LB Uh-Oh: Leveraged Buyouts Spell Trouble in the Healthcare Industry

By: Tarquin McGurrin, Class of 2024

Background

Leveraged buyouts (“LBOs”) occur when an individual, fund, or company wishes to buy another company, but lacks the requisite funding.[1] In these situations, the buyer, typically a private equity (“PE”) firm, will borrow a portion of money (“leverage”) and use either the target company’s assets, such as accounts receivable or inventory, or future cash flows, as collateral for the debt.[2] Consequently, the target’s acquirer will attempt to improve business operations and use the future cash flows from the acquisition to pay these loans and interest, thus converting the debt to equity and eventually selling the business for a profit.[3] The acquirer can realize the financial returns from an LBO by exiting the transaction in multiple ways, including selling to a strategic buyer or PE fund, engaging in an initial public offering (“IPO”), or participating in a dividend recapitalization, where the acquirer issues debt to raise cash and pay shareholders a special dividend.[4]

As recent studies show, a positive correlation exists between increased PE investment funding and problems arising in certain industries due to incompatibilities with this activity.[5] In financing transactions with borrowed money to increase returns, PE firms run the risk of saddling the target company with debt that cannot be sufficiently serviced with the deal’s cash flow to improve the acquired business’s operations and investments.[6] To avoid this result, acquirers will sell off asset divisions, lay off employees, and replace senior management.[7] Elon Musk’s recent and contentious “take-private” of Twitter Inc. (“Twitter”) exemplifies these principles as Musk attempts to satisfy his creditor obligations by turning Twitter into a lean business.[8]

LBOs in Healthcare

In the healthcare industry, a clear dichotomy exists between PE funds, which are focused on generating short-term revenue and consolidation, and health care companies that hope to provide care to ensure the long-term well-being of their patients.[9] Notwithstanding the fact that LBOs are meant to add value to a company, recent data indicates that these deals lead to higher prices and diminished quality of care.[10] These results follow when PE firms in the healthcare sphere implement technically legal strategies to reduce costs, such as hiring employees with insufficient training to perform skilled jobs, thereby putting unsuspecting patients at risk.[11] Additionally, the health care industry already suffers from concentration of services and anticompetitive practices, and PE firms exacerbate these issues and push them onto consumers as a so-called “anti-maverick.”[12] Furthermore, though the healthcare industry is highly regulated, most private equity companies operating in this sector are not subject to discipline by federal antitrust or financial regulatory authorities.[13]

Potential Consequences

As a recent Bain & Company report indicates, global healthcare systems will likely continue to trend toward private markets as recent healthcare initial public offerings (“IPOs”) and special-purpose acquisition companies (“SPACs”) have not fared well and may face enhanced regulation.[14] As a result, the Federal Trade Commission (“FTC”) may increase its scrutiny of PE acquisitions through a regulatory overhaul.[15] Accordingly, PE players in this industry should engage in thorough due diligence and early planning to ensure acquisitions create sufficient value to service debt and preserve an adequate level of care for patients.[16]

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[1] See James McNeill Stancill, LBOs for Smaller Companies, Harvard Business Review (Jan. 1988), https://hbr.org/1988/01/lbos-for-smaller-companies.

[2] Id.

[3] See Paul Pignataro, Leveraged Buyouts: A Practical Guide to Investment Banking and Private Equity 3 (2014).

[4] Id. at 5.

[5] See Larry Roth, The Risks of Becoming Over-Leveraged by Private Equity, Forbes (Oct. 23, 2019, 8:30 AM), https://www.forbes.com/sites/forbesfinancecouncil/2019/10/23/the-risks-of-becoming-over-leveraged-by-private-equity.

[6] See William T. Allen, Reinier H. Kraakman, Vikramaditya S. Khanna, Commentaries and Cases on the Law of Business Organization 316 (6th ed. 2021).

[7] Id.

[8] See Olivia Raimonde, Paula Seligson, More Pain Ahead for Banks as Investors Balk at Risky Buyout Debt, Bloomberg (Sept. 29, 2022, 1:49 PM), https://www.bloomberg.com/news/articles/2022-09-29/more-pain-ahead-for-banks-as-investors-balk-at-risky-lbo-debt. This acquisition included three billion in unsecured bonds, which are more risky and difficult to offload than other types of debt. Id.

[9] See Richard M. Scheffler, Laura M. Alexander, James R. Godwin, Soaring Private Equity Investment in the Healthcare Sector: Consolidation Accelerated, Competition Undermined, and Patients at Risk 4–6 (2021).

[10] See Fred Schulte, Sick Profit: Investigating Private Equity’s Stealthy Takeover of Health Care Across Cities and Specialties, Kaiser Health News (Nov. 14, 2022), https://khn.org/news/article/private-equity-takeover-health-care-cities-specialties; see also Scheffler, Alexander, Godwin, supra note 9 at 8.

[11] See Schulte, supra note 10.

[12] See Scheffler, Alexander, Godwin, supra note 9 at 45–47. It is important to note that in many other industries monopoly prices would reduce consumption, but the healthcare industry is an exception to this general notion. Id. at 46.

[13] Id. at 50–52.

[14] See Nirad Jain, Kara Murphy, Franz-Robert Klingan, Dmitry Podpolny, Vikram Kapur, Healthcare Private Equity Outlook: 2022 and Beyond, Bain & Company (Mar. 15, 2022), https://www.bain.com/insights/2022-and-beyond-global-healthcare-private-equity-and-ma-report-2022.

[15] See Schulte, supra note 10.

[16] See Jain, Murphy, Klingan, Podpolny, Kapur, supra note 14.