By Benefit Street Partners, Franklin Templeton’s alternative credit manager
We ended 2021 with strong momentum for the private credit. Coming into 2022 we have identified inflation shocks, supply chain disruptions and labor shortages as the main risks. These risks have further accelerated due to the ongoing geopolitical backdrop.
While we believe private debt is well positioned from both, origination efforts and deal flow point of view, sector focus and in-depth industry analysis will be key to success in the current environment. In this article, we analyze the current macro environment and how this impacts private credit underwriting, due diligence and modeling process by looking at a specific sector: US healthcare.
Inflation. Labor Shortages. Supply chain disruption.
The last time the US or the global economy faced this type of inflationary pressures was over forty years ago. The assumption that inflation would be transitory has not proven to be accurate and the geopolitical events that we’re now seeing are adding incremental pressure.
The Fed has repeatedly signaled that it is committed to controlling inflation. However, some of the inflation components are here to stay. For instance, when looking at the current shortage of workers in the US it is important to note that we haven’t seen 6% wage inflation for decades. We believe wage inflation will not be reversed when the situation stabilizes and it may result in a permanent increase to the cost structure of a company.
When analyzing the real impact on company margins, we benefit from getting real time data via the ~$40 billion in exposures we have across a broad array of industries. In this way we can learn directly from the management teams how inflation may be impacting their bottom lines, and what challenges they face. Generally, for most of 2021, companies have been able to push price increases through to the end product and thus were able to preserve margins. As we move into 2022 this may be a little more difficult, so we may see some gross margin compression.
On the supply chain side, companies are faced with severe supply shortages, which constrains their capacity to produce goods and services. We’re seeing supply chain disruptions, way beyond just the auto sector. Manufacturer supply delivery times are experiencing incremental time delays to get goods from ports, into factories and other businesses.
Industry focus: Inflation impact on US healthcare
Given this macro uncertainty, we believe that industry-focused private credit specialists have an advantage for deal sourcing, due diligence and monitoring versus a generalist approach. Our team of 19 industry specialists focuses on the following sectors: healthcare, industrials, business services, software & technology, media & telecom, diversified financials and consumer & retail. This enables us to have a better understanding of the nuances of each sector and uncover opportunities.
The healthcare sector has its different and unique challenges from an inflationary perspective. Three main challenges facing the healthcare industry would be Covid-19, labor disruption and core inflation. Each one impacts the healthcare system in a slightly different way as shown in the table below.
- Covid-19’s effect on utilization reshuffled everything – volumes plummeted, mostly recovered but the type of utilization has shifted and continues to evolve. It is important to note that the impact is unequal. The impact to hospitals is different than the impact to nursing homes or to home health. Since December 2020, the $300 billion stimulus approved by US Congress accounted for more than 10% of total national health expenditures.1 Most of the stimulus was directed exclusively to providers of healthcare services such as hospitals, post-acute care providers and physicians and accounted for approximately 15% of total spending on these healthcare sub sectors.
- Labor disruption, this could be the bottleneck to recovery for the industry since 70% of healthcare costs are labor-related. If there’s a shortage of healthcare workers, it becomes challenging to meet the demand; therefore, utilization volume revenues inevitably decline as the healthcare system in the US is mainly driven by a fee for service model.
- The final threat to healthcare is core inflation with wage inflation being the key contributor. Fortunately for the healthcare industry, the Medicare program, which covers all Americans over age of 65, has automatic stabilizers built into its reimbursement formulas. The inflation created by health workers wage increases is captured by the formula and is then reflected by higher Medicare payments to healthcare providers. We don’t want to state that the inflation impact is fully absorbed by these automatic stabilizers, but this mechanism provides the industry with a unique hedge.
Overall, we believe that the key opportunities in healthcare are still available in sectors connected to the Medicare space as well as other sectors such as physician practice management.
Impact on private credit underwriting
In our view, opportunities can be found focusing on the top of the capital structure. With this in mind, we believe investors should take a conservative approach when investing in private credit. When analyzing private credit deals, we think historical KPIs may not reflect the future given the current forces at play and how they affect economic sectors in different ways. For us this means building models differently. For instance, we are thinking about limits to future price increases, considering sustained periods of worker shortages, and supply chain disruptions that could last through 2023. Each sector is unique, so we continue exercising the due diligence for each borrower in each individual sector.
Footnotes and disclaimers
1. Source: Altarum, “Explaining Near-Record Health Spending Growth during the 2020 Decline in Healthcare Utilization.” December 2021.
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