PE Investment In Pharma: The Changing Need Of Due Diligence

From an international perspective, a Bain & Company report of April 2016 highlighted setting a new healthcare M&A record in the year 2015. During this year the total deal value was over 2.5 times higher than the average annual deal value of the previous decade. The report also mentioned that the Asia-Pacific Region grew in the same year by about 40 percent, fuelled by a number of activities in India and China. 

Commenting on India, the Bain report specifically mentioned that during the year, the Private Equity (PE) investors prioritized their investments in the country, not just targeting the global demand for pharmaceuticals, but also based on rapid domestic demand growth.

More popular targets in India were tertiary care, specialty care and laboratories. This is vindicated by TPG’s investment of US$146 million for a minority stake in Manipal Health, which operates multi-specialty and teaching hospitals in the country. Similarly, The Carlyle Group made a minority investment in the pathology lab chain – Metropolis Healthcare. This trend is expected to continue in the coming years and would in all probability include pharma companies of various sizes, with high performance or with high future potential.

In this article, I shall focus only on generic pharma companies in India.

A changing need of due diligence:

Despite some major uncertainties in the generally thriving domestic generic pharma market, this sector has the potential and possibility to come under the radar of many PE investors during the coming years.

However, in this scenario, to embrace success with lucrative returns, I reckon, there is a changing need of due diligence to follow, before suitable pharma companies are appropriately targeted. Conventional pharma due diligence, however stringent it is, may not capture appropriately the high-impact, up and down sides of long term business sustainability for the desired return on investments.

The rationale:

Consideration of significant cost savings in the pharma value chain won’t be just enough, any longer, to tide over any unforeseen rapid downturn in many pharma company’s business performances in the country.

This is largely because, many pharma companies in India have been thriving, so far, taking full advantage of some major loopholes in the regulatory area, including clinical trial; ethical marketing strategy and practices; overall generic product portfolio selection; new generic product developments; besides many others.

The need of a changing format of pharma due diligence in India is largely prompted by this prevailing scenario, even in the midst of stellar success of some companies, and plenty of lush green shoots, as they appear to many. 

The process of tightening the loose knots has commenced:

All these loose knots are expected to be tightened by the governments, sooner or later. In fact, while watching the intent of the Government and from some of its recent actions, it appears that the process has just commenced. Public and judicial pressure in these areas would also increasingly mount, with several related and major Public Interest Litigations (PIL) still remaining pending before the Supreme Court of India.

A few examples in this critical area: 

Thus, for any successful PE investments, especially for relatively long term, alongside conventional areas of due diligence, several non-conventional, but high business impact areas, need to be effectively covered for the Indian generic pharma companies, in general. Following are just a few examples in this critical area:

  • Business practices that the promoters personally believe in and practice
  • Belief and practices of key company personnel
  • Quality of regulatory approval
  • Product portfolio scrutiny
  • Marketing demand generation process and its long-term sustainability
  • Ability to introduce high-tech formulations with differentiated value offerings
  • Ability to come out with cost-effective manufacturing processes
  • Are Independent Directors, if any, really ‘Independent’?

I shall now very briefly try to illustrate each of the above points.

I. Business practices that the promoters personally believe in:

A large number of successful generic pharma companies are directly or indirectly driven, or in all practical purposes managed, and in several cases even micromanaged by the company promoters. Many experts have opined, though a craftily worded handbook of ‘corporate governance’ may exist in many of these companies, on the ground, promoters’ thoughts, belief, ethical standards, business practices and work priorities may easily supersede all those. 

The practice of good governance on the ground, rigid compliance with all rules, laws and regulations may quite often go for a toss. The employees implementing promoter’s decisions, may try their level best to record everything perfectly and as required. Nevertheless, sometimes regulators do succeed to ferret out the fact, which leaves an adverse impact on the business, in multiple ways.

Recent reports of the US-FDA on ‘data fudging’ in the drug manufacturing process, product quality standards and also in Clinical Trials, would illustrate this point. According to a 2015 EY Report on data integrity, ‘Import Alerts issued against Indian plants in 2013 accounted for 49 percent of the total 43 imports alerts issued by the US FDA worldwide.’

In some successful generic pharma company’s repetition of such incidences has also been reported. In my view, for recurrence of ‘data fudging’, no promoter of the concerned companies can possibly wash his/her hands off, putting all the blame on concerned employees, and the system.

