Health IT from the Investor’s Chair 4/3/14

M*Modal from $1.1 billion to Chapter 11 – What Were They Thinking?

"Mr H, can you get Ben Rooks to opine on how smart Wall Street types could pay $1B for a $450M transcription company? Greater fool theory or something sinister?"

Sitting here in the Investor’s Chair, few things make me happier than a thoughtful question. I’m wondering what sinister theory you have in mind (and I’d love to hear it), but my view is emphatically one of the Greater Fool Theory. To support my thesis, let’s enter Mr. Peabody’s WABAC Machine and take a look at the events as they unfolded.

Long-time industry watchers will recall MedQuist (the predecessor company) from the 90s, when its growth was in large part driven by acquiring various transcription companies. As so often happened, earnings were ultimately missed, shareholder lawsuits appeared, and in this case, allegations of fraud emerged based on how MedQuist had been calculating its transcription billing rates. The company emerged from that peccadillo with a new management team. and one assumes, a new outlook on life.

Flash forward to July, 2011, when MedQuist acquired cloud-based natural language processing company, M*Modal (the * is presumably silent) for the fairly princely sum of $130 million in cash and stock. Princely in that it was over five times M*Modal’s run rate revenues, and the multiples of last 12 months revenues paid for medical transcription or HCIT companies were (using data from M*Modal’s later Fairness Opinion) 1.7x and 2.2x respectively. Hmm, interesting choice [valuation].

Back into the WABAC and skip forward to January 2012. Our next noteworthy event was six months later, when the company renamed itself M*Modal, according to its then CEO, “Illustrating our progression from a services-focused business to a provider of technology-enabled services and commercialized proprietary technology solutions.” Corporate brand identity is not part of the Investor’s Chair purview in this instance, but it seemed (even at the time) analogous to buying new carpeting and updating the landscaping prior to putting one’s house on the market.

In actuality, SEC filings show that even in October 2011, One Equity Partners had begun discussions with M*Modal’s management about acquiring the business in a Take-Private Transaction. Readers can review my previous post on how these work here.

Meanwhile, over the next few months, the company was approached by a number of other financial sponsors and a competitor referred to in the proxy as “Party A” (which I would guess was Nuance.) M*Modal went on to retain an investment banker, and by March, 19 private equity firms were invited to participate in the auction, of which 16 signed non-disclosure agreements.

As an aside, the value of NDAs is suspect at best, because over the next 10 days, representatives of five additional financial sponsors, having learned of the process from “unidentified sources,” separately contacted the Company’s financial advisors to indicate their interest in participating in the process and were subsequently invited to participate (because in auctions, the more, the merrier – as long as they can write checks — is usually a good rule). Bids were due April 26 and seven PE firms submitted.

Well, one would think that if financial buyers are attractive, strategic buyers should be more so, because they can bring various cost and revenue synergies to bear. That being the case, the bankers contacted five unnamed strategic players in late May, of which three immediately said, “Thanks, but no thanks” and two others said, “Sure, send us some materials.” Tellingly, neither of those submitted a bid.

Hindsight is generally pretty close to perfect, but this to me is the clearest evidence of the Greater Fool Theory in action. ST Advisors has on several occasions advised private equity investors on potential acquisitions. One of our questions to them invariably is, “OK, if you win this auction, you’ve just outbid all the strategic buyers. What will be different when you try to sell in a few years?” One can only wonder what One Equity’s thesis was. From the outside looking in, it appears to be a case of investors with little to no HCIT market insight believing their financial engineering skills could offset the risk of catching the falling knife that is transcription.

Over the course of the next few weeks as due diligence continued, some of the potential financial buyers notified the bankers that “they were withdrawing from the process, citing concerns about the ongoing profitability of the Company’s core transcription business, the nascent stage of the Company’s emerging healthcare technology business, and execution risks involved in the Company transitioning to a high-growth healthcare technology business.” Again, with the benefit of hindsight, good choice.

Party A was brought back in, but due to various concerns — especially relating to potential anti-trust issues — ultimately did not win the auction, leaving One Equity and M*Modal to announce on July 2 that it was acquiring M*Modal for $1.1 billion (a 19 percent premium over 180-day trading average and an 8.3 percent premium over the prior day’s close.)

