Why Beacon Created an AI Committee for M&A with Harrison Thomas

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1:22Here's to the deal.

1:29I'm Kisan Patel and you're listening to M &A Science. where we talk with deal professionals and learn valuable lessons from their experience. This podcast focuses on stories, strategies, and what actually happened during M &A deals.

1:53Hello and welcome to the M &A Science Podcast. This podcast is part of a mission to rethink how M &A is done, The old school seller-led approach, it's dead. Fire-led M &A is all about strategy, alignment, and efficiency. And let's be real, it's not just about closing the deal. It's about making it successful. We uncover what truly works in M &A by learning directly from the best. I'm your host, Kisan Patel, founder and CEO of Dealroom and chief scientist here at M &A Science. Today's guest is Harrison Thomas, Chief Growth Officer at Beacon Specialized Living Services. Harrison leads growth and M &A in one of the most operationally complex corners of healthcare, home, and community-based services.

2:41From acquiring unsophisticated mom-and-pop providers to navigating high-touch integrations across fragmented state systems, Harrison brings a nuanced boots on the ground perspective on what it really takes to scale in this sector. In this interview, we're going to talk about the unique challenges of M &A in a highly regulated Medicaid funded health care service and learn how to approach due diligence in mom and pop businesses with hidden liabilities. Harrison, how are you doing today? Doing great, Kisan. Thanks for having me. Thanks for hosting your office here just outside of Nashville. Welcome to Middle Tennessee.

3:16It's a pretty day. It's going to rain for the next four days. So I'm glad you're here today. It's been a beautiful day. Can we kick things off a little bit about your background? I'm Chief Growth Officer at Beacon. I've been here at the organization for a little over eight years now. I originally started in healthcare. Nashville is the healthcare capital. A lot of people don't realize that we have some of the largest health systems in the country based out of here. And thus, everybody that makes money knows how to spend their money in healthcare. And that's one place they do it. I started working for a large publicly traded company here in Nashville, doing corporate development for a number of years, learned a lot on finance side, as well as just the strategic partnerships.

3:51Company was actually one going through activist investors. So learned a lot about how do you navigate a little bit of pressure from the external capital space. So that was how I started in healthcare, ended up getting into behavioral health, getting into technology, had a real estate degree from college. So a lot of different experience and that all culminated in Beacon Specialized Living. So I was approached by Darren Hodgson, the CEO at Beacon, and Darren and I had overlap at one of my companies. And from there, started looking at what Beacon did and really got excited about the mission of the company and where we were going.

4:24It's a pretty broad deal experience. Been at the helm of the corporate world and now you're on this platform. Can you talk me through what Beacon's M &A strategy looks like? How you've seen it evolve over the eight years you've been here? So Beacon is a home community-based service provider. So that means we're in the Medicaid reimbursed space serving individuals with developmental disabilities and severe mental health needs. We, as a niche, support some of the most challenging behaviors of individuals anywhere in the country. And because of that, we started in Southwest Michigan. I actually moved my wife to Michigan.

4:59She was 34 weeks pregnant. Last day she could travel. And when we started up there, we had about 200 employees. Now we're a little over 3 ,000 employees. Starting from where we were to where we are, it was really about taking what was a very underserved population. We've taken the mantra and the founder of the business that we will be the provider of choice when there are not other providers that are willing to take on the needs of the individuals to be served. Because we take that mantra, we were really able to step in and look at different market segments, not just where we started in Michigan, but in the other eight states we've entered and been able to focus on that very specific niche of people with challenging behaviors.

5:38From an M &A perspective, we're a little different. We're not a roll-up shop. We're very focused on finding the right type of quality provider, someone that aligns with what we like to think we do and the existing markets that we're in, but that also has a culture of care and compassion and dignity for the individual served. And then saying, what does it look like if we overlay our capital structure, our infrastructure, the supports in the back office and the additional clinical and medical team that we have that most mom and pop providers don't have. And then how do we then accelerate growth and find more people to be served?

6:12So our M &A focus has really been that, to find those type of providers. So you've seen the growth from 200 to 3 ,000 employees operating in one state, now in eight different states. Big focus on operational efficiency and optimizing revenue. Yeah, absolutely. Actually, when I started Beacon, my role, I've had the title of Chief Growth Officer the whole time, but I was a CFO. I was in charge of IT. I was in charge of facilities. So for a number of years, I had the full gamut of experience, which has been great from an M &A perspective because I've really gotten to look at how do these businesses operate?

