Despite significant attention paid to the behavioral health space by private equity over the past decade, workable theses have proven, as of yet, elusive. Certainly deals have been made and some firms have come out ahead, but this has most often been the result of fortuitous market timing rather than any thesis realization or value creation. Additionally, with the cost of capital being at historic lows until just recently, the purchase of any growing company could lead to a successful exit. Many firms were able to ride a wave of low-cost capital or hot markets independent of their ability to create value within the portfolio company.
Yet, despite these tailwinds of cheap capital and apparent high demand, the behavioral health space remains littered with far more dead bodies than it does successful exits.
Having been through multiple waves of rising then declining investor interest within behavioral health service lines and with over $3 billion worth of insights across varying models, we see the primary reason for this as due to a mismatch between investor theses and effective value creation. In short, the investor thesis is wrong and a critical look at value creation within behavioral health is needed to improve future ventures into the space.
In this article, we’ll take a look at the most common assumptions found in private equity theses within behavioral health, what may be incorrect about them, and what overlooked value creation models are likely to be more viable.
Back Office Doesn’t Provide Economies of Scale
A very common component of many a PE thesis is the roll-up model. Underlying this thesis are two intertwined strategies:
- The simple fact of having a larger organization leads to a larger multiple. Running 1-4 facilities requires hands-on management, a headache nobody wants. Investors are sometimes willing to pay for larger organizations which can support an executive management team through existing cash flow. This is the basic size multiplier.
- That economies of scale will come into play through consolidated back office operations.
Both thesis components are unsatisfactory from an institutional investor or strategic buyer perspective. In scenario 1, a larger organization only actually has value if the disparate facilities are standardized with the same EMR, RCM, staffing, and operational systems and processes. Since the roll-up model is predicated upon acquisitions, this is rarely the case, with each acquisition having a completely different set of operations and protocols.
Sophisticated buyers are cognizant of the fact that the PE firm has merely created an ugly patchwork quilt of differing providers. Under this model, rather than the single headache that the usual mom and pop entails, there are multiple mom and pops with compounding headaches. We have seen this model fall flat as multiple PE firms have brought patchwork orgs to market and been unable to offload them as a result. UHS and Acadia also fall under this model. Historically, UHS and Acadia have not been profitable in the aggregate in over a decade. Until just a year or two ago, many UHS and Acadia facilities didn’t even have an EHR; they were still paper-based!
Owning a hodgepodge of different providers under some form of umbrella HoldCo has not proven attractive to more sophisticated institutional investors. The reason for this is twofold:
- Significant amounts of time, energy, and capital would need to be invested to merge and integrate the disparate providers.
- Since behavioral health is hyperlocal, there is no synergy across farflung geographies. A patient calling for treatment in Portsmouth, NH is not going to be interested in traveling to Nashville, TN for treatment. Having wide geographic coverage provides no competitive advantage or additional value creation. In effect, the two locations must be managed independently.
Scenario 2 makes logical sense. It’s reasonable to assume that a single back office could support multiple facilities, leading to economies of scale and, therefore, value creation through strategic acquisitions. After all, this is the case for numerous other verticals.
Unfortunately, it does not hold true for behavioral health. Insurance reimbursement is a laborious, time-intensive process. As a provider grows to serve more and more patients, so does its billing and RCM needs. Most providers outsource their billing, for which they are charged a 3-6% percentage of approved claims. No economies of scale there.
Perhaps building an RCM team in-house will produce better results? Such is not the case. Just like the vendors they hire, providers find that, as claim volume increases, so does the need for additional staff. It turns out that outsourcing is a much more cost-efficient strategy. At 3-6%, for every $1 million dollars in reimbursements, the organization is paying $30,000 to $60,000, not even the cost of a decent FTE! The unit economics track here as the organization grows. There is no point at which performing RCM services in-house is cheaper unless operating with a skeleton crew, which ultimately results in missed opportunities, increased denials, and other lost revenue capture.
Marketing and staffing are the same. Acquiring more patients requires comparable increases in marketing spend and labor. Additionally, because behavioral health is such a people-intensive business, even executive leadership does not provide economies of scale. Organizations find again and again that, as they grow, they need to add in tiers of middle management, whether regions or areas of focus, for multiple departments.
As we’ve seen, there are rarely cost-cutting opportunities as a method of value creation in behavioral health. Care delivery staff, marketing staff/vendors, RCM staff/vendor all require additional investment as an organization grows. Obviously, real estate, software, licensing, and other related costs are also fixed. So there is very rarely opportunity here.