A situation like this necessitates personal due diligence for promoters. It will help ascertain the persons’ business integrity, alongside the company performance as a whole. Accordingly, the PE investors would be able to flag those critical soft areas, which are key determinants for long-term sustainability of any pharma generic business in the country. 

II. Belief and practices of key company personnel:

The findings of the above EY Report also suggest, while most of the generic pharma company professionals are aware of the current Good Manufacturing Practices (cGMP) guidelines, more than 30 percent had still received ‘Inspectional Observations’ from the regulators in the last three years.

This fact calls for due diligence on another critical issue, and that is on the belief and practices of the key company personnel in the new product development, manufacturing, drug quality, marketing, supply chain management, and also covering their interaction with key regulatory and other Government personnel. These are soft issues, but with potential to make the whole business topsy-turvy, virtually overnight.

Conventional due diligence based on the company records may not always reflect the real situation within the organization.

III. Quality of regulatory approval: 

To illustrate this point, let me give the example of a launch of a ‘new drug’ in India. 

A ‘new drug’ has been defined in the Drugs and Cosmetics Acts in India, as any new drug substance which is being introduced for the first time in India, including any off-patent generic molecule, with the permission of only the Drug Controller General of India (DCGI). A ‘new drug’ shall continue to be considered as ‘new drug’ for a period of four years from the date of its first approval or its inclusion in the Indian Pharmacopoeia, whichever is earlier.

Thus, for even for any generic pharma product, be it a single ingredient or a ‘Fixed Dose Combination (FDC)’, if a marketing license is granted by any State Drug Controller, whatever may be the reason, despite the product being a licensed one, it will deem to be unauthorized as the DCGI’s approval was not obtained during the valid period of the 4 years, as per the Act.

Hence, a proper due diligence on the ‘quality of regulatory approval’ to detect presence of any such successful products in the product portfolio, would enable the PE investors in India to flag a possible risk of a future ban, inviting adverse business impact.

IV. Product portfolio scrutiny:

This scrutiny may not be restricted to some conventional areas, such as, to find out the ratio between the price control and decontrol products, leaving future scope to improve the margin. It may also focus on many other important India-specific areas.

One such area could even be the non-standard FDCs in the product portfolio. Some of these FDCs could also be approved by the state drug controllers earlier, scrupulously following the drug laws and rules. However, if the medical rationale of any of these successful products can’t be credibly established, following the global standards, the risk of a future ban of such products would loom large.

Another area could be the percentage of those products in the product portfolio, where the medical claims are anecdotal, and not based on scientific data, generated through credible clinical trials. 

One may draw a relevant example from the Nutraceutical product category. Although, these products are high margin and currently do not come under price control, the stringent regulatory demands for this category of products have already started coming. Strict conformance to the emerging regulatory requirements of both the DCGI of FSSAI may be cost intensive, squeeze the margin, could also pose a great challenge in the conventional demand generating process. I hasten to add that such decision would possibly be dictated by the time scale of PE investment, and the risk-appetite of the investors.                                                            

Yet another example prompts the need to check the quality of generic brands in the product portfolio. According to the Drugs and Cosmetics Act of India, some of these brands would merit to be categorized as drugs. In practice, the company concerned could well be surreptitiously classifying those as nutritional supplements, or Nutraceuticals, with the support of some State Drug Controllers and promoted accordingly, simultaneously avoiding any risk of drug price control. 

V. Marketing demand generation process and long-term sustainability:

This assumes critical importance in the pharma industry, especially when the Government is mulling to give the current voluntary ‘Uniform Code of Pharmaceutical Marketing Practices (UCPMP)’ legal teeth, by making it mandatory for all. As I understand, besides other penal action, in serious cases of gross violations of the code, even the marketing license of the offender may get suspended, or cancelled. Thus, compliance to UCPMP would be critical to business performance. Thus, the level of compliance of a company in this regard could well be a part of the due diligence process of the PE investors.

It is also important to understand, whether the pharma generic target asset is predominantly buying doctors’ prescriptions through various dubious means to increase its brand off-takes, or the prescription demand generation process primarily stands on robust pillars of a differentiated value delivery system. The latter is believed to be more desirable for sustainable long term business success.

