Healthcare Finance: ROFO and ROFR

Agreements in AcquisitionsAshok Bhardwaj Abbott, Ph.D.,

Focus on Healthcare  Consulting  Seminar SeriesNational Association of Certified Valuators and

Analysts Thursday, December 6, 2012

Ashok B. Abbott is an Associate Professor of Finance at West Virginia University in Morgantown, West Virginia. Professor Abbott received his MBA in Finance at Virginia Polytechnic Institute and State University (VPI&SU) in 1984, followed by a Ph.D. in finance also at VPI&SU, in 1987. His Ph.D. dissertation title was "The valuation effects of tax legislation in corporate sell-offs". 

He has published extensively in scholarly research journals and made presentations at national and international conferences. He serves on the editorial boards of The Business Valuation Review and The Value examiner. The Small Business administration recognized Professor Abbott as the Small Business Advocate-Journalist for the year 2002.

His focus area of research and consulting in valuation is the level of price adjustments (discounts/premiums) appropriate for liquidity, marketability, and control attributes of the interests being appraised.

 Professor Abbott consults for valuation divisions of well-known

firms, such as Standard & Poor's, Duff & Phelps, Willamette Management Associates, Houlihan Valuation Advisors, among others. He has served as an expert witness in the business valuation arena for 15 years. You can see his full CV at www.be.wvu.edu/faculty_staff/cv/ashok_abbott_cv.pdf.

Health Care Expenditure ( $ Billions)

Year National health care expenditure

Hospital care

Physician and clinical

services

1980 255.7 100.5 47.7

2000 1,378.0 415.5 290.0

2005 2,021.0 606.5 419.6

2009 2,486.3 759.1 505.9

Annualized Growth Rates

Year National health care expenditure

Hospital care

Physician and clinical

services

1980-2009 8% 7% 8%

2000-2009 7% 7% 6%

2005-2009 5% 6% 5%

Health Care Utilization EvolutionHealth care Utilization 1980 2000 2005 2009

    Admissions

per 1,000 population 159 117 119 116

Admissions per bed 37 40 44 44

Average length of stay 7.6 5.8 5.6 5.4 Outpatient

visits per admission 5.6 15.8 16.6 18.1

Outpatient visits per

1,000 population 890 1,852 1,976 2,091 Surgical

operations (millions) 18.8 26.1 27.5 27.5

Changing Utilization PatternsHospital admissions as a proportion of the

population have declined.Average length of hospital stay has declined.Outpatient visits have more than doubled.Physician offices are gatekeepers of hospital

admissions.

Market ConsolidationLargest 50

participantsNumber of

establishmentsRevenues ( $million)

Market share concentration(%)

Year2002 2007 2002 2007 2002 2007

Health care establishments

11,010 14,074 177,102 252,059 14.7 15.1

growth4.9% 7.1% 0.5%

Ambulatory health care

services10,779 15,403 48,874 72,311 10 10.8

growth7.1% 7.8% 1.5%

Physician offices2,738 3,976 22,376 37,047 9 11

growth7.5% 10.1% 4.0%

Growth through acquisitionPhysician practices are being acquired at a

rapid clip by hospitals, private equity firms, and health insurance companies.Physician office consolidation is growing at

rates approaching eight times the consolidation of healthcare facilities.

Consolidation Trends in HealthcareHealthcare industry is moving towards an

integrated model as a survival strategy.Revenue squeeze is accompanied by cost

escalation.Economies of scale and scope are being

explored aggressively.

Vertical Integration

Hospital

Ambulatory

Community

Physician Office

Acquisition Déjà VuIs 2010 a repeat of 1990?Not quite Contractual problems were rampant in the

HMO creation boom of 1990s.Acquisitions in 2010s are being made with

substantial contractual safeguards.First purchase rights are being used

increasingly in healthcare acquisition negotiations.

Health care acquisition landscapeHealthcare acquisitions are subject to

considerable regulatory hurdles.Anti-trust challenges are being used to block

potential acquisitions.Competing acquirers are using regulatory

challenges to gain competitive advantageSuch actions increase transaction costs

making acquisitions less profitable.

First Purchase Rights Healthcare acquisitions are motivated by

strategic considerations.Wealth gains are expected as a result of the

acquisition.Value of anticipated gains from acquisition is

incorporated in the acquisition negotiations.First purchase rights are being acquired to

gain competitive advantage.

Two forms of first purchase rightsFirst Purchase rights can take the form of Right of first offer (ROFO)Right of first refusal (ROFR)These are rights to purchase the asset but do

not obligate the holder to purchase the asset at the offering price.

ROFRs restrict marketability because they discourage third parties from engaging in the time, effort, and expense of due diligence regarding investment in the asset.

Right of first offer ( ROFO)A right of first offer requires the owner of a

property to let the right holder make a good faith offer to purchase the subject property; if the owner rejects that offer, the owner can sell the property to a third party only at a price above the one offered by the right holder.

ROFO right holder has the first mover advantage.

Strategic considerations in ROFORight holder gets to set the bar.Right holder can set the minimum price

payable by a potentially competitive acquirer.If this price is set high enough it can

preclude the competitor from making an offer

The owner of the asset has the ability to get a higher offer.

Right holder gets one shot.

Right of first refusal (ROFR)A right of first refusal requires the owner of

an asset to offer the property to the right holder on the same terms as those offered by a third party before the owner can sell the property to a third party.

ROFR right Holder has the last mover advantage.

Strategic considerations in ROFRRight holder gets to see the bar and clear it.Right holder can meet and marginally exceed

the maximum price offered by a potentially competitive acquirer.

The existence of this second chance can preclude the competitor from making an offer

The owner’s ability to get a higher offer is restricted.

Right holder gets the final shot.

Comparing ROFO and ROFR

ROFO is exercised with limited information as the competing bid is unknown.

Right holder has to anticipate the highest competing bid and place a marginally higher bid on the block.

Competing bidder can outbid the opening bid marginally to win the transaction.

Owner of the asset can use ROFO as a bargaining chip.

ROFO has value , though limited, to the right holder.

Comparing ROFO and ROFR(contd.)

ROFR is exercised with full information as the competing bid is known.

Right holder has to place a marginally higher bid than the known, competing, bid on the block.

Competing bidder cannot outbid the closing ROFR bid to win the transaction.

Owner of the right can use ROFR as a bargaining chip.

ROFR has value to the right holder which is higher than the value derived from ROFO.

Pricing first purchase rightsFirst purchase rights are valuable.Owner of the asset gives up an opportunity at

an open auction restricting marketability. Right holder is not obligated to make the

highest possible offer.Right holder has to only beat the next best

offer.

Valuing first purchase rightsROFO and ROFR are valuable.ROFO allows the buyer to make a bid for the

asset and can be valued as a simple call option.

ROFR allows the buyer to buy at the highest price achieved for the asset and can be valued as a look back put.

Valuing first purchase rightsFirst purchase rights are valuable when right

holder is likely to value the asset more highly than a third party and/or a third party is likely to value it more highly than seller.

Option Model Implementation

The exchange option, first developed by Margrabe (1978), has proven to be an extremely powerful generalization of the Black-Scholes model.

ROFO and ROFR contracts can be modeled and priced using Margrabe equations.

Questions?Please do not hesitate to contact us for any

clarifications.Ashok Bhardwaj Abbott Ph.D. MBAEmail abbott.ashok@gmail.com Phone 304 692 1385