Payer Negotiations with Volume
Another thesis, common in the PE playbook for medsurge hospitals, is that size brings leverage with the payers. Once a healthcare system serves a large enough portion of a payer’s members, the healthcare system can start increasing rates.
This, by and large, does not apply to behavioral health. The reason is that the percentage of members utilizing high-cost behavioral health services is quite small compared to physical healthcare needs. Behavioral health represents only about 1% of total insurance payer reimbursements, the rest going to high-cost medical needs such as cancer, diabetes, obesity-related illnesses, and other high-cost services.
We have seen examples of behavioral health providers being able to negotiate higher rates, but only at the high utilization end of spectrum, which is the lowest-cost level of care – general outpatient counseling.
This is not surprising. Let’s say a provider has 200 beds in-state treating a commercially insured 30-day residential treatment program. Even at full capacity, this represents only 2,400 patients out of the millions covered by any large payer. That’s 0.1% of a payer with only 2 million covered lives in the state.
And that state-dependent component is important. Even if a provider served hundreds of thousands of members nationally, insurance contracts are still negotiated with state or regional rates in mind, representative of the covered lives in those geographies. Payers may be willing to institute national contracts in order to simplify paperwork and logistics, but this rarely provides opportunity for increased reimbursements due to the aforementioned reasons.
There Is a Supply-Demand Imbalance that Creates Opportunity for Investment
We’ve explored this thesis in depth elsewhere. It’s completely untrue. The reality is that there is far more supply of behavioral health services for the commercially insured than there is demand (providers serving the Medicaid population remain an exception for some service lines). While there may be a large number of individuals who meet diagnostic criteria for various mental health disorders, only a small percentage of those actively seek services in any given year. All cities of any reasonable size are saturated with providers that more than meet existing demand (again, with Medicaid being a potential exception).
These saturated markets prevent opportunistic growth that would equate to value creation. Instead, new entrants simply add to the challenge of acquiring enough patients to maintain financial viability.
Like any other saturated space where products and services become akin to commodities, the only true opportunities are models that significantly improve on what’s already out there. Only if a provider can specialize to service a niche community (with enough volume for that to make sense), or can deliver superior care, does it make financial sense to invest in these extremely competitive markets.
Time and time again, we’ve worked with PE-backed providers attempting a copy/paste model of expansion. Take what’s working in Denver, CO and open a program in Chicago, IL or Las Vegas, NV. The new programs inevitably struggle. Why? Because there are already more than enough providers in those markets and having yet one more provider that offers nothing different than established competition is not going to be able to gain market share from incumbents.
This difficulty in expanding into already competitive markets is a key obstacle to value creation. Single facilities in behavioral health are limited by patient volume in a geographic area and the organizational chaos that tends to result from too many patients in a single location.
Let’s take one of the most common behavioral health issues: depression. On average, 8% of American adults are affected by depression in a given year. Of that 8%, only about 35% will actively seek treatment.
How far are people willing to travel to see a provider? For outpatient counseling, it’s 10-30 miles depending on commute times. For most urban areas, that distance tends to be 10-15 miles due to traffic. In any 10-15-mile radius, a population of 100,000 people is probably a fair average for most urban areas. If we do the math, we find that about 2,800 people per year, or 11 people per business day, will likely seek treatment.
Eleven people a day is not a lot, especially when we consider that the mean number of visits a new patient makes is 1! Most of these people won't come back for even a second visit, as Better Help and other large-scale providers have found to their chagrin.
Of course, there is more volume when we add in other diagnoses, but the point is that volume is, overall, fairly limited. Add in the fact that there are 20-30 competitors within driving distance, and that’s a lot of competition fighting over such limited patient volume.
The point here is that single-location expansion is of limited opportunity, which means that any value creation must come from location expansion. And location expansion requires capital investment. Moreover, as we’ve discussed, opening new locations in highly competitive markets is not an overly attractive investment. Beating out incumbents requires significant investment of time and resources in addition to the need for a differentiated model. Any provider opening a new location needs to be able to answer the question, “Why would a patient or community referral partner choose us OVER the established competition?”
Telehealth Is Not an Exception
During covid in particular, there was massive interest in telehealth providers of behavioral health services. Organizations such as WorkIt Health, with barely $2 million in revenue, were obtaining investments that resulted in valuations of over $100 million! Let’s be honest, those were simply some very foolish investors. But even where firms weren’t engaging in such ridiculous valuations, the thesis that a telehealth provider could evidence a hockey stick growth curve similar to a SaaS provider remained.
