Contenders weigh in with lavish bids to take Health Net for-profit.

Contenders weigh in with lavish bids to take Health Net for-profit

However laudable his stated goals, Chairman Roger Greaves, 53, leader of of the big Health Net non-profit health maintenance organization, found out last week that getting something for almost nothing is hard to do.

It was Greaves who six years ago spearheaded a drive to split Health Net off from its parent, giant non-profit insurer Blue Cross of California, setting off a bitter court battle settled in 1990 -- in Greaves' favor.

Then, last March, Greaves quietly proposed to state regulators that he and 31 Health Net big-wigs buy the 846,000-member HMO for $108 million, or about $128 a member, and convert it into a for-profit shop. Greaves & Co. would put up a tiny cash down payment of $1.5 million.

Although the remainder of $108 million would come out of Woodland Hills-based Health Net coffers, Greaves would own 15 percent of the well-regarded, fast-growing HMO, and other executives and board members the rest.

Should the $886-million-in-revenues HMO issue stock and "go public" in two years, it could command $500 a member or $450 million or more on Wall Street -- a potentially astronomical return on the initial $1.5 million equity downpayment.

The potential rewards are enticing enough that nine members of Health Net's 13-member board of directors are in the management buyout deal -- a fact that to some raises questions about an ethical, if not legal, conflict of interest between board members' financial incentives and their fiduciary responsibilities to the non-profit HMO and the public.

"That is problematic (the board members approving and participating in the Health Net buyout). Personally, I'd like to see the law changed on this area," said David Langness, spokesman for the Hospital Council of Southern California.

The lid was blown off Greaves' all-but-secret proposal last month when news stories hit California papers, including the Los Angeles Business Journal, about his buyout plan.

Other health-care industry chieftains quickly smelled profit, and rival bids for Health Net have poured across the transom, including a $135 million offer from Newport Beach-based insurer Pacific Mutual Life Insurance Co.; a $225 million all-cash bid from the Louisville, Ky.-based Humana Inc., a large hospital operator; a merger offer from Woodland Hills-based Blue Cross of California, the big non-profit health insurer; and a $200 million bid from Century City-based Shamrock Investments Acquisition Corp., a merchant banking shop.

After the news reports, the state Department of Corporations, which must give the thumb's up on any Health Net buyout -- and which was well along the way to approving the deal -- apparently stalled on making a decision.

The situation is complicated by the fact that the department just got a new head, Thomas Sayles, a Gov. Pete Wilson appointee who replaced Christine Bender three weeks ago. Sayles isn't talking about Health Net.

The situation may be even further mixed up: According to Health Net board minutes, Pacific Mutual's chairman, Thomas Sutton, told Greaves that he (Sutton) called Carl Covitz, state Secretary of Business, Housing and Transportation, and had the Health Net conversion application stymied. Covitz is Sayles' boss.

Last week, Secretary Covitz declined to comment on the Health Net board minutes. But Covitz, partner in the Los Angeles-based Landmark Communities real estate development firm, said he would look to Sayles to make a recommendation on the Health Net buyout bid.

Covitz added, "We are not in a position to hold a public auction on Health Net. We can only accept or reject their (the Greaves group's) offer, and honor our fiduciary responsibilities to the state."

Meanwhile, the wagons have circled at the now-embattled Health Net. As of last week, all bids have been rebuffed by Chairman Greaves and the Health Net board. For his part, Greaves, a Los Angeles native, graduate of Compton High and Long Beach State, insists his buyout bid is needed to ensure that Health Net has access to capital in the future, can attract first-class management and can fund a charitable organization, the California Wellness Foundation, devoted to educating Californians on the need for preventative health care.

"Foremost is the California Wellness Foundation," said Greaves, referring to the charitable body. "If I can't fund it through this conversion, I'll stay non-profit and fund it through Health Net contributions."

Too, said Health Net spokesman James Lucas, a for-profit status would allow further expansion, possibly into other states.

