Simplify the M&A Market

The SeniorCare Investor: Senior Care Portfolio's Back

 

Breaking The Logjam In The Senior Care M&A Market

Even though last month’s lead story was based on the seniors housing and care merger and acquisition market being in a near-term slumber, we are going to be very contradictory in just a month’s time. The odd thing is that while nothing has really changed in a month’s time, everything has changed, at least perhaps the perception that everything has changed. What may have summed up the market for the past six months was a quote from someone who prefers to remain anonymous, which was, "I was the only one to show up to bid, and I still didn’t win."

This may say it all. First, although many were invited to the party, not many wanted to show up. Second, just showing up doesn’t mean you are going home with anything. This can have several meanings which can lead to a few questions. First, what was the reason only one bidder showed up and made a bid? Second, is the fact that their bid was not the "winning bid," since it was the only bid, indicative of the problem for the past six months the market has had, namely that we are still going through a price rationalization process in the acquisition market? Many sellers have still not accepted the new reality in the market, whatever that reality may be, and buyers continue to be tempted to prey on the thinned-out market demand and bid a little too low in their attempt to "steal" a deal. But then again, one has to define what the word "steal" means in this market, and no one really knows.

Getting back to the perception that the market may be about to turn for the better, for months we have been saying that it was unlikely that many large deals, defined as over $500 million, would get done this year because of the lack of funding, or the cost of it, for anything that size. In fact, we thought at best there might be one large deal, and perhaps someone would take a run at one of the public companies when it looked like a few of their stock values were getting enticingly low. A month ago, there did not seem to be any real possibilities on the table. Today, the potential dollar value of portfolios that have just come on to the market, or are about to, is between $3.0 and $4.0 billion. Say what? It is almost as if a group of M&A bankers got together, clicked their slippered heels three times and chanted, "Take me back home to…2006."

The first portfolio, and the largest, is privately-held Sava Senior Care, which is basically the remnant of the former Mariner Health Care. On December 10, 2004, the predecessor of Sava, National Senior Care, purchased Mariner for approximately $1.0 billion, which included $615 million in cash for the stock and $385 million of assumed debt, plus the assumed leasehold interests. At the time, Mariner operated 256 skilled nursing facilities and eight assisted living facilities with a total of more than 31,400 beds and trailing 12-month revenues of $1.7 billion. We understand that the portfolio is down to around 200 properties with revenues maybe in the $1.5 to $1.6 billion range.

Sava tried to sell its portfolio of mostly leased California skilled nursing facilities last year, but without the real estate, the pricing was too rich for a market that was beginning to deteriorate. We have heard that there was some talk of just selling the operations of Sava, but we understand that the entire portfolio going on the market will be for the operations and the real estate, when available. Although we thought Credit Suisse was going to be tapped to represent Sava (and may have done some preliminary testing of the market last fall, given that they did the acquisition financing more than three years ago), Gray Hampton and Lyle Wilpon of Banc of America Securities have been given the job.

It is too early to know about any pricing, and usually in these large corporate transactions there is no asking price. That being said, our guess is that they are looking for a price somewhere between $1.5 and $2.0 billion. A few months ago, most everyone would have said, "No way." What we don’t know is how serious the owners are about selling the company. If they didn’t like what they saw in a preliminary look late last year, has something changed in their price expectations, do they need some liquidity for their investors and other real estate interests, or do they simply see a market that is more willing—and able—to finance a large transaction? We hope to find out soon, but since a deal won’t close until the end of the year, that would be a four-year holding period for the asset, which is about the right timing for a sale.

So, who would the likely buyers be for a deal of this size? We have to assume that Formation Capital will take a hard look, as will Fillmore Capital, although we have heard mixed news about how Fillmore’s investment in the former Beverly Enterprises is going. Fillmore would be an interesting player in a deal for Sava, because there is certainly no love lost between Fillmore and Formation after the battle for Genesis Healthcare last year, nor is there any love lost between Fillmore and some of the investors in Sava who thought they were mistreated when Fillmore came in at the last minute to "save" the Beverly deal (whew, too much history here). After those two, we assume that Blackstone Group and KKR will take a look, and a REIT or two should have some interest. Most everyone will want to look, partly out of curiosity about the portfolio, but also to get a flavor as to pricing parameters in today’s market. There is a good chance, however, that nothing will get done.