It is also important to understand, whether the strategic marketing process adopted by the company can withstand robust ethical, legal and regulatory scrutiny, or it is just an outward impressive looking structure, unknowingly built as ‘House of Cards, waiting to be collapsed anytime, sooner or later.

I would now give just a couple of other examples in this area, out of so many – say, a health product, which has been categorized as a drug by the drug authority, is freely advertised in the media, at times even with top celebrity endorsements. This strategy is short term, may eventually not fly, and is certainly not sustainable in the longer term, avoiding regulatory scrutiny. Another example, big brands of Nutraceuticals are being promoted with off-label strong therapeutic claims, and have become immensely successful because of that reason.

VI. Ability to introduce formulations with high-tech value offerings:

India is basically a branded generic market with huge brand proliferations of each molecule, or their FDCs. Just like any other brand, for business success and to overcome the pricing barrier, differentiated value offerings are essential for long term success of any branded generic too. This differentiation may be both tangible and intangible. However, if such differentiation is based on high-technology platforms, it could provide a cutting edge to effectively fight any cut throat competition. Thus, appropriate due diligence to ascertain the robustness of the ability to introduce high-tech formulations with differentiated value offerings, would be an added advantage.

VII. Ability to come out with cost-effective manufacturing processes: 

This is not much new. Many PE investors would possibly look at it, in any case. Just like formulations, ascertaining similar ability to come out with cost-effective manufacturing processes to improve margin would also be very useful, especially for long term investments.

VIII. Are Independent Directors, if any, really ‘Independent’?

If the target company has ‘Independent Directors’ in its Board, as a mandatory legal requirement or even otherwise, there is a need to dispassionately evaluate how independent these directors are, and what value they have added to the company or capable of providing in the future, according to their legal status in the Board.

True independence, given to the high caliber ‘Independent Directors’ in the Board of promoter driven pharma companies, could usher in a catalytic change in the overall business environment of the company. It would, consequently, bring in a breath of fresh air in the organization with their independent thoughts, strategic inputs and involvement in the key peoples’ decisions.

As it is much known, that a large number of ‘Independent Directors’ are primarily hand-picked, based on their unqualified support to the Indian promoters. Many board resolutions, in various critical business impact areas, are passed as desired by the powerful promoters, may be for short term interest and fire fighting. In that process, what is right for the organization for sustainability of business performance, and in the long term interest of all the company stakeholders, may get sacrificed.

When this happens in any target company, mainly for short term business success, taking advantage of regulatory loopholes and inherent weaknesses in the system, a flag needs to be raised by the PE investors for further detailed analysis in the concerned areas.

Conclusion:

Going forward, it appears to me that PE investors would continue to look for attractive pharma investment opportunities in India, though with increasing level of competition. These investors would include both global and local PE firms. Some of them may like to stay invested for longer terms with lesser regulatory and other associated risks and a modest return, unlike a few other high risk takers, sniffing for commensurate windfall returns. 

In India – today’s land of seemingly unparalleled economic opportunities, the PE players should also take into consideration the prevailing complexities of the domestic pharma industry seriously and try to analyze the same properly, for appropriate target asset identification. Many successful local generic players may outwardly project sophisticated, and high standard of business practices. However, these need to be ascertained only through a structured format of India-specific due diligence process.

Corporate governance processes, regulatory compliance, marketing practices and financial reporting systems of many of these companies, may not pass the acid test of stringent expert scrutiny, for long term sustainability of business.

This mainly because, a number of generic pharma companies in India have been thriving, taking full advantage of some major loopholes in the regulatory area, marketing practices, overall product portfolio selection and new generic product development areas, besides many others.

These successful domestic drug companies have indeed the potential and overall attractiveness to come under the radar of many PE investors, who, in turn, should also realize that all the loose knots, fully being exploited by many such companies, are expected to be tightened by the governments, sooner or later.

Keeping this possibility in perspective, to embrace success with lucrative returns, I reckon, there is a changing need of due diligence to follow by the PE investors for right valuation, and much before any pharma generic company is identified by them.

That done, the Indian generic pharma market could soon emerge as an Eldorado, especially for those PE investors, who are looking for a relatively long term attractive return on investments.

By: Tapan J. Ray 

Disclaimer: The views/opinions expressed in this article are entirely my own, written in my individual and personal capacity. I do not represent any other person or organization for this opinion.

 

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