EVCJ Mar 24, 2005

Victor Chua, Candesic’s healthcare practice leader, talks to the European Venture Capital Journal on the care home sector.

Website and online article: www.evcj.com

"Care services: In good health?"

In November, US private equity house Blackstone acquired Nursing Home Properties (NHP) for £560m. In September it acquired Southern Cross Health Care for £160m from West Private Equity. In other recent deals Barchester Healthcare beat off private equity competition to acquire Westminster Healthcare from 3i, German insurer Allianz acquired Four Seasons from Alchemy Capital and HBOS bought Ashbourne from Electra Capital Partners.

Some of these deals have been extremely lucrative for private equity houses. Alchemy, for example, earned more than four times its original investment when it sold Four Seasons and 3i made a similar return in its exit from Westminster. So why is this market so heated at the moment?

There are a number of reasons for the current interest in the care home sector. One is the demographic pressure of an ageing population and a public sector keen to outsource care to the private sector and prevent elderly patients from “bed blocking” NHS hospital beds. This is because a bed in a care home, in which there is a big role for low-paid, non-qualified staff, costs around £500 to £600 a week, while a hospital bed, staffed by nurses and doctors, costs around £350 a day.

Care homes are also good solid businesses with strong cash flow and high-quality earnings, especially in specialised areas such as learning difficulties and psychiatric care, according to Andrew Ferguson, a director at Granville Baird Capital Partners. The firm last year backed the £22.4m MBO of Castlecare Group, a provider of care homes for young people with behavioural difficulties.

But he argues that much of the demographics argument has been overplayed, given that forecasts of increased numbers of elderly people needing residential care often stretch over 25 years when private equity investors have an investment horizon of only three to five years.

The UK’s soaring property market of the last few years has also played its part in the care homes sector’s growth. “Many of these businesses are property backed and that means the banks like them and are willing to lend on high multiples, such as eight to ten times EBITDA,” says Neal Ransome, healthcare corporate finance leader at PricewaterhouseCoopers.

Much of the reason for the heightened interest in the sector is simple supply and demand, says Victor Chua, partner at management consultancy Candesic: “It’s a cyclical industry and, from favouring local authority purchasers in the 1990s, the pendulum has swung to favouring the care providers.”

The background to the current situation is that there was a glut of supply in the care home and nursing homes sector in the 1990s. The distinction between the two services is that nursing homes are for more frail and vulnerable older people and offer a more intensive service. People will often start in a care home and then move to a nursing home when their condition worsens.

With an over-supply of beds local authorities, who fund about three-quarters of the market, were able to hold down fees and operators were under severe pressure. Many quit the market and, tempted by rising property prices in the late 1990s sold off their mansion-like care homes to be converted into flats. This trend has continued and reduced capacity by an estimated 10% since 1996.

As a result, local authorities have been forced to increase their fees and profitability has soared. Chua estimates EBITDA profit margins were between 5% and 10% in the 1990s, but 20% to 25% today.

Chua says: “As profitability has increased, so has the price of assets but the majority of residential homes are still ‘mom and pop’ homes, often started by a doctor and his nurse wife.”

Joseph Baratta, a senior managing director at Blackstone, says the general move of this market from public sector provision to private sector, the demographic trends of an ageing population and the fragmentation of the UK care home market make the industry an attractive investment.

“We realised about a year ago that a lot of assets were going to change hands, either those owned by entrepreneurs or some of the mid-market private equity houses and that there was a lot of scope for consolidation in this sector.”

Consolidation

It’s certainly true that there is still much potential for consolidation in elderly care. Even after the acquisition activity of the last year or so no player has more than a 5% share of the market. According to figures from Candesic and industry consultant Laing & Buisson, Southern Cross/Highfield, BUPA Care Homes and Four Seasons are all at 4% to 5% per cent with between 14,000 and 18,500 beds each. Below these operators are Barchester/Westminster and Ashbourne/Highclear, at 2% to 3% and then a raft of smaller players.

