Anatomy of a Deal: Using Venture Capital to Fund Pharma R&DPublished: November 21, 2005 in Knowledge@Wharton
When the going gets tough, the tough get creative. Dr. Reddy's Laboratories (DRL), a leading Indian pharmaceutical company, has faced rough weather since mid-2004. Some of its molecules haven't been doing as well as expected in the U.S. market, and the Indian pharmaceutical market has been sluggish. But the company didn't want to do the knee-jerk thing -- cut expenditures to shore up profitability -- particularly in research and development (R&D). Becoming a discovery-led company is one of DRL's stated goals, and management didn't want to cut R&D just to boost FY05 profitability.
DRL wasn't alone in this predicament. FY05 -- most Indian companies follow an April-March fiscal calendar -- was tough for most Indian pharmaceutical companies. The U.S. market proved more difficult than most had expected. In earlier years, some Indian companies had made good progress, both in plain generic sales and in ANDA filings. (ANDA stands for "Abbreviated New Drug Application," under the Waxman-Hatch amendments to the Federal Food Drug and Cosmetics Act, passed in the U.S. in 1984.) In FY05, however, most leading companies could manage nothing much of note. Local markets were not proving very attractive either. A tax framework change -- from the prevailing mode to a Value Added Tax system -- in April wreaked havoc on domestic sales in the January-March quarter; many companies witnessed a steep drop in sales, leading quite a few to report losses.
Suddenly, maintaining cash flow to R&D efforts wasn't that straightforward any more. ICICI Venture Funds (IVF), India's leading private equity company, saw an opportunity. Around January-February, a team at IVF conducted an internal assessment of whether there was some way the firm could look at taking exposure to R&D activity in the pharma sector, given that pharma profitability was struggling. "We decided to go ahead and talk to the top five Indian pharma companies," says Renuka Ramnath, managing director and CEO, IVF.
DRL, it appears, was thinking along the same lines. Around the middle of February, DRL approached IVF to discuss a deal on funding its R&D. Given that this was a first-of-a-kind deal for the Indian market, the progress thereafter was quite fast. The deal was signed less than six weeks later, before the end of March. "We were prepared with all the issues since we had done our study already. Besides, we have known the company for a very long time," says Ramnath.
IVF agreed to advance about $56 million to DRL to partly fund its R&D. This amount deals with DRL's R&D filings over FY05, and a subsequent period of 18 months. The deal covers ANDAs, not new chemical entities (NCEs). ANDAs are a way to enter the lucrative U.S. generics market. Most Indian pharma companies have focused on this area, since it involves less risk compared to NCE research.
There are provisions in "like patent" challenges and "exclusivity period" in U.S. patent law, which can sometimes lead to windfall gains for the generics company at the expense of the innovator company. Indian companies have had some success with ANDAs. And exports, particularly to the U.S., have emerged as a major growth engine over the last few years. Most Indian pharma companies now derive more than half their sales from international markets, of which the U.S. accounts for a significant amount.
Under the deal, IVF will fund 50% of all expenses incurred by DRL for development, registration and legal costs related to commercialization of ANDAs over the deal period. It is therefore an exposure to DRL's attempt to target the U.S. generics market. The deal specifies the number of ANDA filings DRL has to make in the U.S. market. In return, IVF gets royalties for a five-year period after each molecule goes on sale in the U.S.
There is some complex math behind this. Some molecules involve patent challenges on drugs which are under patent until 2011 and even 2013. If DRL loses the patent challenges, then it cannot sell these molecules in the U.S. market until that time. So in some cases, there may be no revenue for IVF until 2013. "Our calculations assume that DRL will lose every patent challenge," says Aluri Srivivasa Rao, director-investments, IVF. Winning a patent challenge is very lucrative; it can provide an exclusivity period for the generics company, which can then reap large profits until the rest of the generics pack moves in. "In case DRL does win a patent challenge, then our profitability goes up," says Rao. Over half of DRL's ANDA filings in FY05 involved patent challenges, so chances of scoring a hit are not negligible.
IVF plans to stay invested until 2010, at which time it will decide its future course of action. DRL has right of first refusal should IVF choose to exit at that stage. There is an understanding built into the deal on the valuation formula to be used at that stage.
This deal has understandably created a lot of excitement in the Indian pharma and biotech sectors. This a vibrant area in India, with dozens of fast-growing companies, though they are all relatively small by global standards. India's largest pharma company, Ranbaxy, has revenues of a little more than $1 billion. Most other companies have less than $500 million in revenues. They all started as, and for the most part continue to be, generics manufacturers. This was encouraged by the Indian patent regime, which did not initially recognize product patents. Since 2005, however, India has switched to a product patent regime.
Preparing for this eventuality, Indian companies started focusing on R&D. Some like Ranbaxy and DRL started taking R&D seriously in the late 1990s; many others have put together R&D strategies in the last two or three years. More than a dozen Indian companies want to become "integrated" R&D players. Many more have R&D programs focused on generics.
Lack of resources is an issue for all these companies, however. Global companies have annual R&D budgets running into billions of dollars. While Indian companies have increased R&D expenditures, from around 2% of sales five years ago, to close to 10% of sales in FY05, the amount they manage to spend is minuscule by comparison. A bad year, moreover, can seriously strain cash flows available for R&D.
"Most top companies have expressed interest in such deals. There could be some more happening soon," says Ramnath. Like any good financier, she is perhaps understating the case. Just about every company is in the market now for similar deals. While the DRL deal did not involve funding NCEs, IVF does not rule out that option. "There are only about 15 credible molecules with Indian companies at this stage in NCE development. We are looking at how to create value there," says Rao.
While both Ramnath and Rao are not too keen on saying much beyond this, it appears significant work has been done on NCEs and some deals could be around the corner. Managing risk in NCE funding is somewhat more complicated than the first DRL deal, which involved only ANDAs.
Ramnath offers a few clues. "If we have a bouquet of generics, the risk profile for our investors will be much lower than, say, an equity investor in one company, who may be taking an exposure on 1-2 molecules," says Ramnath. Clearly, if IVF does fund NCEs, it will not fund a single product or a single company's NCE pipeline. It may diversify risks by building a portfolio of NCEs.
Another issue is at which stage to enter. "The clinical trial stage has less risk than the pre-clinical stage," says Rao. Also, IVF may not want to stay invested until the product hits the shelf, he adds. It may be possible to exit at a stage where the deal becomes more attractive to another investor. "In investing in NCEs, you pay different valuations at different stages," says Ramnath.