Bowmark Capital's Kevin Grassby dissects private equity's fittest proposition

Now is the time for many private equity investors to play it safe. That is why, increasingly, the healthcare industry is the sector where they are looking to invest.

According to a Grant Thornton survey, private equity firms are prepared to pay a premium for healthcare companies, which are ranked the joint highest sector alongside media and communications, with buyers anticipating to pay eight times EBITDA over the next 12 months.

Katherine Steiner-Dicks speaks to Bowmark Capital's Kevin Grassby about the market drivers that justify such high multiples in the midst of a credit crisis, and why building a network of seasoned entrepreneurs to tackle the changing dynamics of a maturing private healthcare industry is a smart move.

The healthcare sector, in which Bowmark specialises, has not been as scathed as other sectors throughout the financial crisis. There have even been reports that private equity-backed healthcare businesses on the selling block can expect double digit EBITDA multiples. Is this something that you have witnessed when looking at potential investments this year?
Healthcare has been a popular sector for private equity investors for a number of years. The combination of government-backed revenues and increasing demand based on demographics, with investments often supported by real-estate assets, makes the sector popular with banks and investors alike. There were some businesses that took on too much leverage, usually to fund very high acquisition prices, at the wrong time in the cycle and they have subsequently struggled. However, growth opportunities still remain and well-positioned businesses that can mitigate future government funding pressures are still able to command premium EBITDA valuation multiples.

What are some of the big issues affecting the healthcare sector?
The big issues for the sector right now are the impact of government spending cuts and the opportunities arising from the restructuring of the NHS. From a macro point of view, the private sector should be well positioned to help deliver more efficient and better value services and should be a beneficiary of the drive for cost savings. In the short term, businesses that are totally reliant on government funding will face increasing pressure, but those providing cost savings or improved quality outcomes should be able to offset margin pressures with volume gains.

This new environment will require investors to be more selective and to focus on growth rather than financial engineering as the main driver of investment return.

What makes private equity and turn around expertise a good match for the healthcare and residential home sectors?
As I mentioned earlier, there were a number of high profile deals done before the credit crunch where extremely high levels of leverage were used to fund very high transaction prices. Four Seasons in the elderly care space being a prime example.

At the lower end of the spectrum, smaller operators also geared up, often taking on bank debt to fund developments or acquisitions or to fund dividend distributions to shareholders. Now the environment has changed, a number of operators are at best constrained by their balance sheets, at worst they are in the hands of their bankers. Such situations will often need new management and new capital to help unlock an impasse, which is where private equity in combination with experienced management can have a role to play.

Are there certain steps that Bowmark takes to ensure that going into a deal its management are the best of breed? For example, how does the firm assess them pre-deal and during the life of the investment?
We like to spend as much time as possible with management in advance of investing to make sure we have a shared vision of, and strategy for, the future, and to work out how the broader management team will need to be supplemented over time.

As our industry matures, it is becoming increasingly important to have a very clear understanding of how a business will develop and grow under our ownership and how that is going to be implemented in partnership with management. We see it as our role to help develop a best of breed team for each of our businesses. As a result we have recently been developing a management network, or bench of talent, in each of our target sectors, which can work with us to initiate, evaluate and transact deals and, if the situation is right, to become involved in the management of new investments. In this regard, PILOTpartners has been helpful in introducing people to us, which supplements our own efforts.

How does Bowmark tend to replace and/or add board level executives when making acquisitions?
Supplementing and enhancing management in our portfolio companies is a central and fundamental part of what we do. Small, high-growth businesses always need some level of ongoing investment in the management team. If we are buying a business from an exiting entrepreneur, more often than not we will need to add resources to cover his or her role.

Healthcare companies often provide an additional challenge, which is that many are founded and run by care-led entrepreneurs. We have a lot of experience now at supplementing the founders of businesses with commercial managers. Examples include adding Heads of Marketing and Chief Operating Officers as businesses grow in size to enable founders to focus on the areas where they can add most value, such as maintaining key strategic relationships or identifying potential bolt-on acquisitions.

When it comes to investing in residential care for all ages and abilities, what steps do you take to ensure you are keeping residents' best interests at heart, while still making the business as profitable as possible?
After many years of investing in healthcare businesses we have found that the most important thing to focus on is the quality of care. Getting quality right means investing in the people and the systems in the business. If you can get that right, everything else seems to follow. Occupancy, fee rates, staff costs all seem to fall into place once you get the people and systems right.

At Healthcare Homes, our private pay elderly care business, we have 23 homes, all of which are now rated either good or excellent by CQC. This has taken a significant investment in the business, but we believe that the quality rating of a home will be an increasingly important driver of referrals and determinant of fee rates as the industry matures.

Two of our other healthcare investments, Kisimul and Advanced Childcare, which provide residential care andeducation to children with special needs, are also achieving industry-leading quality standards and generate strong operating and financial performances as a result.

In many respects, this is the sales pitch for the private sector's involvement in healthcare. Investment in the assets, the systems and the people allows us to improve quality standards and patient outcomes whilst also achieving our target return on capital. But this comes from enhancing, not compromising on, quality.

Do you believe that the healthcare sector is one that easily feeds the secondary buy-out market?
Yes. Many growing businesses in the healthcare sector require high levels of capital to fund their continued growth, particularly if they are real-estate based. As a result you quite often see businesses passing from one private equity investor to another, with deeper pockets, to sustain a roll-out. Ultimately these businesses transition from being high growth stocks when they are small to more utility-type/infrastructure stocks as they mature, and you see a gradual transition in the investor type as it goes through this process over the longer term.

Many believe that the private equity market has had to change considerably; how has Bowmark changed its investing philosophies, if at all, from before, during, and now after the era of high multiples, overleveraging, and quick flips?
Most of the change in private equity has been enforced at the top end of the market – the billion dollar, high testosterone, 'front page of the FT' type of deals.

These were often over-priced, over-leveraged, highly financially engineered transactions that generated significant negative sentiment, and in many cases, rightly so. At our end of the market (equity investments of between £10m and £50m), we never really saw those types of excesses. Prices never reached the levels of the larger deals, partly because banks wouldn't lend as aggressively to small businesses and partly because the investment hypothesis was usually based on growth and required cash to be recycled into capex and working capital rather than deleveraging.

Our investment philosophy at Bowmark has always been to back businesses to grow. This has nearly always meant holding on to investments long enough to demonstrate the fruits of our labours, rather than achieving a quick exit where any value growth is based on multiple arbitrage. As a result, our investment model hasn't changed and our focus on medium term growth remains at the heart of what we do.

There are a number of UK based firms that are now looking more towards Europe for value investing; is this something that Bowmark has contemplated?
Everything is leading towards greater specialism these days. So, I see us continuing to strive to get better at what we already do here in the UK rather than moving into new geographic markets.