Buying and Selling Hospitals, Valuations, Due Diligence and Other Issues. Carsten Beith - Cain Brothers

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1 Buying and Selling Hospitals, Valuations, Due Diligence and Other Issues Carsten Beith - Cain Brothers David Felsenthal - Principle Valuation

2 Current Hospital Market Conditions Current Outlook Impact of current national economic condition significant Fewer insured leading to higher self-pay patients and charity care Fewer elective surgeries Capital preservation remains a key mandate for not-for-profits Magnitude, timing, and structure of health care reform adds substantial uncertainty to industry. For sector generally, likely to be neutral to positive Fewer patients admitted for certain procedures that are deemed ineffective, and thus not paid Elimination or reduction of disproportionate share money that now goes to hospitals could hurt some hospitals More patients are likely to get access to care Fewer people will have their illnesses undiagnosed and untreated Recent difficulties in commercial segments of managed care plans may affect future volumes as managed care providers experience significant margin pressure driven by increasing medical care costs Moody s has changed its outlook for the not-for-profit health care sector to negative from stable Short-term risks include capital financing, variable debt rate structures, investment losses and cash positions Both State (Medicaid) and Federal (Medicare) government programs will be under significant pressure from widespread budget shortfalls 2

3 Current Hospital Market Conditions Current Outlook There is a significant current and projected shortage of physicians nationally Hospitals back in practice acquisition mode Larger groups seeking safety of hospital networks Longer term critical shortages may shift balance Physician ownership in hospitals has continued to remain a legislative focus with some likely regulatory limitations expected as part of the broader contemplated health care reform Limitations will create challenges to the core long-term business models of several hospital operators such as MedCath and National Surgical Hospitals Source: Association of American Medical Colleges, Center for Workforce Studies, The Complexities of Physician Supply and Demand: Projections Through 2025, Page 6 3

4 Current Hospital Market Conditions Current Outlook Not-for-Profit Hospital Operators For-Profit Hospital Operators Consolidation for single and small systems is Small and mid-sized operators are challenged as being driven by broader industry challenges access to debt capital has become difficult and cost as well as the increased challenges in of debt, if available, has increased dramatically accessing the debt capital markets Emergence of orphan investor-owned Systems are looking for new ways to raise consolidators without sufficient capital to continue capital including non-core asset sales to buy growth Joint-ventures with for-profit health care systems or other for-profit partners (ASCs, imaging, etc.) are increasingly used to address key challenges Capital constraints Market consolidation Physician relationship enhancement Larger systems are generally focused on capital preservation and selective strategic merger opportunities to further spread significant overhead costs and enhance relative market position Consolidation of small and mid size operators likely Large operators are selectively culling their portfolios through divestitures in part to deleverage by shedding non-core and underperforming assets Mid and large-sized operators are generally still looking for attractive acquisition opportunities; however, most are demonstrating a more selective approach than in the past Newly funded operators likely to be significant factor in 2010 hospital M&A HCA and Vanguard IPOs likely 4

5 Current Hospital Market Conditions Emergence of Orphan Consolidators Ardent Health Services (WCAS, Ferrer Freeman) Capella Healthcare (GTCR Golder Rauner) CHS (public) Essent (Vestar, Thoma Cressey) HCA (Bain, KKR, ML) Iasis (TPG) LifePoint (public) HMA (public) Tenet (public) Signature (Goldman Sachs) UHS (public) Vanguard (Blackstone) Asset Acquiror Asset Seller Liquidity Event Unlikely Neutral/Unclear Likely 5

6 Current Hospital Market Conditions Systems are looking for new ways to raise capital Assets Funding Sources System Response Financing Options Acute Care Hospitals Non-acute Assets and Operations ASCs MOBs Senior housing Home health Hospice Lab Rehab Bh Behavioral health Fixed rate Access constrained Widened spreads Variable rate Dysfunctional auction program VRDN bank bonds due to limited dealer support Limited bank capacity Investment losses & declining philanthropic support Revising strategic capital plans Deferring and/or eliminating projects Value engineering Prioritizing core & non-core projects Implementing hurdle rate discipline to financial analysis of projects Assessing impact on debt capacity & credit ratings Traditional fixed or variable bond financing Spin-off into separate organization with own credit structure SNFs and senior living Project financing using federal guarantee programs Sale leaseback transactions using operating leases Transportation Physician integration assets Other non-clinical businesses Debt covenants & trend of rating downgrades Engaging in operational improvements to restore liquidity Cost efficiencies Program assessment Revenue cycle improvement Sale of non-acute assets/operations Joint ventures of nonacute operations Management agreements Historically, most assets owned & controlled by Systems/Hospitals Higher borrowing costs & reduced reliance on other sources Substantial capital requirements exceeding funding sources Diverse sources to fund capital projects 6

