Question

Discuss some factors that health services managers must consider when choosing between debt and equity financing. Consider both investor-owned and not-for-profit firms in your answer.

Answer 1

HealthCare Markets Group provides unique financial solutions for clients throughout the healthcare industry. The Firm participates in financings and M&A transactions for its healthcare clients.

In an era where providers are attempting to re-engineer their delivery of healthcare, HealthCare Markets Group is re-engineering client balance sheets to meet a higher standard, by developing and executing financial strategies that not only meet long-term objectives, but enhance client value and offer a competitive advantage.

Selecting the Right Investor/Lender
From an early business focus on debt and lease products for general acute care facilities, HealthCare Markets Group has expanded its source of funds from commercial and private lenders, to institutional investors, high net worth individuals, corporate partners, private equity and venture funds. Since each project is unique, HealthCare Markets Group matches its client’s financial needs with a compatible investor/lender whose expectations and portfolio criteria are most synergistic.

Portfolio of Financing Products
~ Asset Based Financing
~ Accounts Receivable Financing
~ Debt Financing
~ Mezzanine Financing
~ Equipment Lease Financing
~ Working Capital Programs
~ Mortgage Financing
~ Tax-Exempt Lease and Bond Transactions
~ Complete Project and Facility Financing
~ Raising Equity for Development Stage to Mature Businesses
(medical device, provider, bio-pharmaceutical)

January 22, 2019Resources
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Equity Financing
Debt Financing
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What are the different types of financing options are you are aware of? What are the forms of business financing that you want to go for? Do you know the difference between debt financing and equity financing? Why are the most important things that is necessary for all business entrepreneurs to keep in mind while looking for financing choices for their businesses? The team at Credit Health Care is here to help the readers know about the difference that exists among equity as well as debt financing and the better between the two.

difference between Equity Financing and Debt Financing

Now, the time has come for you to understand the major difference between these two popular forms of financing out there. The article tries to define the major advantages of going for each form of financing option.

Equity Financing
Do note that equity financing is a method of financing in which a company issues shares of its stocks to obtain money in return. Also, along with that, to fully understand the concept of equity financing one must be clear of the concept of venture capital. This is the money to seed an early stage, emerging and emerging growth companies. The amount of equity financing greatly depends on the stage of a business and the expected risk. The relationship between a venture capitalist and the entrepreneur is also a major factor. Equity financing is normally associated to a startup and emerging businesses. The other choices out there are Seed financing, startup financing, second-stage financing and also bridge financing.

Debt Financing
Let us talk about debt financing. This term is defined as a method of financing in which a company receives a loan against the promise of repaying the loan. You also need to understand that, this particular method of financing with high risk for the lenders but there are a lot of factors involved which bounds the debtor to pay back. The financing includes both secured and unsecured loans. Along with that, in case of unsecured loan the borrower’s credit worthiness is the main security. This type of loan can range from a few hundred dollars to thousands of dollars all depending upon the borrower’s relation with the bank or any borrower for that matter. In addition to that, the different forms of loans which are available to loan buyers as part of the debt financing are long term loans, short term loans and also intermediate term loans.

A s private equity firms grew and developed during the late 1980s and 1990s, they typically avoided investments in health care services, because the operating environment and its related business models appeared more complex than in other industries. Many health care provider services (for example, acute care hospitals, skilled nursing, ambulatory surgery centers, home care, and hospice) have regulatory and reimbursement risk profiles that discouraged private equity investors.

Today, however, private equity funds are increasingly important participants in the health care services sector. They have spent billions of dollars to purchase well-known companies such as HCA ($32 billion value) and Manor-Care ($6 billion–plus value) and are investing in young, unfamiliar companies pursuing innovative strategies in health care services.

Large and small sophisticated private equity firms are investing sizable amounts of financial and human capital in health care services companies because they believe that they can achieve attractive returns during both up and down economic cycles; they can make investments in many different uncorrelated subsectors; and they can fill a consistent need for capital over time. Private equity investors are also attracted to health care services because some parts of the existing health care delivery system have not adequately addressed growing cost concerns, demand for quality, and consumers’ preferences.

Health policy analysts look at inefficiencies and inequities in health services financing and delivery and propose political, regulatory, and structural changes; private equity investors look at the health care industry’s challenges and see opportunity. Many are investing in what they perceive to be companies with better, faster, and cheaper business models that lower costs while increasing (or at least maintaining) quality. They expect to be rewarded with solid returns on their investments when those investments can deliver better products or more-efficient services than those of their competitors.

