The Anatomy of a Deal: Taking The Bid Higher…And Higher
After the slow start during the first six months of the year, the acquisition market has certainly taken on a life of its own in recent months.  Perhaps it all began with the bid for Mariner Health Care (OTCBB: MHCA) at the end of June at a price level that preempted any of the other possible bidders.  It was certainly a sign that the senior care industry had finally awakened from a long slumber.  Many of the reasons for the depressed prices, for properties as well as public equities, and for so many years, had disappeared, helped by occupancy increases, better reimbursement and a renewed flow of capital into the market.  Low interest rates didn’t hurt.
Just after we went to print last month, Extendicare Inc. (NYSE: EXE.A) announced that it entered into an agreement to acquire Assisted Living Concepts (OTCBB: ASLC) for $18.50 per share for a deal value, including assumed debt, of approximately $280 million.  We were surprised by both the price and the ultimate buyer, because when the shares traded above $14 a month ago, we thought that was the limit and it would be difficult for the bidders to match that price level.
We were obviously out of tune with the market (we’re not alone), as there were multiple buyers willing to pay above $14 per share.  And Extendicare was not even on our radar screen as one of the potential buyers, since skilled nursing facility companies seldom venture into the assisted living market on such a large scale.  We shouldn’t have been too surprised, however, as EXE.A had previously stated that they wanted to expand into the assisted living business as a means to diversify their revenue stream.
What makes this deal interesting is that Extendicare came close to not winning the bid, and its offer was not the highest received. The process began in mid-2003 when the board of ASLC started to look into strategic alternatives to maximize shareholder value.  As a result of emerging from bankruptcy in January 2002, more than 95% of the new common shares were issued to a handful of pre-bankruptcy unsecured creditors, including a few industry insiders, such as affiliates of companies controlled by Andy Adams of National HealthCare (AMEX NHC) and Andre Dimitriadis of LTC Properties (NYSE: LTC).  One investor, Bruce Toll, controlled 28% of the common shares.
By January 2004, ASLC management held preliminary discussions with the board about a potential leveraged buyout of the company that would include one board member.  One of the conditions of such a deal, however, was the loosening of the lease terms on 37 facilities leased from LTC Properties.  Negotiations on the lease terms were unsuccessful, so discussions with management (Bidder 1) were terminated, although they resurfaced later in the game.
Nothing much happened until an unsolicited letter arrived in May from a group expressing an interest in acquiring the company (Bidder 2).  This caused the board to re-look at its “strategic options,” including the potential of a management buyout, since now two different interested parties had expressed an interest in the company.  By late June, a special committee of the board was formed and it hired Jefferies & Company to act as its financial advisor.  Jefferies began the arduous task of contacting more than 50 potential bidders, including five that had contacted the investment firm upon hearing that it was representing the board in a possible sale.  During this process, Bidder 1 (management) reappeared, wanting to preempt the auction process with a period of exclusivity.  Appropriately, the special committee decided it made little sense to close off other bidders at this early stage, a decision that probably ended up increasing the return to shareholders by at least 25%.
By the end of July, more than 25 confidentiality agreements had been signed and confidential financial information was released to potential buyers, who were asked to provide a written indication of price and terms by August 11.  Seven “indications of interest” arrived, with values between $11.00 and $16.00 per share, except for one that was at $19.00 per share, and that bidder also expressed an interest in completing a sale-leaseback of almost all of ASLC’s owned assets.  Extendicare was one of the seven, but its price range was between $11.00 and $13.00 per share, far lower than the ultimate price.
Six of these seven were picked to continue the process, with the “sale/leaseback” bidder being told they would have to wait until the offers firmed up from the other six.  These six were informed that a successful bid would have to be in excess of $15.00 per share, with a bid deadline of September 22.  More due diligence was completed by the buyers, but by mid-September they were encouraged to submit bids of at least $16.00 to $17.00 per share, or higher than the original estimates of the six.  It was at this time that the management-led group, which had not submitted an indication of interest in the first round, and was not one of the active bidders, reappeared again, asking for a copy of the draft merger agreement and all materials made available to other bidders.  The special committee complied, since the goal was to maximize shareholder value.
At about this time, LTC Properties hired Cohen & Steers to advise the REIT on potential alternative operators for the 37 facilities leased to ASLC, and Andre Dimitriadis resigned from ASLC’s board.  One of the problems with the lease was that there was a $75 million tangible net worth requirement that would have to be met by a buyer, even though ASLC itself did not meet that requirement.  This could easily preclude a financial buyer, who would not be likely to invest that much equity in the deal.  If a buyer had a tangible net worth of at least $75 million, according to LTC, a change in control would not trigger a default under the lease.  It was obvious that LTC was involved in a little gamesmanship, as it behooved the REIT to have as strong a buyer as possible emerge as the winning bidder.
By September 22, all six bidders plus Bidder 1 (management) submitted revised offers, all without financing contingencies, but only Bidder 1 failed to submit a marked up merger agreement.  The new offers ranged in price from $16.50 to $18.50 per share, with the highest offer coming from Bidder 1.  Extendicare’s offer came in at $18.10 per share, or 50% higher than its original indication, and Bidder 2 (the unsolicited letter last May) was at about the same price as Extendicare’s.