Greaves said Health Net stock for managers is needed to retain and lure management, and that Health Net must have the ability to tap capital markets should it incur losses in the future.

The big HMO, the state's second-largest, ran up $60 million in losses in 1987 and 1988, perhaps threatening the HMO's existence, but as chief of a non-profit Greaves found it impossible to borrow. As a for-profit, Health Net might be able to tap banks and others for loans.

However, since 1989 Health Net has been profitable, earning $42.6 million on revenues of $886.0 million last year. Health Net is on a roll; for the month of April it posted net income of $4.82 million on revenues of $86.6 million. The profit surge has come even as administrative expenses consumed 11.5 percent of Health Net revenues in 1990 -- nearly double the 6 percent administrative costs of 1987.

As of April 31, the HMO had a net worth -- basically excess securities and cash in the bank, not needed to fund claims or administrative costs -- of $96.4 million. Future lean years could reduce surplus, but for now it is growing day by day.

As an HMO, Health Net provides health care to employers through a participating network of doctors and hospitals. Health Net collects about $106 a month for each of its 846,000 enrollees, and uses the money to pay medical bills, administrative and marketing expenses.

Money left over is profit.

To execute his buyout plan, Greaves under state law must compensate the public for buying Health Net, which has been shielded from taxes since it was created in 1979.

The HMO can only be bought out at "fair market value," with the proceeds devoted to a charitable organization -- in this case, the Greaves-created Wellness Foundation.

Seeking to establish a fair market value, Greaves hired the downtown Los Angeles offices of Ernst & Young, the Big Six accounting firm, to render a price tag on Health Net.

Using a valuation formula based on projected and past cash flows, on Feb. 2 Ernst & Young partner Barbara Pitts told Greaves that Health Net is worth a maximum of $104 million, or about $123 per enrollee. The price was lifted to $108 million in subsequent dealings with the state.

State regulators insist that neither rival bids nor Wall Street are good indicators of fair market value. David Meadows, Department of Corporations supervising examiner, said recently that Wall Street values for HMOs are "artificially high."

Greaves' spokesman Lucas -- also a member of the buyout team -- points out that all major issues of Greaves' buyout plan have already been tested in court, following the 1985 conversion of rival health plan FHP International Inc. from a non-profit to a for-profit and finally to a publicly traded HMO.

The federal Second District Court of Appeal ultimately upheld the FHP conversion -- which enriched FHP leadership -- and held that "self-dealing" by HMO boards was in fact legal, if approved by the state Department of Corporations. The department's obligation is to ensure that "fair market value" is delivered to taxpayers via a contribution to a charitable organization, in effect paying back the tax exemptions enjoyed by the HMO in its non-profit era.

The FHP conversion had been challenged by former State Attorney General John K. Van de Kamp, who accused FHP leadership of looting the formerly charitable HMO of $80 million. (Frank Rothman, partner at the downtown Los Angeles offices of Skadden, Arps, Slate, Meagher & Flom, successfully argued the case for FHP.)

Pointing to the 1985 case, Lucas said last week that his organization isn't doing anything not done before. "Everything we are doing is legal, and has already been argued in court," said Lucas.

Still, investment bankers have been commenting on the opportunity for large profit at Health Net, particularly if the company sells stock and "goes public," as it can after one year under Greaves conversion plan.

Broadly speaking, if Health Net can go public at $500 a member or $450 million, Greaves and the other 31 investors could watch their original $1.5 million equity investment balloon to more than $340 million.

The smallest share among the participating 32 Health Net managers and board members is said to be 0.5 percent. Yet even such a small share could become worth $1.7 million, if Health Net can go public at current stock market prices.

However, Health Net spokesman Lucas said last week the HMO plans to cut other managers into the deal in the future, thereby diluting the ownership of the original 32 investors. Too, notes Lucas, "Stock market values go up and down. There is risk in this venture."