Exit time for in­vestors?

Pri­vate-eq­uity firms may be looking to shed deals

Modern Healthcare - - Strictly Finance - Vince Gal­loro

While Cer­berus Cap­i­tal Man­age­ment is draw­ing a lot of at­ten­tion for its plunge into hos­pi­tals, sev­eral of its pri­vate-eq­uity peers might be con­tem­plat­ing the other end of the process—how they will exit their hospi­tal in­vest­ments.

The pri­vate-eq­uity back­ers of four ma­jor hospi­tal com­pa­nies are com­ing up on at least six years in their in­vest­ments in the com­pa­nies. That is sig­nif­i­cant be­cause pri­vate-eq­uity firms typ­i­cally op­er­ate with a five-to seven-year plan to sell on to other in­vestors and bank their prof­its, ex­perts say.

The largest of the pri­vate eq­uity-backed hospi­tal op­er­a­tors is HCA, which is also the largest non­govern­men­tal hospi­tal sys­tem in the coun­try. While HCA’s lever­aged buy­out led by three pri­vate-eq­uity firms occurred less than four years ago, many have spec­u­lated that the com­pany might re­turn to the pub­lic stock mar­kets this year, thanks to good re­sults in 2009 and the boost in in­vestor in­ter­est in hos­pi­tals from health­care re­form (March 29, p. 8).

And Cer­berus is prob­a­bly al­ready think­ing about how the firm will exit its pro­posed ac­qui­si­tion of six-hospi­tal Car­i­tas Christi Health Care in Bos­ton. “pri­vate-eq­uity firms are in a tem­po­rary busi­ness,” says Dan O’Con­nell, di­rec­tor of the Golder Cen­ter for the Study of Pri­vate Eq­uity and En­tre­pre­neur­ial Fi­nance at the Uni­ver­sity of Illi­nois at Ur­bana-Cham­paign. “They’re not try­ing to build a com­pany that they can hold for 20 years. They’re not try­ing to build a legacy. They’re try­ing to cre­ate value for their in­vestors.

“It’s some­thing that’s in your mind even be­fore you get into the deal, be­cause you’re not go­ing to hold this in­vest­ment for­ever.”

The key to un­der­stand­ing the in­vest­ment hori­zon that pri­vate-eq­uity firms work on is to know the terms on which they raise cap­i­tal, says Colin Blay­don, di­rec­tor of the Cen­ter for Pri­vate Eq­uity and En­trepreneur­ship and a pro­fes­sor of man­age­ment, both at Dart­mouth Uni­ver­sity. Typ­i­cally, the firms raise cap­i­tal from in­vestors in funds that of­ten spec­ify what sec­tor or sec­tors they will in­vest in and over a spec­i­fied time pe­riod, usu­ally 10 years, Blay­don says.

“In the first part of the fund’s life, they are mak­ing in­vest­ments, and in the lat­ter part of the fund’s life, they are ex­it­ing them,” so they can pro­vide re­turns to their in­vestors, he adds. Th­ese in­vestors are try­ing to match the tim­ing of their re­turns to their li­a­bil­i­ties, Blay­don says. For ex­am­ple, pen­sion funds need to time their re­turns to their ac­tu­ar­ial es­ti­mates of pay­outs that they will make to pen­sion­ers, he says. When in­vestors put their money in the hands of a pri­vate-eq­uity firm, he adds, they want the firm “to close out that in­vest­ment fund as close to 10 years as they can ac­com­plish it.”

Some­times, a pri­vate-eq­uity firm will trans­fer an in­vest­ment to a newer fund that it has raised from in­vestors, buy­ing more time for the in­vest­ment, Blay­don says. “As far as the com­pany is con­cerned, the names on the own­er­ship shares are chang­ing, but the way the com­pany is ex­ist­ing and go­ing for­ward isn’t nec­es­sar­ily very changed by such a trans­fer of own­er­ship,” Blay- don says. One of HCA’s pri­vate-eq­uity back­ers, Kohlberg Kravis Roberts & Co., trans­ferred HCA shares be­tween its funds this way in 2009, ac­cord­ing to a se­cu­ri­ties fil­ing.

Jon Lehman, as­so­ciate dean for health­care man­age­ment at the Owen Grad­u­ate School of Man­age­ment at Van­der­bilt Uni­ver­sity in Nashville, cau­tions that the gen­eral pat­tern doesn’t nec­es­sar­ily hold for ev­ery in­vest­ment. “Some might have much longer time hori­zons than other firms, par­tic­u­larly if they have liq­uid­ity in those in­vest­ments, and they just want to sit on them,” Lehman says.

One way that pri­vate-eq­uity firms can achieve a par­tial exit is if the com­pany makes dis­tri­bu­tions to share­hold­ers, Lehman says. “Ba­si­cally, think of it as a poker game: They’re tak­ing chips off the ta­ble,” Lehman says. “They don’t have as much at risk as they had be­fore.”

Those dis­tri­bu­tions can be used for pay­outs to their in­vestors, al­low­ing the firms to hold on to an in­vest­ment be­yond the 10-year life of the in­vest­ment fund that fi­nanced the in­vest­ment ini­tially, Lehman says. Pay­outs to in­vestors also pro­vide some cer­tainty of re­turns to the pri­vate-eq­uity firm, which earns the bulk of its re­wards by tak­ing a per­cent­age of the re­turns that its clients’ money earns, known as the carry on a deal, he adds.

Four of the hospi­tal com­pa­nies owned by pri­vate-eq­uity firms an­nounc­ing dis­tri­bu­tions to their share­hold­ers in Jan­uary, and Ia­sis, Franklin, Tenn., made a dis­tri­bu­tion in 2007 as well by pur­chas­ing $300 mil­lion in eq­uity from its back­ers (Jan. 25, p. 20).

Head­ing for the door

Like so many things in the fi­nan­cial world, pri­vate-eq­uity firms are find­ing they have fewer op­tions for ex­it­ing in­vest­ments now that debt is not so read­ily avail­able, Dart­mouth’s Blay­don says. “In the days when there was a lot of easy debt avail­able—prior to the mid­dle of ’07—they would of­ten be ex­it­ing through lever­aged re­cap­i­tal­iza­tions,” Blay­don says. “They would put more debt on the com­pany and pay a dis­tri­bu­tion to them­selves and to other share­hold­ers.”

An­other form of this some­times in­volves a larger pri­vate-eq­uity firm com­ing in to re­place the firm be­hind the orig­i­nal deal, again us­ing new debt on the com­pany’s bal­ance sheet, Blay­don adds. The re­cap­i­tal­iza­tions of Ia­sis Health­care and Van­guard Health Sys­tems brought in new lead pri­vate-eq­uity firms, al­though the orig­i­nal back­ers re­tained a stake in both com­pa­nies, and while each com­pany’s debt grew, both com­pa­nies were sub­stan­tially larger than when they were founded.

Over the past decade, pri­vate-eq­uity firms have re­lied more on sales than ini­tial pub­lic of­fer­ings of stock to exit their in­vest­ments in the

Blay­don: “The strate­gic ac­quirer has be­come the big dog.”

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