Read the Private Equity Case: Merger Consolidation case study. In your initial post, address the following:
- What are the circumstances of the HBR case?
- Evaluate the physical therapy industry for potential investment opportunity by a private equity investment fund.
- Cite the advantages and disadvantages.
- Look at the proportion of health care GDP.
- Look at the outpatient PT and the proportion of yearly medical spending.
- What are the financial circumstances of our case? Explain the financial similarities, particularly with regard to EBITDA and cash flows.
- Could real option financing be used in the healthcare industry to fix it in the long term?
Private Equity Case: Merger Consolidation In early 2006, Aaron Brown, recently promoted to partner, was meeting with JohnFields, the founder of ACE Equity Partners, a mid-size private equity fund inChicago, Illinois. Aaron was recently put in charge of the newest investment oppor- tunity for ACE, the possible acquisition of two physical therapy (“PT”) companies in Ohio and Maryland. ACE’s primary investment strategy for the space was to consoli- date smaller private PT businesses that focused on patient outcomes into a much larg- er enterprise. ACE anticipated selling the consolidated enterprise to a larger private equity fund or taking the company public in three to five years. John: Congratulations on your recent promotion to partner. Now you get the chance to prove yourself on this potential PT investment. Aaron: Thanks. I’m excited to be in charge of this investment opportunity. I now have all the major documents for these two PT companies including (1) the CPA firm’s accounting reports on both PT Companies, (2) the investment banker’s prospectus on both PT Companies, and (3) financial analysts’ reports on the PT industry. John: Excellent. I look forward to your analysis and recommendations on this PT investment opportunity for our partners investment committee meeting next Monday. Aaron: I will be ready. PT INDUSTRY In reviewing the financial analysts’ reports on the PT industry, Aaron noted that one analyst had just initiated coverage of two public PT companies, U.S. Physical Therapy and RehabCare Group. He thought such interest was a good sign for the PT industry although he noted that his recommendations for these two companies were “hold/high risk.” Aaron summarized key PT industry points from the reports of the financial ana- lysts and the prospectus of the investment banker as follows: • The United States spent a larger share of its gross domestic product (GDP) on healthcare than any other major industrialized country. Expenditures for healthcare represented nearly one-seventh of the nation’s GDP and continued to be one of the fastest growing components of the Federal budget. For example, in 1960 healthcare Private Equity Case: Merger Consolidation 1 Private Equity Case: Merger Consolidation* Hugh Grove, University of Denver Tom Cook, University of Denver Copyright © 2008 by the Case Research Journal, Hugh Grove, and Tom Cook. * This case won the Silver Award as the second best case presented at the 2006 NACRA Conference held in Keystone, Colorado. NA0030 For the exclusive use of B. HANER, 2019. This document is authorized for use only by BROCK HANER in FIN-630 Capital Budgeting & Financing 18TW2 taught by SNHU INSTRUCTOR, Southern New Hampshire University from Sep 2018 to Mar 2019. 2 Case Research Journal • Volume 28 • Issue 1 • Winter 2008 expenditures were five percent of GDP. By 2005, healthcare expenditures had grown to more than fifteen percent of GDP. • Economic factors in the healthcare industry were driving growth in PT. Healthcare payers, such as governments, insurance companies and employers, had become increasingly focused on eliminating unnecessary healthcare costs from the system. Because of the trend toward minimizing healthcare cost, many payers were focused on the quality of the care provided to patients. It was less expensive for payers to have a patient treated correctly the first time than to have the patient return to therapy after a recurring injury. Thus, PT companies that focused upon outcome based results were receiving increased referrals from payers and employers. • The PT industry was estimated to be a $12 billion market and had been growing 12 percent annually over the last five years. The industry was highly fragmented with 16,000 companies, the majority of which were small “Mom and Pop” entrepreneurs. No competitor had more than a 5 percent market share and the top five operators, HealthSouth, Select Medical, Stryker, Benchmark, and U.S. Physical Therapy, together had only a 17 percent market share. Smaller private companies comprised the remaining market share. • The PT industry had low barriers to entry because the cost (facilities and exercise equipment) of starting a practice was minimal. Additionally, Congressional legisla- tion in 1998 allowed physicians to open PT clinics, thereby increasing competition for patients. • There were more than 120,000 licensed physical therapists in the U.S. They practiced in many settings, including outpatient clinics, inpatient rehabilitation facilities, skilled nursing facilities, extended care facilities, homes, research centers, schools, hos- pices, workplaces and fitness centers. The Department of Labor predicted above aver- age employment growth for therapists through 2012 as (1) the growing number of individuals with disabilities or limited function, including aging baby boomers, spurred demand for therapy services and (2) therapists’ compensation was among the industry’s highest levels. The growth, however, had created a shortage of therapists in many markets as new job demands exceeded the number of licensed PTs. • The most important driver of any PT company was its relationships with referral sources and payers. Although patients received the treatment, physicians generally controlled the flow of patients to PT companies through referrals. Additionally, large commercial health insurance carriers and Health Maintenance