Leveraging up the aged care sector

Start with well intentioned deregulation or privatisation of existing governmental funded services, driven by the need to meet certain extrapolated trends forecasted by government statisticians.

With potentially billions of dollars up for grabs, entrepreneurs and corporate financiers are more than happy to give the government a helping hand.

Professional services firms publish “thought pieces” and “industry research” along the lines of “Emerging Opportunities in the X sector” with nice graphs showing upward trajectories.

These are copied and pasted into pitch decks, investor presentations, prospectuses etc to help market a plethora of roll-ups and stock market listings that soon emerge to allow investors the privilege to gain exposure and profit from these emerging trends.

In this particular iteration, it’s the Residential Aged Care sector driven by the “grey tsunami”.

And what we are seeing right now is a deluge of capital chasing a limited supply of assets fuelled by the explosive growth of leverage in the form of Refundable Accomodation Deposits.

What are Refundable Accommodation Deposits?

Refundable Accommodation Deposits (“RAD”) are upfront lump sums paid by residents for entry into Residential Aged Care. It is effectively a loan provided by the resident to the aged care provider in lieu of pay-as-you-go arrangements.

The resident is effectively lending money to the provider at a government defined interest rate (currently 6.28%) in exchange for their accommodation. This deposit is guaranteed by the government.

So the provider essentially acquires a “float” of say $300k from each new resident that chooses the RAD (currently around 42% of new residents).

RAD is eventually refunded to the resident (or their estate) upon departure from the aged care services facility. Average tenure of a resident is around 2.5 years.

In short, the intent of the RAD is to allow the aged care sector access to the stockpile of retiree savings to fund the build out of new aged care infrastructure and ready itself for the “grey tsunami”.

Rapid growth in RADs

The RAD makes tremendous sense for the resident (provided they have the savings). Where else can you generate 6.28% return on your cash risk free?

We see below significant net RAD inflow of c.$4.1bn into the industry within a short 18 months post implementation of the Living Longer Living Better reforms:

How are RADs held by the provider?

Given that RADs are essentially retiree savings, surely there must be tight regulatory frameworks governing how they’re held by providers and strict liquidity measures? Not so it seems.

Within this seemingly prudent framework, the critical thing to note here is that the providers are somehow allowed to use RADs to fund acquisitions of other aged care providers.

In other words, providers can use government guaranteed RADs to play the industry consolidation roll-up game and in the process adding nothing to the actual supply of new Aged Care places. And unlike debt or equity funding, providers have minimal accountability to the ultimate owners of the RADs (from the retiree’s perspective, it’s simply a government guaranteed deposit).

This is where a seemingly clever and well intentioned piece of government policy inadvertently becomes a potential landmine for the sector.

Are RADs liabilities or assets?

Accounting rules mandate that RADs be treated as a short term liability (as they can fall due at any time). However, a large portion of industry participants simply do not view it as a real liability because of one fundamental assumption based on their historical experiences:

RAD balances only ever increases and never decreases, hence it never has to be repaid.

Tellingly, Regis and Estia, two of the most aggressive listed player, categorise their net RAD inflow / outflow as operating cashflow despite the fact that this is simply money lent to them by their customers, with a real effective interest cost and theoretically repayable at any time.

Estia’s ROCE formula for acquisitions (with a target of 25%) provides good insights as to their thinking:

The key here is the denominator (i.e. your capital employed) has been pared down twice in Estia’s version of the ROCE formula:

• “Net” capital employed – in other words, the RAD liabilities that Estia has taken on-board is simply ignored
• One-off “RAD uplift” – assumes future increase in RAD balance, so Estia takes this into account as a further reduction in capital employed

These perceived reductions in capital employed are key to industry players touting seemingly high ROCEs despite paying eye-popping acquisition multiples.

As a case study, let’s take a look at the most recent major acquisition by a listed player – that being Regis’ acquisition of Masonic Care Queensland for a “net consideration” of $163m (exclusive of $50.1m in RAD liabilities). The financial impact for Regis is outlined as follows:

So Regis outlaid a total of $232m in capital for an expected NPAT return of $1m-$2m in FY2017!

In other words, ROIC of 0.6%.

Highly leveraged Balance Sheets

Amongst the listed players, we now see Balance Sheets with huge debt balances (i.e. bank debt + RAD), far exceeding cash and PP&E combined in the case of Estia and Regis:

In fact, net tangible assets are negative for both Estia and Regis due to acquisitions made at valuations far exceeding the value of net assets acquired:

In other words, a large portion of RADs held are now backed by nothing but goodwill.

What could possibly go wrong?

Ignoring the headlines, the reality is that the growth rate of Australia’s 65+ demographic is around 3.6% p.a., which is above general population growth but hardly a “tsunami“. As well, contrary to the government’s supposed concern for lack of supply, the supply of new residential aged care places is actually tightly controlled. In the latest ACAR round, 4 applications were made for each of the 10,940 new operating places up for grabs (double the number of applications in the previous year) .

With industry occupancy at around 93%, there is simply little room for rapid organic growth. In fact, the government is in the process of tightening its residential aged care funding which comprises c. 70%-75% of industry revenues.

However, to meet investor expectation of high growths, the myriad of financial sponsor backed roll-ups and listed players predicated on “consolidating a fragmented industry” need to continue to grow and to continue to dance as long as the music is playing.

And what if the government deregulates the current cap on bed licences in line with their roadmap towards more consumer choice? When an unconstrained supply of new aged care places hits the market what will happen to the pricing of new RADs, occupancy levels and in turn the value of balance sheet goodwill?

No one can provide precise predictions for the future. However, we can always reference against history, where there are inevitabilities that follows any boom predicated on:

• forecasts where something can only ever go “up”;
• a flood of easy capital chasing a limited supply of assets; and
• high levels of leverage used to juice up returns from low ROIC assets.

Update (30th May 2016): Quite a timely write-up in the AFR on this same topic.

Update (3rd June 2016): My thoughts after Bank of America downgraded the sector triggering a sharemarket rout of the listed residential aged care players.

Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post.