What Lurks Behind HCA? Dealmakers probe the depth of the liquidity pool after the huge buyout

If the steady stream of LBOs in the first half of this year wasn’t enough to convince dealmakers that 2006 will go down as the year of the big buyout, confirmation emerged in July with disclosure of the HCA Inc. blockbuster, valued at $33 billion. The deal that will take the nation’s largest for-profit hospital operator private offers more milestones than a superhighway – the largest LBO ever, topping the $31.3 billion RJR Nabisco Inc. buyout in 1989; the biggest loan package ever floated to finance a takeover; and the heftiest amount of high-yield debt sold to back a deal. The investment group buying HCA will pay $51 per share – a 6.5% premium over the closing stock price on July 23, the day before the deal’s announcement. That’s a 16% premium over the price earlier that week, before reports of a potential deal surfaced. HCA is also the largest club deal ever done, with Kohlberg Kravis Roberts & Co., Bain Capital, and Merrill Lynch Global Private Equity joining with the founding Frist family to take HCA private. The deal will add $15 billion in new debt on top of the $12 billion the company is already carrying. Debt providers are Bank of America, Citigroup, J.P. Morgan, and Merrill Lynch. This is the second time that HCA has gone private. In 1989 management acquired it for $3.6 billion and it returned to the public markets in 1992. Chairman Thomas Frist Jr. made $247 million on an initial investment of $33.1 million in the first buyout. In addition to carrying the bragging rights for having topped the RJR Nabisco buyout, HCA is becoming a lightning rod in discussions about whether it represents the crest of the LBO wave or whether its size could itself be beaten before the current period of massive liquidity ends. Some professionals are using the record-breaking LBO as a dipstick in an effort to determine the depth of the liquidity pool that will remain to fund other takeovers. But other analysts are suggesting that other large LBOs are in the wings, pointing to undervalued media conglomerates such as Viacom Inc. and Time Warner Inc. and large retail chains that are having trouble getting investor appreciation as potential targets for private equity funds. “It looks like there’s still a lot of juice in the engine to drive more buyouts,” says Jamie Streator, head of health care investment banking at the Susquehanna International Group. Private equity firms like KKR, Bain Capital, Blackstone Group, Carlyle Group, and Texas Pacific Group are the reigning buyout giants. It’s estimated that they control more than $2 trillion in buying power. And while Blackstone found itself on the sidelines of the HCA deal, it raised $15.6 billion in July, creating what is for now the largest buyout fund ever assembled. Also supporting Streator’s thesis was the announcement in July that Lehman Brothers is raising a new $2 billion private equity fund. Another firm that’s increasing its private equity war chest is Citigroup. The financial giant announced in August that its private equity unit is raising a new $3.5 billion fund. Both funds are being marketed as operations aimed at investments with partners in order to sidestep criticism that they could cause their investment bank parents to compete with clients for deals. In all, private equity finds are expected to raise a record $300 billion this year, surpassing the $283 billion they raised last year, according to Private Equity Intelligence, a London-based research firm. The buyout shops haven’t been shy about putting these funds to work. The backdrop for the HCA bid has been a number of large buyouts in recent months. Private equity mavens have spent $347 billion on a shopping spree that includes $22 billion for pipeline operator Kinder Morgan Inc.; $17.4 billion for supermarket chain Albertson’s Inc.; $14 billion for a stake in General Motors Corp.’s General Motors Acceptance Corp. financial unit, and $12.3 billion for Spanish-language TV network Univision Communications Inc. In the United Kingdom, airports operator BAA PLC was sold to a buyout group for $30.2 billion. Add HCA to this list and it’s easy to see why deal pros are focusing on the hospital company not only as a determinant of what point the M&A market has reached in the LBO cycle but also as a gauge of the health of the whole economic system. More Hospital Deals? Analysts differ on whether the HCA buyout will be the first in a wave of hospital deals of great magnitude. In general, the industry is made up of companies that have steady cash flows and undervalued stock prices. These basics meet the general requirements for buyouts. But M&A pros say they should factor in the possibility that HCA could be a one-off because it’s three times as big as any other operator and has by far the freest cash flow. What about the possibility that HCA may suck up much of the financing that’s available for the sector and make it more expensive for any other health care deals that hit the market? Observers have noted that the buyout came as HCA posted another quarter of weak admissions and rising bad debt from uninsured patients. Because these fundamentals remain weak across the industry, stocks of other hospital chains failed to rally on the news of the historic buyout. Sheryl Skolnick, a Senior Vice President at CRT Capital Management, says that Tenet Healthcare Corp., which has gone through an extended period of turbulence, is a potential buyout target. One downside for the company, she says, is the difficulty Tenet has had in retaining physicians. On the plus side, it has a light debt load. She also points to Community Health Systems Inc. and Universal Health Services Inc. as other hospital companies that might be suitable for takeouts by a management-led private equity team. She notes that Community Health has already done an LBO, but says the company is well run and isn’t getting the recognition it deserves. In the case of Universal Health, she says that CEO Alan Miller could veto any decision on the company’s status since he holds a controlling position. One strategic approach for Universal if it were to restructure might be to split off its psychiatric hospitals from its acute-care facilities. Spin-Offs Likely to Continue Spin-offs, both within the HCA empire and in the hospital industry in general, will continue, authorities say. “We expect to see more assets being spun off as companies try to unlock value,” says Chini Krishnan, founder and CEO of Healthia Inc., a health services company in California. He expects more deals to be driven by the trend in health care toward a more “free-market” approach to