Private equity investments in health care services can be controversial, however, because investors are motivated, at least in part, by the prospect of making returns of 20 percent or more. The Service Employees International Union (SEIU), for example, has been a vocal critic of private equity buyouts of mature businesses such as skilled nursing homes. The union points to the wealth generated by individual private equity investors and their managers and asserts that they may have an incentive to deal unfairly with workers and pursue strategies that do not enhance the long-term operations of an acquired company. It advocates increased transparency and disclosure, an increased voice for workers, and a voice for community stakeholders. 1 Private equity participants, on the other hand, counter that they understand that employee layoffs are much less effective in a service industry and that lowering the level of quality does not serve to enhance value. It is also noted by private equity participants that many employees’ retirement and pension funds actually benefit from successful private equity investments.

It is too soon to make a judgment about the ultimate impact of private equity investments on health care services delivery. But, meanwhile, it is apparent that private equity is reshaping parts of the industry by introducing new, aggressive competitors in certain sub-sectors and service areas. This paper identifies the driving forces behind expanding private equity activity in health care services. It describes the private equity fund management groups and the types of health care investments they are pursuing. Biotech, devices, and pharmaceuticals are not addressed, because these sectors have different technical, operational, and investment dynamics than health care services.

THE PRIVATE EQUITY VALUE PROPOSITION
The well-known risk/return trade-off motivates private equity fund managers and those who entrust their investment dollars to them. Investors expect that these managers will outperform returns in the public markets and are willing to accept the higher risk, illiquidity, and volatility that accompany this class of investment assets. Institutional investors such as foundations, pension funds, and educational endowments are important sources of capital. These institutional investors have increased their commitments to private equity investment strategies in recent years to diversify their portfolios, thereby making them less subject to overall trends in the equity markets; to take advantage of private equity fund managers’ value-enhancement skills; and to realize higher investment returns and gains.

Successful private equity investors generate higher investment returns by selecting investment opportunities, such as those where companies have major growth potential, by adding value to the company while it is owned, and by executing a successful exit strategy. Private equity firms generally plan to hold investments in portfolio companies while they develop and grow for three to seven years, after which the investments are “harvested” via sale to another private equity investor, a strategic investor (an operating company that could be a competitor), or the public equity market.

Although the health care industry represents 16 percent of gross domestic product (GDP) and 13 percent of the Standard and Poor’s (S&P) 500 group of publicly traded companies, it represents only 10–11 percent of holdings of major private equity funds, according to a Deutsche Bank analysis. 2 The opportunities that exist in health care services make it worthwhile for fund managers to invest the time required to thoroughly understand the industry, and fund managers have been developing, hiring, expanding their health care expertise and deploying capital. Consequently, private equity has become a major factor in many segments of health care services.

HEALTH CARE PRIVATE EQUITY FUND MANAGERS
We have identified three types of private equity firms that are especially relevant to the health care services sector: venture capital firms, growth capital/mid-market buyout firms, and buyout firms (Exhibit 1 ). They are best distinguished by the size of the investments they make and by the stage of maturity of typical acquisition targets. These differences drive different risk and return expectations among types of investments. Some firms will cross over into one of the other segments, but the majority of their investments tend to fall into one of these categories.

VENTURE CAPITAL FIRMS.
These firms typically make small investments of $5–$25 million in the start-up or early stages of new companies. Since these companies do not often have a proven business model, the risk of failure is high. Venture capital funds have been an important provider of capital for smaller companies in their start-up and growth phases. These companies are generally too risky to access bank funding and the public debt markets, and they lack the solid track records that would permit them to sell equity to the public. Venture capital investors accept the highest level of risk and generally target the highest returns of 30 percent or more from an overall portfolio. As of 31 December 2007, actual one-year venture capital returns were 19.5 percent compared to the S&P 500 returns of 2.1 percent, and ten-year returns were 18.3 percent, compared to S&P 500 returns of 4.2 percent. 3

GROWTH CAPITAL/MID-MARKET BUYOUT FIRMS.
Firms in the middle group typically invest $20–$100 million in target companies that have already demonstrated an ability to generate earnings from operations. The target companies in this group often need capital to grow or to add a different operating platform for expansion of their overall business.

The growth capital/mid-market buyout private equity firms will adjust their percentage ownership objectives and target-company capital structures depending upon the circumstances of the investment. In a growth situation, the private equity firms will not typically seek majority ownership and control, and the capital structure will not be augmented immediately with new debt. In a mid-market buyout situation, the private equity firms will seek to acquire majority ownership and control of the target company, and they will normally use both equity and new debt in the target company’s capital structure.

