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Private Equity Firms Probe For Hidden Corporate Gems

Following a Bain Model, Sponsors Build Businesses from Orphan Divisions

By Martin Sikora

Corporate orphans increasingly are popping up on the radar screens of value-driven financial buyers. A number of private equity firms are actively pursuing adoption of neglected businesses that have been stunted inside major corporations and are willing to give them good homes.

A single division by itself may not be particularly appealing. But in a twist on the buy-and-build strategy, LBO sponsors are trying to snap up two or more undermanaged, under-resourced yet compatible units from different companies and blend them into one stand-alone player. With proper care and feeding, experts say, the resulting roll-up can be a formidable enterprise with the potential to become a tempting acquisition candidate or an IPO down the road.

Bain Capital Inc. has been a longtime practitioner in both buying and rolling up orphan divisions and managing director Steve Pagliuca said, “It remains a fundamental core practice for us.” Among others, Boston-based Bain has created Dade Behring Inc., in medical diagnostic equipment and materials’ Wesley Jessen Visioncare Inc., in contact lenses, and Gartner Group Inc., a market research and information services firm.

The concept is catching on with other sponsors as well. A recent addition to the ranks is LifeStream LLC, a specialist in profusion equipment that is used in operating rooms to help in heart surgery. LifeStream, backed by Banc One Equity Capital, sprang from the trl-partite combinatlon or prlvately owned Surgimedics Inc. the cardiopulmonary unit of C.R. Bard Inc. and the cardio-surgery business of Minntech Corp.

Unlike tne contemporaneous process used in creating LifeStream, Bain’s model was involded acquiring a platform and doing sequential add-ons. The platform for Dade Behring was the Dade international unit of Baxter International Inc. Aad-ons brought in the medical diagnostics division of Du Pont Co. and the Behring diagnostics division of Hoechst.AG. Sales are running in the area or $1.5 billion a year. There is a tie-in between the two firms. Scott Garrett. The veteran health care industry executive who engineered the formation of LifeStream, had been CEO of Dade Behring. Wesley Jessen was a neglected part or Schering Plough Inc. when it was purchased by Bain and was expanded by the acquisition of Barnes-Hind, the contact lens unit of British-based glassmaker Pilkington PLC. Gartner was losing money when it was bought from former U.K.-based advertising giant Saatchi & Saatchi PLC. Both companies later were taken public and recently Wesley Jessen was targeted for acquisition by optical goods firm Bausch & Lomb Inc.

An “orphan division” doesn’t mean a bad company

More company formations built around the transfer of orphan divisions are expected and they are forecast to cover a wide range of industries as well as health care.

Paul Schaye of Chestnut Hill Partners, a New York-based M & A intermediary that represents financial buyers, says that he is seeking out additional opportunities for clients and thinks that the prospects for creating premier performers are enormous. Preferred targets, he says, are good businesses that just haven’t been allowed to flower.

“Orphan doesn’t have to mean downtrodden,” Schaye said. “It just means it doesn’t hang in there. Orphan doesn’t mean it’s a bad company.”

Financial buyers historically have been major purchasers of divested divisions and subsidiaries from major public companies and have even dabbled in neglected properties. But they are hitting on formal programs to harvest and combine orphan divisions as the pressures mount to develop innovations for channeling the huge, untapped hoards in their equity funds into deals.

Buy-and-build programs provide sale options

These projects also mirror the way in which private equity operatives are increasingly adopting fundamental business strategies atop their financial prowess. Additionally, buy-and-build programs provide new avenues for restructuring companies to shed their hard-to-sell operations. They are, however, not easy to execute. It’s a tough job to find promising operations, convince the corporate owners to part with them, structure the deals, and then produce companion businesses that can provide the mass or diversity that makes it worth creating the new stand-alone company.

Garrett himself says that while he is pursuing other projects built around orphan divisions, they principally will follow the Bain model of buying a platform and augmenting it with add-one. There may not be others “as complex as LifeStream,” which was created in one swoop, he said. He credited the network he developed through 25 years as a health care executive (at the former American Hospital Supply and Baxter prior to his stint as Dade Behring CEO) with helping him pull it off. Long-established contacts helped surface the Bard and Minntech opportunities while Surgimedics came into the mix through Banc One Equity Capital. “I was experienced in the ways of getting things done,” he commented.

