Deals with a Difference: Three key factors distinguish the red hot senior care M&A market

The senior care and housing merger and acquisition market – which includes skilled nursing, assisted living and independent living – has been red hot throughout 2014 and 2015. According to Irving Levin Associates, Inc., senior care M&A set a record in 2014; and for the first half of 2015, transaction volume is up 5.5 percent over the first half of 2014. A low interest rate environment coupled with a search for yield on investment has driven M&A activity despite the uncertainty surrounding Medicare and Medicaid reimbursement rates.

Before diving into this market, one must understand the nuances and differences involved in senior care. Below are three key distinctions between a typical M&A transaction and an M&A transaction involving senior care.

Successor Liability

In an asset transaction, the acquiring party will normally assume only the liabilities that it agrees to pursuant to the purchase agreement. The due diligence and closing process identifies potential liabilities that could attach to the assets being acquired. Identified liabilities are normally released as a condition of closing. For example, if the seller has bank financing that creates a lien on assets, the buyer requires the liability to be paid off and the lien to be released prior to closing so that the purchaser does not take the assets subject to the liability.

The situation is somewhat different when it comes to Medicare liabilities. Generally, where a change of ownership (commonly referred to as a CHOW) occurs as defined under Medicare regulations, the buyer is deemed to assume the seller’s Medicare-related liabilities, even if the purchase agreement says otherwise. When it comes to Medicare, an asset purchase agreement is normally considered to be a CHOW. As such, the Medicare liabilities are automatically assumed by the buyer unless an affirmative election is made by the buyer well in advance of closing (which, for the most part, is not practical).

Successor liability will not only apply to typical liabilities, such as recoupments and other cost report-related issues, but also civil monetary penalties (CMPs) assessed against the prior operator.

In many cases, the due diligence process will help the buyer identify any potential successor liability issues (i.e., by reviewing the prior operator’s track record with respect to Medicare recoupments). Further, if the prior operator historically operated a highly effective compliance program, the buyer may be more comfortable assuming the risk of successor liability.

If problems are discovered, but it is important for the transaction to go forward regardless, the buyer may insist upon the seller going through a repayment and/or self-disclosure process as a condition of consummating the transaction. This approach may lead to significant delays and may meet resistance from the seller.

Accordingly, the buyer may agree to go forward with the transaction but make adjustments. Such adjustments may include reducing the purchase price, strengthening the representations and warranties, or increasing the indemnification obligations of the seller. The outcome will depend on the extent of the potential problem and the ability of the seller to make good on post-closing obligations, such as indemnification. Often the seller will be selling its only significant assets and will have limited liability to honor a post-closing covenant or indemnity. Some transactions may permit the posting of security to assure post-closing obligations. Nevertheless, purchasers should be extremely careful before assuming unknown liabilities for acts that occurred prior to closing. The discovery of problems during due diligence may foreshadow additional problems that lie dormant until after closing.

The safest route for a buyer is to perform thorough due diligence and require complete remediation of any known compliance issue that could result in successor liability prior to closing.

Challenges in Accounts Receivable Financing

Typically, when a business is pursuing a working capital line of credit, the business can grant the lender a lien on its accounts receivable. Under the Uniform Commercial Code (UCC), the lender can perfect its security interest in the accounts receivable by directing that all payments made to the business be made to a special deposit account known as a lockbox account. If the borrower defaults on its loan obligations, the lender can take control of the lockbox account and apply any payments against the outstanding balance of the loan.

However, accounts receivable from Medicare, as well as the accounts of other government healthcare programs, are subject to anti-assignment rules. These anti-assignment rules prohibit a healthcare provider from assigning its right to payment for services to any person other than the provider. A violation of the anti-assignment rules could result in termination of the healthcare provider’s participation in Medicare or other government programs. Thus, the lender may be secured and perfected in the account under the UCC but may have practical issues with collecting the cash proceeds because the lender cannot be paid directly from the government.

In particular, the healthcare provider’s deposit account where Medicare payments are made can only be in the name of the provider, and only the provider is allowed to give instructions with regard to the account. Therefore, the debtor will retain the ultimate right to direct the payments of funds into and out of the Medicare deposit account.

In order to provide the secured lender with greater control over Medicare accounts, many secured lenders will require the debtor’s depository bank to sign an agreement pursuant to which the depository bank agrees to regularly transfer (or “sweep”) the proceeds of the debtor’s Medicare account to a deposit account controlled by lender. The agreement would also provide that the depository bank will notify the lender if the debtor rescinds the sweep order. Once the proceeds are swept to the account controlled by the lender, the lender can immediately exercise its rights against the proceeds in the event of a default by debtor.

Due to the extra complexity involved in perfecting rights against governmental receivables, it is recommended that the lender require a healthcare provider to deposit its Medicare reimbursement proceeds into a deposit account separate from the nongovernment healthcare insurance receivables deposit account. Since the nongovernmental receivables do not require the extra sweep arrangement with the depository bank, it makes sense for those receivables to be deposited into a separate account.

Unique Financing Models

Many senior care operators are now acquiring facilities through “sale/leaseback transactions.” In a sale/leaseback transaction, the operator sells its real estate (or assigns its right to purchase real estate) to an investor and leases back the facility pursuant to a long-term lease. A sale/leaseback allows an operator to achieve the full value of the real estate, rather than the typical 70 to 80 percent gained through mortgaging the facility. This allows the operator to acquire the operations of a facility for little to no money down.

This option is particularly popular in the senior care industry, where there are a number of real estate investment trusts (REITs) with capital to deploy.

Executing a sale/leaseback can provide the operator with fixed-rate, long-term control of the asset for 30 years or more (taking into account extension options), 100 percent financing, an increased rate of return on real estate equity that is monetized by putting it to work in the business and the ability to pay down existing bank debt.

Sale/leaseback candidates need to compare the capitalization rate of a lease against the cost of long-term financing, as well as the need to make a down payment of capital in order to obtain long-term financing. The operator/tenant must also understand that this is a long-term commitment and that they will have some diminished control over the asset. Nonetheless, for the reasons mentioned, this is an excellent option for the right operator.

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