Exit time for investors?
Private-equity firms may be looking to shed deals
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.”