6:47What are the key value drivers? What are the financial metrics that matter? And frankly, in the human services space, there's very simple metrics that you pay attention to. What is the labor as a cost of the revenue? What are the staffing ratios that you use to support? A lot of these financial and kind of KPI metrics are simple to focus on. Having the lens of the finance chief, I was really able to say this is what you have to do to make a viable business, but also what are the frankly dis-synergies that we're going to end up overlaying because we're a much more sophisticated organization with a lot more comprehensive back office.

7:21We built the template to evaluate these deals, but then you also got an understanding of disenergies too, I think is things you learn over time. Absolutely. When we talk about our PTO policy, our health benefits, all of the support structure that we have, the technology we're bringing to the table, those other providers don't have that, so we're usually walking them back. How many deals have you done in the years? Here at Beacon, we've probably gone through around 15, 16 deals in the last seven, eight years. That's a good number. That we've closed. The humor of this is, and we can actually talk about how we've leveraged the CRM with Dealroom.

7:54We did a major pipeline cleanup and we were closing maybe two to 3 % of the deals that really enter the front end of the pipeline and that we engage in some form of diligence. And there's just so many factors where they fall out in the deal flow. That 15, 16 deals that we've closed, there's a lot on the front end to be able to get down to that number. We'll talk about that. You are a deal room customer. We aren't going to make this into a big commercial pitch for a deal room. So if we look at these deals, the 15, 16 deals, one of the things you mentioned to me is about 80 % of your pipeline consists of deals that are sub 600K EBITDA.

8:32What makes the size sort of viable or not viable? There's like pros and cons, I guess, going bigger versus smaller. Yeah. So our space is a niche that I didn't even know about in healthcare. Home and community-based services, the very nature of what the providers that are in our space do is a lot of times 24-7 care for individuals with these challenging needs. Thus, most of those organizations really are founded out of kind of a mom-and-pop structure. It's a lot of times it's caregivers that say someone asks them to open a second home or a third home, or it's someone that's coming out of nursing or some other background.

9:07It's very rare that we would have someone come in with an MBA that starts a business in this space. That's unusual. What we see is those providers really scale to the point at which their capacity of their ability to touch the people they're supporting taps out. Building a back office, building training and recruiting and clinical and all the accounting functions and HR functions, it's not what they do. They're caregivers. They just want to support people. Because of that, we almost see these thresholds of EBITDA and earnings that they reach that they don't really surpass. and that threshold of that 600, a lot of those mom and pops can get up to that.

9:44It's that small business owner, but they've not invested in the additional infrastructure that goes beyond their ability to actually go support the home because very often we find out that the owners are the people going and feeling the midnight shift when somebody calls off and there's no one to actually support. That's where it gets really complex because these smaller deals, one, they don't have clean bucks. Every time we go through the numbers, the hardest exercise is actually trying to scrub the financials. No one's doing things on a cruel basis. It's all cash. So when we start talking to them about, hey, the run rate looks like this, what is run rate?

10:18What does that mean? If we actually scrub the timing of your inflows and outflows, this is what it's going to look like. So we spend a lot of time handholding these providers to try to help them understand their own business from a financial perspective or from a KPI perspective. Even if they're doing a half million dollar business, there may only be serving a dozen people. Two of those individuals leave and the census changes. The business has fundamentally changed. So we spend, we have to go into depth with them and explain, hey, this is where the business is trending compared to where you think it's at.

10:48You just get that trust or is it earned? That is very much the complex part of my job. A robot can replace all the diligence that I do, but it's the empathy. It's the emotional intelligence to actually engage with people to try to understand where they're coming from. I spend a lot of time. I've got a kid that came over and is working with me, came from our capital partner side. He's way smarter than I am. But I told him, I said, this is the thing you've got to learn. You've got to learn how to interact with people. You've got to learn how to win the trust. You've got to learn how to win the business.

11:16And it's very much a transparency game. I kind of opened the kimono and let everybody understand exactly where we're coming from, exactly what we're seeing up front, and tell them where we're going to run into issues before we ever get to them so that it doesn't blow up the deal further down the road. Give me an example. Like if you were to tell them like, hey, these are the issues that I could foresee happening. Like what are examples of that? There's a lot of different stuff. When they start unpacking how they run their business, they might have, oh, this is our staffing, or we've got two different operating companies.

11:46Got a lot of companies who, they create multiple operating companies and have people working under each umbrella, but they're not paying them overtime because those individuals are working 40 hours here and 40 hours there. Department of Labor doesn't view that as someone not earning overtime. We have to make them aware of that. Or we'll see that they're billing practices. They're not doing the reconciliations that are the way they're required at the state level. We have to get involved and unpack with them why that's not right. A lot of times I'll bring in a third party. It's a sensitive line to say, are we just trying to push down the numbers?

