Acquisition anxiety.

The 1998 market was strong, but turbulence lies ahead

WHEN HISTORY RECORDS THE EVENTS OF LAST YEAR, 1998 will be viewed as the beginning of a period of transition for the health care market, particularly the long term care sector. Changes in government reimbursement, increased regulatory scrutiny, turmoil in the debt markets, and generally sagging stock market values for health care companies all contributed to a difficult year for growth-minded providers. These forces helped create the first slowdown in overall health care merger-and-acquisition activity in five years, with the number of publicly announced transactions in 1998 declining to 1,138 from 1,269 in the prior year.

Yet the number of publicly announced senior care acquisitions--which include skilled nursing, assisted living, and independent living facilities--set a new record in 1998, increasing 29 percent to 147. In past years, home health, hospitals, and physician groups usually commanded a greater number of deals. But by 1998, with home health and hospitals experiencing a drop in the number of transactions, senior care surged to second place after physician groups.

The dollar value of publicly announced senior care transactions remained unchanged in 1998, with $8.8 billion of deals, most of that attributable to the 13 transactions valued in excess of $100 million (two of which--Mariner Post-Acute Network and HCR Manor Care--were greater than $1 billion). Because prices were never revealed on several smaller deals, and the "private" sales are not included in the $8.8 billion total, the actual total dollar value of senior care transactions in 1998 is estimated to be close to $9.5 billion. This would represent a new record for this sector.

This pace probably can't be sustained in the next couple of years. The number of publicly traded companies has declined by about 20 percent in the past 15 months, and when a few previously announced transactions are completed, the number of publicly traded senior care companies will be at 29, the lowest point since 1994. These companies have been the driving force behind the acquisition market, and as their numbers decrease, there will be fewer players in the market, especially for the large transactions.

Other factors that may result in a future decline in the number of transactions include the tightening up of the credit markets and the lower equity values of most of the skilled nursing and some of the assisted living companies. Without a consistent flow of capital (at a reasonable cost), not only will the number of transactions decline, but the prices paid per bed and unit should, by definition, decrease as well. In 1998, given the turmoil created by wariness of the new prospective payment system, it was expected that average per bed nursing home prices would fall for the second year in a row.

As can be seen in the table, average nursing home per bed prices actually rose in 1998, by almost 2 percent to $41,300 per bed, just shy of the record set in 1996. One of the factors that contributed to this unexpected jump in prices was the 100 basis point decline in interest rates during the year. Combined with an aggressive lending market--at least until late August when the commercial mortgage backed securities market dried up--the environment was conducive to acquisitions. The PPS "threat" was not really a factor during most of 1998. It will, however, be one in 1999.

It must also be remembered that not everyone has been hurt by PPS. While most of the large nursing home chains are currently suffering as a result of the transition to PPS, many small, mom and pop providers and private companies will see no materially adverse impact from PPS and some will even see their operating cash flow increase. Unburdened by falling stock prices, federal investigations, and large ancillary businesses that need to be trimmed (or sold) very quickly, these smaller players have begun to play a larger role in the acquisition market. They may be in a good position to buy if one or two of the major publicly traded nursing home chains are forced into a financial restructuring in 1999 that will require them to sell off several of their nursing homes. If this happens, expect the average price of nursing home beds to decline this year.

The assisted and independent living markets, which are operating under a very different set of circumstances than the skilled nursing market, continue to thrive despite various roadblocks thrown in their way. Since they remain basically private pay, government interference to date has been minimal. For most of 1998, buyers benefited from the same access to relatively cheap financing that the nursing home industry enjoyed, with the result that average prices surged nearly 10 percent above 1997's record levels.

In the past few years, the assisted and independent living market has been dominated by the sale of assisted living facilities, even though independent living communities have brought up the average price of the combined data. The average per-unit price of assisted living facilities has been about $10,000 less than that of independent living communities in four of the past five years. It was only in 1995, when there was a surge in demand for anything with the "assisted living" name, that assisted living sold for more than independent living per unit.

Another reason why assisted and independent living per-unit prices continued to rise last year is that almost 70 percent of the sales involved facilities that are 10 years old or less, compared with 1997, in which 60 percent of the facilities were of such recent vintage. The opposite occurred in the nursing home sector, where about 70 percent of the sales in 1998 were of facilities that were at least 20 years old, compared with 50 percent in 1997. Despite this increase in age, the prices paid managed to increase slightly.

Buyers were not afraid to pay big bucks for properties they really wanted. In 1998, 40 percent of the independent living community transactions sold for more than $100,000 per unit, while almost 20 percent of the assisted living facility sales surpassed this threshold. For these two sectors, the number of sales over $100,000 per unit almost doubled from 1997 to 1998. The sale of high-priced properties is likely to continue as a large secondary market emerges for the substantial number of properties currently being developed. With development costs ranging from $75,000 to $125,000 per unit and more, the future sale of some of these facilities will result in a further escalation of prices paid. The exceptions will be distressed sales in overbuilt markets.

The direction of the stock market will also affect the acquisition market. After posting increases for seven straight years, the Levin Long-Term Care Total Return Index declined by 39.1 percent last year, compared with double-digit increases for most other major market indices. Most of this decline was due to the major nursing home chains dropping 25 to 75 percent in value during the year, much of that in the last six months. Without a rebound in stock market values, the ability to pursue acquisitions will be diminished. What's more, because low stock prices are indicative of financial problems, lenders tend to become extremely wary. This double whammy of a bad equity market and a hesitant debt market should put a chill on the acquisition market. It must be remembered, however, that the big chains represent a relatively small share of the market; small operators have been quite active in the acquisition market.

As far as nursing home pricing goes, it remains unknown whether the coming months will be a repeat of the late 1980s, when Beverly Enterprises was forced to liquidate nearly 50 percent of its nursing homes. The result was a significant drop in average prices paid and a stalled acquisition market for several years. If only one company wreaked havoc on the acquisition market, imagine the impact of several skilled nursing home companies being forced by creditors to sell off some assets. In the nursing home arena, 1999 will certainly be a buyers' market. Assisted living, on the other hand, will continue to be a sellers' market.

Stephen M. Monroe is a partner with New Canaan, Connecticut-based Irving Levin Associates. He is the editor of The SeniorCare Investor.

                              UNEXPECTED JUMP
                           Average price per bed
                              (Nursing homes)
1994 $32,300
1995 $39,000
1996 $42,300
1997 $40,500
1998 $41,300
Source: The Senior Care Acquisition Report, Fourth Edition, 1999
                        THRIVING DESPITE ROADBLOCKS
     Average price per unit  Average price per unit
     (Assisted living only) (Independent living only)
1994        $43,500                  $52,000
1995        $59,600                  $52,500
1996        $56,200                  $70,400
1997        $69,800                  $80,000
1998        $76,300                  $86,700
Source: The Senior Care Acquisition Report, Fourth Edition, 1999