spending. For its part, HCA is expected to continue its program of asset disposals even as it goes private. “HCA may continue to sell some of its smaller hospitals, especially those that are not in vibrant urban or suburban markets,” Skolnick says. The company, she points out, has sold nine smaller hospitals recently and she expects that as many as another 10 to 20 of these facilities might be off-loaded. Skolnick estimates that the sale of these hospitals could raise as much as a half-billion dollars, which could be used to pay down the debt the company is taking on in the LBO. And while the sponsors of the deal have pitched its success as being based more on growth than cost cutting, anything that could help whittle down that mountain of debt may be considered. What Could Go Wrong? Skolnick says she doesn’t see any possibility of a major injury to HCA from a change in government spending on health care. Such a reworking of government health programs would undercut the assumptions the deal rests on. Another health care trend HCA will have to adjust to is the growth in outpatient procedures done at surgery centers and other non-hospital facilities. Some deal mavens point out that between April and the July announcement of the HCA buyout, the closely watched LIBOR rate rose from 1.59% to 5.47%, meaning that the buyout group will pay more for the leverage they will apply to HCA. Still, Streator says that he sees the deal as a win for management, for the PE groups, and for shareholders, even with the increased debt costs. Striking a more cautionary note is Robert Katz, a Managing Director at the Executive Roundtable, a debt advisory firm. He points out that if HCA goes private carrying $15 billion in new debt, it will be paying in the neighborhood of $1.1 billion of interest per year. “If a couple of blips were to happen, things could go awry,” he notes. Katz says that the possibility of increased transport and energy costs as well as an expected increase in administrative monitoring costs are variable outlays whose fluctuations to the upside would make the debt service more onerous. On the other hand, supporters of the deal argue that with a fairly modest multiple of about 7.8 times EBITDA, the leverage isn’t as steep as it is in many of the other deals in the recent wave of buyouts. Another problem that could arise is the emergence of other bidders. In the wake of the deal’s announcement, there were reports that another buyout firm might launch a competing bid. The buyout agreement contains a clause that says: “HCA may solicit proposals from third parties during the next 50 days. The board of directors of HCA intends to actively solicit superior proposals during this period.” That’s not an uncommon provision that boards apply to protect themselves against accusations of breaching fiduciary duty. Despite HCA management’s professed openness to an alternative bidder, deal experts note that in addition to the difficulty of putting together such a large financing package, a potential alternate bidder would be hard pressed to duplicate the relationships between HCA management and the members of the KKR consortium. John LeClaire, a Partner and Chair of the Private Equity Group at Goodwin Procter, says that one problem the HCA deal might cause is a rush to get more LBOs done while favorable conditions exist, even if they are poorly structured. The discipline could “be flooded with amateurs” threatening to increase the number of deal failures and contribute to a bursting of the LBO bubble. Richard Bove, a financial institutions group analyst at Punk Ziegel, says that he sees the HCA buyout as a litmus test for the success of attempts by central bankers and others to cool down an overheating economy. “HCA may become the barometer by which we can judge whether the Fed has totally lost its relevance,” he says. The biggest buyout in history comes at a time of seemingly endless liquidity. Despite tightening by the world’s central banks in recent months, buyout shops are having no trouble getting the credit they need to leverage up their targets. Although the Fed chose to leave rates unchanged at 5.25% in early August, its first pause after two years of steady increases to fight inflation, other central banks have been continuing to lift rates. In early August, the Bank of England and the European Central Bank raised interest rates while the Fed stopped. Bove says that if HCA gets done, it will prove that there is so much liquidity available that the banks’ tightening has no effect. Another effect of a successfully completed HCA deal, which is due to close in the fourth quarter, will be larger deals coming down the pike, Bove notes. “No one at the other private equity firms will be content to not participate in other megadeals,” he says. Indeed, in the weeks after the HCA announcement, foodservice company ARAMARK Corp. agreed to be acquired by private equity investors and CEO Joseph Neubauer for about $6.3 billion. The group includes include GS Capital Partners, CCMP Capital Advisors, J.P. Morgan Partners, Thomas H. Lee Partners, and Warburg Pincus. Neubauer controls one-third of the voting interest in the company. Like HCA, this is the second time that ARAMARK has gone private. Another post-HCA deal features KKR partnering with Silver Lake Partners and AlpInvest Partners, a Dutch private equity firm, to buy 80.1% of the chip production business of Philips Electronics NV for more than $6 billion. Yet, signs of the state of liquidity in the European LBO market in the wake of HCA were contradictory. A possible sign of debt tightening is the reception accorded to the floatation of bonds for privatizing Dutch media company VNU NV. In early August, private equity firms completed the bond portion of the $9.85 billion financing at interest rates about 1.5 percentage points higher than they had hoped to pay. But the consortium buying the chip operations of Philips said it planned to issue a junk-bond offering of more than $4.5 billion to support its buyout. That will be Europe’s largest junk-bond issue. Bove says he expects deals like HCA and follow-up buyout blockbusters to continue to be launched until one deal hits the wall. Not until the first giant LBO fails will the market know the limits of the economic system’s liquidity, he comments. If the pool is deep enough, HCA will be unlikely to hold its title as the biggest LBO for anywhere near the 18-year stretch that RJR Nabisco held the record. Bove says that if HCA succeeds “it will prove that nobody has any clue as to how much financial liquidity has been taken out of the system and how much remains.” (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com