Unlocking Value through the Use of Sponsor-Strategic Partnerships

November 2019

Much ink has been spilled on the increasing number of private equity sponsors and cash-rich strategics chasing after the same limited pool of quality targets. Much less attention has been paid to what we see as a growing and important trend: transactions involving private equity sponsors “teaming up” with strategics in innovative ways that unlock value for both sides. Recent transactions illustrate the various forms these partnerships can take:

  1. The sponsor and the strategic team up to acquire a business, as when OptumHealth and Summit Partners joined forces to acquire Sound Physicians or when KKR teamed with HCA to acquire Envision Healthcare.
  2. A strategic sells a stake in an existing business to a sponsor, such as Thomson Reuters’ sale of its majority stake in its Financial & Risk unit to Blackstone.
  3. A strategic buys a stake in a sponsor-owned portfolio company, such as Tenet Healthcare’s acquisition of United Surgical Partners, a portfolio company of Welsh, Carson, Anderson & Stowe (WCAS).

Data from Capital IQ indicates that there were 13 transactions involving some form of sponsor-strategic partnership out of 43 private equity buyouts with deal values in excess of $500 million that were announced between January 2017 and September 2019. According to PitchBook, over 10% of private equity buyouts in 2018 with deal values in excess of $1 billion involved sponsor-strategic partnerships (in 2019 (through the beginning of October), that figure is closer to 15%).

A number of sponsor-strategic partnership transactions have been concentrated in the healthcare sector, where we have seen sponsors leverage partnerships with corporate buyers to navigate regulatory requirements and exploit commercial opportunities. Indeed, according to the 2019 Bain Global Healthcare Private Equity Report, in 2018, there were 18 sponsor-strategic partnership deals in the healthcare sector that accounted for $7.9 billion, or 12.5% of disclosed value. Further, KKR/HCA’s acquisition of Envision Healthcare and OptumHealth/Summit’s acquisition of Sound Physicians mentioned above were among the 10 largest healthcare deals of 2018.

Advantages of Sponsor- Strategic Partnerships

From the sponsor’s perspective, partnering with a strategic to acquire a business offers a number of important advantages:

  • The partnership may distinguish the sponsor in a competitive process and allow it to tap into synergies and additional sources of capital to afford higher valuation multiples and participate in larger deals
  • The strategic partner may give the acquired business access to more markets, distribution networks, commercial opportunities and economies of scale than a sponsor alone could offer
  • A strategic partner can help mitigate concerns that shareholders and regulators may have regarding a private equity buyer, particularly in regulated sectors such as healthcare and insurance
  • Alternatively, if a stand-alone acquisition by a strategic presents antitrust or other regulatory issues, a sponsor-strategic partnership might allow the partners to “split” the business to avoid such hurdles and create a transaction that could not be completed by either partner acting alone
  • A strategic partner may provide an opportunity for a sponsor to buy a target company and “split” the business based on the assets that are more attractive to each of the sponsor or the strategic partner in order to maximize overall value
  • If the strategic partner has a strong credit rating, a sponsor can often access cheaper debt financing
  • A strategic partner may provide a builtin exit opportunity for the sponsor
  • Recent sponsor-strategic partnership transactions illustrate some of these points. Take, for example, the ability to have a clear exit for the sponsor. In 2017, TPG and WCAS teamed with Humana to acquire the hospice business of Kindred. The following year, the consortium acquired Curo Health Services for $1.4 billion, which it then combined with Kindred to create the largest hospice provider in the United States. The parties hardwired a path to exit by agreeing to a series of put/ call mechanics that enable TPG and WCAS to put their shares in Kindred (after reflecting the addition of Curo) to Humana after a period of three years, with an exercise price multiple determined by certain agreed-upon valuation metrics. Similarly, in 2015, Tenet Healthcare paid $425 million to buy a controlling stake in United Surgical Partners, a portfolio company of WCAS, and negotiated a put/call structure that gave Tenet a path to full ownership over five years. In 2018, Tenet announced it had completed the purchase of WCAS’s remaining stake.

    The OptumHealth/Summit acquisition of a controlling interest in Sound Physicians, a physician staffing company, showcased both the commercial advantages of a strategic partner and the effect on the target’s credit ratings. According to a ratings report by Moody’s, the B1 Corporate Family rating they gave Sound Physicians is supported by its “leading position” as a hospitalist provider and Moody’s opinion that the company is “better aligned with hospitals and payers than many other physician staffing companies” in light of OptumHealth’s ownership stake in the company.

