Nice Insight’s Virtual Panelists explore the deal-structuring shift in the pharmaceutical market from an investor perspective.
Consolidation has been a watchword for the pharmaceutical industry in recent years. Major pharmaceutical companies are looking to enhance their pipelines through the acquisition of competitors with complementary portfolios in terms of treatment classes, geographic markets or other synergies. They are also snapping up small or emerging firms with promising early-stage clinical trial results. At the same time, they are looking to become more virtual and unload mature products facing generic competition.
These activities have affected the contract services sector and other suppliers to the pharmaceutical industry. There are fewer potential customers for contract research organizations (CROs) and contract development and manufacturing organizations (CDMOs), and those that remain are looking to simplify their supply chains and develop deeper relationships with fewer suppliers. CROs and CDMOs are consequently seeking to expand their offerings through acquisition of companies with complementary or specialized capabilities in order to position themselves as integrated, full-service partners that can support pharmaceutical customers across the entire cycle, from discovery through commercialization and beyond the loss of patent protection.
Private equity and venture capital firms have played a role in many of the transactions that have taken place. Indeed, fund-raising for both types of investments continues at a brisk pace despite the fact that a seller’s market has persisted for a number of years. Quality deals have become harder to find, however, and targets are shifting.
The number of private equity (PE) transactions is declining, while valuations have increased dramatically due to the fact that there is a much smaller number of quality companies coming to market. – Robert Auritt – Brant Point Partners, LLC
Meet Lower-Middle-Market Investor Brant Point Partners
Based in Philadelphia, Brant Point Partners pursues three principal activities: private equity co-investing, mergers and acquisitions and investment advising. “We have a strong reputation for identifying valuable targets and getting deals done,” notes President Robert Auritt. The company typically partners with other PE firms and family offices with complementary expertise. In particular, Brant Point Partners actively works with companies with revenues of up to $65 million-$70 million and typically at least $3 million-$5 million of EBITDA.
State of the investment market
The tremendous activity in pharmaceutical investments in recent years has affected the ability of companies to find quality deals, according to Robert Auritt, President of Brant Point Partners, LLC. “The number of private equity (PE) transactions is declining while valuations have increased dramatically due to the fact that there is a much smaller number of quality companies coming to market,” he notes. For PE firms there is, therefore, an ongoing shift to deploy capital for companies that have reached later stages of the drug development cycle.
At the same time, large biotech and phar-maceutical companies are struggling to fill their pipelines solely through internal R&D activities. “There is a drive to achieve growth through the acquisition of companies developing novel compounds, even if they are in early-phase clinical trials,” says Auritt. As a result, venture capital firms find themselves investing sometimes at earlier stages of the drug development cycle.
The state of the market also depends significantly on the particular sector. For instance, pharmaceutical services (including CROs, CDMOs and CMOs) are in high demand, and it’s not just large strategic buyers that are fueling this marketplace, according to Banks Bourne, CEO and Senior Managing Director with Bourne Partners. “We are increasingly seeing top-tier private equity firms capitalizing on the tremendous growth in the industry and acquiring major players as platform companies or bolt-on acquisitions for companies within their current portfolios,” he observes. Contrast that with specialty pharmaceuticals, which he notes have been pummeled over the last twelve months and experienced a tremendous slowdown in what was a historically frothy M&A environment just two years ago.
Fund-raising for both venture capital and private equity deals continues to be quite successful, however. In addition, highly capitalized financial players with the ability to do top-tier deals are feeling some pressure to deploy capital to achieve their strategic goals, according to Auritt. “It has been a seller’s market for an extended period of time, and there is fear that when it ceases to be a seller’s market that attractive targets may take themselves off the market,” he says.
Shift in value creation opportunities driving big changes
On a macro level, the paradigm shift within big pharma to deemphasize early-stage R&D in favor of building pipelines through M&A has had a tremendous effect on both the services and specialty pharmaceutical sub-sectors, according to Bourne. “Ultimately, the value creation opportunities shifted, which led to smaller companies (some single-product) focusing on taking promising opportunities to an inflection point (phase I, phase II or further) with the goal of selling or licensing these more mature development programs to big pharma. Unfortunately, the smaller companies that did not have the same economies of scale for handling clinical trials, manufacturing, etc. were not economically viable. So they looked to outsourced solutions to meet these needs, which helped accelerate growth within the pharma services sector. In addition, it helped fuel M&A activity within the pharmaceutical sector,” he explains.
The increased M&A activity in the space led to expanded multiples, and companies took on sizeable amounts of debt in order to complete some of these acquisitions. With pharma companies trading at such high multiples, most corporate acquisitions were immediately accretive and near-arbitrage opportunities, according to Bourne. Additionally, legacy portfolio rationalization was seen by big pharma as a tool for funding additional acquisitions. “This situation led to smaller companies buying legacy portfolios at a discount (product multiples are historically much lower than corporate multiples) in order to use the newly acquired cash flows to fuel R&D cost or additional acquisition. In a weird way, big pharma was selling products at a discount just to buy them back at a premium as a means to build out their R&D pipelines,” Bourne comments.
