DEALTALK-Private equity takes on Big Pharma's carve-out challenge

Fri Jul 11, 2014 3:26pm EDT

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By Greg Roumeliotis and Olivia Oran

July 11 (Reuters) - Big Pharma companies are trying to offload low-growth, mature drug portfolios to firms such as Blackstone Group LP and TPG Capital LP which need to figure out how to carve them out, in one of private equity's greatest dealmaking challenges.

While these portfolios face declining sales, some buyout firms believe they can make a profit if they buy them at prices that are sufficiently low. In order to achieve this, they must create viable new companies - a highly complex and uncertain feat that now preoccupies some of private equity's brightest minds.

GlaxoSmithKline Plc, Sanofi SA and Merck & Co Inc are just some of the companies looking to shed older drugs, many of which have lost patent protection and face shrinking sales.

These drug portfolios, worth tens of billions of dollars combined, offer an opportunity for private equity firms to put a lot of money to work at a time when stock markets continue a record-setting rally and aggressive corporate buyers are pushing deal valuations to multiyear highs.

Corporate carve-outs, because of their complexity, can be less competitive in attracting possible buyers than outright sales of companies, so valuations of the assets involved tend to be not as frothy. Yet the acquisition of mature drugs differs substantially from other corporate carve-outs with which some private equity firms have become comfortable.

In most corporate carve-outs, the new companies usually have the assets needed to survive on their own or require only temporary support from their parent. The private equity owner of drug portfolios, however, must also sort out the manufacturing and sales arrangements necessary for a stable business.

Some of the world's biggest buyout firms, including Blackstone, Carlyle Group LP and TPG, are evaluating the acquisition of mature drug portfolios, according to people familiar with the matter. Representatives for these firms declined to comment.

While a few buyout firms have in the past acquired one-off drugs to fold into their healthcare portfolio companies, none has bought a big chunk of older drugs on a large multibillion-dollar scale.

Adding to the challenges, mature portfolios typically post annual revenue declines of between 5 and 10 percent. Such negative growth raises questions about how private equity buyers could profitably exit their investments in a few years' time.

"You're buying a sparkler that's halfway burned," said Debbie Wang, a research analyst at Morningstar.

"It's going to burn out soon, and that's my question for private equity - how quickly can they make the proper portfolio changes? Because you're running on a clock once you buy this."

UNCHARTERED TERRITORY

Big Pharma companies are eager to make the deals work because such divestments of low to negative growth businesses could free up cash to invest in higher-margin products. They hope their stock price will then be rewarded.

For private equity firms sitting on a record amount of unspent capital - $1.2 trillion according to market research firm Preqin - the opportunity to write big checks for deals that attract little competition from strategic buyers is sometimes proving hard to resist.

"One of the areas that we really have focused on a lot, frankly, is these large corporate carve-outs. It is a tough, dirty job to take a big division out of a giant big company and set it off on its own," William Conway, co-chief executive of Carlyle, said on the firm's latest quarterly earnings call. He was speaking in general and not specifically about drug portfolio acquisitions.

For example, Carlyle last month completed a large healthcare corporate carve-out with the acquisition of Johnson & Johnson's diagnostics unit for $4 billion.

With mature drug portfolios, private equity firms have to decide if their new company outsources the manufacturing, often to the parent, or also buys manufacturing facilities from the seller that would have been of little use to them otherwise.

If there are manufacturing and operational agreements with the seller, private equity firms may have to negotiate a perpetual relationship versus a transitional period of three to five years seen in other types of corporate carve-outs.

Moreover, the acquired portfolio must have sufficiently attractive and specialized drugs to make it easy to market and so that the new company can resist the pressure on sales that confronts generic medicines.

While private equity firms may have portfolio companies that can serve as a potential platform to add new drugs, like TPG's Par Pharmaceutical Companies Inc, they are likely insufficient to handle the scale of most of the portfolios up for sale, the sources said.

One possibility under consideration by investment bankers running the auctions for these portfolios is breaking them up into smaller divisions based on specific therapeutic areas, allowing private equity buyers to take better advantage of drug pricing opportunities by focusing on a more targeted set of products.

This is because some categories of generic drugs, such as generic injectable drugs, are in hot demand. Private equity firms may choose to expand on such categories through bolt-on acquisitions of drugs following a carve-out.

"You are talking about recreating a generics company in some sense, but without any of the infrastructure," said Jeffrey Greene, global transactions leader for life sciences at Ernst & Young.

"So as a private equity firm, you will have to find a platform to put all that together and potentially outsource key activities such as manufacturing and even sales in some cases." (Reporting by Greg Roumeliotis and Olivia Oran in New York; Additional reporting by Michele Gershberg in New York; editing by Soyoung Kim and Matthew Lewis)

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