The SeniorCare Investor: Senior Care Dominates Health Services M&A Market

While every other segment of the health care services market has seen a below-average amount of merger and acquisition activity so far in 2003, the senior care market is experiencing a level of deal activity not seen since 1998. In the second quarter of this year, there were 25 senior care acquisitions announced, representing almost 30% of the activity in the entire health services sector. In comparison, the hospital segment, historically one of the most active of all segments, has had only four announced transactions in each of the past two quarters, a level of passivity not seen in more than 15 years.

In the overall health care market, the biotechnology, pharmaceutical and medical device segments continue to dominate the merger and acquisition activity, with a combined 53% of the 221 announced transactions in the second quarter and 70% of the $18.1 billion spent for these transactions, based on revealed prices.

In the first half of 2003 there have been almost as many announced senior care acquisitions (52) as in all of 2002 (69), and the second half of this year is expected to be just as active. The market continues to be dominated by single-facility transactions, many of which are a result of companies still trying to shed their troubled assets or exit from specific states that do not fit in with a new strategic direction.

Even though most of this activity centers on the assisted living market, there remain many buyers who believe that the skilled nursing market has hit bottom and that now is the time to buy. The problem for many of these buyers is that the lending pool remains relatively dry and that the expensive, but available, money usually wants the larger deals. With few large transactions in the market, the smaller ones may begin to be more appetizing, but that will also involve a change in mind-set for these lenders.

Speaking of large transactions, the big news of the summer (so far) was the late July announcement of Emeritus Assisted Living’s (AMEX: ESC) winning bid to buy Alterra Healthcare (OTCBB: ATHCQ) for cash consideration of approximately $76 million, subject to certain adjustments. The deal is conditioned on the court’s confirmation of Alterra’s reorganization plan as well as many regulatory approvals, and the transaction is not expected to close until late this year. Emeritus is putting up at least $6.9 million of the purchase price, with Fortress Investment Group LLC financing the remainder.

The entity that is buying Alterra will be a majority-owned subsidiary of Emeritus, and Fortress will have the minority equity interest. Other than its equity interest, it is not yet clear how Fortress will earn a return on its $69.1 million funding for the transaction. With its equity investment in Brookdale Living Communities, Fortress has now become one of the leading investors in the senior care market. There were apparently two other bidders, with the runner-up being an entity related to Five Star Quality Care (AMEX: FVE). A late entrant in the bidding was a group made up of Bain Capital and one of its portfolio companies, Epoch Senior Living.

The auction of Alterra was handled by Cohen & Steers, and the rumor in the market had been that the asking price was $55 million. This was not an actual asking price, but merely the minimum equity that the court, with the help of the company’s advisors, decided was necessary for Alterra to emerge from bankruptcy, either as an independent company or as part of another company. The $76 million that will be received will be used to fund the reorganization and provide working capital, as well as to fund a distribution to Alterra’s unsecured creditors. But most creditors will not be receiving much at all, especially the owners of the $440 million of various convertible securities.

So what does Emeritus get from the transaction, besides the potential of more headaches? The reality is that no one truly knows yet. The stated number of facilities and resident capacity that ESC will take over are approximately 300 and 13,000, respectively, but the situation is still somewhat fluid, with many moving parts. In addition to Alterra’s planned divestitures, there are other facilities that ESC management may not want and some that, we have heard, it wants to keep that had been on the disposal list. More details will be forthcoming in mid-August when Alterra files a disclosure statement which will contain, among other things, pro forma financial statements with certain assumptions.

What we do know is that as of March 31, 2003, Alterra had $43.1 million of senior debt secured by nine facilities and another $308.2 million of senior debt secured by 93 facilities with 4,689 beds ($65,700 per bed). In addition, there were six leased portfolios comprising 225 facilities with 9,609 beds. The lease expense in the first quarter was $15.1 million, but it is unclear how many facilities this relates to. Obviously, some of the remaining facilities will be divested or returned to their creditors before emerging from bankruptcy to get to the 300-facility number that has been used publicly, and there are other facilities that are already under contract for sale that are expected to close in the next several months.

On an operating basis, Alterra’s EBITDARM margin in the first quarter of 2003 was 33% on total revenue of $107 million, compared with just over 35% in the previous year’s first quarter. The decline is understandable given that management’s time has been taken up by the restructuring activities, and at the local level, it is not easy to operate when the parent company is under such financial stress. In a few weeks we will know what the post-reorganization margin is forecast to be.

What is unclear is where Emeritus is deriving its projected $800 million in combined operating revenues when the two companies are merged. In the first quarter of this year the combined revenues of the two companies were $154 million, which is just over $600 million on an annual basis. The only thing that makes sense is that ESC is including the actual operating revenues of their managed facilities in this $800 million total, which based on the annualized management fees are close to $200 million.

It is very difficult to try to determine any cash flow multiples or per unit valuations on the transaction until more details are released regarding pro forma financials and assumed debt and leases. But if anyone thinks that Sunrise Assisted Living’s (NYSE: SRZ) purchase of Marriott Senior Living Services will be difficult to assimilate, they haven’t seen anything yet.

Alterra is more than double the size of Emeritus, and while Marriott was having some operational and fill-up difficulties, these were nothing compared with managing through a huge financial restructuring and bankruptcy. In addition, Emeritus will have to assume management responsibilities for approximately 300 separate facilities, compared with less than 130 that SRZ took over. One saving grace is that Alterra will bring Emeritus into only five new states (38 in total), so there appears to be significant geographic overlap. But it is highly debatable whether it makes sense to be in that many states in the first place (did someone say something about this being a local business?).

The risk profiles of the Emeritus/Alterra and Sunrise/Marriott transactions are also vastly different. Sunrise did not increase its debt or lease commitments, and added significant new management fee revenue with little, if any, downside or financial risk. Emeritus, on the other hand, is already highly leveraged with debt and lease commitments, and will be even more so. We don’t know, however, whether Emeritus, the parent, will be on the hook for Alterra’s debt and leases it assumes. Just because Alterra will become a consolidated, majority-owned subsidiary does mean that Emeritus guarantees its obligations (and our guess is that it will not).

For the assisted living industry, it would have been preferable for Alterra to emerge from bankruptcy as an independent company, probably even smaller than what Emeritus will take over. While everyone will be rooting for Emeritus to succeed, if it fails, and the Alterra portfolio defaults again on its obligations, it will be a disaster for the reputation of assisted living in the market. The jaundiced view is that if Dan Baty, the CEO of Emeritus, has been unable to turn a profit with 185 facilities, why should he do any better with 500? Sure, there may be some economies, and overhead expense will probably be targeted, but there may also be some diseconomies when you get to be that big. All one needs to do is look at the nursing home industry, which took a decade to figure out that operating in 38 states just doesn’t make any sense.

As more details are released we will continue our analysis and may even be convinced to change our mind on the acquisition. Investors, however, have already taken a more upbeat view of the deal, pushing ESC’s share price up 35% since the beginning of July. The good news is that if Emeritus ever does start making money, it will never have to pay any taxes.

Why? It will be picking up approximately $400 million of net operating loss carryforwards with the Alterra acquisition, which is on top of its own NOLs. That alone may be worth more than today’s equity valuation of Emeritus. There always is a bright side to everything.