Shaping strong features into a complete company

He also had good strategic sense working for him. Each of the constituents enjoyed a leading characteristic that helped shape a complete organization. The deal married the sales and marketing capability of the Bard unit, the manufacturing infrastructure of Surgimedics, and the product line of the Minntech business. Subsequently, LifeStream acquired Polystan, a Danish producer of cardiology equipment. The newcomer will broaden LifeStream’s distribution in Europe and give the company access to some important Polystan products that it can bring into the United States, Garrett said. “I am now trying to find the corporate orphan that has the ability to grow but doesn’t have the right support,” Garrett said. “That will make a good platform.” He said he expects to have a few more platform companies in place this year. Financing also can be a tough nut. Like many corporate sub-units, orphan divisions may not have specific breakdowns on cash flows and other key financial measures. Historical data often have to be constructed and utilized as bases for forecasts so they can be presented to lenders in a businesslike fashion.

In fact, a key ingredient in forming LifeStream was the ability to obtain attractive financing from Fleet Capital Corp. Allan Allweiss, senior vice president at Fleet who supervised the LifeStream project, noted that most lenders are gun-shy about lending into roll-ups in their formative stages. They “shy away from the implied information gap and implied credit risk,” he said.

However, Allweiss said that LifeStream passed his credit screen because all of the characteristics added up to a good story. In particular, he was impressed by the management assembled from the three constituents, the combined positioning of the product lines in the health care market, and the strategic synergies formed by melding the different strengths of the founding units.

Schaye said he is trying to unearth subsidiary businesses that are running well but haven’t been supplied with growth capital because they don’t fit the corporate owner’s core operations.

“We have the technology to look at a corporation’s holdings and divisions and see if there’s a fit or a disconnect,” he said. The business that doesn’t fit, he added, is fair game for approaching corporate management about a sell-off.-

A problem with the orphan inside a huge corporate house, Schaye said, is that it often is trapped in a no-win situation. It may not get the investment it needs because it isn’t growing as fast as other operations or because it is generating considerable cash that the parent wants. In either case, Schaye said, the orphan is not running at an optimal rate.

“It may be starved for capital, but sometimes the management will say, “There’s that cash cow over there, why muck it up?” he noted.

By contrast, he said, the private equity firms that take over the former orphans are willing to invest in new product development, expanded marketing, increased production, and other elements of growth.

“It’s not a question of cutting costs, it’s empowering the business,” Schaye said.

Schaye said he thinks it will become easier to extract the orphans because of mounting pressure to enhance performance. “Everybody’s under pressure to fix their balance sheets and increase earnings,” he stated. “They are going back to the basics and asking themselves what their core competency is. If there are little pieces that don’t hang well, they will get rid of them.”

While opportunities in health care are expected to continue as major players “get out of some of the businesses they don’t want to be in,” Schaye believes there is no limit on the number of industries that will contribute unwanted operations. “I think it’s going to be across the board,” he said.

Schaye even sees some prospects developing out of the ongoing consolidation of the auto parts industry which has been driven by the automakers’ demands for fewer suppliers of the myriad products they buy to put together a vehicle. While the assemblers have pushed one-stop shopping from suppliers offering a diversity of wares, Schaye believes that they will partially reverse course and ask the vendors to concentrate more on specialization, e.g., “the maker of interior trims will go back to making interior trims.” This will put non-core businesses on the block, Schaye predicts. “The automakers just don’t want one guy providing all their products,” he said.

Pagliuca said that Bain Capital has additional orphan-based roll-ups in the works. “We are looking for noncore businesses that will benefit from scale and from consolidation,” he said. While the firm has chalked up several successes, Pagliuca acknowledges that it can be tough to make the roll-ups pay off. He said that the businesses have to be integrated (a problem that usually doesn’t arise in one-off acquisitions) and that “it takes a lot more capital” than most single acquisitions to get them into value-creating territory.