Texas hedge fund Q Investments on Thursday initiated a shareholder revolt against Quorum Health (QHC) - Get Report , demanding that its board conduct an independent investigation aimed at its own management and that of Community Health Systems (CYH) - Get Report , the rural hospital operator it spun out of earlier this year.
Q Investments in an Oct. 13 letter alleged that Community management juiced up Quorum's numbers while concealing costs ahead of the spinoff in an effort to raise as much financing as possible, ultimately causing the latter's bond prices and stock price to tumble.
The timing for the Quorum board to act is crucial, the investor said, in light of Community's recently announced sale process. Q Investments, which said it acquired $50 million of bonds and 1.3 million shares of stock in June, requested that the board immediately retain outside counsel to launch an investigation.
"We believe that Quorum's board of directors has a small window to pursue claims against Community Health as it will undeniably become much more difficult to collect any meaningful recovery of the millions in losses caused by Community Health's improper and potentially fraudulent actions once Community Health sells itself," the Fort Worth-based shareholder wrote.
To be fair, the likelihood that Community will conclude its strategic review with an outright sale is viewed as highly uncertain, and perhaps highly unlikely, because such a deal would be very challenging to structure. But a creative deal structure involving real estate or piecemeal sales could be feasible, as The Deal previously reported.
As for the Quorum spinoff, Sheryl Skolnick of Mizuho described the Q Investments' letter as a pretty complete rendition of the facts: "These are questions that have troubled many investors and not just Q Investments in my experience," the analyst noted.
More specifically, Q Investments pinned at least $560 million of value destruction on Community management for knowingly providing an inaccurate Ebitda guidance to potential Quorum investors—first in March, then in April to market debt financings and again in May to attract more investors.
As noted in the letter, Community used the Quorum spin to raise more than $1.2 billion of debt, following which the latter on Aug. 10 unexpectedly slashed its 2016 guidance by more than $82.5 million, or more than 30%. Reasons for the Ebitda reduction included higher costs that Community likely knew about "because, in fact, they were the ones charging Quorum for those very costs," the investor wrote. Based on Q Investment's letter, the costs in question reflect payments by Quorum to Community Health for various services, including medical specialists and other staff.
The hedge fund said it applied a conservative hospital sector multiple of seven to the $82.5 million decrease in adjusted EBITDA guidance to arrive at its estimate of at least $560 million of value destruction.
Shares of Quorum, which completed its spinoff from Community on April 29, have lost nearly 45% of their value over the past three months.
Community denied the claims on Thursday, while a Quorum representative didn't return requests for comment.
"We categorically reject the allegations by Q Investments that Community Health Systems committed fraud or any other wrongdoing in connection with the Quorum spin-off," a spokeswoman wrote in an email to The Deal. "Community Health Systems conducted itself appropriately and made all necessary disclosures throughout the process."
Sources familiar with the situation believe the claims ultimately will result in litigation either led by the Quorum board acting or directly by shareholders. Q Investment's letter suggests an investigation by the Securities and Exchange Commission is likely. A spokesman for the SEC did not immediately respond to a request for comment.
Meanwhile, the possibility of a proxy fight is always possible. A handful of activist hedge funds hold stakes in the company, including David Einhorn's Greenlight Capital with a 9.8% stake, Conan Laughlin's North Tide Capital with a 6.8% interest, Geoffrey Raynor's Amalgamated Gadget with a 3.4% holding, among others.
The Thursday letter comes as debt-ridden Community undertakes its own strategic alternatives process. Led by CEO Wayne Smith, the Franklin, Tenn. hospital company confirmed speculation just a few weeks ago that it is engaging in preliminary discussions with financial sponsors regarding possible transactions, among other options.
Community on Oct. 4 adopted a poison pill after Tianqiao Chen's investment vehicle Shanda Investment Group upped its stake in the company to nearly 14%. However, the Chinese billionaire subsequently reiterated its passive stake.
Community initially announced plans to spinoff 38 of its hospitals as well as its hospital management and consulting business into a separate, publicly traded company named Quorum Health in August 2015. For Community, the transaction was intended to position it to focus on opportunities for growth in larger markets.