Clearly, there is huge potential for further consolidation, says Michael Anderson, a partner at law firm Berwin Leighton Paisner, which advised Barchester on its acquisition of Westminster Healthcare.

Anderson believes the increase in government regulation of care homes is one of the drivers of consolidation. Baratta of Blackstone agrees: “Training requirements have got tougher and half the nurses in a home must now have the NVQ level 2 qualification. If you’re a bigger company you can afford more robust training.”

But has the consolidation benefit been exaggerated? After all, the vast majority of a care home’s budget goes on local labour, even if most of the non-nursing staff will be earning the national minimum wage. No matter how big the company it still has to pay the local market rate for staff.

Baratta acknowledges this but says that there are still some economies of scale to be gained, such as purchasing of food and other items. More importantly, he says, is the fact that public sector purchasers are looking for more credible counterparts for big block contracts. “And that means there’s a need for bigger, more professionally managed operators with diverse geographical reach,” he says.

Another benefit of consolidation, says Chua, is the ability to reduce back-office costs, such as corporate headquarters. For example, when Blackstone, which owns Southern Cross Health Care, bought NHP it consolidated its head office to one location and in so doing is saving several million pounds a year.

Companies with 25% or more local market share can also begin to muscle up the fees paid by public sector purchasers, although there are limits to this and the Office of Fair Trading is reviewing the Southern Cross acquisition of Highfield because in certain geographical areas the merged company has a large market share. The company may be forced to divest itself of some homes, according to market observers.

One other factor in consolidation is the potential in transferring more efficient management to acquired companies. “The chief executive of Southern Cross is a young, dynamic character who has been told to give Highfield the ‘Southern Cross treatment’ and bring it up to Southern Cross’s profitability,” says one observer.

Thus, there are some significant potential benefits in consolidation and it seems inevitable that consolidation will continue given the still fragmented nature of the market.

Aside from the benefits to be gained from consolidation, private equity owners of elderly healthcare companies are asking themselves how long the current boom will continue. This is a crucial question given that investors will want to exit businesses after a few years and the timing may be critical. “The issue for private equity investors is whether the sector will still be profitable when they want to exit in two or three years and we think it will,” says Victor Chua.

He argues that usually, when there is excess demand for a service the supply of the service increases, but that when it comes to care homes this is trickier. This is because many of the homes that have closed since the mid 1990s have been turned into flats and so cannot easily be turned back into care homes. Furthermore, many of these homes were Victorian mansions, which new care standards make less appropriate to be run as care homes because of regulations such as the number of single rooms, en suite bathrooms, and corridor width. “Apart perhaps from certain parts of the country, such as bits of outer London or Birmingham, the economic case for building care homes has yet to be made,” says Chua.

Joseph Baratta agrees, noting that while fee rates have increased in recent years they are still not high enough to justify much new building. As a result of this, experts like Chua believe the current high profitability will last for another four to six years, which is more than enough time for private equity investors to build up the businesses and make their exit.

Adding value

It is clear the best performers will be those that can really add value to the businesses they acquire. Apart from consolidation benefits, much of this will depend on the ability of individual operators to squeeze higher fee income from the public sector by offering higher quality services.

To a large extent these businesses are restricted in what they can do to drive up income. This is because they have to operate to rigorous government standards on how care is delivered and so have little leeway when it comes to issues such as how many staff to employ. There is some scope, however, for cost savings in reducing dependence on agency staff, who typically cost four to five times permanent staff, by efficient staffing and recruitment.

The best way to create value, argues Victor Chua, is to offer a higher quality care package to local authority and NHS purchasers. Instead of charging £500 to £600 a week for the basic residential home service, operators can conceivably invest in more nurses who are specialised in caring for the very frail elderly. The operator could probably charge up to £1,000 a week for such a service but its extra staff costs would only partly offset that fee increase. The benefit for the NHS purchaser would be that it is transferring these patients from a hospital bed costing £350 a day.

Michael Anderson of Berwin Leighton Paisner goes along with the higher value-added/higher fee scenario but for private purchasers rather than public sector purchasers: “Barchester would say that it sees growth in the higher end of the market, principally for private payers.”

