Healthcare companies' default risk steadily rising, with most owned by private equity: Moody's

Amid a weakening macroeconomic environment and ongoing pressure by private and public payers to reduce healthcare costs, a growing number of healthcare companies are faced with credit rating downgrades and potential defaults.

The healthcare industry's social risk is also rising, exemplified by credit negative legislation such as the No Surprises Act and ongoing litigation around opioids, according to Moody's Investors Service in a new report.

Among 193 rated North American-based healthcare companies, 34, or nearly 18%, were rated B3 negative or lower as of Nov. 30, up from nine, or about 4%, of rated healthcare companies as of Dec. 31, 2015. About 80% of North American healthcare companies are now speculative grade, as compared to around 73% in 2015 and 71% in 2010, Moody's reported.

Credit stress is rising in healthcare, which has long been considered a defensive sector for credit investors. The ratings of 24 North American healthcare companies have been downgraded to B3 negative or lower, representing a "material deterioration" in the sector's credit quality, write Moody’s analysts.

Healthcare companies now represent approximately 16% of the 207 companies on Moody's Investors Service B3 Negative and Lower List (B3N List) as of Nov. 30.

Updated monthly, the B3N List includes all nonfinancial corporate issuers in the U.S. that meet the firm's proprietary definition of credit stress—those with a probability of default rating (PDR) of Caa1-PD or lower, or B3-PD with a negative rating outlook or review for downgrade.

“Attracted by healthcare's historical stability and buoyed by accommodative debt markets, financial sponsors have aggressively consolidated fragmented subsectors," including physician practices, emergency medicine and anesthesiology, Jean-Yves Coupin, vice president, corporate finance group, Moody’s Investors Service, wrote in the report.

"The resulting roll-ups carry high levels of debt, which will pressure their cash flows and limit their ability to adapt to the changing macroeconomic environment, as well as to increasing social risk, new legislation and litigation,” Coupin said.

The 34 healthcare companies on the B3N List have nearly $65 billion of outstanding debt, an increase of 57% compared to March 2020 at the onset of the pandemic and more than double the nearly $33 billion in debt outstanding in January 2019.

The increase is largely attributable to two recent additions to the healthcare roster that together account for nearly half of its total debt: Bausch Health Companies with about $21.8 billion of outstanding debt and Envision Healthcare Corp. with about $7.9 billion. Excluding Bausch Health, Envision has the largest debt load among healthcare companies Moody's list, accounting for 18% of total debt outstanding, followed by Team Health Holdings and Radiology Partners, each accounting for nearly 8%.

In September, Moody’s has issued a scathing corporate credit rating downgrade to Envision Healthcare, assigning the physician staffing service and ambulatory surgery center operator its lowest possible junk rating and warning that a bankruptcy or major restructuring is likely on the horizon.

Many healthcare companies rated B3 negative or lower started 2022 with high financial leverage, high levels of floating rate debt and weak operating performance, according to Moody's. With rising interest rates, these companies now have to contend with higher financing costs amid persistent inflation along with slowing economic growth that will pressure earnings well into 2023.

"Finding lenders willing to refinance will become increasingly difficult in the year ahead as the market retrenches," analysts wrote.

Thirteen healthcare companies have defaulted since January 2020, with high leverage and weak operating performance as the two main culprits, Moody's analysts noted. This proves the industry is not immune to the profit and cash flow pressures challenging many industries today.

Operating weakness came from a variety of sources including technological obsolescence, shortages in skilled labor or increases in labor costs, changes in the operating environment or simple mismanagement.

For some defaulters, disruption caused by the COVID-19 pandemic was the last straw.

Looking ahead amid a challenging economic environment in 2023, capital structures of the healthcare companies rated B3 negative or lower will become "unsustainable" as they contend with higher financing costs and find it increasingly difficult to find willing lenders to refinance. 

"Companies with unsustainable capital structures will need to cut their cash interest expense by either seeking to convert their debt to payment-in-kind (PIK) obligations, completing debt-to-equity conversions, or through debt extensions. Lenders will likely accept these maneuvers to avoid borrowers filing for bankruptcy, which would result in greater losses," analysts wrote.

Moody's analysts noted that private equity activity in the sector contributed to the uptick in companies on the lower end of the ratings scale.

Nearly 90% of the North American healthcare issuers on the B3N List are controlled by private equity, reflecting "aggressive financial policies, high leverage and debt structures predominantly funded with floating-rate loans," analysts wrote.

As credit conditions worsen and interest expense rises, these companies' cash flow have increasingly come under pressure, which limits their ability to adapt to changing industry dynamics such as increasing social risk, new legislation and litigation.

Two of the largest healthcare companies on the B3N List are owned by private equity: physician staffing companies Envision Healthcare, which has defaulted on its debt twice since January 2020, and Team Health, which we downgraded to Caa3 in October, Moody's noted.

Analysts warned that many of the downgraded companies face the same factors that caused 13 healthcare companies to default.

Labor costs, which have risen in most industries, have been particularly credit negative for healthcare companies, which have also been plagued by labor shortages. "Labor issues led to ratings downgrades to B3 negative or below for several healthcare staffing companies, which have struggled to find sufficient labor to provide necessary care at a cost at which they can remain profitable," analysts noted.

Technological obsolescence is another factor that has led to recent downgrades. For instance, Lifescan Global is seeing its traditional blood glucose monitoring equipment being replaced with newer technology that is much more popular with patients. Another example is Carestream Health, which specializes in traditional medical film for X-rays—a technology that is being rapidly replaced by digital imaging.

Changing industry dynamics, including new legislation or regulations, can cause additional headwinds and drive downgrades, Moody's said.