Seven is not a natural

With regard to the Cerberus private equity firm's acquisition of the Caritas Christi hospital system, I have been thinking about the request of a number of hospitals to the Attorney General that Cerberus should "commit to not selling Caritas for seven years instead of three"(see below.)

I came across a recent private placement memorandum (company not disclosed.) Here is what it says about this topic. I am not sure if this is the philosophy that guides the Caritas acquisition, but it is illustrative of the way in which private equity firms view the world:

The decision to exit an investment is based on a variety of factors, including the company's progress in achieving its potential, the General partner's view of an industry's competitive dynamics, the appearance of a willing buyer and the general state of the capital markets. The General Partner seeks to exit from a portfolio investment when it believes that the portfolio company has maximized or achieved a satisfactory level of operational improvement. Operational improvements may increase cash flow and allow the Partnership to realize a profit regardless of market conditions.

I read this as saying that imposing a seven-year requirement on sale of the hospital system or parts of it is likely to be a non-starter. Investors in a private equity firm expect that it will have flexibility to sell assets when it wants. While Cerberus has said it would not sell the Caritas assets for at least three years, that would be a minimum period needed to achieve operational improvements. Once you get past that length of time, you are more likely to have a going concern and you need to focus on the right moment to flip the investment to recover your capital and your profit.

I believe the concern expressed by the other hospitals is based on a fear that, if the retention time is short, the private equity group will under-invest in the Caritas hospitals and take the cash flow that emanates from the business to purchase physician practices and otherwise use the money to build market share. That larger market share would enhance the value of the overall business when the time comes to sell it to another buyer or to carry out an IPO.

I am not privy to financial projections or could say that this is the plan for Cerberus, but how could someone do it? It all rides on the existence of a major non-cash expense -- depreciation. If you take a hospital like BIDMC, with revenues of a billion dollars or so, a satisfactory operating margin might be $40 million, or about 4%. But our deprecation expense is, say, $65 million, so earnings before depreciation would be $105 million, or close to 11%.

If you chose not to use that depreciation for the usual purpose of renewal and replacement of capital plant and equipment, then it would be available for other purposes, like those that worry the competing hospitals. You would only do that if you did not plan to hold on to the assets for a long time. If you were planning to be a long-term operator, you would try to invest an amount at least equal to depreciation because you would have a concern for the long-term viability of your hospital.

So, I think these other hospitals are proposing a longer retention provision for the Caritas assets as a way of indirectly dealing with this possibility.

Since a requirement for a longer asset retention period is unlikely, another way of dealing with this concern is to get an enforceable commitment from the buyer that it would invest an amount at least equal to depreciation for the length of the retention period. In that way, it would not be as possible to "milk" the asset base for competitive purposes.

If Cerberus already intends to invest in the hospitals in this manner, such a provision should provide little or no impediment to the deal going through. If the company does not commit, then the regulators need to do a full analysis to see if there is cause for concern about renewal and replacement of capital facilities and equipment in these hospitals, especially if the plan is to use depreciation proceeds for acquisition of market share.