Strategic health care M&A requires strict capital allocation discipline, despite falling rates

The environment of easing monetary policy is encouraging overall dealmaking activity in the health care industry. Even so, leading strategic organizations must continue to evaluate acquisitions, divestitures, joint ventures and other investments through a rigorous capital allocation lens.

September and November’s cumulative rate cuts of three-quarters of a percentage point by the Federal Reserve provided health care organizations, strategic investors, and alternative investors such as private equity a welcome sign that dealmaking would become less expensive and more deals would get done.

It's too early for much of the post-rate-cut dealmaking to show up in official data. Based on our conversations with financial and strategic buyers, we have seen meaningful increased interest in health care transactions since September. Historically, strategic buyers like hospitals, health systems and payers have executed a consistent number of deals quarter over quarter. As the changing rate environment affects the operating environment, we expect strategic players will evaluate more deals, at a rate above the historical averages.

However, the easing rate environment does not mean future dealmaking will necessarily resemble the dealmaking of the past cycle.

RSM expects the long-term federal funds rate to fall to 4.5% by the end of the year, and to 3% by the end of 2025. This still represents a significant premium over the 0.7% rate during the prior cycle (between the end of the 2008−09 global financial crisis and the onset of the COVID-19 pandemic). We expect the weighted average cost of capital, or WACC—which represents the opportunity cost of financing investments—for health care organizations will remain elevated as a result.

The still-elevated rate environment may provide strategic buyers with an advantage over financial investors such as private equity sponsors. Strategic buyers may bring additional synergies to a deal that helps rationalize a higher purchase price; a private equity sponsor may have paid those multiples in the past when rates were lower. Of course, strategic buyers do not want to pay for the value they bring to a deal, but in the real world of competitive bids, they are often required to pay for some portion of that value. 

Capital allocation in the new macroeconomic regime

However, strategic investors need to be diligent capital allocators when negotiating and closing deals. Evaluations of potential acquisitions must weigh the present value of future benefits, such as cash flow, as well as advantages to the community, against the cost of the acquisition. And, most importantly, this analysis must be done within the context of the buyer’s opportunity cost of financing such investments—its WACC. Ignoring the WACC may destroy enterprise value, even if an investment is accretive to the buyer’s future benefit streams.

For example, assume a buyer is contemplating an acquisition of a large portfolio of urgent care clinics, ambulatory surgery centers and other outpatient clinics. The buyer has prepared an estimate of future cash flows and has converted them to present value based on an expected discount rate of 8% to 12%. This range represents management’s expectations of future risk associated with the projected cash flows.

If the risk is 8% to 10%, the acquisition will add to the enterprise’s overall value relative to the proposed $350 million cost of making the acquisition. As a reminder, this is a highly stylized example, although we can assume the “value” of the acquisition includes nonfinancial elements that are important to the buyer, such as expanding its mission.

In the prior rate environment, the analysis may have ended here and been sufficient. The federal funds rate was near zero, and therefore financing was plentiful.

However, in an environment of higher rates, buyers must also consider the opportunity cost of their financing. If the hypothetical buyer from the above example estimates their own WACC at 11%, then purchasing the outpatient provider may destroy stakeholder value even if the estimated risk associated with the acquisition is only 8% to 10%. That’s because the future benefit—the future return on investment—is estimated to be below the opportunity cost of the funds (11%) needed to make the acquisition. This would be analogous to an individual taking out a mortgage to buy an investment property at 6%, and after collecting rent, the investor sees only a 3% return.

These fundamental financial theories are worth revisiting. They were less important—perhaps even unimportant to some investors—during the prior period of near-zero federal funds rates. This is no longer the case.

Strategic investor advantage

Strategic investors may be able to leverage increased synergies in areas such as back-office functions and purchasing, or lower costs of capital, to win deals in a competitive environment. Returning to the previous example, the same buyer may evaluate for potential synergies as they negotiate the deal.

If the buyer expects they can achieve the highlighted synergies net of implementation costs and achieve the 12% return with an 11% WACC, this deal may make sense. It will create stakeholder value, even if the acquired enterprise value less the cost to acquire is zero, because it will generate a rate of return higher than the cost of financing that return. From an enterprise perspective, it may make sense to allocate capital to this acquisition, assuming no other competing uses of funds can provide higher returns.

Certainly, market participants prefer much wider margins of value creation, and may still pass on this deal even if the math supports it as accretive to stakeholder value. However, the point is that this exercise is part of the careful due diligence that is once again a necessary part of strategic decision making.

As an aside, one additional way strategic investors can expand opportunities for value creation is by reducing their WACC. Strategic investors may have additional advantage here over financial buyers, given access to different financing sources and investment horizons.

The role of de novo growth

Ultimately, some business expansion calls for the classic make-or-buy decision process. Strategic buyers cannot always grow the capabilities or market access organically—known as de novo growth—that they could otherwise purchase through an acquisition or joint venture. However, from a capital allocation and stakeholder value perspective, it is worth comparing whether to use cash for an acquisition or de novo growth.

The example below shows the same hypothetical buyer contemplating a de novo expansion into a new market. Note the revenue and cash flow are significantly lower than what the potential acquisition could provide, and the risk associated with the expected return is also higher. However, the cash outflows are also much lower.

The net present value of the investment across the spectrum of expected risk is positive—and because all expectations are above the WACC of 11%, this expansion will likely be accretive to stakeholder value, despite generating significantly less cash flow than the acquisition contemplated earlier.

The takeaway

The increased cost of capital has meaningfully influenced capital allocation decision-making. During the prior macroeconomic cycle, the opportunity cost of making investment decisions was less important because rates were lower. Cash-flow-positive investments would generally increase value. However, despite falling interest rates, we expect the cost of capital will remain elevated. Therefore, leading organizations will need to more carefully evaluate how they allocate capital among acquisitions, de novo growth and other investments.

This dynamic may provide strategic investors with a dealmaking advantage. To the extent they can leverage their unique competitive positions to drive increased synergies or reduce their own costs of capital, they can price competitors out of deals without overpaying.