7 Current Hospital Market Conditions Valuations Hospital transactions have continued to remain generally strong over the past 10 years, although there has been some slowing, especially for larger transactions 2008 saw a decline in total transaction value in the hospital sector by 68% due primarily to fewer large transactions Single hospital and small groups continued to sell Activity was closer to the levels seen in 2005 the last year without a mega-transaction While valuations have remained generally strong since 2001, recent market conditions had put downward pressure on valuations driven by limited access to capital, reimbursement environment and increased levels of bad debt and charity care. Expected economic improvements combined with stronger debt markets are reversing this trend. 2Q09 and 3Q09 has begun to demonstrate increased market activity and appetite for hospital transactions 1.2x 1.0x 0.8x 0.6x 0.4x 0.2x 1.0x 1.0x 1.0x Revenue Multiples (1997 Q2 09) EBITDA Multiples (1997 Q2 09) 1.1x 1.0x 1.2x 0.9x 0.8x 0.7x 0.8x 0.8x 0.8x 0.7x 0.7x 0.8x 0.8x 0.7x 0.6x 0.7x 0.7x 0.6x 06x 0.6x 0.6x 0.5x 0.5x 0.5x 20.0x 15.0x 10.0x 5.0x 16.8x 17.8x 12.4x 13.5x 11.5x 12.8x 13.0x 11.9x 10.7x 10.3x 79x 7.9x 9.3x 76x 9.9x 8.0x 7.6x x 8.0x 9.9x 8.1x 7.7x 7.9x 7.5x 6.9x 7.7x 8.0x 6.5x 0.0x '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 1H x '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 1H 09 Average Price / Revenue Median Price / Revenue Source: Irving Levin Associates, Inc. Average Price / EBITDA Median Price / EBITDA 7

8 Current Market Conditions For Profit Hospital Debt Transactions After a slow start in 2009, for profit hospital debt issuers are coming back to market, although the cost continues to remain relatively high. Date of Close Company Issue Rating Total Amount Coupon Issue Price Yield Maturity Type 2/19/09 HCA B2 $310mm 9.875% $ % 2017 Senior Secured Second Lien Notes Current Price (1) Current Yield (1) $ % 4/22/09 / HCA Ba3 $1,500mm 8.500% $ % 2019 Senior Secured First Lien $ % Notes 5/7/09 Psych Solutions B3 $120mm 7.750% $ % 2015 Senior Subordinated Notes $ % 6/15/09 Tenet B1 $925mm 8.875% $ % 2019 Senior Secured Notes $ % 7/29/09 Prospect B3 $160mm % $ % 2014 Senior Secured Notes $ % Medical 8/11/09 HCA Ba3 $1,250mm 7.875% $ % 2020 Senior Secured First Lien Notes $ % Source: Bloomberg & Reuters. Note: Rating issue based on Moody s ratings. 1: Pricing and Yield as of 9/10/09. 8

9 Current Market Conditions Tax-Exempt Hospital Observations Current capital market conditions makes access to tax-exempt debt capital difficult and costly Weaker balance sheets from investment losses and higher borrowing costs have changed the fundamentals of health care financing challenging access to capital and re-prioritizing projects Capital markets have tightened significantly, with lenders less willing to place extraordinary amounts of fleverage on companies and have returned to more conservative lending practices Although appetite for attractive investment opportunities have seen increased interest in recent weeks, investors are still cautious Constrained access to capital has lead a number of hospitals and health systems to consider various strategies including: Pursuing operational efficiencies and more focused attention to core businesses Reprioritizing capital allocation Divesting and realigning hospitals within their system that are not core assets Attracting ti external capital through h JV and/or affiliation agreements Divesting of non-core assets Hospital systems can often generate significant value with the divestiture of certain non-core business segments. To pursue such strategy, several key considerations must be taken into account by management and boards: Significance of each business segment to hospital system s core operations and mission Impact of divestiture on core operations as well as business line operations Potential for long-term contracts with business unit and ongoing relationship with new partner/acquirer Quality of business services, post-divestiture Impact on community Impact on existing employees and medical staff 9

10 Valuation Drivers Approaches to the M&A Process While the discrete approach offers maximum confidentiality and flexibility, a competitive auction produces greater confidence in maximizing value through multiple potential proposals Maximum Fl lexibility / Confidentiali ty Direct Negotiated Sale Targeted Solicitation Staged Bidding Process Broad Auction Minimum Confidence in Value Maximization i Maximum 10

