Employee Benefits Matters in Due Diligence – Now More Than Ever
By Josh Warren | Published July 2, 2020
Employee Benefits will be the most important aspect of our due diligence and service offering to private equity firms and portfolio companies for the foreseeable future. I have to trust the (actuarial) science on this one. The historical Medical cost trend, as aggressive as it has been in recent years, is a drop in a bucket compared to the tsunami type effect that COVID-19 is having on the healthcare system in the U.S.
I know what you’re thinking – “Every service provider is posting blogs about the effect of COVID-19. Why is this one any different?” We’re here to provide more than just bad news and hypotheticals. We’ll outline the problems that COVID-19 has created in the healthcare market and provide actionable steps that private equity investors can take to contain the potential impact of Medical insurance expense.
The M&A process will change in material ways when deal flow picks up again. There will be more questions and challenges than ever. From our perspective, Employee Benefits due diligence should be an important consideration.
How has/will COVID-19 Impact the Healthcare System
By mid-March 2020, all 50 states, the District of Columbia, and four U.S. territories had reported cases of COVID-19. As of the date that this blog entry was published, new cases of COVID-19 in the U.S. are still rising. This has put Intensive Care Units at many hospitals at or near capacity and cost the Medical insurance community unprecedented amounts.
Provider groups and hospital systems have extraordinary overhead and require steady streams of income to keep them afloat. While ICUs are flooded, their main profit centers (i.e., imaging/ diagnostics and elective surgeries) have not been rendered at the same pace as previous years as people are sheltering in place and trying to stay safe and away from hospitals and the general public. A recent study completed by Milliman projects “a net reduction in medical costs for healthcare payers by at least 5 billion and as much as 75 billion if the deferral and elimination of care continues through the end of 2020.”
There is a lot to consider when estimating how this could impact commercial Medical coverage in the future. In a different Milliman study, they outlined the following high-cost scenario:
Adverse selection during 2021 open enrollment leads to a higher-risk enrollee population
Providers demand substantial increases to reimbursement to remain financially solvent
Severe COVID-19 costs in the beginning of 2021 are paired with a rush of non-COVID-19 costs from pent-up demand and worsening population health once a vaccine (expensive and nonsubsidized) becomes widely available.
Imagine that you acquire a company in Q4 2020 that has 75-100 EE’s, ~0M of revenue, and ~M of EBITDA. Their Medical insurance program renews on May 1, 2021, and they have a market- competitive Employee Benefits offering that costs 00,000 – .1M after employee contributions.
If their May 1, 2021 renewal followed historical trend, they could expect their premium to increase approximately 10% to M – .25M. We do not have a crystal ball, but when that program renews on May 1, 2021, we expect it to increase much more than historical trend. How much is anyone’s guess at this point. We would likely tell you to budget as much as a 25% increase if the structure and funding mechanism of the plan does not change (more on that later).
Employee Benefits Due Diligence – Then and Now
Historically there has been an ebb and flow regarding the relevance of Employee Benefits due diligence in private equity transactions. Unlike Property & Casualty insurance, private equity firms are by and large reluctant to radically change the Employee Benefits offering at a new acquisition. They do not want to walk in on day one, introduce themselves, and alter the offering, regardless of the cost savings. That is why Employee Benefits due diligence has largely resulted in good information to have, but it has not really offered much in the way of actionable intelligence.
However, I remember how the Affordable Care Act dramatically increased the importance of Employee Benefits due diligence overnight. Due diligence findings became much more consultative and forward thinking. The findings resulted in valuation adjustments, changes to growth strategies, and in some cases – deals cratering. It was a major focus from 2010 until at least 2013.
In retrospect, the ACA was complicated, but we were able to create a clear action plan. After it was passed and we had a chance to understand it, we knew what was going to happen, when it was going to happen, and exactly what to look for in due diligence.
While the Employee Benefits expense line item on an income statement has become increasingly more meaningful, major changes and compliance concerns have been relatively quiet since 2013.
That has now changed. COVID-19’s long-term impact on the U.S. healthcare system is a completely different ballgame.
In construction terms, the ACA was a building code enforcement officer telling you to update your breaker box. COVID-19 is equivalent to coming home after a 5-mile run to find your home completely gone. There is nothing but a plot of land, and COVID-19 will make you rebuild it without blueprints or a budget.
