A quick google search of “Health Insurance Private Equity” returns 307,000,00 results. Most of these address the impact of private equity investments from a medical economics perspective, such as videos by Dr. Eric Bricker entitled Private Equity Owning Doctor Practices or Older Doctors Selling Out to Private Equity. But much fewer discuss the impact of health insurance on private equity investment performance.
So let’s address that today! This post is geared towards financially minded business operators and investors, ostensibly private equity professionals but really anyone looking at the financial performance of a business with employees.
Health Insurance Impact on Cash Flow and Financial Performance
Let’s recall that health insurance is a top 2 to 3 expense for most businesses today and it’s rising by double digits each year.
As a human capital expense, health insurance premiums are siphoning cash flow away from much-needed business investments and debt paydown (a key financial aspect of most private equity-owned companies). Thus, slowing and even reversing the health insurance premium trend can add millions to a company’s valuation by freeing up cash flow and accelerating debt paydown.
And despite its financial impact on businesses and employees, health insurance may be the least understood and most opaque expense in a business. Companies spending $1 million, $5 million, even sometimes $10 million or more may receive little to no insights on their claims and what is driving their spending, other than what their carrier may reveal at renewal time.
Using Medical Stop-Loss Captives to Reduce Health Insurance Costs
We find that many groups can unlock savings and improved benefits by considering a medical stop-loss captive to provide health benefits to employees. You can learn more about the use of captives and stop-loss insurance below:
- What is a Medical Stop-Loss Captive?
- Managing Self-Funding Risk with Stop-Loss Insurance
- What does Stop-Loss Insurance Cost?
- Statistics about Stop-Loss Insurance and Claims
A useful yardstick to measure for healthcare spending is on a Per Employee Per Year basis, otherwise referred to as PEPY. Companies may have a PEPY of $5,000 up to $20,000 or more depending on many factors. This could be due to higher claims, lack of cost controls, high cost of healthcare locally, or a high number of members to employees ie there are a lot of families on the plan.
So say you are an investor in a 150 employee business. What’s the value add to your portfolio company in reducing health insurance costs?
Let’s say the group has a $10,000 PEPY for a $1,500,000 annual spend, increasing by 7% every year. Over the next 5 years, their health insurance spending will be $8.6 million, and over ten years, $20.7 million.
If we were able to utilize cost containment solutions and the reductions we typically find, we may conservatively project a $9,000 PEPY in the first year for this group. In the first year alone, this works out to $150,000 in savings. Since these solutions can stabilize the trend in health insurance costs and bring it down to inflation, we can also see significant reductions over time beyond just first-year savings.
Five year spending falls to $7.7 million from $8.6, a savings of nearly $1 million. And with ten-year spending projected at $18.6 million, we project a bit over $2 million in savings.
That’s not too bad! Freed-up cash flow can be redirected elsewhere in the business to capital investments or debt paydown.
So how do we calculate the impact of these realized healthcare savings on the value of the portfolio company?
Health Insurance that Drives Value Creation in Portfolio Companies
Private equity firms aren’t just concerned with cash flow but with overall value creation among portfolio companies.
Taking the 5-year savings of $1,000,000 from above.
This is a direct annual EBITDA improvement to the portfolio company of $150,000 and more each year. Depending on the multiple used in the company’s corresponding sector, this may lead to an enterprise value increase of $1.2 million to $2.25 million.
Now, how can this free cash flow be directed elsewhere in the business to its highest and best use?
Using Health Insurance Savings to Paydown Portfolio Company Debt
Contextually, private equity funds use debt and cash to purchase a portfolio company. The strategy is similar to a homeowner purchasing a house with a 20 percent downpayment. A 10% increase in the value of your home is a 50 percent return on your down payment, less as you pay down your principal.
This same dynamic is present with a portfolio company and the fund’s debt. As the fund uses debt financing to purchase a company, it will observe accelerated returns as enterprise value increases.
And if the fund uses this free cash flow to pay down debt, then we can project even greater value creation over the study period.
The same example above means that the fund can create value of $1.3 million or more over five years if this free cash flow is used to pay down debt.
The fund will need to do the diligence on its operations and expenses to understand the highest and best use of the free cash flow created from more efficient health insurance plans.