The Health Care M&A Monthly: Private Equity Firms Target Long-Term Acute Health Care Systems

Two notable deals were announced this month targeting companies that manage long-term acute care hospitals, or LTACs. In both cases, leveraged buyout firms initiated transactions to buy out operators of multiple LTACs. The rationale for each, however, is different, reflecting different business plans and different stages in the growth cycles of the two companies.
Long-term acute care hospitals provide services for patients who require acute care, on average, for at least 25 days. The typical patient is over 80, suffers from a range of complications and is often transitioning from a general acute care hospital to a skilled nursing home. With the aging of the population, particularly the baby boomers, the demographics point to a growing demand for the services that LTACs provide, along with the corresponding business opportunities that increased demand implies.
There are currently two publicly traded companies that specialize in LTACs, Kindred Healthcare (NYSE: KND) and Select Medical Corporation (NYSE: SEM), but that number is due to fall to one.
New York-based Welsh, Carson, Anderson & Stowe (WCAS) is offering $18 a share to buy Select Medical Corp. Adding in the value of stock options and the assumed debt, the total value of the transaction is calculated at $2.3 billion.
Based in Mechanicsburg, Pennsylvania, Select Medical currently operates 83 LTACs in the U.S. and four rehab hospitals in New Jersey. The company also runs numerous outpatient clinics, specializing mainly in providing rehabilitation services.
Out of SEM’s 83 LTACs, only eight are freestanding facilities while the remaining 75 are "hospitals within hospitals," or HIHs. Established as a distinct operation within an existing host hospital, generally an acute care facility, an HIH is in a position to receive patients and services from the host. This cozy arrangement has relieved SEM of many of the capital costs associated with owning and operating a stand-alone facility. It has also allowed it to grow over a diverse geographic base. During 2003, 53% of SEM’s LTAC patients were referred from the host hospital.
On a trailing 12-month basis, SEM generated revenue of $1.6 billion, EBITDA of $241 million and net income of $102 million. The deal is therefore valued at 1.4x revenue and 9.54x EBITDA.
This transaction offers SEM shareholders a 36% premium over the stock’s prior-day price. But, other than give shareholders a decent pile of cash, why would a financially healthy company, in what appears to be a growing market, want to go private? True, the recovery of the public equity markets is a bumpy one, and the privatization of SEM will insulate it from those unpredictabilities without having to satisfy the demands of shareholders quarter after quarter. But more is at stake.
The problem, as Select recognized in a press release in August, is CMS’ intervention in—and potential distortion of—the market for LTAC services.
Medicare regulations promulgated in August 2002 began to transition reimbursement for LTAC services from a cost basis (with caps) to a prospective payment system (PPS). We have seen this in other sectors of the health care industry, often with mixed results, but in and of itself, PPS would not be overly daunting for LTACs. What has proved worrisome for providers such as SEM are new regs that limit the interaction of HIHs with their hosts.
Under the new regs, which became effective October 1, an HIH must limit the percentage of services it obtains from its host to just 15% of total operating costs, or it must limit its patient intake from the host to 25% of total admissions. Behind these limitations lurks the same theory that bans physicians from referring a patient to facilities, such as diagnostic imaging centers, in which they have an ownership interest. It keeps the parties from getting too cozy financially. Exceeding these limitations will result in lower rates of reimbursement from Medicare, and therein lies the reason Select issued its August press release indicating the need to explore strategic alternatives.
As a private company, Select may better weather the implementation of the PPS and the HIH regulations, as it refocuses its business strategy. The regulatory transition should be complete by 2007, at which point WCAS may consider taking Select public again. SEM’s prospectus on this deal does not currently envisage a major shift in business strategy, or divestments of various business units, and while privatization may not wholly answer the questions raised by the new regulatory environment, it does give SEM some breathing room.
At a time when Select is ducking for the cover of privatization, another operator of LTACs is agreeing to a leveraged buyout to spread its wings.
TA Associates, a Boston-based venture firm with a capital base of $5 billion, is buying Triumph HealthCare. Triumph currently operates five long-term acute care hospitals with 458 licensed beds in the Houston metropolitan market, and is building three others. By the end of 2005, the company will have added 220 more beds.
The company needs money to grow. While it currently generates annual gross revenue of $350 million, available cash from operations is likely to be low. The reason for that is the same reason that distinguishes it from Select Medical: Triumph operates its LTACs as freestanding facilities, avoiding the HIH model altogether. This means that it requires capital for acquiring and refurbishing stand-alone facilities or constructing them de novo, and that is where the leveraged buyout comes in: to provide a fresh infusion of capital resources.
The focus on freestanding facilities has another consequence: in order to achieve the synergies and cost savings that would come from the relation between an LTAC and its host hospital in the HIH model, Triumph plans to build local and regional networks rather than disperse operations over a wide geographic base. It will therefore concentrate on markets with a high proportion of elderly and aging, such as Texas, California and Florida.
While some news sources have bandied about a price tag of between $185 million and $200 million for the deal, principals at both TA Associates and Triumph essentially scoffed at these figures without revealing whether the true value lay north or south of that range.
Although it may be too early to speculate on an exit strategy just as Triumph is entering a new phase in its development, TA Associates’ string of successful IPOs suggests that such a move might well come within three to five years.
Both Select and Triumph may seek to further their individual business plans by buying additional facilities in markets where each already operates. The most cost-effective way to do this would probably be to acquire shuttered rehabilitation or general acute care hospitals. In the case of Select, this would lessen the impact of the new PPS and HIH regulations, allowing it to stabilize revenue. In the case of Triumph, it would allow the company to expand its revenue base. Mark your calendars for mid-2007, when both companies may be in play again.