Call to Action for Private Equity Investors
We implore you to make sure that your colleagues are informed and that your portfolio companies are on top of this. Here is what we recommend:
Vet your chosen due diligence vendor. Even if you have been working with them for years. Have them explain how their approach to due diligence has changed due to COVID-19. You should reconsider that relationship if they are not intently focused on its impacts to Medical insurance. In short, you need to identify whether they are an insurance broker or a true consultant. Now is the time for consulting.
Reconsider When you project expenses during your hold period, you no doubt add conservative Medical trend of 10% or more. If you want to be conservative and assume that the offering will not change, we recommend increasing that to 25% per year.
Ask Contact the management teams at your portfolio companies and ask them to consider self-insurance instead of the traditional fully insured approach that is common at companies with <200 employees. Administering a fully insured plan makes for a cleaner liquidity event, but groups with as little as 50 lives are now considering self-insurance. A self-insured approach is the only way to have clear transparency into your actual expenses and reduce external market factors.
Consider Portfolio programs have been widely discussed over the years, and there is no better time to consider it than now. Insurers are well versed in the nuances of private equity, and the combined buying power of an entire portfolio represents the best opportunity to navigate these trying times.
Reevaluate The old school way of managing a Medical program on a year-to-year basis will not get the job done. There must be a grander, multi-year, vision. If you do not have a direct relationship with the broker at your portfolio companies, we created the following message that you can use as a guide when contacting your management teams:
We are concerned about the future impact of COVID-19 on your Medical insurance program. We anticipate a fundamental shift in the cost of Medical insurance and want to make sure that you and your broker are on top of this. Will you please get us some answers on the following questions?
Is your broker actively discussing the impacts of COVID-19 on your Employee Benefits offering?
Are you confident that your broker is the best one to navigate the impacts of COVID-19?
Has your broker created a 3-5-year strategy that outlines potential cost increases and what you can do to mitigate them? If so, please share it.
Do you have a specific plan around controlling Pharmacy expenses?
What kind of data sources is your broker utilizing to back up their recommendations?
Vendor relationships evolve over time. The right vendor for you six months ago might not be the best partner today. A lot has changed. Please let me know if for any reason you do not believe that your current broker / consultant gives you every advantage in our current economic environment.
ABD is committed to providing world class service to private equity transactions and portfolio companies of all shapes and sizes. We are here to serve as a sounding board, a second set of eyes, or as your chosen consultant. Let us know how we can serve – we will adapt to whatever you need.
About the Author and Contributors:
Josh Warren is a Senior Vice President and M&A Advisory Practice Leader at ABD Insurance and Financial Services. Prior to joining ABD, Josh spent 15 years at Equity Risk Partners, an insurance brokerage and consulting firm that concentrated exclusively on private equity firms, venture capital firms, and family offices. Josh was twice named a Power Broker by Risk & Insurance Magazine in the Finance – Private Equity category. He was also named to multiple “40 Under 40” lists, including Business Insurance magazine, Risk & Insurance magazine, and the M&A Advisor. He can be reached at firstname.lastname@example.org or 312-300-5759.
Derek Poirier is a Senior Vice President and a Lead Consultant for ABD’s Employee Benefits Practice. He brings over 20 years of health care consulting and employee benefits brokerage to his role at ABD. Derek has extensive experience leading employee benefits due diligence projects for private equity firms and has leveraged his vendor partners to bring best in class outcomes. He can be reached at email@example.com or 858-256-7908.
Jason Jurgill is a Vice President of Employee Benefits for The ABD Team and brings to the company 12+ years of industry experience. He enjoyed success on the carrier side pricing, building and implementing cost containment and member engagement strategies aimed at mid-to-large-sized employers. He is not afraid to roll up his sleeves and fights passionately for the things he believes in. He can be reached at firstname.lastname@example.org or 925-278-6339.
Senior Vice President
Josh is a Senior Vice President and M&A Advisory Practice Leader of Newfront Insurance and Financial Services. His responsibilities include operational leadership, client management, program design, and risk analysis for alternative asset managers and Newfront clients facing a merger or acquisition.