Private Equity, HCA and a Lot More Zeros

By Allan Sloan
Tuesday, August 1, 2006

Fashions on Wall Street come and go, but two forces are eternal: investors' never-ending search for higher-than-average returns, and Wall Street's never-ending search to make money from those investors. Those forces are what combined last week to create the $33 billion deal to turn HCA Inc., the nation's biggest hospital operator, into a privately held company.

This deal has generated much more media and Wall Street buzz than larger and more important corporate takeovers (such as AT&T's pending $88 billion purchase of BellSouth) because it's the biggest going-private deal in history.

The price -- about $21.5 billion for HCA's shareholders, plus the assumption of about $11.7 billion of debt -- tops the legendary $31 billion "Barbarians at the Gates" buyout of RJR Nabisco in 1989. That's the deal in which Kohlberg Kravis Roberts & Co. won a spectacular bidding war that ended about the time the junk-bond market, which had provided cheap money for such deals, began melting down. KKR ran into major problems with RJR and suffered huge hits to its reputation and to its investment record.

But now KKR and two other "private equity" firms -- Bain & Co. and the private equity arm of Merrill Lynch -- are combining with HCA management and the company's founding Frist family to do a deal that tops RJR. "If you live long enough, everything comes back," says Ted Aronson of Aronson & Johnson & Ortiz, a Philadelphia money manager.

These going-private deals, which involve borrowing lots and lots of money, are back because private equity is hot. Private equity investments have produced consistent double-digit returns the past few years, way outperforming the broad stock market, so money is pouring into private equity investment pools. They raised $98 billion for the first half of 2006, according to Thomson Financial, compared with $179 billion for all of last year -- and less than $60 billion for 2003.

The private equity players have to put that money to work. Thus, private equity has accounted for 24 percent of the dollar value of U.S. corporate takeovers so far this year, up from just 8 percent in 2003. Quips Richard Peterson, a senior researcher at Thomson: "There's nothing new under the sun except for a lot more zeros."

Wall Street loves private equity because so many fees are involved: fees for helping private equity firms raise money, fees for helping them invest the money, fees for helping finance their deals, fees for helping the company go public again a few years down the road.

On HCA, the Street will probably get about half a billion dollars for helping to put the deal together and raising the $16 billion the new company will borrow to buy out its public shareholders. (The other $5.5 billion is coming from the buyers.)

Shareholders will get a premium $51 a share for their stock, which had been trading well below that before news of the deal leaked. But HCA's managers and its founding Frists do better than anyone else.

By my read, the Frists will swap their current 4.4 percent stake in HCA for 12 percent of the new company plus $200 million of cash. Here's how this works. The Frists own about 16.9 million HCA shares, worth about $860 million in the buyout. Their 12 percent stake in the new HCA will cost $660 million. But rather than forking over cash, they'll surrender about 12.9 million of their HCA shares, paying no tax on the difference between $660 million and the shares' original cost, which is probably close to zero.

The Frists will still own about 4 million HCA shares, for which they'll receive about $200 million -- though this would be subject to capital-gains tax.

I asked several parties in this deal to confirm (or deny) my analysis, but none of them would comment.

(An aside: Senate Majority Leader Bill Frist, who came under fire for his sales of HCA stock last year, isn't involved in this transaction, according to an aide who says that he's sold all his HCA shares.)

HCA's management, which will trade $550 million worth of stock and stock options in return for a 10 percent stake in the newly private company, would get a tax-advantaged deal similar to the Frists'. The managers would have a chance to become super-rich rather than merely rich if HCA, which has gone private twice before, goes public at a high price within a few years, as the buyers intend.

As a bonus for HCA's managers, a privately held HCA won't have to deal with Sarbanes-Oxley rules that affect public companies and won't have to care what Wall Street thinks.

Consider that the same day HCA unveiled the buyout, it also reported second-quarter earnings below Wall Street estimates. Under normal circumstances, HCA's managers would have been berated by the Street and the stock would have been clobbered. But with the buyout pending, the sub-par profit didn't matter.

With so much money pouring into them and interest rates rising, can private equity firms continue producing outsize returns? Probably not. But by that time, return-hungry investors will be off chasing a new fad. And Wall Street will still be collecting fees from them.

Jessica Ramirez contributed to this column. Sloan is Newsweek's Wall Street editor. His e-mail issloan@panix.com.


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