So far, relatively few operators are thought to have really developed a strategy of improving the quality of care and offering more acute services in return for higher fees. But for those that can make it work, the rewards in terms of increased fee income are thought to be impressive. Baratta of Blackstone believes this is the way to go: “The aim is really to create a high-quality operator where you can justify a higher fee with higher value-added.”

As for the soaring prices being paid for assets, Baratta believes they can be justified when taking into account issues such as the property portfolios attached to such businesses. Others are less convinced. One private equity investor, who asked not to be named, says acquisitions are being justified on the grounds of expected synergies. But he adds that some sellers have been taking a run rate of profits over a few months (sometimes immediately following a fee increase) and extrapolating this to an impressive annualised rate that is not necessarily accurate. He says: “If you’re already in the sector then it can make sense to acquire and reduce costs through synergies, but I couldn’t justify a private equity investor entering the sector at current valuations.”

Andrew Ferguson of Granville Baird says one of the drivers in higher valuations is that there is a lot of private equity money around looking for investments, especially at the larger end, and there are a lot of intermediaries and advisers interested in the healthcare sector and seeking to deliver opportunities to investors. Despite this, he argues that current valuations are generally justified because the cash flows of the businesses are so strong and mean that investors can borrow at high multiples.

Exits

The healthcare sector may be thriving at the moment but what is important for private equity investors is being able to exit at the right time. While the strategy of mid-market private equity houses, such as Granville Baird, has been to sell to bigger financial investors or trade buyers, the exit strategy for the large houses is flotation.

Andrew Ferguson says that, while the AIM market has begun to show some interest in the sector, there are very few quoted companies that run care homes. “There used to be some listed companies but, with the problems in the 1990s, they left and it’s unclear how much appetite there is in the equity markets for new listings from this sector.”

Neal Ransome of PricewaterhouseCoopers says the larger houses are looking to float their businesses at some stage and so are looking for bolt-on acquisitions to build critical mass. He believes there would be significant interest in the capital markets for such listings: “I can see this sector filling the gap that used to be occupied by the drug companies, in other words relatively safe investments that are anti-cyclical and don’t depend on consumer demand.”

In terms of future deals, most of the significant assets in the elderly healthcare sector have been or are in the process of being sold. Among those expected to be put on the market before long are Craegmoor, which Legal & General Ventures acquired in 2001. Beyond that, it is the mass of smaller operators that are likely to be snapped up by bigger players.

Ransome says: “There’s quite a lot of activity still to come in the recycling of assets among private equity houses, so that a business that started out with a small investment is built up and then there is a larger secondary buyout and then a bigger tertiary buyout.”

Outside the elderly care market there are other healthcare opportunities in areas such as children’s care, learning difficulties and psychiatric care. These niche areas often offer higher profits but also require much more specialised care. They are also a much smaller market than the elderly care sector, with around 80,000 beds for people with learning difficulties or the mentally ill, compared with nearly 500,000 beds for the elderly.

Ken Lindsay of ECI Partners, which has invested in children’s homes, says there has been much interest in niche, specialist residential care. But, he says, investors in such sectors need to be cautious and that the price of businesses is not always realistic: “Some operators can’t believe what venture capitalists are prepared to pay.”

Whatever the attractions of some of the niche sectors, it is the elderly care market that will continue to be the main focus because of its size. After the scale of activity in the UK in recent years, it could be time for expansion into continental European markets.

This next step, however, is not a natural one because there are few economies of scale to be gained when each country has different reimbursement systems, standards and regulations. Also, in much of Europe, profitability is lower than in the UK. For example, in Spain profit margins are between 5% and 15% compared to between 20% and 25% in the UK.

“In most of Europe it’s a respectable business but not one that generates great returns and until investors sense that returns will increase there won’t be the same level of transactions as in the UK,” says Victor Chua. Neal Ransome of PricewaterhouseCoopers agrees: “It’s been very much a UK phenomenon so far, but perhaps the next step is for some of the UK players to look abroad.”