The Forces Behind Consolidation

David Reilly
Cronus Partners

Private equity firms (or financial buyers) are extremely active and an important dynamic within consolidating industries. While corporations (or strategic buyers) continue to re-lever their balance sheets for key strategic deals, now it is not uncommon for a financial buyout group to prevail against major strategic buyers in a controlled auction. A recent SEC filing revealed that Smith & Nephew’s (S&N) offer for Biomet was $45 per share—that’s higher than the prevailing offer of $44 per share by a consortium of private equity firms. Among the cited risks that made the offer inferior despite the higher bid was that Biomet believed S&N might become a takeover target itself, as there were apparently two other “strategic bidders” for Biomet. Any potential strategic bidders for S&N likely would face competition again from private equity.

The private equity marketplace does not suffer from the significant agency costs associated with divergent management-shareholder objectives and information asymmetry that have brought about heightened regulations and class action lawsuits to the public market. Without public disclosure requirements, a management team and its private equity partner can take a longer-term strategic view without the tyranny of hitting quarterly estimates. The combination of using leverage to improve returns, employing a clean governance model, perfectly aligning the financial interests of shareholders and management as well as avoiding pressure from short-term investors focused on the quarterly earnings cycle are compelling attributes to management teams and owners for remaining or going private.

Overall, approximately 32 take-private transactions by financial buyers have been announced in the United States over the past five months with a total value exceeding $150 billion. This dynamic could be a cyclical phenomenon, given the historically low cost of debt capital and the overflowing and seemingly countless pools of capital available within the private equity market. More likely, however, private equity influence on the merger and acquisition landscape is a permanent, structural phenomenon—including within the orthopedic marketplace.

Financial Versus Strategic Buyers

While it is difficult for a financial buyer to be price competitive with a strategic buyer without the synergies of combining two complementary businesses, strategic buyers cannot always produce sufficient value to offset other challenges in merging two entities. With large orthopedic combinations, it is much more difficult for a merged entity to sustain significant growth rates (a large valuation determinant) on a substantially higher base of business.

It’s true that the combination of two orthopedic players may strengthen its position against larger players when competing for hospital customers who are looking to consolidate vendors. However, the challenges in integrating overlapping sales forces make it difficult to realize such synergy. Similarly, overlapping product portfolios with minimal differentiation leads to cannibalization of products, upsetting critical relationships with surgeons along the way.

Strategic buyers also do not want to be distracted by unwinding and divesting acquired non-core businesses. To financial buyers, these integration and strategic alignment challenges are non-issues, and divestitures can be viewed as an opportunity to pay down debt post-closing. The auction environment for financial buyers also is improved when anti-trust concerns limit the number of qualified bidders and when the prospects of a drawn-out process with strategic buyers have the potential to impair the business.

Orthopedic OEMs Versus Suppliers

Successful strategic transactions for orthopedic OEMs tend to have little overlap in sales forces and product lines and, therefore, are relatively small and do not influence overall market share. Other than the Biomet and Encore transactions, most of the acquisitions listed in Figure 1 enabled the acquirer further to penetrate an under-covered territory, augment its product portfolio in a specific area or bolster its IP platform to feed the new product pipeline. Although a much larger transaction at $3.4 billion, Zimmer’s 2003 acquisition of Centerpulse (prevailing against S&N) provided Zimmer with a necessary strategic position in Europe.

On the orthopedic supplier side, financial buyers have been fueling the rampant consolidation for years. This dynamic is due to the sector’s highly fragmented nature and private (non-institutional) ownership structure (as described in this column in the January/February issue of ODT). Private equity firms serve as an attractive liquidity alternative for many privately held companies looking to diversify wealth away from the business while retaining aserve as an attractive liquidity alternative for many privately held companies looking to diversify wealth away from the business while retaining asubstantial stake and role in the future of the business. In suchrecapitalizations, an owner potentially can receive more than 80% of the fair market value of the company in cash and still retain greater than 50% of the equity. Furthermore, certain private equity firms infuse substantial financial and professional resources to support management, particularly in the area of acquisitions.

With OEMs looking to consolidate vendors, many suppliers recognize that acquisitions can enhance shareholder value by expanding manufacturing capability, adding capacity, diversifying customer and product mix and improving customer service. Of the 34 transactions in Figure 2, more than 80% were driven by private equity financing. Of those 28, eight were platform acquisitions by private equity firms and 20 were subsequent tuck-under strategic acquisitions by those platform portfolio companies.

Private equity firms will continue to be an active and competitive force in further consolidating the orthopedic marketplace. Each year, thousands of private equity firms are looking to invest hundreds of billions of dollars. Generally controlled by a handful of partners, each firm has a unique approach and style, specific areas and industries of focus and expertise as well as different investment criteria. To understand the influence any may have on a particular company in a consolidating industry, it is important to know the players and how they operate, as the right partnership between management and private equity sponsor is the key to maximizing value for all shareholders.

David Reilly is a managing director of Cronus Partners LLC, an investment banking firm that specializes in mergers and acquisitions, private placements and financial advisory services. He leads the firm’s healthcare practice and can be reached at (203) 642-0200 or DReilly@CronusPartners.com.   Author’s Note: Nothing contained in this article is to be considered the rendering of financial, investment or professional advice for specific circumstances. Readers are responsible for obtaining such advice from professional advisors and are encouraged to do so.