Simplify the M&A Market

The SeniorCare Investor: Holiday Retirement Sale Soon -

Pricing Gets Very Aggressive For The Largest Deal Ever

The seniors housing acquisition market, as we have been saying for most of the past 18 months, has never been as strong, with so much depth, capital, product and willingness to deal, as it is now. It may last through next year, or this bull market could continue indefinitely as long as the financial markets cooperate and we don’t have a rash of new development. In any event, when you have been through the worst of times (four to five years ago), and you emerge into the best of times just a few years later, a prudent seller may not want to wait for the market to get even better. That seems to be the case for the owners of Holiday Retirement Corporation and its controlling shareholder, industry legend Bill Colson.

With the rumors first circulating two months ago that the company was going to be put up for sale, it was apparent that only the largest players, with access to at least $1.0 billion to $2.0 billion of equity, would be invited to the dance. The obvious names were mentioned—Health Care Property Investors (NYSE: HCP), Ventas (NYSE: VTR), the Chartwell/ING joint venture, a Canadian pension fund or two, Kohlberg Kravis Roberts & Co., The Blackstone Group and Fortress Investment Group—and all with various reasons why they made sense for the deal as well as why they didn’t. We reported last month that the rumored asking price was in the $6.0 billion to $7.0 billion range, and we subsequently heard that the effective cap rate would be between 5.50% and 6.0%. Both the price and cap rate would be records, and are eye-openers even in this market.

We heard that about a dozen potential bidders were contacted by Holiday’s representatives, Bank of America and Cohen & Steers, and that perhaps four to five were going to be invited to the now standard "second round" of bidding. But a funny thing happened on the way to the party. It appears that one of the bidders really wanted to get the deal done, and in a hurry, and decided to accommodate the seller in structure and price, mostly, we hear, by agreeing to a quick closing and being the least demanding with regard to due diligence. Although we heard about a closing by the end of the year, we believe a signed contract by then is more realistic, which in itself is optimistic with the holidays coming up and some unresolved issues, with a closing later in the first quarter of 2007.

It will come as no surprise that the winning bidder, or so we hear, is none other than Fortress Investment Group, the controlling shareholder of Brookdale Senior Living (NYSE: BKD). Apparently, negotiations with any other bidders have been terminated or put on hold while Fortress and Holiday negotiate the details, but in addition to the fast timing and accommodating structure, the Fortress bid was also the highest among the final group, and it is doubtful that any of the others would have topped it if given more time for due diligence.

Since there has been no announcement yet, the following numbers are still what could be called speculation, but we think they are close enough to mention. In the last days of November, we heard prices of $6.5 billion, $6.7 billion and $6.9 billion had been agreed upon, but we are going with the lowest of the three, and not just because it is the mid-point of the original estimate, but because the higher two numbers make even less sense. But we also heard that back-up offers were not too far behind the $6.5 billion number. And this price comes to more than $185,000 per unit, which is quite high given that Holiday serves a middle market population in mostly secondary markets.

Although we have not had access to the Holiday offering package, we have learned that the projected EBITDA for 2007 is close to $350 million, but this is based on a G&A expense that is considerably lower than the standard 5% of revenues management fee. It is also unclear how aggressive that $350 million forecast is, but most forecasts tend to err on the side of optimism when a portfolio is for sale. On the face of it, this translates into a 5.4% cap rate, which is a tad lower than the earlier estimates we had heard. And as far as we know, it would also be the lowest cap rate for a stabilized portfolio in the history of the seniors housing acquisition market. As my mother would say, put that in your pipe and smoke it.

Speaking of pipes, there have been the customary jokes that someone has been smoking something to get to this valuation, although no one is really complaining because what is good for the goose is good for the gander (or the other way around in this case). And when you have several bidders possibly within 4% to 8% of the deal price, either the pipe has been passed around a lot or the market has really become this aggressive for a once-in-a-lifetime portfolio. Perhaps it is a little bit of both.