The market got crowded with buyers, however, and as a result portfolio prices got higher and acquirers resorted to riskier strategies to recoup these higher costs. A common lever to increase these returns was raising price (most commonly to a normalized market price, but in some instances profiteering occurred). “Given the recent public criticism over ethical pricing practices within pharma, we’ve seen a tremendous devaluation across the industry,” says Bourne.
He notes that this description merely scratches the surface of the market dynamics. “Ex-U.S. manufacturing quality concerns, generic drug approval backlogs, the Affordable Care Act, the steady rise in opioid abuse, drug pricing, managed care coverage and tax-inversion strategies have all played equally large roles in the current environment,” Bourne asserts.
You have to be able to identify the highest quality companies with unique value propositions and operational excellence. It’s a losing strategy to overpay for companies that are being positively affected through association only. – Banks Bourne – Bourne Partners
Meet Bourne Partners: Focused on Healthcare and Life Sciences
Bourne Partners is in equal parts a private equity firm and an investment bank that focuses exclusively on fulfilling the unique needs of established, middle-market healthcare and life sciences companies. The firm has assisted clients around the world with corporate sales transactions and divestitures, assets sales and licensing deals in the areas of specialty pharma, pharma services and consumer health and has been exclusively dedicated to this sector for nearly 20 years, investing in and advising some of the best healthcare corporations and financial sponsors in the business, according to CEO and Senior Managing Director Banks Bourne. “Across the board, our strength is getting the right talent on ‘the bus’ and keeping them for the long term.”
Seller’s market for services
While pharma is a buyer’s market right now with plummeting values, the life sciences service segment is experiencing the exact opposite trend, according to Bourne. That can be a challenging situation for buyers. “As a buyer, we are more attracted to markets that are in turmoil because we believe our expertise will allow us to pick the quality companies that have been negatively affected through association only. We think this ability holds true in a similar sense for operating within a seller’s market. You have to be able to identify the highest-quality companies with unique value propositions and operational excellence. It’s a losing strategy to overpay for companies that are being positively affected through association only,” he explains.
Given how competitive some sectors of the life science market are, it is important for buyers to focus on companies with strong growth potential, according to Auritt. “Buyers are paying additional EBITDA turns in this market than they would at other times in the cycle. It is critical, therefore, to choose targets that not only have already demonstrated successful organic growth, but also have a number of promising initiatives planned and underway that will lead to further growth. Portfolio synergies and the company’s position in the industry are also important,” he says. Auritt adds that it is absolutely crucial to do a proper basic analysis in order to identify such targets.
Buyers in the middle market (up to $1 billion in sales) should also be prepared to find themselves in a broad bidding situation given the limited number of quality companies that are available today. Head-to-head battles are much less likely, according to Auritt.
Venture investments are typically targeting companies with strong track records of performance and established expertise in the life sciences. Good chemistry between the VC team and the principals of the target company is also a common requirement. These factors can, in fact, be more important than price. “We have, for instance, seen deals that have closed with investors with the best track records over those with the better deals,” Auritt observes. Here again, homework is key and quality matters.
Attracting investors
So what should a company that is looking for investors do to ensure a smooth and successful financial experience? How can they become an attractive target given the current market conditions?
First and foremost, according to Bourne, companies need to know what kind of capital they’re looking for, and knowing the differences between private equity and venture capital isn’t sufficient. “A savvy company will understand the various subcategories of each larger group and identify firms that can provide the best fit (both from a cap table perspective and from an operational perspective). Depending on the size of the company and its financial position, I would almost always recommend hiring a banker to help with the capital raising process, because I truly believe that having an experienced team vetting potential capital providers, negotiating terms and helping to pull the deal together on your behalf is worth the cost in the long run (and often leads to a better overall deal for the company net of fees),” he says.
Pharmaceutical companies looking to attract venture capital need to have products at a reasonable stage of development and a nearly complete management team, including a CEO preferably with extensive commercial experience and proficient technical knowledge, according to Auritt. While they typically haven’t yet achieved any sales, they do have a highly developed understanding of the approval pathway; have identified a CRO partner and completed the clinical trial design, a comprehensive business plan and impressive scientific advisory and corporate boards; have succeeded in raising some initial financing; and have appointed a leading IP attorney and corporate securities firm and have a reputable accounting firm. “Credibility is key. All of these items point to a company that has more than a promising drug candidate; they have shown that they have the commitment, wherewithal and understanding needed to convert a business based on drug development into a value-generating enterprise,” Auritt states.
Smaller, middle-market companies looking for private equity investors need to have an established market profile and generally have niche products with the potential to hold, or which are already holding, leading positions. They also have a demonstrated growth rate of 20+%, a complete management team in place, including sales, and an expanding product portfolio based on internal R&D efforts and in-licensing deals. Ideally they are also exploring, if not entering, international markets. On the softer side, Auritt notes that there should also be board and management consensus regarding the desire to sell and the willingness to give up controlling interest to the PE firm.
Bourne agrees that each firm will look for different things. Bourne Partners focuses on finding companies within its areas of expertise that have solid management teams, cultures that strive for operational excellence and unique differentiators that are underexploited or not exploited at all. “We prefer to invest in companies that are at or near an inflection point where our expertise and guidance as operators will be equally as valuable as the growth capital we can provide,” he adds.