The Reasoning Behind a Debt/EBITDA Ratio Surge and the Healthcare Industry.by Christopher_NW // October 8, 2017
Recently I interviewed at a firm in London for a Healthcare Mergers and Acquisitions (M&A) role and the CEO asked me a question during my presentation where I had mentioned that the company I was analysing had a very low debt/EBITDA ratio which was in contrast to the overall market. He asked why I thought more companies globally were taking on more debt. I gave an answer along the lines of ‘we are in the longest or second longest running bull market since World War 2 and both companies and investors know it cannot last as the market will inevitably readjust itself, therefore companies are hedging on taking on more debt to fund novel products through increased R&D spending and more M&A activity so as to try gain a higher market share for when the bull market turns bearish’. I followed up by saying I do not know this to be the exact reason, just an educated guess from what I have read and seen in the market, and that I was very interested in going away to find out more about this. So I decided to turn it into a Mostly Science article to share with you all.
But first, for some of you, many of the terms I used above will sound like gobbledygook as they are more specialist finance terms. So let me define a few. M&A is the area of companies merging with each other or one acquiring (taking over) another. This can be done for various reasons, including wanting to capitalize on a particular segment of a market or opening up a new one. A debt/EBITDA (earnings before interest depreciation and amortization) ratio is essentially how long a company would take (in years) to pay off its debt; more cash than debt would see a negative number. A bull market is one where share prices are increasing, encouraging buying (a bear market is the opposite). Now that we have that out of the way, here is my more nuanced and researched answer to the CEO’s question (novel terms will be hyperlinked).
Low interest rates have facilitated a surge in borrowing by corporations which is continued to be underwritten by banks. This is essentially what is behind the rise of debt/EBITDA ratios across a range of sectors (including healthcare, utilities, energy and industrials; click the image atop the page or see here) with an average ratio of 2.25 in 2016; the highest in the past century. Whilst this has some investors spooked, many of the companies are well-established and generally solvent. It therefore makes sense that they would exploit low interest rates, especially during one of the longest running bull markets seen since World War 2. This also allows these businesses to diversify their product range through increases in R&D spending and increased mergers and acquisitions activity since the financial crisis of 2008 (both in terms of transactions and value). Indeed, with respect to M&A activity, the post-crash US market surpassed peak pre-crash 2000’s activity in 2015. This of course goes hand-in-hand with an increase in the debt/EBITDA ratios of many companies. Further, with respect to the global market of M&A activity, similar trends are likewise seen.
However, even well-established companies need to ensure they do not overstretch their spending in a financial ‘arms race’ with competitors. This would see potential good debt materialize very quickly into bad debt; something investors are particularly wary of. This is why banks, particularly since the last financial crisis, are stipulating the debt/EBITDA ratio does not surpass 5 (only 2 of the top 25 companies surpassed this). Fortunately in the healthcare sector the net debt/EBITDA ratio is relatively low, at 1 as of 2016 (an increase from 0.1 a decade before), whilst many key areas within the sector continue to grow in terms of profits ad investments. These include vaccines (projected to increase to be worth $70 B by 2024), healthcare analytics (purported future growth to be valued at over $24 B in the next 5 years), biometrics (a young area with huge growth potential), and the pharmaceutical industry. In fact, the pharma industry saw a doubling of M&A activity in 2016 ($724 B globally) compared to the previous year, whilst also seeing surges in profits despite large-scale losses in market exclusivity (for products coming off-patent) and overall market volatility (which is inherent to the pharma industry). In fact, the global pharma market is projected to be worth $1.12 trillion by 2022. Overall the healthcare industry is in a strong position, but one that should not rest on its laurels, with increased vigilance required.