We understand that there are still a few things up in the air in terms of what is included in the deal, but using the $6.5 billion price as a good estimate, with approximately 35,000 units (all owned, to our knowledge), that comes to just over $185,000 per unit. The Holiday communities, on the other hand, might cost $100,000 to $120,000 per unit to build today, so there is a large premium to that market metric. In addition, we have heard that Holiday develops between 15 and 20 properties a year, so not only will the future cash flow from this activity kick into EBITDA growth, the spread between development cost and market value appears to be quite wide, although the premium should decline significantly when looking at a few properties compared with a 300-property portfolio. So on a stabilized basis this development activity could add about $20 million per year to EBITDA, and before you know it you have a pro forma cap rate moving closer to 6.5% in a few years.

Which brings us to an interesting discussion. Should an acquisition of this size, which includes about 300 communities with 35,000 units (mostly independent living) and a significant development arm, be looked at from a cap rate perspective or some other valuation metric? The easy answer, at least from the buyer’s perspective, is that a cap rate is not that relevant for a large corporate acquisition, and that a discounted cash flow analysis is more appropriate. This would include the additional cash flow from new property developments, rate increases at the existing communities, the cash flow from additional services brought in and the residual value several years hence.

The problem with the internal rate of return (IRR) concept is that a significant portion of the total value comes from the residual value, which is the riskiest part of it with assumptions that are the most variable over time. If Fortress is looking at the deal from an IRR perspective, we assume they are coming up with at least an 8% to 10% annual return, counting on a high multiple of cash flow for the terminal value (and a low discount rate).

How do they achieve an IRR that could be double the cap rate? In addition to the new developments each year, they may be looking to rate increases in a business that has recently seen annual increases between 5% and nearly 10% in some markets. Given many of the markets where Holiday operates, however, we believe that line of thinking could result in some serious occupancy problems down the road.

There has also been some talk that Fortress believes it can bring in ancillary services to the Holiday communities in the same way it is trying to do at the Brookdale facilities with the newly acquired management skills from American Retirement Corporation. It is said that these can range from $100 to $200 per month per unit in revenues, which in the case of Holiday could add up to $50 million of annual revenues to the portfolio over time. But with the current staffing shortage in key disciplines such as physical therapy, we think they would be lucky to reach half that number, at best.

It is important to note that as it stands now, this acquisition by Fortress will be separate from Brookdale. As we understand it, most of the Holiday corporate staff would stay in place, and be a lot wealthier as well, with Mark Burnham tapped to be president. What happens in the future, however, is unclear. One possibility is that Fortress creates a new REIT out of Holiday in a few years, but would have to create a taxable REIT subsidiary for the management company part of the business. Another scenario is to build up the cash flow of the portfolio and then sell it to Brookdale and hope there is a positive spread between the two. We wonder who would make that investment decision, the Brookdale independent board members? An added twist to the situation is that Fortress itself filed in early November with the SEC to go public, and we don’t know how a $6.5 billion transactions fits into that.

No matter how you look at the transaction, or what assumption is used for an exit strategy, the pricing is rich. Although nothing is settled, we understand that about two-thirds of the purchase will be financed with floating rate debt and one third with equity (we believe there is just over $2.0 billion of existing debt on the portfolio, but we do not know what is assumable). That means the current cash-on-cash return will be in the low single digits, and a spike in interest rates could really put the squeeze on.

But we don’t want to underestimate the financial savvy of the Fortress people and their ability to structure transactions for the benefit of their investors. After all, who would have thought that Brookdale would more than double in price within six months of its IPO? Our guess is no one. Three months ago we heard that Fortress had a goal of reaching 100,000 units in a year or two, but through the Brookdale vehicle. We laughed. We are no longer laughing.

What we have not heard about is how Holiday will allocate the price among the 300-odd properties and the 300-odd limited partnerships that own them. Past and present Holiday employees have small interests in many of these deals, with senior management obviously having a significant stake. It would make for a lucrative appraisal assignment, but that may be avoided.

And finally, what can we say about Bill Colson? A gentleman, an honorable man, a straight-shooter, a sage of the industry and obviously one of its smartest investors. But the difference is that he really loves this business, and that is a big reason why he has been so successful. He is looked up to by his employees, his peers and his competitors, and we have never heard an unkind thing said about him. In an industry with a lot of behind the back sniping, that says a lot.

But fear not, he is not going anywhere. We don’t believe his small assisted living company is part of the deal, and we are unsure about his construction business (separate from the development business), but we are sure his lumber mills are excluded. In other words, he’s not going anywhere, and we expect to report on his activities in the future.