Over the counter deals going over private equity's head

Pharmaceutical corporate mergers have dominated both the markets and the headlines in recent months: London-headquartered GlaxoSmithKline (GSK) and Basel-based Novartis are effectively swapping two assets and creating a new one in a deal to be approved by shareholders on 18 December. The new entity will see sales of around €8bn per year in the over-the-counter (OTC) space – forecast to be worth $106.3bn by 2017.

German pharmaceutical behemoth Bayer finalised its acquisition of the consumer care division of Merck & Co in October for €10.2bn. It is set to be in second position behind Novartis and GSK, with expected turnover of €5.5bn. Given the recent impressive corporate activity, has an opportunity opened up for private equity?

Size matters
"Trade buyers often have huge synergies so it's hard for private equity to compete and win," says Adrian Yurkwich, partner at Silverfleet Capital. However, Amit Nayyar, partner at Hogan Lovells, does not think private equity should be put off: "The barrier to entry is primarily the size of the other players in the market. It's not that private equity can't work with an over-the-counter company because corporate players are inherently better at it; it's simply that they will struggle unless they have genuine sector expertise. You need scale in order to compete."

According to a joint survey by Management Engineers and Insead, 64% of pharmaceutical company CEOs believe their unique investment requirements will see private equity turn away from the industry. The majority of respondents see the requirement for long-term investment – around a decade – as unattractive to the asset class. The industry itself will be the driving force behind its own investment and restructuring, with the survey concluding the risk versus reward profile of OTC has lost its charm for third party investors.

However, Kai Deusch – CEO of Ardian-owned Riemser Pharma, former healthcare director with Apax Partners and senior adviser to Waterland Private Equity – explains how the landscape for private equity and pharmaceuticals has changed: "Ten years ago, nobody would have touched OTC as a private equity player; all the big firms were trying to sell their portfolio companies in the sector. Consumer goods had low margins, no growth – it was a stale business model. But OTC has become a growing trend in the last 5-10 years. It is attractive today because of the change in decision-making in medical care."

He suggests that the internet has enabled patients to self-diagnose, leading to a bigger uptake in the market. The increasing consumerism of OTC products could play to private equity's advantage. Says Nayyar: "A pharmaceutical company might be great at its core business but not have much of an eye on the consumer aspect. Private equity's wider eye on the consumer market plays quite well."

Pharma chameleon
But is consumer awareness enough to stave off competition from strategics? "I don't think by any means there is a closed sign on the door," says Nayyar, "but I do think private equity has to be pretty nimble to get in ahead of trade. We've seen this recently from the private equity houses that specialise in pharma, especially in the US. Assets are more likely to go to players who don't just say they are 'pharmaceutical-specific' – it is a massive sector so you need to demonstrate sub-sector expertise."

Nevertheless, the corporates themselves have no trouble with specialisation. Big pharma is clearly in acquisition mode, suggesting private equity has the opportunity to generate hefty returns if divestment is on the cards.

Furthermore, opportunities in the sector may also be found as corporates dispose of non-core assets, in order to consolidate their positions and focus on their strengths. Additionally, anti-trust regulations following M&A activity may force a sale of specific assets to prevent overlap.

It is clear, then, that a degree of specialisation is needed for success in the OTC segment, but so too is having large amounts of cash. "There's little if anything for small pockets anymore," says Deusch. "Opportunities that were there to create huge multiples, from say €40m, are over. You have to do it on a much larger scale with a big fund." Scale is not something that big corporates have to worry about, but is necessary, according to Deusch, because it spreads risk. When certain brands come under pressure, it falls to others in the portfolio to succeed.

Trade secrets
Although OTC companies probably have had their day as far as generalist private equity companies are concerned, there are pockets of opportunity available to specialists with cash to deploy. Nayyer outlines one advantage of private equity's involvement in an industry dominated by a few key players: "There are some good reasons to sell to private equity, such as wanting an incentivisation and exit plan for management or keeping confidential business information out of the hands of competitors."

Equally, private equity companies that are considering their exit options are in a good position following a strong IPO market in 2014. According to unquote" data, this year saw as many private equity-backed pharmaceutical listings as during the last three years combined, and the most money raised since 2007. However, this should be seen in the context of the overall flotation frenzy that hit the market in the first half of the year – particularly for those companies with a retail aspect, notably Pets At Home and Just Eat. Says Nayyer: "If you're the owner of a good quality pharma asset right now, the world's your oyster!"

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• Topics
• Healthcare
• Pharmaceuticals
• Top story
• Silverfleet Capital
• Ardian (formerly Axa PE)