No smoke without fire

For most private equity fund managers, regulation is normally considered a cost of doing business. 

In some cases, however, it can also help generate substantial value – as lower mid-market firm Huron Capital demonstrated in June, when it sold Labstat for a 6x return multiple.

The largest independent tobacco testing lab in the world, Labstat measures the amount of harmful constituents in tobacco smoke and smokeless tobacco. Its customers are typically global tobacco companies that need to comply with regulatory reporting requirements, government agencies involved in tobacco control and universities conducting tobacco-related research and development.

Not many firms provide these services – which was partly why the investment appealed to Huron in the first place. “There aren’t a lot of folks in the world that can do what they do, particularly that are independent of the laboratories within the global tobacco companies,” says Nick Barker, a partner at Huron. “There is a lot of expertise in capturing that smoke and putting it in a position where you can get reliable results from those tests.”

Equally important to the decision, however, was the fact that Health Canada (the Canadian equivalent of the US Food and Drug Administration) had recently introduced a new regulatory requirement: that all tobacco companies selling into Canada undergo toxicology testing to measure the biological impact of tobacco smoke. 

At the time of Huron’s investment, there were no such requirements in the US. But that changed in 2009 when the US government passed The Family Smoking Prevention and Tobacco Control Act, a federal statute giving the FDA the power to regulate the tobacco industry and require US tobacco companies to perform tests on cigarette smoke.  As a result, the regime now looks a lot like the Canadian system.

“When we invested back in 2006, we saw that at some point other government agencies were going to do something similar,” says Chris Sheeren, a partner at Huron. “We didn’t know where it was going to happen, [but] we thought that would maybe be the next big thing.”

The FDA is currently implementing new legislation that starts at the end of 2012 for mandatory testing in the US – which is estimated to be about a $100 million market on its own. 

Since investing in Labstat, Huron has also helped the company achieve an important methodology certification known as “Good Laboratory Practices”. While Labstat had been GLP-ready for a number of years, it was not operating in a GLP-compliant environment at the time of Huron’s investment.

“Anticipating that that might be important in an FDA-governed world, that was something we embarked on midway through our investment,” Barker says. Today, Labstat has fully validated and accredited methods for the complete list of the FDA’s Harmful and Potentially Harmful Constituents.

While private equity firms rarely embrace new regulation, Huron’s investment in Labstat proves that regulatory change can sometimes actually lead to and go hand in hand with value creation – especially in rapidly changing areas like tobacco testing, where there are public health issues involved. In fact, for companies like Labstat, new regulation is more of an opportunity than a threat.