July 30, 2008
Health care services companies have become a core target for private equity investors. Distressed health care services companies are particularly attractive for the right investor. Private equity funds are eager to seek investments that create value for their investors and are investing where they believe the opportunity for value creation exists. Generally health care companies have assets that can be used as debt collateral, and investors see fragmented markets as opportunities for consolidation, operational improvements and cost cutting. In the current economy, distressed opportunities offer an even bigger opportunity, but with some understated risk.
The Attraction: Using debt to leverage their equity investment and buy or invest in such companies has allowed private equity firms to penetrate a host of segments. By 2007, private equity firms had purchased six of the largest chains in the nursing home industry, which represented about 9 percent of the nation’s nursing home beds. An example of a major nursing home transaction includes the Carlyle Group’s $6.3 billion acquisition of nursing home operator Manor Care Inc. in December 2007. The transaction was financed through a combination of commercial mortgage-backed securities, other debt financing and equity provided by Carlyle. Also in 2007, Affiliates of Formation Capital LLC and JER Partners acquired nursing home operator Genesis HealthCare Corporation. The Genesis deal closed in July and was valued at approximately $1.7 billion, of which $450 million was funded with debt. In March 2006, Beverly Enterprises, Inc. announced the completion of the company’s merger with Pearl Senior Care, an affiliate of private equity fund Fillmore Capital Partners.
These acquisitions are attractive due to the asset base of the nursing home target and the potential for increased growth of profit. Nursing home companies (and particularly the many stand-alone facilities) traditionally owned the real estate underlying the operations. Such real estate can be used as collateral to finance a leveraged transaction and, in some cases, can be sold to pay down acquisition debt. The core risks of any senior care facility include increased staffing costs, inability to sell the real estate, stagnant admissions, and increased Medicaid pressure on reimbursements. Another standard risk is litigation; as the demand for nursing home services rises, so does the level of interest in the plaintiff’s bar. Private equity investments in nursing homes must be preceded by effective and knowledgeable due diligence focused on the risk management practices and loss history of each investment.
The Understated Risk: The once low-value, “golden years” cases, have evolved into profitable opportunities for plaintiff lawyers. Historical risk exposure in this demographic tended to be on the low side; the same changes in demographics that make this industry enticing to investors, however, have also changed the make up of jury pools. As a result, the plaintiff’s bar has focused on the industry; with this “attention” comes additional risks to a potential investment in this sector. Typical “due diligence” by purchasers in the sector involves a review of loss runs and/or claims made in the past. In some cases this is legitimate starting point—the best prediction of the future lies in the past. In the case of a distressed opportunity, however, past loss runs may not provide an accurate picture and will generally understate the actual risk. It is not uncommon for operators to focus almost exclusively on the financial operations in the last 6 to 12 months before a distressed sale, having little time to pay attention to risk management practices. In this instance historical loss runs may not accurately predict the litigation exposure lying beneath the statute of limitations surface. In distressed purchases, smart investors will seek assistance to understand the scope and efficacy of the risk management practice at that facility. This analysis will provide a much better understanding of the true risk of exposure that comes with a seemingly brilliant opportunity.
Despite the risks health care services companies (and particularly the senior care demographics) remain a sound investment strategy because there is essentially unlimited consumer demand as the baby boomers age. Likewise, distressed facilities have always and will continue to be potential opportunities for value creation. Special attention to the risk lying beneath the surface, however, should be an important part of any potential investment. Careful investors will seek a knowledgeable and experienced legal opinion about understated risk as part of their due diligence in this sector.