As the private equity industry matures, and the deal landscape becomes more competitive, private equity sponsors are becoming more prepared and capable of investing in sectors previously considered overly-regulated, requiring advanced chemistry or biology expertise or where binary regulatory decisions can make or break an investment.
One area where deal activity is clearly increasing is in deals involving specialist pharma companies, and biotechs.
Over the course of the next three articles, we consider various aspects of committing capital to Life Sciences companies and assets, namely:
- Value drivers and risks;
- Common deal structures; and
- Typical deal documents and their characteristics.
The life sciences sector is relatively broad and comprised of three key constituent assets/services – Pharma/medicines, medical devices, and healthcare. Pharma and medicines relates to the discovery, development, production and marketing of drugs and pharmaceutical drugs for use as medications to patients to cure them, vaccinate them or alleviate a symptom. This article focuses on acquisitions of companies in this part of the life sciences sector.
Key value drivers for pharma acquisitions
The value of a pharma company is driven by several key factors. Note that sophisticated intellectual property (IP), although important, is not of itself generally sufficient and the value of a target will usually lie in how readily this innovation has been, or can be, turned into sustainable profit. The following factors are important to consider when assessing the value of a pharma or biotech M&A target.
Traditionally, a drug begins life as a molecule following extensive screening and optimisation. The path from discovery to commercialisation is lengthy and expensive. There is no hard and fast rule, but industry experience demonstrates that getting a commercially-successful drug from "bench" to "patient" (taking into account failure rates), can require roughly $800 million to $2.5 billion in capital, and take seven to ten years. The path to approval in a major market for a drug requires several phases of clinical testing, and approval by an appropriate regulatory body. So, the point that a drug is at in its life cycle is of critical importance to value; the later in term that a molecule is, the more it is generally de-risked. A promising molecule for the same indication for first-line treatment which is about to commence Phase I testing (where a drug is tested on healthy volunteers, for safety and limited, if any, efficacy) will be worth many multiples less than one about to complete a successful Phase III study (a test of efficacy in a statistically well-powered clinical trial, before submission for regulatory approval). Where a molecule is in its life cycle has a multiple of impacts, not least remaining costs to get a drug to market, but also its likelihood of failing to achieve commercial success. Even once approved and on sale, the remaining time that a drug has "on patent" (see below, IP/ patents) will further affect its value.
For innovator companies, physical assets, other than manufacturing facilities, are significantly less important than intangible assets (IP in particular). For a pharma company, it is important that the right to exploit, manufacture and distribute the drug(s) it owns can be protected and enforced. This ability directly affects its value. The primary source of IP protection for an innovator company is via patent protection. Patents have specific scopes, validity and duration. "Stronger" and "weaker" patents will have direct effects on value; as will a lack of patent protection itself. The value of a drug or molecule will be driven by the owner's right to use the technology and to protect such use. Patenting a technology provides exclusivity to protect against competition. When a product's patent exclusivity finishes, it will be exposed to the risk of competition from generic drugs and biosimilar drugs.
Like any industry, the life sciences industry is subject to trends, and areas of particular focus and interest. Areas such as oncology, immunology and inflammation and chronic pain, are currently regarded as growth areas where there is both increasing demand for new products and drugs, and several innovative advances in treatments that may make it possible to improve quality of treatment. Companies which operate in these sectors may therefore benefit from a value boost.
Although a substantial portion of the commercial value of a life sciences asset is driven by its innovation and IP protection (to defend that innovation), and also the stage in the life cycle of its assets, the value of high quality and proven management teams cannot be overlooked. A target which has a strong person, team or division, and/or has a good record of moving assets out of the lab and on to patients, may be deemed particularly valuable because of the potential for further innovation, and because of the demonstrated experience the management team has. An assessment of how transportable or well-motivated a target's personnel are is also important, as value could be lost if a key person or team does not stay following an acquisition.
A target company with a strong brand or profile may have more value on an acquisition. Having proven products or robust clinical trial data may contribute to a company's profile, as well as scientific breakthroughs and innovative approaches.
Primary risks affecting pharma acquisitions
The life sciences industry is seeing growth through the introduction of disruptive technologies such as 3D printing, artificial intelligence and bioinformatics. Growth is also driven by increasingly empowered consumers. While technological advancements often bring about positive outcomes in terms of creating effective drugs, tracking the outcomes of treatment, and preventing disease, this can in fact pose significant risks to pharma and biotech companies. A new piece of technology may be cheaper to produce or more effective than an existing drug or product and may undermine the value of certain products being developed by these companies. For example, applications which sit on a mobile telephone and help monitor and manage a patient's mood may be beneficial for society in general, but likely to be negative for a pharma company with an innovative product to treat depression (due to a reduced potential market for the drug).
A substantial part of the value of an innovator company derives from the patents that protect its key drug assets (usually with around twelve years for the effective life of its typical 20-year lifespan, taking into account the approximate eight years it will take to get for a molecule to receive regulatory approval for it to be sold).