Wow. $1.1 billion (2.4x LTM revenues) for a transcription vendor, albeit one with some spiffy speech rec, though Nuance certainly seemed to have that as well. Readers of this blog (or anyone not living under a rock) should realize that the ARRA-driven growth in EMR adoption is (very) likely to shrink demand for transcription. Based on the market dynamics, transcription pricing has been declining for several years. And other methods of data capture are becoming both more prevalent and easier to use. And other NLP vendors (Coderyte and A-Life Medical) were out there, again, wow. Over a billion seems like a lot here.

But did One Equity really spend over a billion dollars? Well, they did and they didn’t. Recall that the “L” in LBO stands for leveraged. A quick perusal of the data suggests that of the money paid:

• $425 million was a term loan due in 2019
• $250 million was a corporate bond due in 2020
• $75 million was the company’s line of credit

leaving about 25 percent (or $250 million) in cash paid by One Equity and its investors. This left the rest to be borrowed from a syndicate of banks and investors (Fidelity was the largest debt holder, by the way).

Because there was a public market for these corporate bonds, we can track investor sentiment over the subsequent months. The bonds issued that summer at par value (meaning, you pay $100 for the bond for which the company has committed to pay you the $100 back, along with the agreed-upon interest). Shortly after Labor Day, approximately 90 days after the transaction was announced, the bloom began coming off the rose as the bonds started trading in the resale market at the mid-80s, showing that investors were beginning to get a tad skittish about the relative safety of this investment.

The bonds seemed to stabilize for some time, though in April 2013 the debt ratings were downgraded by Moody’s to “Outlook Negative.” Perhaps as a result, in June 2013, a new chairman and CEO were announced – Graham King and Duncan James, respectively – two industry executives with strong pedigrees and track records of creating shareholder value (disclosure: Duncan was QuadraMed’s CEO when it was a client of ST Advisors).

Despite this change, bond investors apparently continued to have misgivings, because by October 29, 2013, the bonds were trading at $60. A month later, they dropped from $58 to $45, indicating investors thought there was little likelihood the company would deliver on its financial commitments. On January 14, 2014, the bonds were trading at $37, and on March 20 of this year, in announcing its bankruptcy filing, M*Modal’s CEO made the understatement of the year (this being the biggest healthcare-related bankruptcy filing of the year so far): “When M*Modal was taken private in 2012, the acquisition was financed with a capital structure aligned with a specific set of assumptions that are no longer relevant.”

It’s hard to point the finger at anything sinister. I’m not privy to One Equity’s Investment Committee’s report or findings, but it definitely appears to be one of two components.

First, there’s sum-of-the-parts: (1) transcription – admittedly not a great business (and, in fact, worse than expected), but one generating cash, which can both cover some debt and fund some development; (2) technology (aka the original M*Modal), whose voice recognition and NLP solutions could be used for things such as data analytics, coding (hello ICD-10) and other sexier (read: high growth / margin / high multiple) businesses.

These two issues, together with a healthy (or perhaps unhealthy) dose of the aforementioned Greater Fool Theory likely drove the valuation discussion. In addition, its competitor Nuance was performing well, the company had a fairly attractive client base, and the new investors ultimately brought in a very talented CEO in Duncan James.

Still, weighing the fundamentals, it’s hard to imagine why One Equity thought this was a company worth over $1 billion or that it could support the debt service that a billion-dollar valuation required. As a result, their equity has likely been wiped out and the debt holders have been both crammed down and converted to a new equity.

This likely raises a follow-up question. Hey Ben, if the original M*Modal business was the gem here, why didn’t a PE firm just buy that? Recall that M*Modal at the time was a technology vendor with less than $25 million in revenues. That’s just not the kind of business that a PE firm can acquire as a platform acquisition, as it can neither be leveraged nor can it be big enough to generate the associated fees that drive the PE business model.

On the subject of transcription in general, I’ll close with a quote from arguably the world’s best (and wittiest) investor, Warren Buffett:

“Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.”

Thanks again for your questions and keep them coming!

Ben Rooks spent a decade as an equity analyst and six years as an investment banker, where he worked on transactions such as this. Five years ago he formed ST Advisors to work with companies on issues that don’t solely involve transactions. He lives in San Francisco and absolutely loves e-mail.