* Private equity auction delayed by merger talks - sources
* Deal worth up to 7 billion euros - sources
* Discussions with Elanco at preliminary stage - sources
* Bayer likely to retain stake in merged entity - sources
By Arno Schuetze and Pamela Barbaglia
FRANKFURT/LONDON, July 9 (Reuters) - Bayer has approached U.S. drug firm Elanco Animal Health to discuss a possible combination of their pet-health businesses to create an industry giant, three sources familiar with the matter told Reuters.
The two companies are working with banks to ensure any merger would secure regulatory approval, the sources said, speaking on condition of anonymity.
Bayer has delayed the launch of an auction to private equity funds to clinch a bilateral deal with Elanco, the fourth-largest player in the animal health industry globally, the sources said.
The German drugmaker is under pressure to raise cash and boost its share price after its $63 billion purchase of Monsanto.
Bayer ranks fifth in veterinary medicine. Aside from Elanco, its bigger rivals are former Pfizer unit Zoetis, unlisted Boehringer Ingelheim, which bought animal health assets from Sanofi, and drugmaker Merck & Co.
Bayer Chief Executive Werner Baumann said in November his company would divest several assets including its animal health division, which analysts have said could fetch 6 billion to 7 billion euros ($6.7 billion-$7.8 billion).
The sources said discussions with Elanco were at an early stage and Bayer remained interested in receiving bids from private equity investors later this year.
An auction process was initially expected to start in June but Bayer would only dispatch information packages to prospective bidders towards the end of the summer, they said.
A Bayer spokesman said the firm was “progressing as planned” with efforts to separate the animal health business.
“After the strategic review of the possibilities, the main focus is on a sale,” he said, adding Bayer continued to “consider all value-maximising options.” He declined to comment on Elanco.
Elanco, which also declined to comment on any deal, offers more than 125 products to veterinarians and food animal producers in more than 90 countries.
The company, based in Greenfield in the U.S. state of Indiana, has a market value of $12 billion but it might struggle to finance an outright acquisition of Bayer’s unit unless the German drugmaker decided to retain a stake in the combined entity, two sources said.
Elanco inherited a significant amount of debt from its previous owner Eli Lilly, which spun it off last year.
As of December, it had about $2.5 billion of overall senior debt. In its annual report, it warned investors about the risk of failing to generate sufficient cash to service all its debts.
The sources said an all-cash sale to Elanco was unlikely, adding Bayer would need to keep a stake in the merged company to secure a deal.
Private equity firms may offer an easier exit for the German group but they are expected to value the company at a much lower price due to its declining business, the sources said.
Buyout funds had tried to take control of Elanco when it was part of Eli Lilly but the company opted for a more lucrative spin-off and listed the business in New York where it trades at about 20 times earnings.
$1 = 0.8923 euros Additional reporting by Patricia Weiss and Caroline Humer Editing by Edmund Blair