Organizations (HMOs) often determined the reimbursement rates that PT companies received. PT companies typically negotiated directly with these commercial payers for reim- bursement both contractually and for each individual claim. • Price was always an issue in the PT industry as payers viewed low prices as the easi- est way to cut down on expenses. Pricing pressure in the industry, intensified by leg- islation that allowed physician office-based clinics, had created a difficult environ- ment for providers to offer the right quality of care at the right price. For the exclusive use of B. HANER, 2019. This document is authorized for use only by BROCK HANER in FIN-630 Capital Budgeting & Financing 18TW2 taught by SNHU INSTRUCTOR, Southern New Hampshire University from Sep 2018 to Mar 2019. Private Equity Case: Merger Consolidation 3 THE OHIO PT CHAIN The Ohio PT company was founded in 1997 by physical therapists and exercise phys- iologists. By the end of 2005, it had grown to eight clinics located in major cities across Ohio. Patients typically ranged from 16 to 55 years of age. The Ohio firm focused upon combining and applying best practices from the disciplines of physical therapy, exercise physiology, and athletic training. The company focused on large clinics with extensive equipment, located in major population centers, marketing itself as providing one-source or one-stop rehabilitation solutions. Each Ohio facility had a minimum of 5,000 square feet, as opposed to the typ- ical “store-front” PT facilities of about 1,000 square feet. With state-of-the-art equipment and one-on-one sessions with physical therapists and trainers, the Ohio facilities appeared to be gyms where people were enjoying rehabilitation. Such practices led to a 10 percent appointment cancellation rate, as opposed to the normal 50 percent cancel- lation rate in the PT industry. Such practices also helped retain and attract physical ther- apists. Additionally, the Ohio firm was well known throughout the industry as providing the best rehabilitation services in the industry and had recently been honored as the best private practice in the U.S. by a rehabilitation magazine. THE MARYLAND PT CHAIN The Maryland (MD) PT company, founded in 1999 by physical therapists, was some- what younger than the Ohio company. It had grown to fourteen clinics located in major cities across Maryland and Delaware and treated patients ranging from 16 to 55 years of age. MD focused primarily upon the discipline of physical therapy. MD also tried to concentrate on large clinics in populated areas, but it did not have state-of-the-art equipment and was known as a “churn and burn” provider, focusing on putting as many patients through the system as possible. MD’s focus was similar to the typical PT approach, relying on many “store-front” clinics to increase the number of patients. Therefore, it did not have an established, favorable reputation to facilitate the growth rate that the Ohio PT company had. However, MD did provide a number of services that the Ohio firm did not, including aquatic therapy, hand therapy and spine therapy. Also, MD had a very efficient collection system that focused on ongoing com- munications with its payers, especially for accounts past 30 days old. ESTIMATING EBITDA FOR BUSINESS VALUATION Working with the information from the CPA firm, Aaron planned to recast the financial statements in order to derive earnings before interest, taxes, depreciation, and amortiza- tion (EBITDA) for the last two years. He knew that an accurate EBITDA calculation was needed to help determine the final valuation for each PT company. In order to accu- rately calculate this figure, Aaron had to adjust or recast whatever revenues and expenses had been reported in the income statements by the PT firms’ unsophisticated bookkeep- ers. Such initial numbers were mainly cash accounting with attempts to do accrual accounting for accounts receivable, prepaid expenses, and accrued expenses. These adjustments focused on recasting this unsophisticated combination of cash and prelimi- nary accrual accounting to complete accrual accounting for revenues and expenses under generally accepted accounting principles (GAAP). Neither company had ever had an For the exclusive use of B. HANER, 2019. This document is authorized for use only by BROCK HANER in FIN-630 Capital Budgeting & Financing 18TW2 taught by SNHU INSTRUCTOR, Southern New Hampshire University from Sep 2018 to Mar 2019. 4 Case Research Journal • Volume 28 • Issue 1 • Winter 2008 audit of its financial statements but ACE’s potential lenders would require the use of GAAP and an audit by a CPA firm. Aaron summarized the last two years of unadjusted financial statements for both companies (the only reliable historical information available due to the limitations of both companies’ bookkeeping practices) in Exhibit 1. The most complex calculations involved converting the reported revenues to actu- al accrual revenues. This process focused on converting gross revenues to net revenues once reimbursement rates were determined for different types of PT services. Such rates depended upon individual states and insurance company procedures. Various payers, such as Blue Cross or Kaiser, negotiated with various service providers (HealthSouth or Humana Hospitals or the PT companies in this case), to agree upon various reimbursement rates. These service providers would bill at full rates (gross rev- enues) but the payers would pay just the negotiated rates (net revenues) to the service providers. The patients (subscribers) were only responsible for their co-pay amounts, if any, to their insurance companies and did not have to pay any differences between gross and net revenues to the PT companies. Thus, the amount billed by the service providers often represented a total cost computed with full overhead allocation that the payor would negotiate down to a lesser amount (with less than a full overhead charge), Exhibit 1 ACE Private Equity Fund—Ohio and Maryland Physical Therapy Firms: 2005