Over the past year, the Federal Reserve has increased the upper limit of the federal funds rate to 5.0% from 0.25% to combat inflation. Higher interest rates translate to increased costs of capital, lower valuations for businesses, tighter lending standards and lower deal volume. The rate environment has put a pause on many deals in the health care space as investors reassess macro and industry trends and instead focus on improving existing organizational operations. According to Forbes, as a result, there is over $2 trillion in dry powder that investors will look to deploy back into the market when the time is right, whether through acquisitions, portfolio enhancements or improvements.
Health care services buyout activity has cooled to more normal levels
According to PitchBook, in the fourth quarter of 2022, deals in health care services fell to their lowest level since the nadir of the pandemic; then, first-quarter 2023 activity fell even lower to an estimated 159 deals, the second-lowest level in the observed period. However, capital invested increased to an estimated $19 billion due to several megadeals.
Signs show that M&A deals will continue to take place throughout 2023. While the number of deals may not be as high as in 2021, major deals may be on the horizon. And despite governmental intervention to stop some acquisitions, recent court wins by acquirers have encouraged health care systems to proceed with dealmaking efforts. This factor, in combination with other mergers and acquisitions activity we saw in the third and fourth quarters in 2022, could lead to more finalized health care M&A for 2023.
While M&A has the potential to help health care companies overcome many of today’s issues, such as addressing labor costs, improving community access and meeting social determinants of health requirements, these deals also come with several challenges, including consolidating for inorganic growth, enhancing core operations, and creating buy and build strategies. As lending has become more expensive and banks take fewer risks, a merger or acquisition could do more damage than good for organizations if challenges aren’t addressed. Here are some key considerations to navigate this somewhat uncertain market.
- Define a clear rationale for growth: Successful health care M&A depends on an organization’s clear vision for continued growth. Without a comprehensive plan to maximize the business’ ability to grow, M&A deals may not provide desired results.
- Address limited funds: Inflation concerns and limited funds can prevent some companies from investing in any type of health care merger or acquisition. Some organizations are turning to private equity funds to overcome this challenge.
- Assess ineffective IT integration: IT integration can be highly complex, especially when merging two organizations with completely different platforms. Without a comprehensive road-mapped plan for effective IT integration, the organization could experience disruption and patient services delays.
Despite challenges, health care M&A will likely continue to rebound in 2023. Even though the interest rate environment has certainly cooled activity from the frantic pace of 2021 and early 2022, the challenging operating environment will continue to drive consolidation and expose investment opportunities as multiples stabilize.
Considerations for tax-exempt organizations
Tax-exempt organizations engaged in M&A activity with for-profit organizations must be cognizant of generating unrelated business taxable income that could be considered outside of their charitable mission and affect their tax-exempt status. Tax-exempt organizations must accurately capture and measure their activities that further their exempt purpose, including how they address social determinants of health and related environmental, social and governance efforts.
State law often limits ownership of professional practices, such as medicine, to a licensed practicing professional. A transaction with private equity may require a master service agreement that governs a number of supporting agreements and, in turn, may result in questions of ownership for tax purposes.
The fervent deal-making of the zero-interest rate era may be over, but both strategic and financial buyers are eager to invest. As the uncertainty over future interest rates and operating environments abates, the industry will see an increase in deal flow. This may represent an opportunity for organizations that are able to put money to work acquiring new operations and entering new markets. At the very least, the health care industry will see increased investment in existing operations.
The health care M&A market may not have come out of the 2023 gate as robustly as it did in 2021 and 2022, but there are definitely signs of activity and opportunities for buyers to allocate their resources strategically. Many investors will no doubt continue to thoughtfully expand via roll-ups and investments in emerging specialties, while hospitals and other health care facilities will seek out smaller community providers and ancillary service lines to bolster their bottom lines.