Bidder 1 had the advantage of knowing the company better than the others, and it wanted a three-week period of exclusivity for negotiations, but it did not want the board to disclose the proposed price per share for fear that a losing bidder may try to block the acquisition by purchasing shares from one of the few shareholders.  However, less than a week later, Bidder 1 reduced its proposed price to a level below the next two highest bidders (including Extendicare), so discussions with them were terminated.The special committee met on October 1 and after reviewing the next two best offers, recommended that the board move forward with Bidder 2 because they believed Bidder 2 was more familiar with ASLC and its operations and because it had fewer closing conditions than Extendicare.  Similar to Bidder 1, Bidder 2 did not want the board to issue a press release identifying the name of the buyer and the per share offer price.  In addition, Bidder 2 asked for significant expense reimbursement in the event that ASLC went with another buyer.
While these negotiations were going on, Jefferies was still holding discussions with Extendicare, a company that would clearly satisfy the $75 million net worth hurdle for the LTC leases.  Jefferies got Extendicare up to $18.50 per share with no request for expense reimbursement during a period of exclusivity.  That was enough for the board, and on October 15 it entered into an exclusivity agreement with Extendicare, which was followed a few weeks later by the November 4 acquisition announcement.  Who would have thought that four different buyers would have proposed deals above $18 per share, even though a few backed down from that level?
At first blush, we, along with almost everyone we talked to, believed that $18.50 per share was too rich, even in this increasingly frothy market.  It just seemed too high relative to where the stock had been, and the ASLC model (average facility size just under 39 units) is not one favored by many operators, or lenders.  In addition, many of its facilities are intentionally in states with Medicaid waivers, so ASLC has more Medicaid-waiver residents than any of its large competitors.  The stock price history, however, can be viewed as somewhat irrelevant, since with just five shareholders controlling 90% of the stock there was next to no public float.  And even though almost all of ASLC’s facilities were built in the past 10 years, which helps the valuation, the small average facility size and Medicaid census hurts it, in our view.
But after doing the math, we were surprised to find that the pricing is actually reasonable, especially in this market.  Using the $280 million transaction “value,” plus capitalizing the leases at 12.5%, produces a total cost of about $382 million.  The third quarter annualized EBITDAR comes to $42.3 million, yielding a cap rate of close to 11%, or a cash flow multiple of 9.0x, which is not too aggressive compared with other transactions in the market these past few months.  Looking at the deal after lease payments, the cap rate is 10.5% (or 9.5x EBITDA), using just the $280 million value.  Historically, cap rates for individual assisted living facilities have averaged in the 11% to 12% range, which include old and new facilities, stabilized and nonstabilized.  Consequently, when looking at the ASLC portfolio, which is getting close to stabilization at 88% to 89% occupancy and is relatively young, the multiple being paid by Extendicare is certainly consistent with the market.  And there is not the “control premium” usually associated with the purchase of a large company.
Dissecting the transaction further, the purchase price, using the full $382 million cost (with the leases capitalized) and total units of 6,838, comes to just over $55,000 per unit.  That seems quite reasonable for newer facilities and should be below replacement cost.  After incorporating the company into Extendicare’s corporate structure, some money should be saved, and if they can continue increasing the occupancy and get it above 90%, the multiple based on projected earnings should be even lower.
Readers have known that we have never been fond of the ASLC model, and even after several discussions with the company’s founder and the IPO underwriters back in the 1990s, we were not persuaded.  Small facilities in certain markets, or for certain types of residents, can make sense, but we never thought it did for a national roll-out of assisted living facilities.  The ASLC facilities serve mostly secondary markets, which is similar to the Extendicare market approach, but we do not see the geographic synergy that Extendicare does.
There are only four states where both companies each have more than five facilities (Indiana, Ohio, Pennsylvania and Washington), and 65% of ASLC’s facilities are in states where EXE.A has five or fewer facilities, including seven states in which Extendicare has no presence.  Assisted Living Concepts’ largest concentration is in Texas with 40 facilities, compared with just two for Extendicare, which divested most of its skilled facilities there because of the litigation environment.  That environment has improved somewhat, and EXE.A may consider a nursing facility portfolio acquisition in the future.
That being said, the deal does combine two companies with about the highest proportion of owned facilities in their respective segments.  Given Extendicare’s recent strong financial performance, this will result in a company with significant financial flexibility moving forward.  The deal should also be accretive, and in the realm of things a $120 million cash investment by a company the size of Extendicare is not that large.  But its last significant acquisition, skilled nursing provider Arbor Health Care at over $100,000 per bed before the big crash, ended up being as close to a disaster as you get, even though Arbor’s CEO was heard to complain he sold the company too cheap.  Kudos should go to Steven Vick, who came in after the bankruptcy and helped turn ASLC around and get it ready for a sale (he gets a $1.7 million change of control bonus), and to Jefferies & Co. for getting a price that no one thought possible.  It has not been disclosed what Extendicare plans to do with the ASLC home office and its staff.