Following the successful listings of WuXi PharmaTech (NYSE: WX) and medical device maker Shenzhen Mindray Medical (NYSE: MR), China Nepstar (NYSE: NPR), the country’s largest drug store chain, went public on the NYSE on November 9. The company is China’s first drug store chain to be listed overseas. Perhaps a function of the euphoria surrounding Chinese healthcare companies, all three firms (at the time of this publication) are trading at EV/EBITDA multiples of over 50x.


Another company about to list is Jointown Group, China’s largest privately owned pharmaceutical distributor, which received financing from a group of foreign investors for expansion of its business. The company plans to list on the Hong Kong Stock Exchange. Sinopharm Medicine Holding Co., another large pharmaceutical distributor, also plans to conduct an IPO in Hong Kong early next year, said Joseph Chee, Executive Director of UBS Securities. He believes that in 2008, there will be about 40% to 50% more health care companies listing at home and abroad.


Adding to the hype, China health care conferences are drawing significant investor interest. In the space of two weeks this November, two high-level conferences — “2007 2nd China Healthcare Investment Summit” and “China Life Sciences Conference 2007” — attracted hundreds of investors, analysts and entrepreneurs to Beijing and Shanghai to discuss the unexplored potential of the industry.


Big names that are actively involved — including Fidelity Ventures, JAFCO, O’Melveny & Myers, Orchid Asia, Burrill and others — all expressed interest and confidence in the sector. “This is a favorable time for capital markets to invest in China’s health care industry,” said Zhang Xin, president of Sinocro Partners, a U.S. merchant bank specializing in China’s health care and life sciences industry. “Reaping returns of five to 10 times your original investment in three to five years is no longer an easy thing in the United States.” In comparison, China’s fast growing economy, a huge unmet need for medical services, and reduced costs for firms when operating out of a developing country are providing a host of opportunities for investors. 


Erik Bethel, director of Shanghai-based merchant bank ChinaVest, points out that outsourcing to China is growing because, among other reasons, well-trained PhDs will work for a fraction of the salary of their counterparts in developed countries. “People often think of China solely as a manufacturing outsourcing center. They forget that China produces well educated and very talented engineers, computer programmers and chemists. There’s a reason why multinational biotech and pharmaceutical companies are moving R&D to China.”


These views are echoed by Darren J. Carroll, senior managing director of Lilly Asian Ventures, which announced the launch of its China office in Shanghai on November 7th. “We think now is the right time to start investing in health care in China,” Carroll says. He cited an increased ability to afford health care expenditures and the government’s commitment to spend more in the healthcare sector – all of which suggest a growing demand for heath care services. And people really need good health care. According to estimates by IMS, the number of cancer victims in China will continue to accelerate, with forecasts of as many as 13.5 million cancer sufferers by 2020. Furthermore, by the year 2025, China will have the largest population of type II diabetes patients in the world after India, and the number of senior citizens in China is expected to reach a record high of 250 million by 2020. “That all guarantees some market opportunities for people who want to provide innovative technologies and innovative services to the Chinese people,” Carroll said.


IMS also predicts that China’s spending on health care will leap from the present 5.6% of GDP to somewhere between 8% and 9% by the year 2020. “I think (health care) reform is generally moving in the right direction,” Carroll suggests. “Intellectual property protection is moving to the right direction, too, and that is critical for investors, especially for those who invest based on proprietary advantages.”


Sectors Hot for Investors

Health Care is a very broad sector and some segments are generating more investor interest than others. According to analysis done by Fidelity Asian Ventures, medical devices, distribution/retail and CRO (Contract Research Organization), and “traditional” Chinese medicine sectors are comparatively more favorable for investors who seek lower risk and short-term returns (within five years).


Zhu Xuejun, executive vice president of the China Association of Medical Devices, spoke at the 2007 2nd China Healthcare Industry Investment Summit earlier this month. He noted that there are around 12,000 medical device manufacturers in China and 145,000 medical device distributors. However, the annual gross industrial output value of the country’s whole medical device industry is roughly RMB 70 billion ($9.33 billion), which means the industrial output value of each manufacturer is less than RMB 7 million ($933,000). Zhu predicted that the medical device industry will begin consolidation in the near future. “Very little attention has been paid to R&D in the Chinese medical device sector so far,” he added. But with investors swarming into health care industry, he expects this situation will change. “Openings for investment will multiply when more R&D phases undergo commercialization,” Zhu predicts. Furthermore, with the government’s commitment to bringing medical costs down for the average citizen, Zhu said the distribution system for the medical device industry is expected to be streamlined.


The CRO sector will also continue to be a hot area for investors. “If you are doing late stage investment, these companies might be very interesting because they can benefit from the present momentum of the stock market and go public,” said Greg B. Scott, an early-stage investor and president and CEO of ChinaBio Accelerator, a non-profit organization created to accelerate the globalization of China’s biotechnology industry.


