Post-Acute Sector M&A: Currently Under a Yellow Flag

Nothing kills the momentum and excitement of race day more than the yellow flag and deployed safety car. Unsafe track conditions, usually caused by an accident, debris on the track or a stopped
vehicle, can cause the marshals to slow down the race. Momentum moderates and
adrenaline wanes. Drivers are forbidden from overtaking, and victory is temporarily out of
sight for all but the lead car. As I watched the Indy 500, 24 Hours at Le Mans and a
handful of Formula One grand prix over the last several weeks, it struck me that postacute sector M&A (home health, hospice, Medicaid PCS, pediatric PDN/therapy) is currently racing under yellow flag conditions. Temporary, but nonetheless frustrating for all constituents involved.

The post-acute sector’s two record setting years in terms of transaction activity, valuation
multiples and quality of companies acquired, 2020 and 2021, now appear to be in the
rearview mirror. In their stead is a sluggish 2022, with companies staying in their lanes,
focused inwardly on operations and trying to regain levels of growth and profitability of
prior years. It should come as no surprise that sector activity has slowed: (i) the supply of
actionable platforms is materially lower than in the prior two years; (ii) the COVID spawned labor market continues to create one of the most challenging operating
environments in recent memory; (iii) home health reimbursement faces a potentially
challenging outlook when the CY 2023 HH PPS rule is finalized in the Fall; and (iv) buyers
are less willing to give credit for COVID-related EBITDA adjustments.

Lower Inventory of Actionable Platforms
Many of the most actionable privately-held and sponsor-owned platforms transacted at a
kinetic pace in 2019, 2020 and 2021. As a result, the number of available platforms is
relatively low, and the sector is currently in a holding pattern, where businesses are (i)
focused on operating in a challenging environment, (ii) too early in their hold period, or (iii)
waiting for financial performance to improve, before coming to market. There is a large
and growing backlog of businesses that we expect to come to market when overall
conditions improve, potentially as early as Q4 2022. But in the meantime, the market is
generally in wait and see mode.

Labor Market’s Impact on Performance
Q4 2021 was one of the most challenging quarters for post-acute operators, particularly
hospice, as the Omicron variant wreaked havoc on staffing and admissions volumes.
Despite strong referral volumes and demand for post-acute services, the inability to

sufficiently hire and retain clinical staff has had a material impact on monthly sequential growth and TTM performance. For many, Q1 2022 was only marginally better, and for some, Q2 2022 continues to present challenges, although, anecdotally, the clinical labor market appears to be improving and may even accelerate due to the looming recession. As a result, companies are deciding, or being forced, to delay sale processes as they attempt to replace poor financial performance in Q4 2021 and Q1 2022 with improved 2H 2022 growth and profitability.

Pending CY 2023 Home Health PPS Rule
Based on the proposed rule released last week, CMS estimates that Medicare payments to home health agencies in CY 2023 would decrease in the aggregate by -4.2%, or -$810 million compared to CY 2022. Without getting too technical and comprehensive, this decrease reflects the effects of the proposed 2.9% home health payment update percentage ($560 million increase), an estimated 6.9% decrease that reflects the effects of the proposed prospective, permanent behavioral assumption adjustment of -7.69% ($1.33 billion decrease), and an estimated 0.2% decrease that reflects the effects of a
proposed update to the fixed-dollar loss ratio (FDL) used in determining outlier payments ($40 million decrease). Prospective home health sellers will most likely wait for better clarity on the final rule before coming to market.

Market Push Back on COVID-Related EBITDA Adjustments
Buyers and lenders have materially increased their scrutiny of COVID-related volume adjustments to EBITDA. Early in the pandemic, the market was quite willing to pay sellers for normalized volumes and financial performance, as if “COVID had not happened.” 27 months later, the market is taking a harder line. “What if” earnings credit is no longer being given wholesale. The market has taken the position that labor staffing challenges and higher labor wage expense are here to stay (for now), and, unless a seller has clearly demonstrated a trend to the contrary, little to no valuation / leverage credit
will be given for such adjustments. As a result, prospective sellers must increasingly rely on actual earnings to ensure the achievement of valuation expectations.

Returning to our racing analogy, post-acute sector M&A is currently under a yellow flag. And while yellow flag conditions produce little to no racing action, and can last for many laps, they are still only temporary. Drivers and their teams can use the time to their advantage – to “box” or “pit” in order to change tires, refuel or tweak the car – so that they are ready to drop the hammer once the yellow flag is lifted. This is exactly what the higher quality post-acute platforms are doing. Some of the most exciting action in a race comes once the safety car exits the track and green flag racing resumes. Given the strong near- and long-term demographic and sector trends supporting the post-acute sector, and the almost unlimited demand for high quality post-acute platforms, there is little doubt that M&A activity will resume with a vengeance.

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