11 Process Management Disclosure Progression The following depicts how the closely controlled process protects a seller s competitive position while maximizing value and minimizing time to close Phase Initial Contact Initial Contact Post LOI / Closing Nature of Activities Cain Brothers Confirms and Qualifies Level and Nature of Interest Upon Execution of NDA Limited Information in Memorandum Select Potential Buyers Based on Submission of Competitive Bids Management Meetings Access to Virtual Data Room Select Buyer Executes LOI Confirmatory Diligence Documentation Negotiations Incremental Information Disclosed No names Historical and Detailed financial Unbinded agreements discussion describing projected financial information and Individual nature of potential information supporting schedules management opportunity interviews Industry segment and business model Approximate revenues and margins If qualified, name of company upon delivery of NDA Description of Landmark s: Strategy Investment Highlights Products and Services Organizational Information Organization and related legal documentation Material contracts without customer names, pricing, salary information, etc. Key employment and benefits information Employee and client names blinded from HR diligence materials Client calls 11

12 Process Administration Identification of Transaction advisors Legal Investment banking Accounting Pension Insurance Real estate matters Data management Disclosure Data room Ongoing operations Continue to execute the business strategy that is judged to be in the best long-term interest of the seller As the process evolves, there will be various decision points that will allow for an exchange of information and views Communications Manage turmoil that can occur Gain support for process Gain support for transaction Manage competitive threats Retain physician loyalty Confidentiality How to manage When to disclose Identification and management of communication to constituents Medical staff (Managing organized opposition) Employees (Retention risk) Employers Payors Community leadership Community at-large Media Timing and form of communication 12

13 Process Timeline A typical investor-owned sale process will require approximately 3-5 months to execute a definitive agreement. Not-for-profit transaction 2-3x longer. Preparation of Marketing Materials Solicitation & Marketing Due Diligence Negotiation & Documentation Weeks: 1-4 Weeks: 5-8 Weeks: 8-12 Weeks: Organizational meeting / Internal due diligence Detailed review of 5-year financial model Prepare Confidential Information Memorandum ( CIM )/marketing materials Prepare and handicap potential buyer list Contact potential buyers Disseminate CIM/marketing materials & bidding procedures Follow-up with parties to respond to questions Prepare and finalize management presentation Prepare and finalize data room Preliminary indications of interest due Evaluate Proposals / Select Phase II candidates Conduct management presentations Access to data room (virtual or on-site) Distribute draft purchase agreement and final bidding procedures Final proposals due Evaluate proposals / Select Phase III candidates Buyer confirmatory due diligence Negotiation and finalize terms Sign definitive iti agreement / announce transaction Regulatory and other approvals Closing 13

14 Sell-Side Process Review Keys to a Successful Process When considering a sale, there are a number of keys to a successful process Process Management Internal Issues & Preparation The nature of transaction process is dictated by consideration of a wide range of factors, including: Tax efficiency and form of transaction; Value objectives; Desired contractual terms; Confidentiality Continuity of management; Overall pace of the process; Interest in post-transaction ownership; Alignment of incentives; Competitive sale environment Rigorous up-front due diligence and preparation; Proper positioning of the Company; Aggressively sell the investment opportunities Proactively address the potential buyer concerns and/or issues Ability to demonstrate sustainable growth in earnings; and Provide well-conceived and supportable financial projections to potential buyers. Limit management contact with prospective buyers/maintain a small inner circle Only key managers should be present at meetings Exchanging of contact information may be limited as appropriate Utilize Cain Brothers as conduit for information Coach management on purpose and format of meetings Define prohibited discussion topics Elements of the process Number of buyers/timing of previous meetings Discussions with other buyers Internal sentiment regarding process and/or potential buyers Discuss potential questions and responses in advance 14

15 Buy-Side Process Review Keys to a Successful Process When considering a purchase, there are a number process considerations include: Process Management Internal Issues & Preparation Understand seller process Auction vs. negotiated transaction Seek exclusive purchase opportunity Preemptive premium can be determined Tax efficiency and form of transaction; Value minimization; Desired contractual terms; Confidentiality; Seller interest in post-transaction ownership Alignment of incentives; Due diligence Determine critical information needs early Focus on details with knowledgeable support Rigorous due diligence Financial discipline Determine maximum price Don t overestimate synergies Understand seller financial projections and impact on existing operations Emotions and motivations are important considerations Risk assessment External environment Competitive threat Impact on internal operations Gather market and process intelligence Put your self in position of seller Respect seller process Establish informal lines of communications where possible Foster relationships Prepare rigorous projection model and valuation estimate Conservative but realistic Differentiate between synergy value and financial value Employ capital asset pricing i model or other value discipline to ensure accretive impact Not-profit: credit profile Investor owned: IRR Every contact is an opportunity 15

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