Leiner Health Collapses Into Chapter 11 Again

For the second time under North Castle Partners’s ten-year ownership, vitamin and over-the-counter drug maker Leiner Health Products has filed for Chapter 11 bankruptcy protection—an ignominious distinction known in restructuring circles as a Chapter 22.

The one-two punch of federal investigations and high leverage contributed to Leiner Health’s latest Chapter 11 filing, much as it did to its first. With its over-the-counter drug operations shuttered in the wake of a government investigation, the California-based company on March 10 filed plans with the U.S. Bankruptcy Court of the District of Delaware to restructure its $430 million in debt commitments and to explore a sale. As a result of the Chapter 11 filing both North Castle and co-owner Golden Gate Capital are expected to lose their respective $132.5 million equity investments.

Leiner Health first filed for Chapter 11 in 2002, five years after North Castle bought it for $353.8 million using an $80 million equity investment from its first fund. The company had lost money on $150 million of overpriced inventory after the U.S. Justice department broke up a price-fixing cartel among its suppliers. Sinking earnings led to defaults on debt totaling $295 million.

North Castle managed to revive the company and eventually realized a 3x return on its money in a 2004 recapitalization—a rare happy ending for a buyout-backed Chapter 11 filing. But North Castle decided to press its luck. Rather than make a clean break from the company, the firm re-invested from a special-purpose investment vehicle alongside Golden Gate Capital in the 2004 recapatilization, a deal that valued the company at $650 million.

The loss is believed to be North Castle’s first black eye and follows a series of lucrative exits in 2007 that include the sales of Avalon Natural Products Group, HDS Cosmetics Labs and Naked Juice Company. The firm, a specialist in consumer products companies, paid for Leiner Health with money from an annex to its third, $176 million fund. For its part, Golden Gate Capital enjoys a sterling reputation with investors since its founders left Bain Capital and Bain & Co. in 2000 to invest in a variety of industries including software and direct marketing; its first two funds were heavily over-subscribed and evidence points to similar results for its third, now in the marketing stage. An earlier foray into the vitamin and supplement space yielded far better returns; in 2004 the firm scored a 550 percent return on its IPO of Herbalife International.

The mid-market vitamin and OTC drug industry has proven to be a risky place for buyout shops in part due to federal scrutiny and regulation. Another buyout-backed vitamin company, Airborne Health, also hit a rough patch this year. On March 7, the Summit Partners-owned business settled a $23 million consumer lawsuit based on false advertising claims. Just prior to the lawsuit’s settlement, Standard & Poor’s downgraded its rating to CCC+ from B- based on diminished demand for its product. Airborne Health is believed to have generated about $200 million in revenues in 2006.

Analysts say Leiner Health and Airborne Health were particularly vulnerable to regulatory setbacks because of their small size. The vitamin industry is considered less vulnerable than the over-the-counter drug market, which is where Leiner Health met trouble, said Bea Chiem, a Standard & Poor’s Rating Service analyst.

Leiner Health manufactures generic and store-brand, over-the-counter drugs and vitamins sold at retail chains like Costco and Sam’s Club, with 67 percent of its sales coming from its two biggest customers. North Castle and Golden Gate Capital invested in the company partly based on faith in the growth potential of Leiner Health’s over-the-counter drug business. With many prescription drug patents set to expire back in 2004, the firms saw a growing opportunity to sell generic versions of those previously proprietary drugs over the counter.

The big blow to Leiner Health came last March, when the Food & Drug Administration accused the company of falsifying test results related to its over-the-counter products. The allegation and subsequent factory raid led the company to suspend manufacturing, a move that wiped away nearly 30 percent of the company’s revenues. Sales for the fiscal year ending in March 2007 hit $745 million, but by September trailing twelve month revenues had sunk to $606 million. Levered at 5x debt to equity, Leiner Health buckled under vanishing liquidity, said Nicole Lynch, a managing director with Standard & Poor’s.

In its Chapter 11 filing, Leiner Health stated that while it is in compliance with FDA regulations, its over-the-counter drug operations are still suspended because of customer concerns over product safety.

Moody’s Investor Service estimates that creditors will get a 50 percent family recovery rate on the company’s $430 million in debt securities, based on a potential sale price of four times EBITDA. The business generated trailing 12 month EBITDA of $95.1 million, adjusted for the cost of closing and consolidating its manufacturing facilities, as of September 2007. Leiner Health’s largest unsecured creditor is U.S. Bank NA, based in St. Paul, Minn., owed $150 million.

Golden Capital Capital’s latest fund, Golden Gate Capital II, closed on $1.87 billion in 2004. Both Golden Gate Capital and North Castle are seeking commitments on new funds, with Golden Gate Capital targeting $3 billion for an evergreen fund, its third, and North Castle Partners seeking $300 million for its fourth. Golden Gate Capital declined to comment; calls to North Castle Partners managing director Chip Baird were unreturned.—E.G.