Capital Infusion - May 2013: Dealmaker’s Corner

In this issue’s installment of “Dealmaker’s Corner,” Jon Finger, a partner in our private equity group, had the opportunity to visit with Kyle Bradford, Managing Director with American Capital, Ltd., concerning the pharmaceutical services industry.

Capital Infusion: What are the significant benefits of outsourcing services in the pharmaceutical industry?

Kyle: There are many benefits and I think you will see outsourcing continuing to build on its growth that has been going on for years. Two of the main benefits that pharmaceutical companies realize are a reduction of fixed costs and more cost flexibility. This helps companies maintain margins and increase profitability, which has become increasingly important over the years as the pharmaceutical industry has evolved and become more competitive with the advent of the small biotech and midsize pharmaceutical manufacturers that operate, in many instances, a fully outsourced model. In the 1990’s and the early 2000’s, there were very large blockbuster drugs driving an incredible amount of growth for pharma companies and many of those drugs have seen patent protection expire recently. The loss of these big “cash cows” with a relative slowing of development of new blockbuster drugs has contributed to the rise in outsourcing. In addition, novel new compounds are becoming more complex and more targeted, focusing on smaller populations. This trend will only continue, and specialized Contract Development and Manufacturing Organizations (“CDMOs”) are in a unique position to capture increased share as they have the technical capabilities to develop complex and unique compounds.

Capital Infusion: In what other ways do service providers help companies in the pharmaceutical industry?

Kyle: As drugs become increasingly more complex and targeted, pharma companies cannot often rationalize having "all of the necessary technology “in-house,” and so they look to the providers who have varied technologies available for instant utilization. Also, in today’s environment with increased scrutiny by the Food and Drug Administration ("FDA), the cost and timeframe of getting drugs to market has increased substantially. Outsourcing has allowed pharma companies to become more nimble to address this reality, offering companies the ability to lower employee count and become more virtual and flexible.

Capital Infusion: How have you seen the pharma services industry evolve over the years?

Kyle: It was probably 20 years ago when you really started seeing the industry take off and we’ve seen it play out on chemical entities or small molecule drugs. Today, I suspect more than half of all clinical trials, as well as greater than half of the manufacturing of small molecule drugs, are now being outsourced. I contrast this with the biologic space, where a much smaller percentage of the manufacturing is being outsourced right now. However, you are starting to see more specialized, biologic-focused CDMOs and so, over the next decade, I think you will see the percentage of biologic CDMO demand grow like we have seen in the chemical space.

Capital Infusion: How did the recent recession affect the outsourcing industry?

Kyle: The recession definitely affected the industry, particularly on pre-clinical R&D spending, where we witnessed a pretty significant drop in pre-clinical R&D spending after the recession. Pharma companies started really focusing their R&D dollars on later stage products and so the earlier stage R&D got hit hard. That decline seems to have bottomed and I would expect that segment to start coming back over the next 5 years or so. Obviously, drug development is not going to go away, and so people are eventually going to have to start reinvesting in the earlier stage molecules to get them in the pipeline and in clinical trials. Right now, pharma companies seem focused on drugs that are further along and closer to commercialization; trying to get them out to market in order to start realizing returns.

Capital Infusion: Have you seen service providers moving more toward specialty areas as opposed to trying to be more of generalists?

Kyle: I think that really varies by provider. You have the larger players who are able to be larger and more generalists. They are acquisitive and buying smaller companies that are specializing in order to acquire certain capabilities instead of developing them. We certainly see smaller players that are popping up and focused on areas such as genomics, proteomics and combinatorial chemistry. As they build this expertise, you will see larger players coming in and making acquisitions to further diversify their offerings to the industry. I expect to see more consolidation taking place, driven by other dynamics as well such as credit availability, cash on the balance sheet, and increasing market levels and confidence.

Capital Infusion: One of the most significant issues facing the whole health care industry is the implementation of “Obamacare.” How do you think outsourcing has been impacted by this legislation?

Kyle: As with the entire industry, it is the overall uncertainty that also leads to more conservative behavior from pharma companies, which causes lower spending on R&D and obviously impacts the outsourcing market. With greater clarity, you should see further improvement in R&D spending.

Capital Infusion: What other significant challenges are outsource providers facing today?

Kyle: Competition, and in particular, Asian competition, has been a significant challenge and it certainly depends on where you are focused. While international low-cost competition is present, anecdotally, we are starting to see projects return to the U.S. as a result of better quality, a creep up in prices overseas and IP leakage. Outsource providers also continue to need to be aware of and accommodate the increased FDA scrutiny that impacts all the players in the market. Collocation in North America and Europe, the centers of drug development, is very important in the development process, especially for small and mid-sized specialty pharma and biotech.