This thesis was incorrect for all the reasons we’ve already discussed. More patients means comparable increases in marketing, labor, and billing costs. Additionally, the demand for telehealth services in general was significantly overrated. Behavioral health services are deeply personal. Many people, particularly for higher levels of care, prefer in-person services. Telehealth certainly has its place at low levels of care, but it is not the dominating force that many at first believed it would be.
Services have remained undifferentiated. Besides convenience, what does a telehealth provider offer that’s different or better than existing brick-and-mortar providers? The answer so far has been, not much. Offering telehealth requires little more than a laptop and a Zoom link. There is no competitive moat and patients are not able to distinguish one telehealth provider from another. This inability to differentiate, add value above and beyond often-preferred in-person methods, or obtain cost-effective patient acquisition have all prevented telehealth models from achieving sustainable profitability.
What Are the Value Creation Opportunities?
If traditional theses have proven insufficient, then what opportunities do exist for value creation? There are three that we’ve seen work:
- Turnarounds. Acquiring a struggling provider and improving it.
- Synergistic levels of care either through acquisition or de novo expansion
- Differentiation which creates dominant positioning in a market
We’ll take a look at each in turn.
Turnarounds Through Operating Partners
A turnaround is probably the least favored value play. In an ideal world, firms buy a profitable and growing company that continues to grow and becomes more profitable over time.
A turnaround is either losing money or has been stuck for years at the same size. During the low-cost of capital boom of the past 15 years, many PE firms were content to buy companies, watch them grow with minimal operating support, then sell them for a higher price.
That model is no longer viable in today’s interest-rate environment. As a result, many firms have started to add on operating partners as part of both their pitch to investors and for actual value creation within the thesis.
However, such efforts are far easier said than done. For a turnaround to be successful, we first have to understand what’s wrong. Maybe the call team is poorly trained and doesn’t convert well, maybe the organization has a bad reputation in the communities in which it operates, maybe clinical care is weak or mediocre resulting in limited referrals and reduced patient retention, maybe the marketing strategy is ineffective.
Having helped over 50 companies in the behavioral health space navigate turnarounds, we can confidently state that it is almost never one thing. If only it were so simple! Your average operating partner with experience as a CEO, CFO, or COO is not going to have all the required skills sets. Training a call center is very different from building an effective outreach team which is very different from implementing a strong, differentiated clinical care model.
And if the PE firm doesn’t have partners with related experience, it is unlikely to be able to identify the opportunities for value creation in the due diligence phase. Firms can’t fix what they don’t have expertise in.
Additionally, these are rarely small tweaks. One can’t simply hire better clinicians, change a process, or install an onboarding program to fix these problems. They are often multifaceted, requiring ongoing expert focus from an experienced leader in each domain.
For a PE firm to be successful here, they need partners or operating partners who can clearly identify areas for improvement and who also have the capacity to lead implementation. The current ownership/executive team isn’t able to do it, or they already would have. The usual PE playbook of asking questions and making recommendations at a monthly board meeting is not going to be enough to facilitate a turnaround.
There is the option of firing the heads of any underperforming departments and hiring a rockstar replacement. However, sourcing talent in behavioral health is difficult, especially at the executive level. This should only be the plan if the firm already has candidates in the wings they know are willing and able to take over.
If all this is in place, then the successful thesis details the gaps in the organization that are resulting in underperformance with clear selection of operating partners or new hires that the firm is confident can bridge those gaps to drive growth.
Synergistic Levels of Care Represent the Easiest Method of Value Creation
Imagine a provider with a single level of care that only takes commercial insurance. They get calls all day long, but turn away 80% because the callers don’t meet criteria for their level of care or do not have the appropriate insurance.
Here is a massive opportunity for value creation. The provider already has systems, processes, licensing, accreditation, and insurance contracts. What’s better, it’s already got excess patient inquiry volume. The problem is that they simply can’t convert it.
Acquiring a provider at one level of care, then adding on additional levels of care to extend the continuum enables a provider to convert larger and larger portions of its existing call volume. In addition, that same provider can now also generate more revenue per patient! Instead of just billing for residential, now the provider can bill for residential, PHP, IOP, and OP if a full continuum is in place.
Insurance contracts work in the same way. Don’t take BCBS because of the low rates? Well maybe BCBS has 60% of covered lives in the market. Rather than pay for all that marketing only to turn away 60% of inquiries, a better model is to develop an operating cost structure that enables profitability at even the lower payer reimbursement rates.
