What healthcare capacity is most essential and similar to fundamental infrastructure?

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By Freddie Evans, Junior Associate; Adam Scott, Senior Partner

Mansfield Advisors

April 2022

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Introduction

Infrastructure funds have significant capital to deploy, but a dwindling supply of traditional assets available to target. We explore what healthcare targets, including long-term care, is suitable for ‘infra-like’ investment in the current environment of a pandemic turning endemic, a major war in Eastern Europe and the return of the inflation bogeyman. The pandemic has thrust healthcare into the spotlight, and highlighted how robust and resilient the sector can be when growth in sectors like retail or travel faltered or there was suddenly no income at all.

Infrastructure investment has normally comprised two segments: economic and social. ‘Economic’ contains the core you might visualise as traditional infrastructure: transport (roads, bridges, ports and airports), energy, utilities, telecommunication and more recently, digital and cloud services. These fundamental assets are the foundation of a strong economy. These are essential services, with low risk and no real alternatives that offer strong, predictable cash flows into the long-term future. Pension funds are the typical investor example, where liabilities extend out decades into the future.

Core investments typically have effectively monopolies as they fully meet the need of the area and there’s no need for a further toll road or a power station. It would not make economic sense to build a competing asset, and there would not be backing from authorities to do so.

However, too much capital chasing these safe investments has sent prices up and encouraged fund managers to look to alternatives for their core returns, joining that smaller percentage already set-aside for higher risk/return assets.

Infra-like investments

The social segment comprises services and facilities that contribute to a good quality of life, including healthcare but also housing, education, culture and recreation. There is an estimated social infrastructure funding gap in Europe of between €100bn and €170bn annually (1)(2).

Recently acute hospitals have been the busiest sector, see Exhibit 1, with specialist care seeing a number of deals. Infrastructure investors have also started to look at children’s services (special schools often with a residential element) and elderly care homes, with their property portfolios mitigating against execution risk and market growth. Mental health hospitals would also be there, but provider pricing power has been less predictable than those segments. Otherwise investors seek to own and manage the capital equipment needed in adjacent sectors such as clinical laboratories, mobile operating theatres or diagnostic imaging MRI or CT suites.

Traditional healthcare infrastructure investments would also have been in assets such as large hospitals, as part of public-private partnerships or what the UK called private finance initiatives. Once developed, these assets are then rented to national operators such as the NHS. This funding method has become less popular in Europe, and represents smaller investment sizes compared to most economic infrastructure investments. The most well-known example were the private finance initiatives from the nineties into the noughties, used in the UK for £13bn in new hospitals (3).

The rationale was that construction companies would build for a set price (and be accountable to their shareholders for delivering the asset on budget and in-time) and then would lease the building to the state for 30 years. Cynics argued that the state (or the UK Government in power) avoided the debt on the balance sheet but had to pay private sector interest rates for 30 years, and therefore far more in total than if construction had been funded directly by the state. The proponents would argue that without the risk being held by the construction companies, and if they were able to charge cost-plus, the original cost estimate would have always substantially exceeded and the net present value of the cost equal or greater to the taxpayer. From academic research, we can see that investors made an attractive return on capital, which we define as greater than the investors’ cost-of-capital as calculated by those same academics. Outside some poorly negotiated early projects, we surmise the PFI hospital building program was a reasonable deal for taxpayers along with being a good opportunity for investors. Though to be sure we would need more insight into the counter-factual world where PFI had not existed, based on international or historical examples. This is only theoretical since there isn’t any apparent interest in such projects from the current UK Government. It doesn’t help that modern accounting standards (IFRS 16 to be precise) mandate that long leases be capitalised, though of course this isn’t the only factor. There’s no sign yet of whether the expansion of state debt from the Covid pandemic measures will encourage the Government to look again at private finance initiatives.

Infra-like, also known as infra-adjacent or core+ investments, have a higher risk profile than traditional infrastructure investments. They must still be deemed ‘essential’, however the definition has stretched to include the operating businesses along with the physical environment and its rent.

