Or, The Law Of Unintended Consequences
The announcement that Universal Health Services (NYSE: UHS) emerged as the winner in an auction to buy Psychiatric Solutions (NASDAQ: PSYS) caught many of us off guard, for a couple of reasons. First, what little M&A activity the behavioral health care sector has seen in the past several quarters has been small, so a $3.1 billion offer leaps out. Second, UHS has been a desultory buyer over the past few years, adding small facilities here and there, but nothing of this magnitude. And third, PSYS appears to have been primarily interested in finding a financial backer for a management-led LBO, not a strategic buyer that would replace management and its vision. How this deal evolved is traced out below, but first some details on the deal, its terms and participants.
Universal Health Services currently owns and operates 25 acute care hospitals with 5,484 beds and 102 behavioral health centers, including hospitals, with 7,921 beds, as well as ambulatory surgical facilities. On a trailing 12-month basis, UHS generated revenue of $5.2 billion, EBITDA of $731.0 million and net income of $264.0 million. In 2009, 73% of its revenue came from its acute care segment, with the remaining 27% from its behavioral and surgical facilities.
Founded in 1997 and focused on providing inpatient behavioral health care services, Psychiatric Solutions has grown to 94 facilities with 11,000 beds that it owns or leases in 32 states. On a trailing 12-month basis, PSYS generated revenue of $1.85 billion, EBITDA of $320.0 million and net income of $124.0 million. The company has grown through a steady stream of acquisitions, many of which are detailed in past issues of this newsletter.
Under terms of the agreement, Universal Health is offering to pay $33.75 per share in cash and to assume PSYS’s net debt of $1.1 billion, for a grand total of $3.1 billion. UHS’s bid offers PSYS shareholders a 3.4% premium to the stock’s prior-day price; however, the premium is more than 40% since news emerged in March that PSYS was actively pursuing a deal. In terms of acquisition multiples, this deal is worth $281,820 per bed, 1.7x revenue and 9.7x EBITDA. The transaction has fully committed debt financing provided by JPMorgan Chase Bank and Deutsche Bank AG.
The deal is transformative for Universal Health, making it the country’s largest provider of inpatient behavioral health care, and this is reflected in its financial projections. Once the deal closes, UHS will generate 45% of its revenue and 55% of its EBITDA from its behavioral health operations.
How did UHS enter the picture? Our April issue reported that PSYS had been in the sights of a number of private equity firms since last fall. Top management, it now appears, initially wanted to pursue a management-led LBO to privatize the company, insulate it from the reporting demands and costs of a public company and grow the business organically and through acquisitions. CCMP Capital Advisors and Kohlberg Kravis Roberts & Co. both looked at PSYS last fall but passed. Apparently, The Blackstone Group also scouted out PSYS with a view to merge it with the acute care operations of its portfolio company Vanguard Health Systems, a move that would have derailed PSYS’s CEO’s plan for a management-led LBO. Nothing came of that, either.
As of March 2010, the smart money seemed to be on Bain Capital as the frontrunner with an offer estimated at $2.9 billion. Some observers thought that Bain might merge PSYS’s operations with those of acute care operator HCA, one of its portfolio companies. True, PSYS’s CEO, Joseph Jacobs, had been at HCA for 21 years before founding PSYS and so knew the hospital giant’s inner workings well, but his time there might also have been a disincentive to merge behavioral and acute care operations. At any rate, such an integration would have needlessly complicated plans for HCA’s impending IPO, so management could still hold out hope that Bain would preserve PSYS’s operational and managerial independence.
Thanks in part to the law of unintended consequences, events then took a turn that PSYS management had not fully foreseen. Goldman Sachs was engaged by a special committee of PSYS’s board to offer advice on a potential transaction and help maximize shareholder value by running an auction for the company and soliciting higher bids. That opened the door for Universal Health’s bid. The board ultimately accepted UHS’s bid over Bain’s, and was likely swayed by the all-cash offer. The upshot is twofold: a strategic buyer displaced a financial buyer and PSYS’s management and vision for the company was supplanted by UHS’s. The divergence created by this deal between PSYS management and the board was palpable in the UHS announcement of the deal and ensuing conference call, where only the PSYS board was represented.
With the benefit of hindsight, we can see how what started out as a management-led LBO for PSYS became an acquisition opportunity for UHS. Having run through and discarded a number of private equity groups last fall, PSYS was left with a smaller field of potential financial buyers. And once the board was brought into play, they had to do right by the shareholders, and this opened the door to strategic buyers. In theory, strategic buyers can generally outbid financial buyers because the combination of a strategic buyer and a target in the same business can usually wring synergies and costs out of the deal. Such operating synergies are generally not available between a PEG and a health care facilities operator. And with cheap debt still scarce, there was not much of a chance for a financial buyer to pursue a concerted bidding war with UHS.
Although PSYS entered into this process with the goal of continued growth for its business, it is far from clear that UHS will embrace PSYS’s strategy of quick, steady acquisitions; instead, it may well substitute a business plan that relies on being the largest behavioral health provider in the industry. PSYS management must feel frustrated by this outcome; what they do now will be determined in part by the strictures of their noncompete clauses. However, many of them are still young enough to re-enter the business after the period of seclusion ends.
J.P. Morgan Securities provided UHS with financial advice; the ubiqitous Goldman Sachs provided PSYS with similar advice.