It is this patent protection which supports the prices charged for the drugs. As patents for a small molecule drug begin to expire, that usually heralds the entry into the market of "generic" competitors for the drug – usually sold at much lower prices, and often demolishing the drug's previous market share. In recent years, this cycle of competition and price reduction has been playing out with biologic (or large molecule) drugs when so-called "biosimilars" come to the market. Without another asset to replace the now off-patent drug, the revenues of an innovator company can fall significantly.
It is noteworthy, however, that the expiration of patent protection does not always herald substantial generic competition. This is often driven by an assessment of the addressable market for a drug. Some successful PE buy-and-build investments have been built by acquiring drugs with soon-to-expire patent status, but which do not address a sufficiently substantial patient population to make generic entry worthwhile for generic manufacturers.
Non-compliance with regulatory and legal obligations can both reduce the value of the target and expose it to civil and criminal liability. Fines under EU law in relation to marketing authorisations can be significant. The U.S. has a similar landscape. Non-compliance could also lead to certain authorisations being suspended or withdrawn, which may affect the target's ability to market its products. In the U.S., one pharma company, Akorn Pharmaceuticals, went from being sold for $4.3 billion to the brink of bankruptcy by compliance failures. It will be important for a buyer to assess a target's compliance profile during its due diligence process.
Pricing and reimbursement challenges
A key element of a drug company’s success is its ability to negotiate pricing and reimbursement with both government authorities and insurance companies. In the UK, a company must prove the value of its drug against any competing products for the NHS to be able to provide it to patients. Insurance companies will also need to approve the drug for it to be prescribed to certain patients. Pricing and reimbursement will have a significant impact on the profitability of a product as without reimbursement approval, a drug may never generate any meaningful profits (noting that several categories of drugs may be exempt from this rule, for example, "life style"-type drugs for which reimbursement is often less relevant to the decision to use). Making a drug cost-effective can be difficult given the huge costs of development. Currently, in the US, significant attention is being paid to the rising cost of drugs, and public pressure is being applied to drug companies to restrict the yearly price increases that have driven significant revenue growth.
Drug companies often need to adapt to changing regulatory developments in different parts of the world. Currently, in Europe, Brexit has created significant uncertainty and the transfer of several regulated activities from the UK to other EU member states may lead to disruption in supply chains.
The life sciences industry is particularly vulnerable to cybersecurity risks as it relies heavily on technology, sensitive IP and trade secrets. Smaller biotech companies may be more at risk as they tend to have less sophisticated IT systems and could provide a gateway for those looking to attack larger pharma companies. Cybersecurity breaches could lead to loss of vital IP, regulatory fines and disruption of operations which could, in turn, cause significant monetary losses.
Traditional buyers of innovator companies face increased competition from non-traditional buyers such as Amazon. The rise of such buyers is linked to increasingly empowered consumers (and vendors) and technology companies which are quickly developing innovative ways to engage with those consumers, and to extract further value from pharma companies in an environment which may already be financially pressuring them.
Other key factors
Presence of private capital
The life sciences industry benefits from the involvement of a range of specialist venture capital investors, who use sophisticated structures and capital to attempt to accelerate and maximise the value and growth of biotech companies. This increases the amount of capital available to fund research and development (R&D) in the industry and can increase the level of sophistication in their exits, some of which can be at a level to interest growth-capital and PE investors.
Creating focused portfolios
Life sciences companies have tended towards consolidating their portfolios in recent years with a desire to focus on key areas of therapy. This allows companies to raise their profile and concentrate on key assets. It also means that companies are looking to make strategic divestitures which could lead to more assets being on the market. PE funds are the natural acquirers of some of these assets.
Alliances and partnerships
It is increasingly common for life sciences companies to form alliances to hedge potential risks and share potential rewards on some of the more uncertain clinical trials. For example, Merck KGaA and Pfizer set up a strategic alliance in July 2017 in relation to a particular drug. The rise of alliances allows assets to be developed to the fullest extent possible and to test combinations, and also to share the significant costs of R&D.
Among the partnership options being considered by pharma include deals with PE funds. For instance, a PE sponsor will fund a late stage clinical trial of a promising molecule, in return for priorities over initial royalty payments that can represent very significant returns. In other cases, JV companies can be formed between PE sponsors and pharma to accelerate the development of certain drugs. For instance, in late-2019 Blackstone and Ferring inked a large partnership in relation to nadofaragene firadenovec (rAd-IFN/Syn3), an investigational novel gene therapy in late stage development for patients with a certain type of bladder cancer.
The increased wealth of the population means that there is an increasing demand for new drugs, including for conditions that are elective. In a society that is increasingly consumer-led, patients and customers are calling for a wide range of solutions for superficial and aesthetic conditions. This is driving demand for new drugs.
An aging population and a higher percentage of citizens over 65 in the West, and Europe in particular (together with Japan), is creating opportunities for the pharma industry. Many people over 50 have at least one chronic health complaint, and the need to treat conditions such as arthritis, diabetes and cancer is driving drug development and market consolidation significantly.
In the next article, we will discuss the common deal structures used for pharma acquisitions.