GE Portfolio.
Speaking of pricing parameters, we hear some rumblings that GE Healthcare Financial Services is about to go to market with a large portion of its owned skilled nursing facility portfolio that is leased out to third party operators. Apparently, this will be a bit different from the portfolio that GE tried to sell last year, with the former Beverly, Mariner and Genesis Florida nursing facilities included, but perhaps with the Laurel Health Care assets added this time around instead of the Centennial Healthcare assets. This would be a pure real estate play since GE just collects the rental income plus a share in the extra cash flow based on a formula.

Although we don’t know for sure, GE may have some concerns because of the profit-sharing arrangement in some of the leases and the appearance that they then have some control over operations, and thus some liability. As we have always stated, we believe there is no operational control or influence over what happens inside these skilled nursing facilities, but with people like Henry Waxman and Pete Stark populating Congress, a company such as GE is forced to proceed with caution. Since the big up-tick in Medicare census and cash flow has already occurred, if GE can’t get a deal done, one solution might be to convert some portion of the participations into the base rent to avoid the potential liability problem.

We believe that GE paid about 10.5x (or slightly higher) rental income, which we assume includes the participations, but that the asking price may be closer to 12.0x, which would put the asking price just over $1.0 billion. The timing of last year’s attempt to divest some of these assets was awful, to say the least, so the fact that they are coming out again may indicate that they see the market strengthening a bit, or they are hedging their bets. Once again, the success of this potential deal will have a significant psychological influence on the market, perhaps not quite the impact of the original purchase in 2006, but important nonetheless. We hear that Houlihan, Lokey has been tapped to handle the sale this time around.

AL/IL Potential Portfolios.
The two skilled nursing facility portfolios mentioned above have a combined potential value of $2.5 billion or more, but there are also some deals brewing on the assisted/independent side of the market. Although not technically for sale (yet), the first one we have to mention is Capital Senior Living (NYSE: CSU), which announced on May 29 that a special committee of the board hired Gray Hampton and Michael McIvor of Banc of America Securities as its financial advisors to assist the committee in actively exploring a range of "strategic alternatives" to maximize shareholder value. Now, this does not always mean that a sale will be the outcome, and in this market that is certainly not a given. Shareholders were certainly not impressed, initially sending the stock price down by 4.5% on the news, which is unusual when the ubiquitous "strategic alternatives" announcement is made. Our view has been that if truly maximizing shareholder value is the goal, they should continue to grow the company and, when cash flow is higher and the markets stronger, they should then look to capitalize on that increase in cash flow and value through a sale. That may end up being the recommendation of the advisor, but current shareholders may be impatient since there is certainly no guarantee that values will be higher in 12 to 24 months’ time, and there is that notion of the time value of money.

Capital Senior Living has been trading between $8.00 and $9.00 per share for the past few months, and while we are not sure what would entice a buyer to pay a 20% to 25% premium to get control of the company, we don’t think that kind of price would be acceptable to the board in terms of "maximizing" shareholder value, even though there are some shareholders who would now jump at that higher price level. In a simplistic way of valuing the company, by taking the first quarter EBITDA (annualized), adding back the G&A expense and then subtracting a 5% management fee, you derive a $9.90 per share value using an 8% cap rate after deducting the outstanding debt. That represents an attractive 23% premium to the closing price at the end of May, but is that really what shareholders want? When Mercury Real Estate Advisors, which used to own 9.8% of CSU, was pushing for a sale of the company two years ago, we came up with a theoretical value of $10.65 per share with some different assumptions (7% cap rate, for one), which was less than the then market price.

In a recent report by Stifel Nicolaus after CSU’s first quarter earnings came out, Jerry Doctrow came up with a $15 per share net asset value (which usually overstates the value), a $10 per share value using a cash flow from facility operations analysis and an $8 per share value using a discounted cash flow analysis. Frank Morgan of Jefferies & Company has a price target of $11 per share based on an 11.25x multiple of his estimated 2009 EBITDAR. These are wide ranges which just illustrate why valuing these companies, and assets, in this market is so difficult. It is also why you should attend our audio conference on June 17 (new date) to learn how four seniors housing and care equity analysts view the current state of the market and how they are valuing the industry.