Growth capital/mid-market buyout investments are often less risky than those of venture capital firms; investors therefore generally target returns of 25–30 percent. As with the venture capital group, companies using growth capital private equity funds often have difficulty accessing the bank loan and public capital markets, and private equity is one of their few options. Growth capital/mid-market buyout funds will also sometimes fill other gaps in the health care delivery system. For example, a number of private equity–funded hospital operating companies have purchased nonprofit acute care hospitals that otherwise would have been closed by their sponsors.

BUYOUT FIRMS.
This third group of private equity investors typically invest larger amounts of $75 million to in some cases $1 billion or more in later-stage businesses. Increasingly, hedge funds, which use a variety of sophisticated financial tools and trading strategies to increase returns, are also participating in buyouts of health care companies; we have included them as part of the buyout firm category. Because private equity investors are motivated to effect profitable change, they can bring increased market credibility to a transaction and create better access to debt financing for the target company. There is less risk in investments in later-stage businesses, so large buyout firms generally target lower portfolio returns of 20–25 percent. Actual returns for all buyout funds as of 31 December 2007 were 21.2 percent and 8.3 percent for one-year and ten-year investment horizons, respectively. 4

Venture firms have been, and continue to be, an important source of capital for start-up and early-stage businesses, but health care buyout activity has increased dramatically in recent years. Fueled by plentiful private equity money, merger activity in general in the United States was strong in 2007, with total merger volume of $1.6 trillion, up 9 percent from 2006. 5

Institutional investors are investing heavily in private equity and are putting more of their money into funds managed by buyout firms. U.S. buyout volume grew from $233 billion in 2006 to a new high of $434 billion in 2007. 6 Buyout firms have started to focus more resources on health care, and the managers have been using more leverage in their transactions than they did in the past. The risk profiles shown above reflect differences based on the stage of company and type of investments undertaken. The level of risk is also increased by expanded leverage.

In the early quarters of 2007, and prior to increased credit and liquidity concerns stemming from 2007’s subprime mortgage industry problems, buyout firms generally had been funding on average only about 30 percent of a transaction’s value with equity. That kind of equity ratio was down ten points or so from what banks required as recently as 2002, when equity contribution was slightly over 40 percent. Leverage multiples in sponsor-to-sponsor transactions went as high as about seven times earnings before interest, taxes, depreciation, and amortization. More recently, in recognition of continuing financial institution stress, equity ratios have been forced back up, and leverage ratios have fallen. In many cases, financial maintenance covenants in borrowing structures have also been tightened.

We expect that the tightening of the credit markets in 2007 and 2008 will make very large health care services buyouts the size of HCA or ManorCare much less likely in the foreseeable future. Nonetheless, growth capital/mid-market buyout and buyout firms still have large amounts of equity capital to invest, and they are actively seeking opportunities, with an increased focus on health care services.

PRIVATE EQUITY INVESTMENT THEMES
Private equity has had much activity in acute care hospitals, long-term care facilities, ambulatory surgery centers (ASCs), dialysis centers, clinical labs, home health services, hospice care, “storefront” medicine, disease management, behavioral health, and physician practice management. Fund managers identify segments of the industry where they believe that they can outcompete existing businesses or establish new business models that will supplant other forms of service. These private equity–financed businesses may bring a sharper level of competition to the markets they enter. When they are able to deliver better-quality or lower-cost services, or both, they will challenge the status quo and incumbent providers. Since private equity investors gravitate toward investments in sectors where reimbursement rates and methodologies are stable or expected to be predictable, established nonprofit health care services organizations will likely face increased competition in lines of business with better reimbursement and profitability.

We have distilled the motivating factors behind private equity interest in health care services into four broad investment themes.

INVESTMENT THEME 1.
Provider sectors that are large and have relatively stable cash flows such as acute care hospitals, long-term care facilities, and ASCs allow private equity mangers to invest large amounts of capital to increase the returns of these companies. Large private equity funds have raised significant capital and therefore have the capacity to buy out public or private investors in these relatively mature sectors, which have relatively predictable, albeit intricate, reimbursement structures that result in stable operating cash flows. Stable-cash-flow environments make it safer for managers to spend sizable amounts of capital to lower costs and increase profitability over the long term. In the private setting, managers can deploy capital with longer-term investment horizons and potentially much greater rewards than can publicly traded companies, which often find themselves managing quarter-to-quarter financial performance. Significant buyouts and recapitalizations have been completed in the hospital, long-term care, and ASC sectors (Exhibit 2 ). Going forward, uncertainty surrounding long-term care reimbursement may dampen some interest.

