Towers Watson (NYSE: TW) has leveraged the acquisition of a private Medicare exchange to launch a broad exchange strategy. It's a story that others looking to buy or sell in the middle market information technology space can learn from.

In May 2012, professional services firm Towers Watson acquired Extend Health Inc., which operates a large private Medicare exchange, for $435 million.

In November, the company announced the acquisition of Liazon Corp., which develops and delivers private medical exchanges, for $215 million.

On Sept. 9, news broke that IBM would no longer be managing health care coverage for its Medicare-eligible retirees. The announcement meant that Towers Watson's Extend Health acquisition would pay off-IBM was deciding to use Extend Health.

The prize catch in this M&A deal was Extend Health's private Medicare exchange.

When IBM decided to transition its retirees to the Medicare exchange, it affirmed Extend Health's value. Case in point: when Extend Health was purchased, it had about 100 employers as clients and was serving 170,000 individual retirees. Since then, the number of employers served has risen to 300 and the number of retirees to around 500,000.

Towers Watson, which offers large employers solutions in the areas of benefits, talent management, rewards, and risk and capital management, earned revenue of $3.4 billion in its fiscal year that ended July 31, 2013. Revenue reported in the quarter ended Sept. 30, 2013, was $810 million.

Adding to the tally, effective Jan. 1, IBM Corp. (NYSE: IBM) planned to move about 110,000 of its retirees to the Towers Watson private Medicare exchange from company-sponsored health plans.

It was also reported that Time Warner Inc. (NYSE: TWC) plans to move its Medicare retirees to private exchanges from company health plans in 2014.

While public exchanges aim to provide health insurance for uninsured Americans, private Medicare exchanges enable large employers to continue funding retiree health care benefits while managing costs.

Exchanges also give retirees choice and buying power for their existing health care coverage, which is delivered through group plans selected by their former employers. An exchange offers thousands of individual plans from dozens of carriers, so carriers compete for retirees' business.

Not surprisingly, the outsourcing of retiree health benefits to private exchanges by IBM and Time Warner created a firestorm of media interest.

The media coverage focused on whether large employers will deliver retiree health benefits through private Medicare exchanges in the future. The coverage also contributed to speculation that employers will eventually use private exchanges for active workers.

Before the Towers Watson acquisition, in January 2012, Extend Health filed an S-1, signaling that it was planning an initial public offering.

At the time of the S-1 filing, Extend Health reported $50.5 million in revenue for the fiscal year ended June 30, 2011, up 16 percent from the previous year. For the fiscal year ended September 30, 2011, revenue was $15.8 million.

When Towers Watson announced May 14, 2012, that it would buy Extend Health, it ended the company's journey to the public markets. Considering that the Towers Watson balance sheet at the time showed just $427 million in cash, this was a bold, highly leveraged move. At the time, some analysts said that Towers Watson might have paid too much.

Additional financial details were not disclosed, but based on expected fiscal year 2012 revenue, Extend Health was acquired at a valuation of about 6.8 times revenue. This valuation is right in line with comparable transactions at the time.

On the day of the acquisition announcement, Towers Watson stock closed at $64 per share, but had been trending downward. On May 29,, 2012, when the acquisition was completed, Towers Watson stock closed at $59.78, for an enterprise value that day of $4.22 billion.

There was no remarkable change in value either way on the news. But Towers Watson stock continued to slowly decline with the market.

After hitting a low of $49.60 on November 14, 2012, however, Towers Watson gained steadily for months. In 2013, from Friday, Sept. 6, to Monday, Sept. 9, over the weekend that the IBM and Time Warner news broke, the stock jumped $6 a share - increasing Towers Watson's enterprise value to $6.3 billion.

One month later, on October 7, 2013, the stock eclipsed $115 a share - for a gain of more than 100 percent in just 10 months - giving Towers Watson an enterprise value north of $8 billion.

That value represents an increase of more than $4 billion since the acquisition was announced, and more than nine times the purchase price of Extend Health.

Much of that increase can be attributed to investors' expectation of the future value of Towers Watson, driven by the promise of a burgeoning market for private health insurance exchange services for all employee populations, including active workers.

The Towers Watson stock run-up was sparked by two Fortune 500 companies adopting the Extend Health retiree health care service, but this is just the tip of the iceberg. It is clear that even with a rocky start for public health care exchanges, exchanges are the way health insurance will be delivered in America. And Towers Watson has a long-term strategy for developing private exchange solutions for employers in parallel.

The Towers Watson/Extend Health example presents three compelling messages for other buyers and sellers in the middle-market IT space:

First: What you do matters, and specifically, the higher the value of your offerings to customers, the higher your valuations will be. If you are an emerging growth company offering a high-value product, you will reap the rewards. But even established companies breathe new life into their businesses through acquisitions that give them scale or enable them to enter new markets, as was the case with Towers Watson and Extend Health.

Second: Being in a fast-growing vertical niche or industry creates opportunities, especially if your focus is on an industry undergoing major shifts. In health care, these shifts are the result of key provisions of the Affordable Care Act going into effect in 2014. But there are also great opportunities in areas such as human capital management, financial services, business analytics, security, electronic data integration and payment processing systems.

Third: A company is worth more to a buyer that can unlock or accelerate value. Towers Watson CEO John Haley said that in this case, because Towers Watson has relationships with many large U.S. employers and a large number of consultants and advisers who manage those relationships with them, "the value proposition of the Medicare exchange was immediately recognized by our consulting businesses."

"The acquisition of Extend Health helped reposition our company into a high-growth area with outstanding results," Haley said.

Of course, buyers must properly align and integrate acquisitions once they are completed, and a poorly managed M&A process will nearly always fail.

It remains to be seen how the private exchange market will evolve. But if private exchanges remain appealing to employers and can be extended to all of their employee and retiree populations, Towers Watson can leverage even more value from its acquisition of Extend Health.

But so far, the $435 million bet has paid off.

Martinwolf was not the adviser in this transaction and the author does not own Towers Watson stock.


Sunil Grover is executive vice president of Martinwolf, a global M&A adviser specializing in mid-market transactions involving information technology services-based business models.

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