For Capital Senior Living, there are not many logical cash buyers in the market, and we are not sure the board would, or should, accept the stock of a strategic buyer, and there are not many of them looking to do a deal right now anyway. It is always better to sell from a position of strength; on a sequential basis, CSU’s EBITDAR and occupancy declined, and a buyer will have to wonder if there will be any more census weakness. Since the company mostly targets the middle market, and with that kind of consumer usually having a larger percentage of their net worth tied up in their home value, the current housing market weakness does not help matters, which is another reason why we say CSU should wait. There has been some mention of selling the assets in pieces and not the company as a whole, but that is a much higher risk today than 12 months ago, because if half the assets (the better ones) were sold off, what would be the value of what’s left, especially if the remainder couldn’t be sold?

Obviously, the Banc of America advisors are going to have to do some homework to decide whether a sale of Capital Senior Living is in the best long-term interests of shareholders, but another portfolio that we hear has recently come onto the market may shed some light on current investor demand. We understand that Arcapita, Inc., formerly known as the First Islamic Bank, has just gone to market to try to sell its 80% interest in The Fountains, which was purchased with Sunrise Senior Living (NYSE: SRZ) in the middle of 2005 for a total of $483 million. At the time, there were 18 retirement communities, many of which were CCRCs, with a capacity for 2,769 independent living residents, 1,318 assisted living residents and 779 skilled nursing beds. Arcapita actually purchased an 80% in the real estate of 16 of these properties, with Sunrise paying about $67 million for its 20% interest and, of course, the right to manage the entire portfolio. And that may be the rub in this deal.

Although the portfolio has been difficult for Sunrise, especially with regard to some occupancy issues at some of the newer properties, we have to believe that Sunrise wants to continue managing the portfolio for a new buyer. So, just as GE wants to sell the real estate with leases in place, it looks as if Sunrise and Arcapita will be trying to recapitalize the Fountains portfolio, but with the Sunrise management contracts in place. That obviously limits the appeal of this acquisition for those strategic buyers who want to operate the communities themselves, as well as for any investors who, for whatever reason, may not want Sunrise in as the manager. We have not heard of an asking price, if there is one, nor whether Sunrise will be selling its 20% interest as part of the deal. Since the original price was about $483 million, that may be a starting point, and the middle of 2005 was still 18 months from the peak in the acquisition market. But…if the portfolio’s performance has not improved, the original price may have no bearing on today’s value at all.

Other Portfolios.
The big transactions always make the headlines, but there are several smaller portfolios that either have recently come to the market or are about to go. We had mentioned last month that Heavenrich & Company was working on the sale of an assisted and independent living portfolio that may go for $180 million, but we also hear that CB Richard Ellis will have in the market a portfolio of more than 1,000 independent living units that could have a value in excess of $200 million. In addition, Mark Myers of Marcus & Millichap is marketing a portfolio of assisted living facilities located in various states that can be expanded up to 50 facilities. A buyer who can purchase all 50 will have the higher priority, but these properties can be sold individually or in small groups. We assume the maximum value for the entire group would be in the $400 million to $500 million range, but the individual prices would have a wide range because of quality and occupancy.

On the skilled nursing side, Senior Living Investment Brokerage is going to market with a five-facility portfolio, and there has been a $300 million deal (or so we hear) in the works for several months through Lee Haris, who quietly returned from China a few years back. The point is that, in addition to the single-facility sales, there is a lot of inventory on the market with prices between $50 million and $2 billion, not to mention a few medium-size portfolios that are set to close in the next month or two.

This represents the most potential sales activity since the first quarter of 2007, but there is a little debate as to exactly what it all means. Is the fact the a few very large portfolios are coming to market at a time when the capital markets are still troubled, to say the least, a sign of distress selling by investors who may be worrying that the markets and values will get worse before they get better? Or, is this a signal that some people believe that the debt markets are strengthening, and with some liquidity returning, investors are ready to put their money to work?

If one or two of the large transactions actually get done, it will be a huge boost to the seniors housing and care acquisition market and we may see a substantial increase in inventory coming to market late in the year and into 2009. However, if the market basically says no, and they don’t get done, then a certain degree of pricing reality may finally set in with all players, and we may see more deals getting done and the current disconnect between many buyers and sellers disappearing, with the logjam of deals breaking up. It is important to remember that under either scenario, M&A activity would theoretically increase, just not for the jumbo transactions.