From the go-go years to the present, acquisition strategies in the outpatient diagnostic imaging field have not always worked
As we sit on the precipice of a meltdown in the credit markets, I am reminded of a quote from Winston Churchill: “Those who forget history are bound to repeat it.” In 1998, a hedge fund called Long Term Capital Management (LTCM) bought securities using approximately $30 of debt for every $1 of equity, and eventually owned a portfolio valued at $125 billion (not including its assets off the balance).
Later that same year, the Russian bond crisis set off a chain of events that precipitously reduced the value of LTCM’s portfolio, quickly eroding its equity value and thereby requiring massive write-offs. The Federal Reserve invited the large Wall Street companies to its headquarters to devise a bailout strategy, for fear that the failure of LTCM would negatively affect the credit markets. Does this sound familiar yet? As a result, 13 companies participated in a $3 billion bailout of one hedge fund.
The only two companies that did not participate, because it was too risky, were Bear Stearns and Lehman Brothers. Had the heads of these two companies dusted off the credit analysis used in evaluating the LTCM bailout and applied it to their own balance sheets in 2008, they might very well be going concerns today.
Merger-and-acquisition activity in the diagnostic imaging industry has often suffered from the same selective amnesia. Perhaps the repetition of some bad history can be avoided through the review of mergers and acquisitions in diagnostic imaging over the past 15 years.
The timeline from 1993 to 2008 (see figure) is divided into five distinct periods: the go-go years, the Balanced Budget Act and multiple arbitrage fallout, the days of cheap credit, the DRA and the overbuilding hangover, and the revenge of the operator.
1993 Through 1997
The go-go years: The original Stark law was enacted in 1989 and prohibited self-referrals only in clinical laboratory services. In 1993, an amendment was made to the Stark law (Stark 2) that went beyond clinical laboratory services and into several other health care services, most notably diagnostic imaging. With the stroke of a pen, Congress unwittingly catalyzed the creation of the modern diagnostic imaging industry.
Historically, diagnostic imaging centers had been predominately owned by physicians, many of whom referred patients to these centers. As a result of Stark 2, doctors were required to divest themselves of their interests in these centers, creating a glut in the market. Concurrently, acquisition financing was readily available for energetic entrepreneurs who wanted to roll up the industry. In the early days, before too many players entered the market, valuations were quite reasonable, ranging from three to four times EBITDA.
Two companies quickly emerged as industry leaders: US Diagnostic Inc and Medical Resources Inc. Their darling status in the investment community was primarily the result of their successful financial engineering. US Diagnostic Inc and Medical Resources Inc closed a series of acquisitions at around three to four times the target companies’ EBITDAs while maintaining a public market implied valuation of six times EBITDA.
Furthermore, these acquisitions were completed using debt, not equity, which created instant value for the shareholder by improving the earnings per share of US Diagnostic Inc and Medical Resources Inc. This multiple arbitrage strategy worked so well that it allowed management teams to focus less on key fundamentals, such as local market clustering, that would maximize local staff efficiencies and increase negotiating leverage with managed care payors.
As the market heated up, more and more competition developed in the diagnostic imaging markets. Valuations crept up to six to seven times EBITDA, increasing the need for more debt. In a four- or five-year period, US Diagnostic Inc and Medical Resources Inc acquired more than 100 centers each. Not surprisingly, many of the acquisitions were in disparate markets and were poorly integrated.
1998 Through 2000
The Balanced Budget Act and multiple arbitrage fallout: In 1997, Congress passed the Balanced Budget Act, which drastically reduced reimbursement rates for diagnostic imaging. For large diagnostic imaging companies, the Balanced Budget Act, coupled with rapid growth in the previous years, triggered a number of negative consequences,