How will private equity backed veterinary hospital consolidators navigate 20203?
Since I wrote on the topic last, we have seen multiple private equity (PE) backed veterinary hospital network mergers consummated (NVA > ETHOS, Rarebreed > VetsBest Friend). We have also seen a material rise in interest rates which has dampened the enthusiasm of some corporates to acquire some individual veterinary hospitals. Finally, I have seen the launch and / or expansion of multiple private-equity backed hospital networks which grow exclusively through new site build-outs.
These developments are related and a natural response to the opportunities afforded (or shut) to private equity or venture capital investors in the veterinary services market.
A typical private equity backed veterinary consolidator in veterinary services will be financed with equity capital contributed from a private equity fund, and debt capital provided from one or multiple lenders. How much debt is used is generally determined by the Company’s EBITDA with max debt of up to 7x EBITDA for the largest consolidators in veterinary services. Equity capital is used for the rest. A PE firm can estimate a “cost of capital” for a portfolio Company using the marginal interest rate on debt with the marginal estimated return on equity (typically at least 15% for a PE but oftentimes more) and the “optimal” mix of debt and equity for the Company.
Private equity backed veterinary corporates generally get their debt financing in the form of term loans. Terms loans are 5 to 7 year, senior secured loans that carry a floating interest rate (sometimes with a cap or floor) based on Libor. These loans typically have a balloon repayment schedule, and are therefore almost never paid back outside of a refinancing or business sale.
Under-writers of these loans include large wall street banks, but also “shadow banks” or credit funds which structure more bespoke financing packages with less regulatory scrutiny. In many cases, the under-writer’s goal is to sell the loan to someone else, usually a Collateralized Loan Obligation (CLO), or a large institutional investor. Like the mortgage-backed securities that unhinged the financial markets in 2008, CLOs are derivatives designed to partition out the risks associated with lending to highly levered corporate concerns.
When interest rates rise or volatility increases, lenders before more fearful. When they become fearful, they demand higher interest payments, more compensation for the risk they take, but also more lender friendly terms in the loans themselves. These demands have the impact of increasing the cost of debt capital and reducing operating flexibility for the private equity owners of veterinary services platform. If you are a private equity firm needing to refinance a term loan from a few years ago, you are certainly going to be paying much higher interest rates in today’s markets.
When the cost of capital increases for private equity firms, they seek to lower the valuations they pay for their investments, including “tuck-in” investments like the acquisition of a single veterinary hospital by a larger veterinary services network. I say “seek” because the market is the ultimate determinant of the valuations that need to be paid, provided sellers use the market to their advantage (I’ve talked at length about why this isn’t always the case with independent practice owner sellers).
For veterinary medicine, the valuations for premium, high growth animal hospitals have remained attractive despite the increase in interest rates because there continues to be a lot of competition to purchase high quality practices. Consolidators recognize that a premium hospital is more likely to continue to grow in a sustainable way than a turn-around. While some consolidators may be stepping back from the market, very few will turn down the opportunity to acquire a premium asset in a strategic location.
Also, for every consolidator taking a step back from acquiring hospitals, another is just starting in the market. The reason there remains a flow of new private equity backed entrants is because an investment in veterinary medicine is considered to be “safe” relative to an investment in, say a network of doctors of human medicine. A lot of investors lost a lot of money investing in human medicine in the late 90s. No such “blow-up” has happened in veterinary medicine. In fact, there have been almost no complete private equity failures in veterinary medicine.
A private equity failure is a matter of degree. Most funds seek to deliver a 15 to 20% annual return on equity invested. If a private equity investment results in equity investors “just getting their money back”, the investment is a semi-failure. I can put my money in government bonds with very little risk and “just get my money back”.
However, a total blow-up, which does happen, occurs when equity investors are “wiped out”, meaning the portfolio Company must restructure with most, or all of the value in the operating assets being used to compensate debt claims. This is a very bad outcome for a private equity fund. We haven’t seen such an outcome in veterinary services, though maybe 2023 is the year.
Tight labor markets, combined with rising input costs owing to inflation makes the operating environment more challenging for veterinary practice consolidators and veterinary practices. In a tougher operating environment, the strong begin to acquire the weak. Some consolidators have already chosen to combine with other consolidators. I think we will see more of that in 2023.
With consolidator mergers, called strategic acquisitions, come synergies, in theory. On the expense side, a consolidator can eliminate the duplicative corporate infrastructure of the target creating synergies. On the revenue side, a merger might afford the combined entity the ability to drive more sales from a broader customer base. In practice, much can go wrong with poor execution. Time will tell whether the mergers completed by NVA and Rarebreed turn-out well.
In a more difficult operating environment, where interest rates are rising, yet valuations are still holding for premium assets, some investors have decided to build their own. Enter Veterinary Emergency Group, Modern Animal, Bondvet etc. The advantage to this strategy is that you can establish a premium veterinary hospital for far less than the cost of purchasing that same hospital.
The disadvantage to this strategy is that you must recruit all of the staff and DVMs. In today’s labor market, you will need to provide a demonstrably superior set of benefits and compensation to do this, at bare minimum. You may also need to provide a better work life balance or other attractive perks. All of the “build your own” players are offering this in some flavor, with some layering on new approaches to delivering veterinary services.
Success will depend on execution. It does not take much to get a reputation for being a poor employer, and it is not easy to build and maintain a reputation as a great employer. One or two serious missteps can blow years of carefully managed goodwill when it comes to recruiting key staff. At that point, superior wages and benefits will not be sufficient to recruit the staff needed to create premium hospitals. When this happens, the cost advantage relative to buying a premium hospital can disappear.