12:18Are we trying to negotiate with them? And I try to make sure, look, this is not me negotiating with you right now. This is me trying to open up and make sure you understand what's actually happening here and whether or not that meets labor laws, billing laws, regulatory laws, and why that's something we have to account for in the way we build the structure. And that's where we spend a lot of time in the handholding. Sounds like fun. But yeah, being candid, upfront, hey, these are how we operate to this level of standard in terms of how you're following the rules and building practices. I always just think about like my personal expenses.

12:52That was my thing. When I brought Fick in the finance, when I brought CFO, no more personal expenses of the company. That's funny that you say that. There's not a single mom and pop business that I haven't had to spend majority of my time I'm discussing what adjusted EBITDA means. So whether it's their family's cars, whether it's their NBA basketball tickets, their condo in Miami, the whatever it is, every deal we look at, there's all that stuff that's kind of buried in there. And it takes a little while to actually get in and figure out what's real and not real on the adjusted side. I can actually give you an example of a company that led to one of the more complicated situations where they had represented a lot of adjustments in their EBITDA.

13:34We gave them credit for those adjustments. I saw all the individual transactions come out, but they had actually never booked them to the P &L. It was all sitting on the balance sheet. Had we had a quality of earnings done, we would have easily have picked up on that. But I was at the time still wearing CFO hat doing multiple different actions, but it was too small of a transaction. I didn't want to justify paying six figures for quality of earnings on this little deal. And then when we got done with it, Six months later, finance is looking at the numbers. They're saying, hey, this is not at the run rate we thought we were buying.

14:06We start unpacking. We go, the adjustments aren't trending the way they were. This piece is not showing up. And we start looking, where were those actually sitting? And the controller started working with the controller of the company. We looked at it and go, oh, you represented all of these adjustments in the P &L that were never in the P &L. Because of that, even though we had all the detail, we'd seen all the transactions, it was sitting to the side. and we had to have a real conversation around escrow, around what does that mean because you've misstated the financials. That's very often a complex situation in trying to give people appropriate credit.

14:38And they always want all the credit when they're with a broker, but stepping back from it and saying, look, you don't get the credit for it if it's not real. Let's break this down for the people maybe new to M &A is when you do sign your purchase agreement, you represent these facts. What do they call them? They call them your disclosures, basically. It's a disclosure statement. Yeah. You got your disclosure schedule, which is like, this is what you're confirming. This is what you're agreeing to. And then if some of those things turn out not to be true, essentially your risk course is either there's an escrow on the side or there's like a reps and warranty policy, which you can put a claim against.

15:12Yeah. So a couple of pieces there. Reps and warranty and the size deals we're talking about, they're hard to come by. And the reps and warranty market as a whole is very difficult in the smaller deal space. And they're not underwriting policies anymore. So reps and warranty is really not even something we consider. And when Beacon actually recapped, we struggled to even pursue a reps and warranty policy in our space. They actually didn't do that. To your point, escrow is the other place. When we start negotiating a deal with a seller, we come to them with a term sheet. One of the terms that we're presenting is what are the escrow amounts that we're looking for.

15:45That escrow amount, I'm looking for a larger percentage of the sale proceeds to go into escrow based on how small the deal is because you need a higher percentage. The liability that we're exposed to as an acquirer is substantially higher and there's potential for things that don't actually transpire the way we thought they would. We'll talk a little bit about the liabilities we have, but that is what we're focused on is making sure that we have enough dollars in escrow. And when that starts feeding into a bigger chunk of the total purchase price, sellers get very concerned because they think that they're getting all the money today.

16:18If there's nothing found and everything you stated is factual and we have no issues down the road, every one of those dollars will come back to you. But every once in a while, you have to tap into the escrow. What's the usual range of an escrow? Is it a percentage typically? Yeah, it's a percentage for us. We're usually 15%, 20 % of purchase price is what we're going to be looking for. And then what's the hold period? In our space, it's going to be anywhere from 12 to 30 months. And what we usually see is kind of a stepped escrow, depending on how big the deal is. particularly for larger deals.

16:48There can be a lot of money sitting on the sideline. We'll look at a release at 12 months and release at 24 months. Nice. Regulatory burden and then historical liabilities. How does that work in your industry? What are the things you uncover? How do you get around it? The complexity being in healthcare is that you don't just get to close a deal and set the liabilities to the side. So asset deal, stock deal. Fundamentally, you acquire the stock, you acquire all the historical liabilities of the company. Asset deal, the intent of doing an asset deal is that we will be able to acquire the company without the liabilities.