    Benefits of sponsor-strategic partnerships accrue to the strategic as well. These include deal sourcing for potential add-on acquisitions, better management rollover packages to help retain and motivate management and key employees, and expertise in rationalizing the target’s business and improving its efficiency. More importantly, a partnership with a private equity firm provides the strategic with the opportunity to learn a new business over an extended period of time with less economic exposure.

    In deals where a strategic sells a piece of an existing business to a sponsor but continues to maintain a sizable position in the investment, the strategic may partner with the sponsor to avoid a lengthy auction process, deconsolidate a (typically underperforming) business, refocus its resources and management attention to its core business and record a gain on sale, while continuing to participate in the upside of the business under the stewardship of the sponsor until an ultimate exit. Examples of such transactions include the 2018 sale by AmTrust of 51% of its U.S.-based fee business to Madison Dearborn and the 2017 sale by FIS of 60% of its management consulting business to Clayton, Dubilier & Rice.

    Challenges of Structuring Sponsor-Strategic Partnerships

    Although sponsor-strategic partnerships can offer clear advantages, realizing these benefits requires time, effort and commitment. For one thing, incentives may not always be aligned: a sponsor may have a three-to-five-year horizon, whereas a strategic may have a longerterm focus. A sponsor and a strategic may also have differing views about the optimal exit scenario. For example, a strategic may want restrictions on the ability of the sponsor to sell to the strategic’s competitors. A strategic buyer may be sensitive to certain issues that are of less concern to sponsors, such as regulatory matters and other aspects of the target that may affect the strategic buyer’s ongoing business.

    These partnerships may provide sponsors with a leg up in competitive bidding, a clear exit plan and access to more markets, while strategics may get access to increased deal flow, better packages to retain and motivate management and expertise in improving the efficiency of the new business.

    Moreover, the key terms of these partnerships – which are often complex and critical to a successful outcome – may have to be negotiated in the midst of a fast-moving auction process, and sponsors are often better positioned to make decisions and act quickly than a large strategic buyer. It may be difficult to agree on the terms of a partnership in time to win a bid, or alternatively, parties may decide to work out specifics after a deal has signed, only to find that they lack a clear understanding of each other’s interests and goals. In deals where the sponsor-strategic value proposition includes entry into longterm commercial relationships between the acquired business and the strategic, these issues can be particularly acute, as negotiating those arrangements often requires the input of target management, access to whom can be difficult outside of a proprietary process.

    Overall, it is critical for the partners to develop a good working relationship, if one doesn't already exist, and establish trust early on in the transaction in order to set themselves up to be successful.

    Best Practices for Sponsor- Strategic Partnerships

    While every sponsor-strategic partnership is different, there are a number of best practices that sponsors should keep in mind when considering these combinations:

    1. Define the partnership at the outset. Discuss the goals of each party up front. Agree to the greatest extent possible on key issues with respect to partnership governance and go-forward arrangements, including post-acquisition board composition and veto rights.
    2. Have the exit in sight. Formulate a common understanding of when and how the sponsor will exit the deal and discuss potential exit mechanisms, including a right of offer/first refusal, put/call rights (including pricing mechanism for a put/call, although it may be difficult to agree on a put or call price in advance) and drag-along rights.
    3. It can take work to align the interests of sponsors and strategics, with possible sticking points, including different investment horizons, sensitivity to potential regulatory issues and restrictions on selling the new company to competitors.
    4. Consider the implications. Anticipate the projected impact the partnership will have on the contemplated transaction, including the partnership’s effect on substantive antitrust analysis and possible additional regulatory requirements. In the case of a publicly traded target, consider whether the combined holdings of a sponsor and a strategic partner make them subject to earlywarning disclosures and, in some jurisdictions, formal tender offer and bid requirements.
    5. Focus on the presentation to the seller. Consider how best to present an attractive and unified message regarding the partnership to a seller throughout the bid process. Predict seller concerns with the sponsor-strategic partnership bid and proactively offer solutions to avoid a seller discounting the partnership bid as too complicated or conditional to get done.
    6. Be flexible and creative. These transactions generally require solution-oriented and creative dealmakers to work through issues efficiently and commercially to keep the deal on track. Consider establishing “rules of the road” up front to be able to move quickly to respond to changing auction dynamics and other deal issues that will inevitably arise throughout the bidding, negotiation and even implementation phases.

    Armed with an understanding of what issues have the greatest potential to create problems down the line, deal teams can prioritize resolving those issues earlier in the process, enabling the parties to focus on working together to bring a transaction over the finish line, and ultimately maximize the value of their partnership to achieve a successful investment outcome for both the sponsor and strategic partner.

    The Private Equity Report Fall, 2019, Vol 19, No 2