Healthcare credit ratings dip amid M&A binge
Merger and acquisition activity is weighing on healthcare companies' credit ratings, according to a new report.
Fitch Ratings maintained a positive outlook for the industry given the solid underlying demand for healthcare products and services, particularly as the population ages. But it notes there has been an uptick in ratings downgrades as the industry consolidates and companies fund large acquisitions.
The healthcare sector is one of the largest contributors to the increase in total high-grade bond issuance over the past decade, according to Fitch.
The aggregate amount of high-grade bonds (AA- or higher) in healthcare grew at an 18% compound annual growth rate since 2008 to $609 billion as of Sept. 30, rising nearly three-fold since the end of the Great Recession. Healthcare investment-grade bonds with a composite rating in the "BBB" category represent 58% of the total outstanding for the sector compared with 18% at the end of 2009.
While healthcare organizations take on more debt to execute acquisitions that promise better cash flow and efficiencies of scale, those projections are not fully offsetting their growing debt loads, according to Fitch.
"M&A digestion can affect some systems' aggressiveness—or at least cause a pause—in terms of other future acquisitions and other capital plans," said Eb LeMaster, a managing director at consulting firm Ponder & Co. who focuses on hospital M&A. "But at the end of the day, good strategy should come before consideration of incremental balance sheet or credit ratings impact."
Lower credit ratings limit providers' ability to access capital. If a hospital loses its investment-grade status, which means its credit rating dips below "BBB-" or "Baa3" depending on the ratings agency, certain bond issuers will deem it too risky. It also caps how much the hospital can borrow elsewhere.
Credit downgrades affect a hospital's reputation and upset bondholders who won't get the same return if they try to sell the bonds. Also, if a hospital is not investment-grade, it has to implement a costly credit enhancement process that could restrict its spending.
Consider ProMedica Health System. Moody's Investors Service and Standard & Poor's downgraded ProMedica several notches to "Baa1" and "BBB" respectively following its acquisition of HCR ManorCare, the bankrupt post-acute provider.
The acquisition weakened ProMedica's balance sheet as it issued $1.15 billion in debt and spent $524 million in cash to acquire HCR's assets, ratings agencies said. They also noted the risky proposition of restructuring governance, management and operations amid the flux in payment models and lower reimbursement levels.
But ProMedica also has a leading market position, strong cash flow and a proven expansion process bolstered by its full continuum of acute and senior care services, they said.
When a provider acquires an under-performing company, that can drag on its financial position for a year or more, LeMaster said. Credits are often placed on negative watch or are downgraded, but long-term investments and synergies should bear fruit, he said.
"The key is looking long term enough so that the acquirer can obtain the benefits and synergies of an acquisition," LeMaster said.
Still, the returns of scale are mixed, even years later. Purchased services and supply-chain synergies, for instance are often a sizable part of the rationale driving mergers and acquisitions, as executives claim that their bigger footprint will lead to greater leverage in supplier negotiations and clinical standardization. Yet, a recent working paper from University of Pennsylvania's Wharton School academics found that hospitals only realize a fraction of their projected savings.
According to the Fitch report, 10 companies account for 51% of the investment-grade healthcare bonds outstanding, including of CVS Health and Cigna.
CVS issued $40 billion of senior unsecured bonds to help finance its pending $67.5 billion acquisition of Aetna, which has a negative rating watch and an "A" rating, while Cigna issued $20 billion to fund its proposed $67 billion purchase of Express Scripts, which has a "BBB" rating and also holds a negative rating watch. The top 20 and 30 healthcare companies account for 76% and 87%, respectively, of total healthcare investment-grade bonds outstanding.
On the pharmaceutical side, generic drug manufacturer Teva Pharmaceutical Industries was downgraded last November from "BBB-" to "BB" as the company struggled following its acquisition of Actavis' generic drug business, Fitch noted.
Earlier this month, Fitch downgraded the ratings of Cardinal Health to "BBB" from "BBB+" as it remains over-leveraged following a series of acquisitions.
Still, the appetite for M&A won't wane in the near-term, experts said. Pricing pressure, regulatory changes, pressure from activist investors and still historically low interest rates will stoke consolidation, according to Fitch, which was affirmed by PricewaterhouseCoopers' third-quarter deals report.
More than 250 industry deals are in the works for the fifth consecutive quarter, increasing by 0.4% from the third quarter last year.
While the number of hospital transactions decreased by 11.8% year over year, the sector represented the largest by deal value for the first time since 2016, driven by RCCH HealthCare Partners' $5.6 billion acquisition of LifePoint Health. Long-term care remained the largest sub-sector by deal volume (102), continuing a multiyear trend. Behavioral care also saw a 66.7% increase in deal volume.
M&A interest will remain through the rest of the year and 2019, said Thad Kresho, the leader of U.S. health services deals at PwC. Regulatory uncertainty, income pressure, technological innovation and consumer centricity will continue to pressure healthcare organizations, he said.
"Volume levels remain strong across numerous sub-sectors both in the corporate and private equity arenas," Kresho said. "We expect this momentum to carry through the remainder of 2018 and beyond."
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