The End of 'Hypergrowth'

March 7, 2006

Monday's announcement that two private equity firms had agreed to pay $3.4 billion to buy Education Management Corp. means at least one thing: Some well-known and well-heeled financial folks decided that one of the country's most successful publicly held providers of for-profit higher education was a smart investment.

What else the deal signals -- that the era of "hypergrowth" in for-profit higher education is over, that it is increasingly difficult to function as a publicly traded college business, that more consolidation in for-profit higher education is on the way -- was the subject of much discussion but less clarity among analysts and others in the field in the wake of Monday's announcement.

Education Management, which operates 72 art institutes and other colleges in 24 states and Canada, has been a strong, steady company -- neither as profitable nor as visible as the Apollo Group (parent of the University of Phoenix) or Career Education Corporation, but also less likely to find itself in the sights of federal regulators. (One of the company's institutions, the Art Institute of Dallas, is on probation by the Southern Association of Colleges and Schools, but it has largely avoided the wrath of federal regulators and the negative publicity that typically follows.)

Monday, Providence Equity Partners and Goldman Sachs Capital Partners announced that they would pay $43 a share to buy the Pittsburgh-based company, which is 16.3 percent more than the company's per-share stock price last Friday, and 26.4 percent higher than its average share over the past month. The deal, which must still be approved by the company's board and by federal and other regulators and is expected to close this summer, would make Education Management the largest privately held higher education company.

The proposed purchase comes at a time when the growth of the for-profit higher education is seen as moderating from the overheated days of the late 1990s and early part of this decade. Profit margins have fallen slightly and institutions are spending more to keep their enrollments growing. Last week, the stock of the University of Phoenix fell after it reported that it would miss its earning targets this quarter amid stalled enrollment.

That slowdown in growth has prompted questions in some quarters about whether investors' appetite for for-profit higher education would abate. Monday's deal for Education Management, said several analysts, suggests not -- but it may portend some other changes in the sector.

Richard Garrett, senior analyst at Eduventures, an education research and consulting firm, said that as the era of "hypergrowth" ends, it is unlikely that Wall Street investors will see for-profit providers of higher education as the darlings they were for much of the past decade, given the tendency of public institutional investors to focus on immediate gratification in the form of rapidly rising quarterly earnings.

As a result, the dozen or so companies that are now publicly traded have two choices: either work harder to find innovative and aggressive approaches to sustaining exceptionally high levels of growth (expanding into new market areas like Apollo has with its Axia College for younger students, perhaps, or international programs as Laureate and Kaplan have), or contemplate turning to private investors, which might be more accepting of longer-term approaches and strategies that might not pay off on quarterly income statements.

"While the fundamentals of these firms remain strong (respectable enrollment growth, decent profit margins and returns to shareholders), the visibility of the public company means that what are often predictable and cyclical problems generate a disproportionately negative climate," Garrett said.

Indeed, in a conference call Monday morning, Education Management's chief executive, John R. (Jock) McKernan Jr., said that the company had been motivated to accept the offer from Providence and Goldman Sachs in part by the "market environment," which he described as "quite different from how it was." Officials at the company still see "significant opportunity for longterm growth, but many of these initiatives will take many years to bear fruit," he said -- approach that is "not always favored" in the public market. The new investors, he suggested, would provide "patient capital" for Education Management's "longterm strategic horizon."

Another analyst who follows the for-profit industry closely, Jerry Herman of Stifel Nicolaus, agreed that going private would provide some added flexibility to Education Management, and would certainly free it from the buffeting ups and downs that come with having to report financial statements every quarter (and from the close scrutiny that comes from having to report that often to regulators), it would be a mistake to assume that expectations won't remain high for the company. "Make no mistake: private equity groups are very demanding of what they expect out of management," he said.

Herman said he believed that the deal for Education Management portended the possibility of "additional activity" in terms of consolidation or purchases of for-profit higher education companies, noting McKernan's statement during the telephone conference that the company had had discussions with other possible suitors, too. Stocks of other leading for-profit higher education companies rose Monday on news of the sale.

While Education Management appears to have found its path out of the era of "hypergrowth" and into one of "steady state" growth, the rest of the for-profit higher ed industry still faces that challenge, warns Garrett of Eduventures. "It's going to be interesting to see how the investment community adjusts to the idea of steady state," Garrett said. "Investors need to adjust to the realities of running a higher education company and accept slower growth, without seeing it as a fundamental failure."

But Wall Street, he noted, is not always known for realism.

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