The sector’s historic use of debt financing is chequered. Around ten years ago, large private equity investors began to identify the sector as one with good growth potential, driven by an ageing population. Private equity funds started to invest in very large care groups and built sites across multiple regions in the UK. However, the return on investment from these assets does not tend to benefit much at all from economies of scale, and the running cost of a care home, for example, can be very ‘localised’ to each individual site. This made it difficult to discern whether an individual service would be a viable investment.
A troubled past
One way for these equity investors to extract capital value was to enter into sale and leaseback agreements, where the underlying property asset, for example a care home building, was sold, often to a specialist property investor, and then leased back over a very long-dated, inflation-linked lease structure. This allowed large, one-off capital injections to come into the business, but at the same time left the operators with often onerous, high, fixed lease costs.
When revenue started to come under pressure, there was no flexibility in these leases and operators were forced to succumb to their lessors under the burden of the high cost of servicing debt.
The fate of Southern Cross is one notable example, where expensive leases could not be paid, so the landlords made a call on the assets. The financial problems of Four Seasons Healthcare Group, which are down to different circumstances, although still debt-related, have also been well publicised, and this has added to some lenders’ concerns about lending to the care sector, making debt raising more difficult for some.
During the pre-financial crisis years – up to 2007 – bank lenders (mainly the UK clearing banks) had a strong appetite for lending to care home owners and operators. Much of their lending was focused on smaller, mainly family-owned businesses with a handful of localised assets. These businesses did not have the same sale and leaseback structures as their larger competitors and, on the surface, their financial reports would not have looked to be overly stretched in terms of debt levels; in financial terms, their level of ‘gearing’ would have been low.
However, it was during this time that the bank lenders started to sell large amounts of financial derivatives – contracts that require payment of a fixed rate of interest over a long period of time – and many care homes entered into these. They were positioned as safe risk-management tools (to limit risk from rising interest rates), but in reality, many of them were very complex, structured products. Once interest rates started to fall (2008 onwards), the financial costs for owners and operators began to soar. There was no opportunity to exit these contracts, as their termination penalties were prohibitively high. In some cases, the termination penalties were higher than the actual underlying debt. For example, one borrower had a loan of £25m, and a fixed-rate derivative, which, if cancelled early, had a termination penalty of £28m.
What came next was a slew of lawsuits against the banks. These lawsuits were driven by the Financial Conduct Authority (FCA) investigation into the banks’ sales practices, and those found at fault were issued with an instruction for how compensation had to be calculated.
Given this history of debt financing, it is no surprise that both borrowers and lenders are approaching debt with some trepidation.
However, the debt financing market has moved on in the last three to four years and there are now many more choices of suitable debt sources that come with much lower risk. Furthermore, lenders are now attempting to evaluate borrowers on their own merits and not treat the sector as one homogenous group.
The presentation of your business in terms of its operating metrics and financial status is critical to ensure the debt structure and the cost of debt are optimised to your particular situation. Operating metrics, acquisition opportunities, capital expenditure plans, and the mix of private pay versus local authority clients in your service will all be scrutinised when assessing your business.
The cost pressures facing the sector are well-documented and, when combined with constrained revenues, are forcing operators to undertake detailed analyses to forecast their financial performance and demonstrate to lenders that they have some resilience.
Know the market
Analysis of key organisations across, for example, the not-for-profit care sector, reveal operating margins (before accounting for debt and investors being paid) of around 12% on average over the past four years. The range of profitability in the not-for-profit care sector is broad, with some organisations showing negative operating margins, to organisations with margins of around 40%.
This range is further impacted by the differences seen in cost of capital – the cost of debt and the amount paid to investors – and the different types of funding that operators have in place. The cost of interest and capital repayments, including debt and operating leases, can take up over a third of available cashflow (the average for the whole care sector over the last four years).
The way the sector operates means it is left very exposed to adverse changes, such as increasing staff costs or reduced payments from local authorities, as well as potentially rising interest rates, to name just a few. Borrowers need to be able to demonstrate to lenders how they are managing these risks and demonstrate their strength against industry benchmarks.
While large private sector care groups can access a wide range of funding sources due to their scale and diversity, charitable groups have been more restricted to bank debt or some type of leasing product.
The growth of the socially responsible investment market has opened other avenues, in particular the bond and private placement market, where borrowers can raise medium- to long-term funding. Access to this market can be direct; charities can use the Retail Charity Bond (RCB) platform, which issues a bond in the charity’s name and then lends the proceeds to it.
These 7- to 12-year fixed-rate bonds are sold to a wide range of socially responsible investors (SRIs) as well as institutional investors and can be bought by retail investors via their stockbroker, substantially widening the charity’s potential supporter base.
A hopeful future
Overall, there are still many headwinds facing the social care sector, and some tarnished reputations remain from past troubles. However, as an industry that serves such an important social purpose, ensuring its financial viability should not only be the focus for owners and operators, but also advisers, financiers and Government.
Funding markets have changed materially since 2014/15. New investors and lenders who are not carrying any pain from previous losses have entered the market, and they are keen to make successful equity investments and debt offerings.
Structuring your business plan and sensitising the assumptions (cost of debt, inflation assumptions, wage costs, revenue mix) to evidence your adaptability will give lenders confidence. Due to the much broader source of finance available now compared to before the financial crisis, debt structures can be better tailored to each individual circumstance, with flexibility built in to accommodate potential shocks. The sector has realised there is no one-size-fits-all approach, and it is now beginning to shake off the misjudgements of the past and reset expectations for the future.
To discuss any of the issues raised in this article, please contact Jackie Bowie or call on +44 (0)207 493 3310.