INVESTMENT THEME 2.
Sectors such as dialysis and clinical laboratories, where one or two dominant players have emerged in recent years, still have room for platform companies to assume the “number three” or “number four” role. 7 Private equity fund managers will often ride the wave of consolidation as they seek to aggregate smaller participants in various fragmented sectors.

Exhibit 3 illustrates how private equity investments have recently come into both the dialysis and clinical lab sectors to create next-generation competition for established dominant participants. These investments are smaller than those identified in the first theme and can be done regionally, but the strategy is dependent on the expectation of a large, growing health care market with room to accommodate additional competition.

INVESTMENT THEME 3.
Alternative-site investments that create value provide opportunities in home health, hospice, and “store-front” medicine (Exhibit 4 ). Problems in the current health care system and demands for improvements in the delivery and financing of health care can provide opportunities for private equity investors. Many alternatives to traditional hospital- and physician office–based care attempt to improve quality, deliver consumer convenience, and decrease costs. Investors in these alternative business models are seeking opportunities to develop more-effective care in businesses where reimbursement allows profitable operations. Areas such as home health and hospice have a longer history as part of the traditional nonprofit health care system, but for-profit companies are now participating in these kinds of businesses as well. 8

Other similar strategies are in earlier stages of development and are still relatively small in terms of revenue and profits. “Storefront” medicine and urgent care centers are two examples, and this is the natural domain of growth capital firms. In response to consumers’ demands, the retail clinic–oriented service model provides limited patient care services that are convenient and cost less than traditional services. The private equity investors in the storefront medicine companies Minute-Clinic and Take Care Health Systems recently sold them to CVS and Walgreen Company, respectively. These and other sales of private equity portfolio companies to strategic buyers are consistent with typical private equity fund objectives of three-to-seven-year holding/development periods before harvesting gains.

INVESTMENT THEME 4.
Improving the delivery of clinical services offers opportunities for profitably improving quality and lowering costs (Exhibit 5 ). Improving disease management and behavioral health programs and emerging new breeds of physician group practice companies have therefore been the focus of private equity dollars.

DISEASE MANAGEMENT.
Disease management puts in place systems that increase the likelihood that patients with chronic diseases will receive consistent care based on evidence-based treatment guidelines and that care will be coordinated among providers. For chronic conditions, it has been shown to improve the process of care and disease control for patients, but cost savings have been harder to demonstrate. 9 The disease management growth opportunity is driven by prevalent chronic illnesses in the Medicare population and rising eligibility. These factors create demand for disease management approaches that can both improve quality and decrease spending through development of models of care that combine current disease management approaches with innovative uses of remote monitoring and new technology.

BEHAVIORAL HEALTH CARE.
Behavioral health is an important chronic condition with a shortage of effective treatment settings and therapies in many areas. Opportunities vary by state, but twenty-three states now have ”strong” parity laws that require insurance coverage of behavioral health services and limit higher cost sharing for mental health services. 10 Equity investments in this sector seek to fill a demonstrated need with business models that generate sufficient revenues to deliver profitability. Although uncertainty in reimbursement for behavioral health dampened investments through 2007, new reimbursement stability is a positive motivator for future investment.

PHYSICIAN PRACTICE MANAGEMENT.
The story of physician practice management in the 1990s ended with mostly unsuccessful companies and sizable investor losses. The business model used then to create and grow these entities was flawed. Capital arbitrage and financial engineering could not overcome the lack of value-added infrastructure or operating synergies, which resulted in productivity losses and disappointing operating margins.

A different breed of physician group practice companies has emerged into increasing prominence. These companies are different from their predecessors in that they originate from best-in-breed, physician-centric entities that have invested in operationally excellent patient care. Physicians in these organizations have often worked together for long periods of time and are equity owners of the organizations in which they work. These groups are more tightly organized than in the previous model and are able to achieve measurable synergies and better care delivery through an integrated organizational structure and better aligned physician compensation incentives. Because of their strengths in particular markets, they will frequently command superior managed care reimbursement, as well.

Private equity investors believe that segments of health care services present important opportunities to put large amounts of capital to work profitably both in mature, large-scale companies and in new business models that aim to provide care with lower costs and more convenience for patients. Private equity can be an important source of otherwise unavailable capital for innovation, and it also represents a competitive force for change in established health services markets as private equity investors grow focused, bottom line–oriented competitors. Although it is still too soon to tell how big an impact private equity entrants will have on changing the overall health care delivery system, established health care services organizations should be aware of both the competitive threat of these investors and the possibility that useful quality, care, or cost innovations will arise from these companies.