LBO Signposts: An LBO Firm Lends a Hand In a Pharmacy Benefits Purchase Joseph Littlejohn & Levy’s Investment Helps Advance Paradigm Take a Leadership Position

They started out as competitors but wound up as teammates on the buy side of one of the most important strategic divestitures of the year. By joining forces, pharmacy benefits manager Advance Paradigm Inc. and New York-based financial buyer Joseph Littlejohn & Levy Inc. were able to pull off a major industry coup with Advance’s acquisition of PCS Health Systems Inc. from Rite Aid Corp. for $1 billion. Advance and JLL had been among the contestants for PCS when it was put up for auction by the beleaguered drug store chain. As individual bidders, both found Rite Aid’s asking price too rich. As partners in a unique alliance, they were able to pay the freight in a deal that catapults Houston-based Advance from fourth place to No. 1 in the pharmacy benefits administration field and locks in the benefits of scale that go with market leadership. Strategic and financial buyers have teamed in the past to swing acquisitions of targets that become jointly owned so the partners spread the cost and the risk. The Advance-JLL arrangement differs from the typical “club bid” in that the financial partner invested in the acquirer to get the deal done. This rarely used approach could interest other LBO firms scurrying to commit huge sums of equity capital to dealmaking, and JLL says it is willing to consider similar transactions that essentially involve investments in the deal. “We haven’t made investments in the past where we were not the whole owners,” says Ramsey A. Frank, senior managing director at Joseph Littlejohn & Levy. “This is the first time we got into an investment in an acquisition, but we are willing to consider them and are looking at it.” The acquisition involved a complicated deal structure. The $1 billion purchase is split between a cash payment by Advance of $675 million, a $200 million senior subordinated note, and issuance of $125 million in Advance stock to Rite Aid. JLL entered the structure by purchasing Advance stock for $150 million that was earmarked toward the cash portion of the price. The remainder of the cash was generated by senior secured debt committed by Merrill Lynch & Co. In the final analysis, Frank says, JLL liked the deal from a variety of standpoints, including the division of the price, Rite Aid’s willingness to hang in with an Advance stake, the potential of the pharmacy benefits management industry, and the strategic advantage of being No. 1 in the growing business. “Economies of scale are very important in this industry,” Frank notes. The deal unites No. 4 Advance with No. 2 PCS, putting the combination – which will service 75 million people enrolled in business, government, and insurance-sponsored health care plans – ahead of former industry top dog Merck-Medco Managed Care and No. 3 United Health. Advance, whose services include acting as agents for these plans in processing and paying drug bills, says that it expects to handle 450 million claims a year, involving $16 billion in drug expenditures, and to generate about $3.2 billion a year in revenues. “Scale gives us greater negotiating leverage with pharmaceutical companies and retail drug stores,” Frank says. “It gives us greater buying power. That translates into more value added for customers and helps in reducing prices. It also allows Advance to make its pharmaceuticals-by-mail service much more effective and to provide more services.” Advance PCS, the new name of the combined company, not only becomes the leading publicly traded pure play in pharmacy benefits but also the only independent entry – not owned by a drug manufacturing or retailing company – in the field. PCS itself has gone through two changes of ownership in the last decade, including Eli Lilly & Co., which sought to put more of its own drugs through the benefits systems, and Rite Aid, which wanted to use it to generate more retail traffic. “Advance PCS is now the leading independent player,” Frank says. “There are no conflicts, no issues, no direction from a parent. That is a better model for this industry. We are free to maximize value for the customers and there are no strings attached as to the drugs that are sold.” Frank says Advance initially will concentrate on integrating the two firms but may look at more acquisitions in the future, as well as the potential for offering other services in the health care field. JLL is not looking for a quick exit, Frank asserts. “We are looking to hold on for a considerable period of time,” he says. “But all options are available. And the public market likes this sector more than others.” Reaping a Payoff In Used Goods In a retailing segment populated primarily by mom-and-pop stores, charity-run outlets, and hospital thrift shops, TVI Inc. is the closest thing to a corporate giant. Bellevue, Wash.