17:24Doesn't work that way in healthcare. The government doesn't view it that way. States don't view it that way. You're able to set aside a lot of the liability in an asset transaction, not as favorable to the seller typically. And I'll give you a little more detail. We often have to get in a conversation with the seller around doing a 338 H10 election and a step up in basis because for them to treat an asset transaction the same way they would in a stock transaction, which is more favorable on the tax side for them. And I'm not a tax attorney, so don't owe me this. They're usually set up as an S Corp, which allows us to engage in a 338 H10 and step up their tax exposure to such that they are treated on a cap gains basis.

18:07They have the same net proceeds as they would if it's a stock deal. So we usually have to walk people down the path of why we want to do an asset deal in states where we already exist. States where Beacon doesn't exist, we're actually using a stock deal because a lot of times that's how we're going to get a license in the state. We've entered a couple of states de novo without having any presence or any acquisition. And in doing so, it's taken up to 24 to 36 months just to get through the provider licensing process. Whereas if I can go acquire a company, that's going to give me the ability to actually get the license in that market at the time of close.

18:42If I do it under a stock transaction, I'm carrying a lot more of the liabilities. Do it under an asset transaction, I can set some of that to the side. But the reality is Department of Labor and or Medicaid billing, Medicaid fraud is something that you don't just get to say, oh, that was on the previous owner's plate. So we spend a lot of time on the diligence trying to understand, one, where do they sit with their billing practices and are there potentially issues that were uncovered? And if there are, we actually have a duty to report that information. That's where we have to come to the seller and say, hey, we saw such and such.

19:20I'll give you an example of that. We acquired a company. The state had changed its billing practices during COVID. The state was actually leveraging this provider to teach other providers in the state how to do the new billing practice because he was so advanced in the way he was doing the billing. After acquisition, the provider moved on, retired, and we used a third-party biller, an expert in the state. And when the third-party biller started reviewing the billing, realized that person was not actually doing the additional step of reconciliation of billing that was required. In doing so, there was actually money owed back to the state.

19:55Then you start getting into treble damages and some other major issues. and we had to bring in that third-party biller, meet with the seller, explain not just what is the liability to tow back to the state, but now fundamentally we're running a much lower run rate business than we were expecting. We need to actually come in and we had to renegotiate purchase price a little bit tied to some of the escrow. So you have billing issues like that. You have the labor issues I alluded to earlier. It's overtime practices. We're providing 24 hours support care. A lot of times people are doing incorrect nighttime shifts, paying people whether or not someone's awake on call.

20:32Those things can impact what rates of pay they receive tied to minimum wage. That gets a little sticky for us. So we have to pay attention to labor practices. And then there's also the compliance issues and regulatory burden of how are they operating the program such that if there had been multiple different compliance hits on the quality side, which there is a tremendous amount of oversight with state regulatory bodies assessing how operations work in each of our programs. If somebody had been hit with multiple different incident reports that could have happened in the past, if I acquired that company, it's not like that was the previous owner, now Beacon's the new owner.

21:09It's, hey, we may absorb whatever those historic incidents are, and that's a part of our record now. And you may have gotten away with 10 incidents, but then the 11th one is going to be the one that triggers a provisional or conditional license that could really put us into a tailspin. For anyone who's listening to this, you shouldn't be complaining about the deals you're working on. This sounds like way more. There's complexity in our space, even though it can be very small deals. There's a lot of complexity and liability that we really have to dance around. This is serious liabilities. You gave examples of billing practices, the labor issues, the fact that this accountability transfer is over, whether you're doing a stock or asset sale.

21:45You mentioned the strategy of leveraging stock for these, getting to the new market and the regulatory systems approvals faster versus asset. Do you ever get any pushback from the sell side in terms of how it impacts their taxes between asset and stock sale? Yeah, that's where people start pushing back when they meet with their accountant. Their feedback is, I'm going to make a lot more money if we do this on our stock deal. But the majority of companies that are organized appropriately are organized as S-corps in our space. The ones that are organized as an S-corp, that's where we have the ability to do the 338 H10.

22:20And I'd try to take a very honest approach to negotiating deals with people. If I want to do the asset deal badly enough, I'm usually willing to pay the step up in basis with the 338 H10 election such that we can treat it as an asset deal, but that the owner is going to be able to walk away with the same amount of money that they would have if it was an asset or a stock deal. Got it. So not a huge difference. No, not for them. But now that doesn't apply in every transaction, but so many of the companies that we're dealing with are S-corp, so we can do that. Got it. So that's like a special election that allows them to not have the same treatment as like a C-corp.