July-August 2015

INSIDE VIEW: A caring home with fixed income

Residential careCare homes appeal to people on few, if any, levels. But John Godden of Montreux Capital Management urges investors to look at the demographically driven sector as an alternative to fixed income.  Fixed income yields on developed market government debt and much of the credit markets are hovering at historically low levels, creating difficulties for those investors requiring high and steady income streams. Many investors seeking higher yields today are being forced to take on unacceptable risk to extract the desired yield in fixed income – which has led many market participants to look to other, more uncorrelated investment areas. The residential care sector – a relatively unknown but growing space that remains the preserve of a small band of investors – is increasingly recognised as a credible portfolio diversifier that provides a solution in the continued search for truly alternative assets and income. One of the rare sectors to exhibit defensive qualities as well as growth opportunities, residential care is currently benefiting from the convergence of shorter-term trends and long-term demographic tailwinds. DEMOGRAPHIC TRENDS
Residential care is a market of considerable size and potential growth. LaingBuisson estimates the sector in the UK to be worth approximately £7 billion (€9.7 billion) and anticipates it will appreciate at a rate of around 1% per annum. Importantly, the provision of residential care is not subject to market forces, nor are the payers for such services influenced by fluctuating market sentiment. The care home sector’s emergence as an alternative form of investment is underpinned by irrefutable demographic trends: one in six of the UK population is currently aged 65 and older – a figure projected to reach one in four by 2050 and representing a total increase of 5 million people. The number of those aged 85 and over is set to almost quadruple within the same period. Expenditure on health and specialist care tends to rise exponentially with age. In the UK, the number of older people unable to live independently – whether due to limited mobility, frailty, or other mental and physical health impediments – is forecast to quadruple by 2050. Most will require some form of long-term care. The demand for residential care is set to rise even among those suffering from chronic mental and physical conditions unrelated to age. At present, only 8% of families get health and care services from their local social services. This figure will soar as the population ages and unpaid caretakers such as parents or relatives are increasingly unable to provide support. Many of the 29,000 adults with a learning disability, for instance, live with elderly carers who are too old or too frail to continue in this role. As demand rises, the total capacity in residential care homes has in fact declined. Mental health capacity, for example, has shrunk by 24.8% over the past decade. The supply/demand imbalance offers unrealised investment opportunities and contributes to the asset class’s low correlations to traditional and alternative forms of investment. As both the providers of care and owners of real estate, operating companies are the sweet spot for investing in residential care. The leading UK operators are generating profit levels in the region of 25%-28% for care provision, with gross fees linked to the Retail Prices Index. In addition, regulatory requirements have raised high barriers to entry in the sector, leading to significant returns. These returns provide investors with an inflation-proof income stream, currently in the region of 7%-8%. Consistently high income levels are a rare commodity in today’s low interest rate environment – particularly among alternative assets, which frequently generate no income at all. The valuation of care homes is driven by the net fees generated by each bed, rather than property market dynamics, thus insulating returns from a property market, bond market or stock market correction. However, there remains a real estate value underpin to any portfolio, which acts as embedded risk support. Consequently, the return stream from the care home sector looks very different to any bond, equity or alternative asset and more closely resembles an inflation-linked, high-yielding liability, such as a pension or endowment. THE M&A DRIVER
In addition to long-term drivers, a shorter-term driver of returns is emerging in the form of mergers & acquisitions (M&A). A commonality of any large, developed market is the hegemony of its largest participants. Grocery sales in the UK are dominated by the ‘big four’ supermarkets that had a combined market share of 72.8% in the 12 weeks ending 29 March 2015. The publicly owned ‘big oil’ super majors, big tobacco and telcos are similarly structured.  The conglomeration in these sectors came about during intense periods of M&A, during which smaller players were absorbed and larger entities brought together. Identifying a market where such event-driven value creation can be found is a sensible investment strategy. However, most markets of significant scale are largely consolidated and will remain so until regulatory ‘trust busting’ or macroeconomic pressures engender change.  Until recently the UK specialist care sector has been overlooked. Investors are now beginning to recognise the sector’s strong long-term fundamentals as well as the scope for M&A-driven returns. Despite its size and potential, the care home sector is highly fragmented. The top 10 providers control just 15% of the market, while more than 81% of assets lie outside the top 16 operators. This presents a significant opportunity for larger participants to buy some of the many smaller care groups at low price/earnings multiples.  Transactional activity has accelerated over the last year, driven primarily by private equity and real estate investment trust buyers. Activity shows that smaller assets are being bought at six times earnings by larger assets trading at 10 times – some as much as 13 times – earnings. This process is lucrative for investors.  The UK care market is a compelling investment case. Underpinned by irrefutable demographic trends, the asset class provides strong natural returns and a high inflation-linked level of income. The private healthcare sector will continue to grow unabated on the back of these inherent fundamentals – however, the window of opportunity for M&A-driven value uplifts will peak over in two to three years as the larger participants attain greater market share. John Godden is head of investment strategy at Montreux Capital Management ©2015 funds europe

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