-based TVI is the world’s largest for-profit merchandiser of secondhand goods whose 172 stores in the U.S., Canada, and Australia sold nearly $287 million worth of discarded apparel and other products in fiscal 1999. And, according to Berkshire Partners, which recently acquired control of TVI, the company has a lot of room to get bigger. Among the attributes that attracted Berkshire was TVI’s highly systematic approach to securing, selling, and turning over merchandise, says Kevin Callaghan, a managing director of the Boston-based private equity firm. TVI sources its wares through agreements with regional and national charities that quickly turn donated merchandise into cash by selling it to the chain. Most of the merchandise is apparel, but more than 20% includes pre-owned hard goods, such as furniture, household goods, books and toys. “TVI locates the stores in regions that allow it to take whatever quantities they want,” Callaghan said. “They have a well-trained staff that sorts and prices and merchandises on the floor, hitting the right value points for a particular region. They emphasize a quick turn of merchandise. If they can’t sell the goods in a couple of weeks, they discount them to move them out to make room for a fresh supply.” If the deeply discounted goods still don’t sell, TVI unloads them through other channels, selling them overseas or into recycling markets. With its heaviest concentration of outlets in the western U.S. and scatterings in the Midwest and New England, TVI is ticketed for expansion in both the U.S. and overseas through additional store openings and acquisitions. The stores, located mostly in suburban areas, serve a “broad demographic” mix that includes middle-income consumers, college students, and senior citizens. “We think the business is recession-resistant and Internet-resistant,” Callahan says. “The goods have a real touch-and-feel element to them.” Distributors Seek New-Economy Status As publicly held companies, building maintenance product distributors Wilmar Industries Inc. and Barnett Inc. were considered too mundane to inflame the passions of stock market investors. Now combined under the auspices of private equity sponsors, the firms not only to expect to thrive in their basic businesses but also to engineer their conversion into a new-age company. Wilmar, based in Moorestown, N.J., went private in May when it was acquired by an investment group led by Pantheon Capital of Boston. Less than two months after changing hands, Wilmar struck a deal to acquire Jacksonville, Fla.-based Barnett for cash. Size is a compelling feature of the union. The merged business distributes a wide range of plumbing, electrical, hardware, and related products – some 18,000 stock-keeping units (SKUs) in all. With sales of around $600 million a year, the combination is believed to be the nation’s largest distributor of MRO (maintenance, repair, and operations) goods in the country. But diversity is a big kicker. Wilmar’s major customer base consists of apartment complexes, but the company also sells to hospitals, hotels, and government agencies. Barnett principally sells to repair and remodeling contractors. While Wilmar sells through field service representatives and a network of distribution centers, Barnett peddles its wares via telemarketing and direct marketing. “Both are great systems and there are synergies,” says Ernest Jacquet, the private equity veteran who is supervising the distribution roll-up. “We feel we will learn a lot from Barnett on telemarketing and Barnett will benefit from our field service and delivery system. We have a fleet of trucks at Wilmar capable of same-day delivery.” Jacquet’s comments point to one of the great disconnects in evaluating businesses today. Although Wilmar’s and Barnett’s operations appear routine to the naked eye, making them work is a complex exercise involving the plugging of trucks, distribution centers, and a spine of management information systems (MIS) into customer demands for quick delivery at the lowest price. Investing for the long pull in that kind of business is better handled by the private equity-sponsored company, Jacquet says. “The principal difference is that as a private company we can invest in the infrastructure, such as MIS and distribution centers, without having to be concerned about quarter-to-quarter EPS,” he says. “We were able to put a lot of money into integration at a faster pace and not worry about the impact on our bottom line over the next six months. If we were public, we would be at the mercy of the vagaries of the market analysts.” “The research community is more enamored of the new economy and not excited over the old economy,” Jacquet continued. “It’s our intention to transition Wilmar from the old economy to the new economy.” The principal approach is to “put a substantial amount of capital into our web page.” That, he said, would open new channels of distribution as an increased number of products and services are purchased on a business-to-business basis over the Internet. While enhancing its technology, the newly enlarged Wilmar is eyeing additional business opportunities that a “new economy” concept would afford, including acquisitions in the core MRO business and related distribution operations. “We would seek horizontal, vertical, and international opportunities,” he says. Wilmar also could be in a position to sell its services, such as order fulfillment and delivery, to other firms.