Private credit outlook for health care: Leveraging capital for growth

OUTLOOK | February 23, 2024

Authored by RSM US LLP

Private credit will play a larger role in health care merger and acquisition activity and corporate financing decisions in 2024 and beyond. The asset class has grown substantially as investors have taken advantage of rising real interest rates and companies struggle to secure traditional bank financing. Market expectations of lower interest rates in 2024 will drive deal-making, which, along with company refinancing, will provide private credit investors with a plethora of additional investment opportunities.

While the asset class is not new, private credit has recently attracted considerable attention from investors. One measure of investment is the par amount of loans held by publicly traded business development companies (BDCs). These companies issue private loans primarily to small and medium-sized enterprises and are an important channel of capital into the middle market. In the last 10 years, the par value of all BDC loans rose to over $217 billion from $55 billion—a 40% annual increase—and nearly one-third of this increase has occurred in only the last two years, according to PitchBook and Leveraged Commentary & Data findings compiled by RSM. 

Some of the recent increase was driven by new BDCs going public, further underscoring the attractiveness of private credit. In fact, in the first few weeks of January, four BDCs filed for initial public offerings, according to Bloomberg.

More health care organizations will tap private credit markets

Health care organizations, particularly health care providers, will need to raise and refinance capital to meet operational challenges. Those funds will increasingly come from private credit. Not only is the asset class growing at a considerable pace, but health care is a favored sector of private credit lenders. BDCs, for example, hold a significant concentration of loans in the health care industry.

Refinancing old debt will be one key use of private credit funds. According to data compiled by Bloomberg, health care providers hold $25 billion of debt that matures this year, and $36 billion maturing next year.

Typically, companies refinance debt with similar terms and similar lenders. However, in the time since much of this debt was issued, rates have increased dramatically, and lenders that were eager to finance a company at lower rates are now hesitant to take on the risk associated with higher-yielding debt. Enter private credit lenders, which are often more willing to accept higher risk and we expect will participate heavily in refinancing.

The second primary use of private credit will be to underwrite new mergers and acquisitions. Last year marked a slower period for deal-making across industries, and health care was no exception. This year deal-makers are more optimistic. They expect the Federal Reserve to cut interest rates, which will provide some relief to investors making new acquisitions (and to companies refinancing debt). Indeed, reports from the January J.P. Morgan Healthcare Conference, an industry bellwether, suggest 2024 deal-making will surpass 2023, although it is unlikely to hit 2021 levels of frenzy.

Deal-making activity will be further encouraged by the desire of private equity sponsors to exit investments. Sponsors need to regularly sell their investments to provide liquidity to their investors—the limited partners—to continue raising and deploying new capital. Previously, as interest rates increased, business valuations decreased, and many sponsors sat on the sidelines waiting for conditions to improve before exiting. Many sponsors have now waited about as long as they can and will sell in the current environment, which will drive deal flow and demand for private credit.

Challenges facing health care lenders

Experienced lenders understand that financing a business in a heavily regulated industry like health care presents a variety of challenges that do not exist in other market sectors. This is particularly important as new market participants work in health care for the first time or seek to expand their presence in the sector. Considerations include:

• Structural challenges. In the last 10 years, an extraordinary amount of capital has been loaned to physician and dental practice groups. To comply with state laws limiting the delivery of medical care to licensed practitioners (“corporate practice of medicine” statutes), private credit lenders typically issue loans to a management services organization (MSO). The MSO owns many of the assets needed to conduct a medical or dental practice, including contracts with third-party payers, accounts receivable, medical equipment and office leases.
• Regulatory challenges. The health care industry is regulated heavily at both the state and federal levels. Compliance within a constantly changing maze of health care laws and regulations is labor-intensive, expensive and fraught with risk.
• Liability challenges. For a financially troubled company that needs to restructure its balance sheet, all liabilities are challenging. But for health care companies, certain types of liabilities are more acute than others. For example, Medicare overpayments and liabilities arising under the False Claims Act and anti-kickback statutes pose unique threats to health care businesses and private credit lenders. 

The takeaway

Private credit lenders will expand the funding options for health care organizations, particularly providers, as they navigate the challenging operating environment. These organizations will seek to refinance debt, much of which was issued at low interest rates, or acquire competitors. Investors will continue to allocate capital to private credit funds, which will provide liquidity to health care organizations—a favorite target for private credit. Meanwhile, the availability of these funds and desire to transact among private equity sponsors will drive increased deal flow in 2024.

As new private credit players and funds enter the ecosystem, they must expand their evaluations of industry challenges. The structural challenges present in health care will not abate in the foreseeable future, and cautious underwriting will improve returns.