Sustaining investment in the face of uncertainty

Julian Smith, partner at national law firm Mills & Reeve, discusses how M&A activity in the healthcare sector might be impacted by continued
uncertainty

The Brexit debate has sadly become a way of life, but is that enough stability for M&A in the sector to continue to thrive?

M&A remained buoyant in 2018– probably boosted by the availability of private equity capital and bank funding for acquisitions. On top of that, especially in parts of the sector that aren’t highly dependent on EU workforce, the health and care sector’s reputation for being relatively Brexit-proof has seen M&A activity sustained by investors looking for a safe haven.

But is Brexit impacting deal flow in 2019?

It’s a mixed picture but on the whole, it looks in relatively good shape, particularly in the medium to long term, to weather any storm. The major issue is timing. Why?

PE seeks safe havens in healthcare

Global M&A markets have rarely seen so many private equity funds hunting for investments. As The Economist observed recently in its article, PE is Piling into Healthcare, “People who need medical care rarely wait for an economic recovery”.

Added to that, healthcare has traditionally been seen as more insulated from the effects of Brexit than most other sectors of the economy. The larger funds that have more flexibility to invest outside of the UK are arguably showing signs of erring on the side of caution – and being more hesitant in completing deals.

But for the majority of PE houses who are focussed on the UK, the business of looking for suitable targets continues unabated. This is because the sector is more attractive than others that face multiple Brexit-related problems ranging from cross-border supply chain delays to unpredictable forex fluctuations.

Buy-outs and platform acquisitions are only the starting point: PE-backed corporates are perpetuating the competition for worthy acquisitions by looking for buy and build opportunities.

Recently infrastructure funds have accounted for a flurry of deals as investors seek to diversify their portfolios, fuelling further interest in the sector. This has particularly been the case in the specialist care market with AMP Capital and iCON snapping up Regard Group and Choice Care respectively and other infra funds regularly coming to the table for some of the other larger deals rumoured to be in the pipeline.

The banks and other sources of finance, crucial for PE structured deals, are seeing brisk levels of business. This is particularly the case in lower and mid-market deals where the clubbing together of banks to provide in a syndicated debt package is less necessary.

Forex uncertainty

However forex uncertainty appears to be slowing deals down in 2019. The volatility of sterling, reflecting the turbulence of Brexit, is making some decision-makers, particularly the PE funds, sit and wait for more stability. Sale processes which started in Q4 of 2018 are on hold or moving slowly, particularly some of the larger social care processes.

Until forex rates stabilise, hopefully by Q3, the bigger, geographically diverse funds will probably wait or invest in more forex stable currencies.

Staffing uncertainty

Brexit’s biggest shadow for the sector is the feared impact on staffing. Uncertainty about immigration rules and, sadly, the growing sense that the UK is less welcome than it has historically been is already suppressing immigration. For businesses heavily reliant on EU staffing, further HR shortages will be unwelcome and damaging to margins and valuations.

Vacancies in social care are soaring and staffing shortages across NHS trusts are indicative of the problem faced by the independent. According to The Kings Fund there are reports of unfilled vacancies in excess of 100,000,which is around 1 in 11 posts, in the NHS. That’s great for staffing businesses but not for the people-hungry social care and domiciliary care providers.

The signs are not encouraging, with natural wastage not being replaced at the same levels as before: recent reports highlight a 13% drop in nurse registrations in 2018.

The EU Settlement Scheme will enable EEA/Swiss nationals currently working in the UK to obtain settled status and remain in the UK on a long-term basis.

But the longer-term immigration picture is less clear. The Immigration White Paper published in December 2018 sets out proposals for a new unified immigration system to take effect from 1 January 2021. A work visa category is proposed, to include intermediate skill level roles, but with a proposed minimum salary threshold of £30,000. There is limited provision for low skilled workers with a proposed transitional 12 month visa route, but this is likely to be limited to certain sectors including social care and will be relatively unattractive to prospective migrants. It will not, for example, enable migrants to access public funds, or be accompanied by dependants, or lead to settlement.

As is the case under the current points-based system, various exceptions may be made for key health sector roles – in terms of lower salary thresholds and through use of a shortage occupation list – but we are unlikely to know further details until 2020.

The growing regulatory burden – stimulating M&A opportunities?

The other factor often put forward as a downside of investment in the sector, the increased regulatory burden, doesn’t hold much water. Healthcare everywhere is, and always will be, heavily regulated and carries with it bigger than normal risks when things go wrong. Publicly listed businesses have typically found the negative reputational impact of “incidents” more of a challenge than privately owned counterparts who can afford to ride out the temporary but uncomfortable storm of an investigation or prosecution.

This has led some to remove themselves from the spotlight and share price fluctuations of a stock market listing by seeking to go private. But, as a general rule, the increase in regulation is incremental and not disruptive to M&A. Experienced trade buyers and well-advised financial buyers know what risks and difficult regulatory issues come with the territory – and which are not market standard. If anything, the CQC and regulatory environment drives consolidation and M&A.

NHS procurement

The bigger question for bidders of NHS contracts are the possible changes to NHS procurement rules.

Under the consultation announced in late February, it is proposed that the existing procurement legislation is repealed. Instead, commissioners will be required to apply a ‘best value’ test that could mean fewer large contracts are put out to the tender.

The Independent Healthcare Providers Network has sounded a note of alarm that this could favour incumbency over quality and decisions to award large contracts becoming less transparent.

Knock on macroeconomic effects of Brexit

Apart from staffing issues, healthcare businesses – particularly those that are dependant on a robust and growing economy – are likely to see the ripple effect of any wider economic downturn. For example, if Brexit dents employer confidence, then headwinds in the PMI sector will stiffen and reduce some of the demand enjoyed by independent sector providers.

But, in reality, most of the revenue that forms the bedrock of the sector is publicly funded or non-discretionary. Whilst under pressure, public funding seems unlikely to change dramatically, at least in the short to medium term.

The appetite for transacting remains high and, critically, prices and multiples appear to be unaffected. However forex fluctuations are dampening activity currently and that’s likely to continue until Brexit begins to look more orderly.

In the meantime the market dynamics are favourable compared to other sectors. That will keep the investment-hungry PE and infra funds looking and, more importantly, even more ready to buy when forex rates stabilise.

As a result we can probably expect a surge of activity from pent-up demand (on the buy and sell side) when the tide changes. Hopefully that will be by Q3.