Healthcare as infra-like

Health and social (long term) care have a good story to tell the investment committee, since we are not getting any younger and until very recently at least, we were living longer with ever-growing entitlements to healthcare. Demand for healthcare is inelastic; treatments will be required regardless of economic outlook and developed countries prioritise healthcare spending.

Other sectors like care homes and retirement villages are property backed. Be warned that much UK elderly care stock is very dated and may not be suitable for a long investment period of ~20-30 years.

However there are plenty of high quality, future-proof properties, and these will remain so if maintained. Elderly care homes’ local authority and NHS payors do not default.

One Octopus Group healthcare infrastructure survey found that 60% of global healthcare infrastructure investors are focused primarily on the UK (n=100) (4).

Traditional infrastructure investments provide a rate of return between 8-15%. Infra-like investments possess an increased risk-profile, and therefore investors demand an increased reward. Healthcare assets can achieve much higher rates of return in the realm of 20%, as targeted by private equity, however the long term goals differ.

The yields required by PE are 20%+ over a shorter investment period. The priorities of PE are to maximise the exit multiple over a 3-5 year investment period, and as such invest profits into growing businesses rapidly.

Infrastructure investments have a longer term outlook of ~10 years, but have a focus on achieving strong cash yields over that period to receive dividends payments. There is a focus on value creation over the long-term, often driven organically, which supports creating processes for maintaining high quality environments to achieve this. This long-term position, with fewer changes of ownership, can be seen as more attractive to management and other business stakeholders.

Healthcare drawbacks

There are of course some drawbacks to healthcare investment for infrastructure investors. Infrastructure investors have typically avoided taking on operational and reputational risk, and healthcare is seen as a sector which can pose both.

Operational risk can be mitigated against by choice of model. Traditionally UK private hospitals tried to offer a model which minimises clinical risk exposure; the hospital provides the physical site, equipment and nursing staff, while patients paid surgeons separately for the procedure. This is no longer the case, as providers such as Spire Healthcare spend substantially more on clinical governance than they did a decade ago in order to lessen reliance on the clinical direction of external surgeons. They have found that necessary to maintain their public reputation, inspection ratings and avoid legal risks. Of course, the major PFI deals in state hospitals had no such clinical exposure risk, and neither should propco only investors in UK private hospitals.

In other segments, it can be safer for investors to invest directly in operators and retain direct control over service quality and avoid defensive capex falling between the opco and propco’s responsibilities.

Reputational risk is present through healthcare, but once again being selective in the quality of acquisitions can minimise this exposure. Indeed, many argue that core infrastructure investments offer similarly high levels of reputational risk as faults or failures can affect the public. Unfortunately, bridges and other concrete structures can fail and smart motorways may not that be that smart reputationally.

The rewards offered by the long-term macro trends and value creation opportunities in healthcare should warrant the performance risk.

Future trends

Long-term tail winds for healthcare, and value creation opportunities are sufficient mitigants against the risks posed by the sector. Coupled with limited core opportunities, infrastructure interest in healthcare is continuing to rise. Given the global uncertainty and rising inflation, healthcare is a safe option seen as an inflation hedge and has the added benefit of diversifying infrastructure funds’ portfolios.

Over the past 15 years, digital has emerged as a leading sector for infrastructure investment, who’s to say healthcare can’t follow? That Octopus Group research argued that $200bn could be invested in global healthcare infrastructure over the next five years (4). Our analysis of factors by segment  – see Exhibit 2 – helps explain why investors have prioritised different segments when aspiring for infra-like returns. Looking outside the almost traditional segments of hospitals and specialist care – and now that the Covid catastrophe has passed by – we expect more interest in the absolute highest quality mental health and elderly care assets.

1. Georg Inderst, Inderst Advisory, Social Infrastructure Finance and Institutional Investors, A Global Perspective, March 2020
2. Boosting Investment in Social Infrastructure, European Commission, January 2018
3. IPPR, September 2019
4. Healthcare Infrastructure Report, Octopus Group, 2020