Healthcare’s inflation-linked health check

The economic and geopolitical landscape changed dramatically early in 2022 with all parts of the economy, including healthcare and life sciences, left to face a new set of challenges. Healthcare, however, is tipped to retain its traditional safe-haven appeal for investors, although there will be pain for some. Nick Herbert, reports.

Russia’s invasion of Ukraine has been a disaster for a global economy already suffering from Covid-related supply chain constraints. Since the turn of the year, rising energy and food prices – a direct result of the war – have pushed inflation to levels not seen since the 1980s. Central banks are hiking interest rates in response, debt is more expensive, and equity markets volatile.

Yet, despite the headwinds, activity in the healthcare sector remained remarkably lively during the first six months of the year: M&A transactions continued to flow, private equity and venture capital firms closed oversubscribed targeted funds, and healthcare is still one of the sectors of choice for real estate investors.

“It’s been a surprisingly busy first half for M&A from a healthcare perspective,” said Paul Tomasic, head of European healthcare, Houlihan Lokey. “By some indications, M&A activity by value has come down but by volume we continue to see a lot of business, primarily driven by mid-market deals.”

Investment opportunities will continue to present themselves during the second half of the year, but market dynamics will affect valuations and some capital raising options for companies will close completely – the flow of IPOs , for instance, has slowed to a trickle, and liquidity is being drained from the system. Valuations are sure to head lower alongside falls in the equity market and as monetary policy tightens.

“I think it’s inevitable that valuations will come down, not just because money is getting more expensive, but because there’s less liquidity in the market overall,” said Dr Victor Chua, senior partner, Mansfield Advisors.

The impact of these new conditions will be felt differently across the various segments of healthcare and the types of deals contracted. There are already signs the market is bifurcating.

“Large deals are more impacted by movements in the debt markets as they rely more broadly on institutional support to get done, but the mid-market remains active,” said Tomasic. “The second half of the year is going to be fascinating to watch.”

Deals continue to be pitched, but whether the current interest translates into actual business depends on “whether we’re entering a period of disconnect between buyer and seller expectations,” said Tomasic.

Sellers will undoubtedly prefer to stick with valuations from 12 months ago, but buyers have been quicker to adjust their pricing expectations.

Sector security

The impact of rising inflation and interest rates will be felt more acutely in some areas of healthcare than others.

“Pharma and Large Biotech are relatively resilient because many companies are quite cash rich and low in leverage. The biotech sector, for instance, can cope with inflation better than many other industries,” said Forbion co-founder and managing partner Sander Slootweg. “Energy and labour costs certainly eat into margins, but it means your cash reach is two or three months less than expected and you may need to go back to market sooner than planned to raise funds.”

It is a different story in other parts of the market. Any business heavily reliant on human capital is going to suffer from rising wages, particularly in an industry already beset by staffing and skills shortages. It means one thing: margins coming under pressure.

“Inflationary costs really hit those industries with large staffing requirements,” said Tomasic. “As wages go up for nurses and elderly care staff, firms will find it difficult to pass those costs on to customers.”

An inability to pass on costs is singularly difficult for those businesses where income is generated in the public sector. Operating in the public space also comes with the additional challenge of managing the time lag that exists before payment is received.

“There’s a one-year lag for UK hospitals between submitting their costs and receiving any payment – in Germany it’s two years,” said Chua. “Hospitals will experience a margin squeeze and the current financial year, ending April 2023, is going to be tough.”

For private hospitals and care homes where revenues are less reliant on the public purse there is more opportunity to pass higher input costs onto patients by raising prices, but margins will still come under pressure.

“The private sector can increase pricing, but you are a price taker in the government paid segment, and that means pain,” said Chua. “If you’re investing in elderly care, it’s probably wise to only invest in the self-pay or private segment. There will definitely be winners and losers.”

And margin pressures for operators will feed into potential problems for real estate investors. Care home leases are long-dated and tied to consumer prices and passing on the current high levels of inflation to residents may prove increasingly difficult.

Operators are also faced with absorbing the huge jump in energy and manpower costs while investors must manage supply chain and manpower issues in the construction industry. It will make developing care homes more expensive and, potentially, unaffordable.

Countering the negative effects are the industry’s positive demographic trends and historical performance, which continue to attract new investors into healthcare from other parts of the real estate world. The recent period of yield compression might finally be coming to an end.

High hopes

There is something fundamental about the healthcare sector that appeals to investors. The sector benefits from positive long-term trends where demand for services, treatments and cures is only set to expand as part of the overall demographic trend.

“One thing that’s assured in healthcare is that demand is going to stay pretty constant,” said Chua.

Private equity is flush with cash, and it is those existing cash levels that should keep deal flow going for now. Raising new funds in the future, however, might prove more difficult. It could lead to bifurcation in the funds sector and a change in profile of limited partners.

“Large investors can take a long-term institutional approach to investing, whereas private wealth is looking at their own liquidity and can take some time to see where things are heading,” said Dirk Kersten, general partner at Forbion Growth. “Existing funds with a certain critical mass, broad coverage, and a good track record will still be able to raise funds fairly easily, but overall, investors are becoming more selective simply because they have other options.”

Higher inflation will test margins and valuations will fall. But falling valuations could be seen as a great buying opportunity.

“There are still thousands of  diseases to be addressed,” said Kersten. “And with all the advancements in technology and biotechnology, and a better understanding of disease, this is an industry with great potential for investments  for the next 10 years, at least.”