Healthcare’s Interest in Private Credit, Other Funding Sources Grows

August 23, 2023 - There has been a lot of buzz around private equity's growing reach in healthcare, but providers have other options to fund growth. And one of those funding sources is gaining popularity.

"Private credit is filling a void right now," explains Everett Wilson, managing partner of Polsinelli's Miami office and a shareholder in the law firm's Health Care Practice Group.

According to Goldman Sachs, private credit encompasses several strategies that cover the capital structure and borrower type, ranging from secured loans for blue-chip corporate borrowers and junior unsecured credit for financing new building construction to loans against specialized assets and distressed situations.

The private debt market has increased more than six-fold since the global financial crisis in 2007 and 2008. As of 2022, the private credit market stands at $1.2 trillion, according to data analyzed by the global investment firm.

Private credit is not new to healthcare. However, other alternative sources of funding —alternative to a loan from a traditional bank, that is — have taken the spotlight as of late. Notably, private equity has taken a major interest in the healthcare industry, garnering a lot of backlash and skepticism because of its financial mission to generate a return on investment.

However, the tides are turning once again. Private equity is seemingly on its way out in the healthcare industry, at least for now, while private credit is pushing in.

What alternatives do providers have?

"This is capital not so much for operations, but really to help a company achieve long-term goals like expansion through acquisitions," he tells RevCycleIntelligence. "This growth capital usually comes from traditional lenders, so your banks."

"However, banks are subject to all sorts of regulations, which creates a lot of limitation around what they can lend to companies," Wilson says.

Banks are limited in the amount they can lend, how they lend, and what assets they can secure for loans. The process of obtaining growth capital through traditional banks is wrought with red tape, but the latter issue Wilson identifies is especially troublesome for providers seeking growth capital. Those assets may be receivables, a building, or equipment; in other words, a finite object. If providers want to expand, the bank's lending power is limited to what is there physically in the moment, not in the future.

To avoid the red tape and limitations, alternative funding sources have emerged. As mentioned earlier, private equity investment can help healthcare providers grow through a firm injecting capital into the organization for a certain percentage of equity in the enterprise. That can range from a minority to a majority investment, depending on the deal.

Private equity investment has gained traction in healthcare, with private equity entities accounting for 65 percent of physician practice acquisitions by 2019, the American Hospital Association (AHA) reports. Private equity firms also had $29.2 billion in capital waiting to be invested in healthcare at that time, according to the Private Equity Stakeholder Project.

But private equity investment isn't the only alternative funding source. Healthcare providers can also form strategic partnerships, often involving competitors or peers in different geographic locations to achieve economies of scale through joint ventures. Some providers can also go public through an initial public offering (IPO) or form a special purpose acquisition company (SPAC) to raise money through an IPO.

"SPACs have cooled off as of late for various reasons," Wilson notes. "IPOs have all sorts of requirements, and SPACs are an alternative to that, which offers a way of going public without the degree of regulatory hurdles that you would normally have to face if you do an IPO."

Finally, there is private credit.

"Private credit has always been around, but it was mostly used as short-term or bridge financing," Wilson explains. "It wasn't really a way to secure longer-term capital, and it has been used a lot in conjunction with private equity."

All of these funding sources still exist, but various factors have prompted some sources to exit the market temporarily or decrease activity, according to Wilson.

"That has left it open for private credit to fill the gap, and it's not because private equity is better or worse. People just still need credit and capital to grow," he says.

Growing pains in healthcare

Healthcare is in growth mode. Merger and acquisition activity has regained momentum in healthcare after the COVID-19 pandemic dampened dealmaking in 2020 and shortly after. Industry experts expect this energy to continue in 2023 as healthcare leaders across the continuum focus on growth.

Healthcare organizations are seeking economies of scale to lower costs while increasing efficiencies. Some research has also suggested that consolidation within healthcare can improve care coordination and quality of care, especially as more providers switch to value-based contracts that financially reward those and similar metrics.

Regardless of the reason, many healthcare providers are looking to expand operations. However, the environment is no longer favorable for some popular growth capital funding sources.

"There's been a compression on valuation, which, for private equity, is a major concern," Wilson states.

Private equity firms focus on value enhancement and are looking for a return on their investment within a couple of years. These firms ask themselves: Will the capital and management expertise I put in result in a higher value for the enterprise I'm investing in?

The answer to that question is more positive when valuations are up, Wilson explains. However, Wilson sees decreasing valuations across industries, including healthcare.

"Whether it be in the public markets or the private markets, healthcare companies just aren't being valued for as much anymore. As a result, private equity funds aren't going to invest just to get out where they are now. That doesn't make any sense," Wilson says.

"And what if it's less than what they are at now? That would not be a good investment. Remember, they leverage their investments, so if they have to go out and get credit, with interest rates so high, that would also decrease the return they would be getting," Wilson continues.

Valuations can change. Wilson points out that valuations were high two years ago, prompting investment in healthcare. Two years from now, valuations could shift again.

"But right now, private credit is really coming in as the alternative," Wilson says.

What providers need to know about private credit

If healthcare providers could go to a bank and get a low-interest loan, they would. However, that is no longer the reality. Private credit, on the other hand, is available for providers, so it may be a choice of necessity for those looking to grow.

"It's a high-interest loan, but it's one that you probably wouldn't be able to get at the bank," Wilson says. "And instead of giving away equity, for the most part, you are simply paying a higher interest for growth capital. Rates are also high, but at least you're not giving away your company at a lower valuation than you think it's worth, too."

Typically, borrowers are subject to a couple of years of interest-only payments because of the nature of private credit. So, healthcare providers need to do some math to ensure they can manage this type of funding.

"If I need the capital for growth, I need to analyze how I'm going to be able to grow this business with that additional capital and how much that growth will produce," Wilson says, breaking down the equation for providers. "Am I able to pay the interest with that?"

If providers feel confident the loan will lead to enough to cover the interest, private credit is likely a good option to support expansions and, eventually, a higher valuation.

Healthcare providers must also ensure smooth and steady cash flow because cash is king in private credit.

"In the beginning, you just are making interest-only payments, but after that, it's going to have some principle put into that. The point is there are these financial covenants in the agreements that the borrower, or in this case, the healthcare company, has to comply with, and they have to do that from day one."

That focus on cash flow may be different for healthcare providers who are used to private equity investments that focus more on long-term profitability. For private credit, providers must have the cash to pay off the high-interest loan every installment.

"You can't have any interruptions in cashflow because then it puts the borrower in breach of the lender's covenants, and the lender can't sit back and wait five years," Wilson stresses.

Wilson cautions providers and private credit issuers to do their due diligence, especially with acquisitions. They need to be aware of whether new facilities and providers are enrolled in Medicare, Medicaid, and other relevant payers because credentialing issues can lead to claim denials or temporary payment restrictions. They even should take into account expected changes in reimbursement rates after negotiations.

"That's all cash for the organization," Wilson says.

Private credit can be tricky for healthcare providers focused on delivering quality care versus profitability. But, the alternative funding source is growing in popularity as providers weigh their options to expand. In the current economic climate, they may want to consider how private equity can help them to achieve their goals.