GP Profile: Water Street Healthcare Partners Turns Toward Exits

The founders of Water Street Healthcare Partners spun out of One Equity Partners back in 2005, confident they could extricate outsized returns from the labyrinthine U.S. health care system. Five years later, pressure is on the firm to generate results just as the government embarks on a monumental overhaul of the health care system.

The firm is one of many emerging managers that raised funds at a time when limited parters were competing with each other to find new and intriguing buyout strategies. Water Street raised two funds—a $370 million debut in 2006, followed by a $650 million follow-up in 2008—with support from notable investors such as the University of California and Goldman Sachs Private Equity Group. But now LPs across the board are starving for distributions. And as the deal market improves, the firm and its investors will be looking for exits from a number of portfolio companies that Water Street has nurtured these last few years.

“If we got to the end of 2011 [with no exits], that would become a bit of a concern,” said Brett Johnson, who as a director of private equity at the University of California backed Water Street’s first fund. Johnson is now a partner at Pantheon Ventures Inc., a fund-of-funds that invested in Fund II. “Clearly before they go to the market with Fund III, LPs will be looking for validation of the post-One Equity strategy.”

Through a mix of add-on acquisitions, expanding the geographic reach of its portfolio companies, and product line growth, Water Street aims to make 3x its invested capital by creating market-leading platform companies in diagnostic devices, medical products, specialty distribution and other niche segments. It generally positions its companies for sale to strategic buyers. The firm’s 13 investment professionals are led by Managing Partner Tim Dugan, a founder of First Chicago Equity Capital who in 2000 helped establish One Equity Partners, the former investment arm of JPMorgan Chase. The firm also has five former health care industry executives on staff as operating partners, including Curt Selquist, a former executive with Johnson & Johnson (see chart for more details on executives).

The firm’s strategy centers on identifying companies that help insurers more effectively manage utilization, reduce costs and improve clinical outcomes in oncology and other areas. Oncology-related spending in the U.S. totaled approximately $90 billion in 2008, said Dugan. Water Street also targets companies that help health care providers avoid making patient safety mistakes—operating on the wrong limb, for example. And it likes companies that make proven “mid-tech” medical products, such as intravenous catheters and other infusion products, remote monitoring systems and specialty surgical instruments. “There will be cases where more costly, cutting-edge products are determined to be unnecessary for broad use in place of existing, proven technologies,” Dugan said. “Our expectation is that established, mid-tech products that have demonstrated positive patient outcomes will better maintain share of procedures and/or patients in the future compared to new, high-tech products.” On the flip side, the firm avoids insurance companies and investments related to imaging products and services, which Dugan believes will become a target of federal cost-cutting.

Water Street believes it has proven to its investors that it knows how to find deals and build companies in an extremely complex industry. Now it has to prove it can generate returns from those investments. “Clearly we’d like to see realizations, but we’re not at the point where we think they’ve missed an opportunity to have any,” said Mike Pohlen, a partner with Piper Jaffray Private Capital Group, a fund-of-funds that invested in both Water Street vehicles.

Exit Opportunities

Since spinning out of One Equity, Water Street has completed 21 transactions toward building 11 portfolio companies. To date the firm has one partial exit: Last year it sold the neurodiagnostic business of Alpine Biomed to Natus Medical Inc. As of March 31, 2009, Fund I had generated 1.03x and a 1.69 percent investment rate of return for the Regents of the University of California.

But the fund is still relatively young, and Dugan said the firm has actually written up its portfolio in each of the last eight quarters, while earnings across the portfolio were up 18 percent in 2009 compared to 2008. Among the strong performers, he said, is Access MediQuip, a portfolio company that manages the acquisition, financing, and reimbursement of medical devices. The company has doubled its sales and achieved double-digit revenue growth for the past two years, Dugan said. Another portfolio company, CareCentrix, which coordinates home health services for insurers, increased its revenues to more than $500 million in 2009, way up from $325 million in 2008.

Dugan declined to discuss specific exit opportunities, but a number of the firm’s investments appear to be strong candidates.

Perhaps the ripest is its first portfolio company, PLUS Diagnostics Inc., a Union, N.J. based laboratory that Water Street has watched expand through an acquisition and by increasing the number of services it provides. The firm bought the company, then known as Lakewood Pathology Associates, in May 2006 for $50 million, when it generated annual revenue of about $11 million. In August 2008, CEO Doug Berg told Laboratory Economics that the company expected to double its revenue to more than $50 million in 2009, partly on the strength of a new gastrointestinal services line. In April the firm expanded its footprint with a West Coast laboratory in Orange County, Calif., and in December the company expanded its services further, launching hematology and oncology services lines.

Another possible candidate for exit is Sierra Scientific, a Los Angeles-based company that makes devices that help doctors diagnose gastrointestinal disorders. The investment started in August 2007, when Water Street backed Alpine Biomed’s acquisition of Medtronic Inc.’s neurodiagnostic product line. In January 2009, Alpine Biomed bought Stellate Systems Inc., a Montreal based company that develops advanced neurodiagnostic systems. Later in 2009, Alpine Biomed sold its neurodiagnostic division—marking Water Street’s first and only partial exit—and merged its gastrodiagnostic business with Sierra Scientific to form a major provider of devices for the gastrodiagnostic market.

Then there’s Precision Dynamics, a San Fernando, Calif.-based company that Water Street bought in July 2007 for $75 million in equity. That company has since made one add-on acquisition and won a plum multi-year contract from the National Health Service to provide identification wristbands to hospital patients in England and Wales. Under Water Street, the company’s revenues have increased to more than $114 million from $73 million when the firm made its investment, and EBITDA has more than doubled, according to a source familiar with the company’s financials.

“This year we will start to see an increase in Fund I exits, provided the markets are at least stable,” Dugan said.