This is an exclusive BHB+ article
Earlier this week, BHB’s Chris Larson reported that behavioral health giant Discovery Behavioral Health was taken over by its lender, Capital One.
According to court documents, the Webster Equity Partners-backed provider defaulted on $280 million in debt. Capital One took issue with Discovery’s debt-to-earnings ratio in its quarterly reports, leading the bank to seize control of the provider’s assets, dismantle its board, and install its own.
And while I’ve heard of dozens of providers entering bankruptcy, this is the first time in my decade-plus career as a journalist that I’ve seen a bank essentially repossess and run a behavioral health provider.
It raises many potential questions for the provider, investor, and even the patient community. Providers may begin to carefully evaluate partnering with private equity firms that are keen to expand through debt. Additionally, it may prompt investors to consider the risks in behavioral health.
In this BHB+ Update, I will explore:
–Why behavioral health companies should take a measured approach to debt
–What behavioral health can learn from the retail industry
–How Capital One’s seizure of Discovery could impact PE investment in the sector
Provider risk
This news could highlight the risk providers take when getting involved with private equity companies. While providers commonly take on debt from banks, once private equity becomes involved in an asset, the emphasis shifts to growth. This pursuit of growth can cause providers to assume more debt than they can feasibly handle.
This practice nearly crushed the retail industry, with many stores unable to handle their debt obligation. Still, it is common in health care as a whole. But founders and executives who have sold to private equity could risk losing everything if their back pushes them over their skis in debt.
And Discovery was once a major acquirer in the sector.
From a provider perspective, there are also some major questions about what happens to the day-to-day operations when a bank takes over the company. In Discovery’s case, Capital One put in place its own board and Tom Britton, who was named CEO of the company just a few months before the takeover, appears to no longer be with the company.
While I can’t imagine that a bank has any interest in running a behavioral health company in the long-term, court documents show that the judge imposed a restraint to prevent the bank and the board from commencing a “fire sale” of the company or its assets.
Still, a sale is clearly on the horizon. According to court documents, Webster Equity Partners gave Capital One assurance that it would sell Discovery’s outpatient care division and use the proceeds to help resolve the dispute. While a sale never materialized, it’s easy to speculate that it could have saved the company from its current fate. And a sale is still likely the only way for the bank to get back its money.
There is also the workforce issue. Mental health professionals remain in short supply. I could see an exodus of providers who are cautious of the uncertainty that comes with being owned by a bank and the imminent sale of the company. If equity incentives were ever on the table, they are now null and void. Additionally, many providers are skeptical about working for a private equity-backed company, but a bank-owned firm? That could be one step too many.
Investor fears
While behavioral health companies have been the investor darlings for the past decade, the Discovery news could be a cautionary tale.
Webster Equity has been involved with Discovery since 2011 and recapitalized the company in 2017. The firm has clearly dedicated significant time and financial resources to the provider and its limited partners are expecting returns.
While it’s unknown what the financial implications are for the private equity firm in this case, in these types of cases, investors could lose big on the investment, including the trust of their limited partners, whose funds are tied up in the investment.
I think there are two major takeaways for investors from this case. The first is for investors to be actively involved with your portfolios’ nitty gritty financials. It’s likely that an experienced firm like Webster was closely involved with Discovery’s books, but the pair appear to have been counting on the sale of the outpatient business.
This comes to my next takeaway. Loading assets up with debt can backfire. It’s happened in other industries and it can happen again. And when it comes to behavioral health, slow and steady growth may win the race.