HCA Already Paying Dividends

The following is an opinion piece by Dan Primack on the recently closed HCA deal, taken from peHUB.com.

may not be destined to own the title of “largest LBO ever” for long—that title now belongs to Blackstone’s proposed purchase of Equity Office Properties Trust—but its private equity sponsors still are taking some massive first-day fees.

According to an 8-K Form filed by HCA on the Friday after Thanksgiving, HCA has paid $175 million in transaction-related fees to Bain Capital, Kohlberg Kravis Roberts & Co. and Merrill Lynch Global Private Equity. It also has agreed to pay a $15 million annual management fee that can increase annually beginning in 2008, based on the company’s EBITDA. Moreover, HCA would be required to pay some sort of termination penalty if the management agreement is ended, most likely due to an IPO or other liquidity event.

Finally, the private equity sponsors are entitled to a fee equal to 1% of the gross transaction value in the case of certain subsequent financings, acquisitions, dispositions or change of control transactions. In other words, an additional $330 million.

Not bad for a deal in which the sponsors have yet to make any operational improvements, save for freeing HCA from Wall Street scrutiny and Sarbanes-Oxley compliance.

Such fees aren’t terribly surprising, as it’s been years since most mega-buyout firms have relied on annual management fees and carried interest to keep the lights on. But such extraordinary payouts raise a number of concerns. For example, questions arise as to whether a company’s “owners” should get paid just for finishing a transaction. If that is so, then private equity deals become like retail rebates, whereby the consumer gets cash back merely for being a consumer. The termination fee complicates that analogy even further, to the extent that a consumer would get additional rebates for returning the purchased item.

But, the counterargument runs, since it is the private equity firms that now own HCA, they are in theory the only ones who get hurt if the company’s valuation is reduced. This is partially true, but doesn’t take into account any current HCA employee who holds company options. More importantly, not all private equity firms share either the transaction or management fees with limited partners.

Bain, for example, almost never shares any of those fees with LPs, because it first takes out all of the (undocumented) consulting fees generated by affiliate Bain & Co. Even firms with more generous sharing—which usually means 50/50 or 60/40 in the LP’s favor—still apply carried interest, which means that even firms that give 100% to LPs may only end up giving 80 percent. It’s worth pointing out that buyout firms all used to take 100% of such fees for themselves, but progress in this area has moved slowly.

Many LPs grumble about such arrangements, but suck it up so long as returns stay strong. And, according to the HCA 8-K filing, the HCA sponsors are expecting to produce a 2x cash-on-cash return—or $102 per share. Such a liquidity event is expected to occur by 2011, by which point the massive fees will have been long forgotten.