for its cash flows and turned into a bond is getting bought. The competition for these “assets” is incredible, by all accounts I’ve heard. Money is no object.

Here’s why – low interest rates (yes they’re still low) for a decade now have pushed huge pools of capital further out onto the risk curve. They’ve also made companies that rely upon borrowing look way more profitable than they’d ordinarily be.

This can go on for awhile but not forever. And when the music stops, a lot of these rolled-up private equity creations will not end up being particularly sexy. Whether or not the pain will be greater for private vs public companies in the next recession remains to be seen.

The Institutional Investor outright calls a bubble in its recent piece, “Everything About Private Equity Reeks of Bubble. Party On!” They note:

The private equity capital-raising bonanza has at least one clear implication: inflated prices.

Buyout multiples last year climbed to a record 10.2 times earnings before interest, taxes, depreciation, and amortization, according to S&P Global Market Intelligence. This year they remained elevated at an average of 9.5 times ebitda through May, a level surpassing the 2007 peak of the precrisis buyout boom.

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When you’re buying assets at inflated prices/values and levering them up to fund the purchase, what could possibly go wrong?

*****

What really caught our eye is Brown’s statement about medical practices. Ownership there can be direct via outright purchases. Or they can be indirect, through loans. Which, in a rising rate environment, may ultimately turn sour.

Consider for a moment the recent news that private equity is taking over from and competing with banks in the direct lending business. KKR, Blackstone Group, Carlyle Group, Apollo Global Management LLC and Ares Management LP are all over the space, raising billions of dollars, the latter recently closing a new $10 billion fund in Q2. They’re looking at real estate, infrastructure, insurance, healthcare and hedge funds. Per The Wall Street Journal:

Direct loans are typically floating-rate, meaning they earn more in a rising-rate environment. But borrowers accustomed to low rates may be unprepared for a jump in interest costs on what’s often a big pile of debt. That risk, combined with increasingly lenient terms and the relative inexperience of some direct lenders, could become a bigger issue in a downturn.

Regulators like that banks are wary of lending to companies that don’t meet strict criteria. But they are concerned about what’s happening outside their dominion. Joseph Otting, U.S. Comptroller of the Currency, said earlier this year: “A lot of that risk didn’t go away, it was just displaced outside of the banking industry.”

What happens when the portfolio companies struggle and these loans sour? The private equity fund (or hedge fund, as the case may be) may end up becoming the business’ owner. Take Elements Behavioral Health, for instance. It is the US’s largest independent provider of drug and alcohol addiction treatment. In late July, the bankruptcy court for the District of Delaware approved the sale of it the centers to Project Build Behavioral Health, LLC, which is a investment vehicle established by, among others, prepetition lender BlueMountain Capital Management. In other words, the next time Britney Spears or Lindsay Lohan need rehab, they’ll be paying a hedge fund.

The hedge fund ownership of healthcare treatment centers thing doesn’t appear to have worked out so well in Santa Clara County.

These aren’t one-offs.

Apollo Global Management LLC ($APO) is hoping to buy LifePoint Health Inc. ($LPNT), a hospital operator in approximately 22 states, in a $5.6 billion deal. Per Reuters:

Apollo’s deal - its biggest this year - is the latest in a recent surge of public investments by U.S. private equity, the highest since the 2007-08 global financial crisis.

With a record $1 trillion in cash at their disposal, top private equity names have turned to healthcare. Just last month, KKR and Veritas Capital each snapped up publicly-listed healthcare firms in multi-billion dollar deals.

Indeed, hospital operators are alluring to investors, Cantor Fitzgerald analyst Joseph France said. Because their operations are largely U.S.-based, hospital firms benefit more from lower tax rates than the average U.S. company, and are also more insulated from global trade uncertainties, France said.

Your next hospital visit may be powered by private equity.

How about dentistry? Well, in July, Bloomberg reported KKR & Co’s purchase of Heartland Dental in that “Private Equity is Pouring Money Into a Dental Empire.” It observed:

In April, the private equity powerhouse bought a 58 percent stake that valued Heartland at a rich $2.8 billion, the latest in a series of acquisitions in the industry. Other Wall Street investment firms -- from Leonard Green & Partners to Ares Management -- are also drilling into dentistry to see if they can create their own mega chains.

Here’s a choice quote for you:

"It feels a bit like the gold rush," said Stephen Thorne, chief executive officer of Pacific Dental Services. "Some of these private equity companies think the business is easier than it really is."