The same goes for Medicaid. Most inquiries into behavioral health providers are individuals with Medicaid. Most programs see their Medicaid call volume as high as 80% of all new patient inquiries. That’s a lot of patients to be turning away. By having a Medicaid program option, which is often a separate facility due to the lower cost structure required to operate a sustainable Medicaid model, the organization can now convert all those inquiries into reimbursable services.
A full continuum and the ability to accept all kinds of insurance also increases referrals overall. Community partners don’t need to scour through brochures and websites to see which provider offers what level of care or takes which insurance. Instead, they know that they can call provider X and they’re guaranteed to be able to help the patient. The provider can convert more of the inquiries it receives and also will start to receive more inquiries as well! Win-win.
This method of value creation works best through acquisition. Different levels of care and cost models require different setups, which most PE firms are unfamiliar with. For that reason, it’s better to acquire the different levels of care or providers with different reimbursement-based cost models.
Also, extremely important, this method of value creation is LOCAL. The patients need to be able to access the additional levels of care or insurance-differentiated programming. That should go without saying, but we’ve seen numerous firms acquire programs in different states hundreds of miles away. That won’t achieve the kind of value creation outlined here unless the model is being built out in each location along a multi-year timeline.
A final note here is that this is where a telehealth model could come into play. Perhaps the organization is already receiving calls looking for telehealth. If that’s not an option currently offered, then initiating that offering is one more way to convert existing volume.
Differentiated Models: Beating Incumbents
As we’ve already covered, simply opening up or acquiring more same-type facilities is not a successful method of value creation. In the saturated behavioral health market, incumbents have the upper hand. They have established referral relationships, community mindshare, and strong linkages in the community.
A new provider trying to open up shop has none of those things. Moreover, to try to obtain them, they need to prove to the existing community why they are a better choice over and against the established provider they’ve known and trusted for years.
Obviously, in that scenario, coming in with the same programming as everyone else, spouting the buzzwords of the day, does not set one apart or provide any kind of incentivization for the community to make a switch.
We could write an entire article on various differentiated models. But, really, every organization needs to analyze its own strengths to make that determination. Taking this a step further, what expertise does the PE firm have that it can bring to the table to enable a differentiation thesis? Execution is everything.
In our experience, it’s too often been the case that partners within the PE firm will make generic recommendations. For example, “Trauma treatment seems of high interest. We should get really good at that.” This rather empty statement demands answers to numerous very important questions:
- What does great trauma treatment look like?
- How are competitors in the market currently providing trauma programming? Can we do it better to such a degree that the market will see us as a clear leader?
- What hiring criteria do we need and what internal training programs are required to enable consistent execution of the proposed higher caliber program?
We’ve heard similar statements for demographic targeting. “We should open an LGBTQ track.” “We should start a veterans program.” The overly simplistic hypothesis is that there is some kind of demand for such services and simply providing supply will be enough to engender success. This is not the case.
Almost every market already has these options, which brings us back to our original question. If the community already has an established provider with these services, why would anyone choose your new program over the tried and true program they’ve known for years?
Just like with our questions around trauma treatment, for a demographic focus to foster recognition as a leader in serving a specific patient population, there has to be strong differentiation that is clear to the community and consistent execution of the differentiated programming.
Value Creation Requires Rolling Up the Proverbial Sleeves
It’s not easy. Every investor dreams of the private business acquisition that works like a stock pick on a growth trend, just purchase and watch it grow. However, it’s rarely the case that the owner of a profitable and growing business is in the market to sell. Instead, owners are most often looking to exit when things turn south or they see serious obstacles on the horizon.
There are certainly sophisticated operators who are aging out of the business, recognize the need for outside capital to achieve growth targets, or who simply want to take some risk off the table while they continue to grow the business. But as any PE firm knows, these opportunities are in the minority.
Operations held together with bubblegum and duct tape, quixotic owner personalities, rapidly changing marketing dynamics, and businesses looking for a lifeline are the lion’s share of opportunities.
The silver lining is that bringing standardized business practices to such operations has the potential for significant value creation. But these are not easy opportunities. They require rolling up the sleeves and getting one’s hands dirty, heavily involved in the day-to-day operations of the business all the while combating an owner or leadership team who may not be welcoming of such intrusions.
Hopefully this article has helped structure your thinking around value creation as it relates to your thesis in behavioral health. Looking for a partner that can help you unlock value and drive results? Get in touch: engage@circlesocialinc.com.