“I think in the service area, biology-oriented CRO will be much more interesting in the longer term,” Scott noted. “What we see in the CRO sector will transform to ‘late stage and biology’ versus ‘pre-clinical and chemistry’. And that will be recommendable areas for getting into the service side.” However, the price is now going up sharply. “At present, investing in CRO companies is becoming too expensive,” Tang Haisong, a venture partner in Monaco Capital Partners, said.


Chee of UBS Securities suggested that the growing interest in the CRO sector will continue because its potential has been well understood by the investors. “A lot of investors are still paying a lot of attention to CRO companies,” which he predicted will follow the example of WuXi PharmaTech and go public in the future.


Hospitals are another area drawing investor interest. In China, privately owned hospitals today only constitute 10% of the total hospital services market, and very few hospitals in China have international management. As of yet, China’s public hospitals have not opened up to foreign investors. Most of the foreign investment in health care services focuses on high-end physical examination check-up chains and dental care chains. However, given recent buzz from the government and private sector about upcoming health care reform in China, many international investors are watching this field with great interest.


Investing in “true” biotech or pharmaceutical firms (as opposed to outsourcing companies) is difficult. Investors have not put much money in the space as innovation in China is not particularly strong in these sectors. “Investors feel more comfortable in Chinese pharmaceutical companies which have one or two leading products on the market, as well as a strong pipeline that [bodes well] for the future,” said Steven Duan, manager of the finance department at Liaoning NuoKang Bio-Pharmaceutical Co. His company is just about to close the first round of a financing deal with three U.S. venture capital firms, worth $15 million to $20 million. The company currently has several new drugs and is a market leader in hemorrhage-preventing drugs as well as drugs for the treatment of cardiovascular diseases. That said, finding companies in China with 1-2 products and clear intellectual property remains a difficult prospect.


High Risks Remain

High returns are always accompanied by high risks, and China’s health care industry is no exception.


Besides the so-called “hidden rules” of China’s complicated health care industry and the uncertainty of governmental regulations, the industry is also facing quality-trust issues. “There’s a perception that products from China may not be high quality products,” said Greg B. Scott from ChinaBio Accelerator. “The world outside China doesn’t see the improvements here as they occur.” In Scott’s words, “product tainting” is one of the obstacles to investing in China’s health care industry.


For early-stage investors, two additional issues discourage investments. “One is Intellectual Property — not IP protection, but the quality of IP,” he said. “The legal system in China is just now figuring out how to produce high quality patents that can be accepted globally. However, there are some intricate timing and structuring issues between U.S. and China patents. You can file for a valid U.S patent, but it will make your China patent invalid. So you have to be very careful when working with attorneys who are not particularly familiar with the global patent environment.”


The other issue relates to the exit strategy of investors. “It is more difficult for us to bring U.S. capital to the company if the entrepreneurs are not willing to consider alternatives, such as off-shore corporations,” Scott said. As early stage investors, they are looking for companies run like U.S. corporations with a China subsidiary or joint venture. Moreover, China still has strict regulations on the management of foreign currencies, which makes it hard for foreign investors to exit.


ChinaVest’s Bethel also points out that valuation remains a large hurdle. “The Shanghai and Shenzhen stock markets have increased well over 100% in the past year and are trading at egregiously high multiples. Similar to Silicon Valley in 1999, every entrepreneur in China is talking about going public and have inflated perceptions of their worth. I don’t know how you can justify making an investment at these valuation levels. I realize that China’s population is huge and that people need health care. But in the back of my mind, I hear the echoes of tech companies in San Francisco justifying extremely high valuations because they were in a ‘new economy.’ This is a momentum driven market, and who knows? Maybe the party will continue for a few more years and people will continue investing in pre-IPO companies, doubling their money in a year. But at some point this will end. Call me old fashioned but at the end of the day, a firm’s valuation should ultimately be linked to the cash it produces, not based on ephemeral promises in an uncertain future. There are definitely plenty of good investment opportunities in the Chinese health care sector but investors should exercise due caution.”


Carroll, of Lilly Asian Ventures mentions that, “unpredictability brings frustration for investors everywhere. I think the unpredictability comes from several sources,” he states. “First, corruption is an issue in [the health care services sector]; second, regulations are evolving, sometimes quickly, and it is very hard to predict how this will impact business; and third, some people believe there is room for a great deal of consolidation.” In China, more than 10 administrations are involved in China’s health care system. For example, the Ministry of Health is both the administrator and supervisor of public medical institutions and is responsible for the general health regulations; the State Food and Drug Administration plays a role similar to that of the Food and Drug Administration in the U.S.; the National Development and Reform Commission is responsible for price-fixing of drugs covered by basic medical insurance, while social and medical insurance regulations are under the Ministry of Social and Labor Security Bureau. The Ministry of Finance is the national body that decides to what extent the public health system is financed.

With such a large number of official administrations involved, it will be very time consuming for all parties in the health care reform debate to come to any decisions. As observers note, the complicated issues – and the various turfs and self interests involved — indicate the difficulties that lie ahead for reformers, not to mention for outsiders who want to understand, and invest in, this industry.