Hang on. You’re saying to yourself, “dentistry?” Yes, dentistry. Remember what Brown said: recurring revenue. People are fairly vigilant about their teeth. Well, and one other big thing: yield baby yield!

The nitrous oxide fueling the frenzy is credit. Heartland was already a junk-rated company, with debt of 7.4 times earnings before interest, taxes, depreciation and amortization as of last July. KKR’s takeover pushed that to about 7.9, according to Moody’s Investors Service, which considered the company’s leverage levels "very high."

Investors were so hungry that they accepted lenient terms in providing $1 billion of the leveraged loans that back the deal, making investing in the debt even riskier.

Nevermind this aspect:

Corporate dentistry has come under fire at times for pushing unnecessary or expensive procedures. But private equity firms say they’re drawn by efficiencies the chains can bring to individual dental practices, which these days require sophisticated marketing and expensive technology. The overall market for dental services is huge: $73 billion in 2017, according to investment bank Harris Williams & Co. Companies such as Heartland pay the dentists while taking care of everything else, including advertising, staffing and equipment. (emphasis added)

Your next dental exam powered by private equity.

Sadly, the same applies to eyes. Ophthalmology practices have been infiltrated by private equity too.

Your next cataracts surgery powered by private equity.

Don’t get us wrong. Despite the fact that we harp on about private equity all of the time, we do recognize that not all of private equity is bad. Among other positives, PE fills a real societal need, providing liquidity in places that may not otherwise have access to it.

But we want some consistency. To the extent that Congressmen, members of the mainstream media and workers want to bash private equity for its role in Toys R’ Us ultimate liquidation and in the #retailapocalypse generally, they may also want to ask their emergency room doctor, dentist and ophthalmologist who cuts his or her paycheck. And double and triple check whether a recommended procedure is truly necessary to service your eyes and mouth. Or the practice’s balance sheet.

The Great Escape

"The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds." - John Maynard KeynesThe General Theory of Employment, Interest and Money (13 December 1935).

This past week, Michael Batnick, from Ritholtz Asset Management deployed a version of this quote to make a point about investing; he provided a nice callback to Blockbuster and an equity analyst's repeated bad calls vis-a-vis Netflix (which popped this week after impressive subscription growth - despite negative free cash flow (-$600mm+) and an increasingly levered balance sheet). TL;DR: don't be too wed to your ideas. 

This applies to the actual businesses that investors pour money into too. In today's rapidly transforming environment, businesses must now, more than ever, pivot, and innovate. They can't be too wed to legacy ideas. Recognizing that is the first step. It then becomes a question of execution in the face of constraints.  

Enter Avaya Inc., a privately-held provider of contact center, "legacy" unified communications and networking products and services with 176 global entities, $940mm of adjusted EBITDA, 200,000 customers and 9700 employees. To Avaya's credit, the company pivoted in 2009 away from its historical hardware-based operating model - recognizing the shift towards software-based and cloud-oriented services solutions. It undertook a massive reinvention, adapting its revenue model and streamlining operating performance in a manner that cut $700mm in costs since 2014. To some degree, the company's private equity overlords - TPG Capital and Silver Lake Partners - deserve some credit, too, for working with management and reconciling the need to pivot. After all, they had a $8.2 billion LBO to rationalize. 

But sometimes the constraints are insurmountable. Avaya has $6 billion of debt on its balance sheet; it has $440mm of annual interest expense along with an additional $180mm nut for annual pension and OPEB obligations. And it faces stiff competition from the likes of Microsoft, Cisco, and others, necessitating another ~$400mm in expenditures to fund R&D and other investments. It's been bleeding cash, losing over $505mm in the fourth quarter and over $750mm in fiscal '16.

And so the company is now a bankruptcy filer. Notably, the papers accompanying the filing have zero specificity about the company's go-forward business plan. Its one small victory is a robust DIP financing commitment and milestones intended to achieve a rapid turn in bankruptcy court. But then what? 

We rarely see big freefall bankruptcy cases anymore. Clearly there seems to be disagreement among the various constituencies about how best to proceed with this business in the face of competition and technological headwinds. That said, the company was able to secure $425mm of its proposed DIP facility at the "First Day" hearing on Friday. So there's that. 

"Software is eating the world," we noted last week (per Marc Andreesen). We'll see very soon whether Avaya gets swallowed along with TPG and Silver Lake's investment. Yes, they pivoted. But was it too little too late?

Thoughts? Opinions? Let us know at petition@petition11.com. 

Odd ad to place in the WSJ on the day after bankruptcy.

Odd ad to place in the WSJ on the day after bankruptcy.