In the 2022 CPHI Annual Report, the health of the CRO/CDMO sector was covered, and the question asked, “Has the bubble burst?” on the explosive growth observed in the years leading up to, and including, the pandemic. The prediction was for continued, but modulated, strength in demand for pharma services in the near- and mid-term. Given that biotech funding levels appeared to be “bottoming out” at pre-pandemic (historically robust) levels, and with emerging pharma still sitting on 2-3 years of cash reserves, and the amount of cash sitting in Big Pharma’s war chest, demand would remain relatively strong, albeit somewhat muted versus the past two years. As long as global pandemics and geopolitical tensions were in check, the sector appeared to be weathering the storm.

In the 2023 CPHI report, which was published 12 months later and ahead of CPHI Barcelona (October 24-26, 2023), we looked at the events of the year, and updated our predictions on both the near- and long-term health of the sector. Generally speaking, with the pandemic mostly behind us, global geopolitical tensions appearing in check, the level of demand has not lived up to expectations. With some exceptions, contract research organizations (CROs) and contract development and manufacturing organizations (CDMOs) saw a softening in demand—particularly from emerging pharma and in earlier phases of development—which we believe will extend well into 2024.

Despite the current softness, the underlying demand drivers remain very strong for the sector. As such, the years 2023 and 2024 are viewed as a period of re-calibration or re-alignment. So, what happened in the 12 months between the 2022 and 2023 CPHI reports? Let’s take a look.

Demand for pharma services and the long-term outlook

Before we look at the current demand for CRO/CDMO services, it is important to understand the long-term growth drivers for the industry. Over the past 10 years, the number of molecules in the R&D pipelines has more than doubled (Figure 1), with growth rates for small and large molecules around 5% and 12% CAGR respectively. The split between small and large molecules in development pipelines is approaching 50-50. Generally speaking, with the average drug taking over 10 years to go from discovery to commercialization, the molecules in the development pipelines of today represent a key demand driver for the CRO/CDMO industry for the next decade, and both small molecule and large molecule services will be required to progress these new therapeutics.


One of the major contributors to growth in the CRO/CDMO sector is the emerging pharma/biotech community. These companies need to outsource most, if not all, of their R&D and manufacturing requirements to service providers. Figure 2 demonstrates the importance of emerging pharma to the current and future success of the global pharma industry’s innovative new therapeutic development.

What’s going on with emerging pharma?

A proxy for the health of the demand for the CRO/CDMO sector is funding levels into the biotech/emerging pharma sector. After a period of significant decline (vs 2020/21), funding into the sector seemed to have stabilized over the first two quarters of 2023 at levels seen just prior to the pandemic (Figure 3). Q2 2023 saw funding into the sector of $12.0 billion which was down only 3% y/y. Many in the industry have been asking when/where the funding “trough” would bottom out. If, in fact, we’ve reached the bottom, then one level of uncertainty (risk) will be reduced, and more predictability can be factored into the future spending habits of emerging pharma. Will a belt loosening ensue?


Taking a closer look at funding into the sector (Figure 4) shows a mixed bag with venture capital (VC), Follow-ons, and PIPE’s all resuming near normal growth trends, albeit starting from pre-pandemic levels (2019). However, IPOs remained anemic through the first half of 2023 and were down 6% y/y. Total funding into the sector through July 2023 was $30.2 billion and full year 2023 trended ahead of 2022.


Too many companies, too little capital
Although non-IPO funding appears to have stabilized, there are still too many emerging pharma companies vying for too little capital. The number of companies with active R&D pipelines globally grew from nearly 4,800 in 2020 to over 5,500 in 2023 (Figure 5). That’s an increase of nearly 15%, while funding levels have dropped to nearly half the 2020 levels during the same period.


As a result of this, two things have happened:

1. Emerging pharma companies are reassessing their R&D product pipelines and will need to evaluate their approach to continue, or pause, slower growth programs to maintain a financial cushion to ensure that their lead compounds take the lion’s share of the resources. This equates focusing cash burn on fewer programs, reducing CRO/CDMO demand.
2. Emerging pharma valuations have become subdued. Since the second half of 2022 and extending through the first half of 2023, the prevalence of down rounds accelerated dramatically (Figure 6) with at least one-third of venture growth-stage companies and over 10% of late-stage companies in down rounds.

The capital supply and demand dynamic is out of balance. According to Pitchbook, the demand for capital at late-stage biotechs is nearly 3-times the supply, and demand for capital at venture growth-stage companies is 1.3-times supply. 

IPO exits are clogged
Contributing to the challenge is the IPO market is clogged (Figure 7). Investors who saw a pathway to exit just two years ago are now stuck until the valuations come back. There is some evidence that IPOs are starting to pick up, but it will take time until the structural imbalances work their way through and get back to a more robust opportunity for IPO exits. For now, the system is clogged.

To cure this, any combination of three factors must happen: 1) VC/non-public funding needs to increase; 2) IPOs need to increase; 3) the number of biotechs need to decrease (fold, M&A, reverse merge). The result for now is an investor’s market.

How long is the cash runway for biotechs?
Given the biotech funding environment mentioned above, CROs and CDMOs are left wondering how much cash runway is remaining within the emerging pharma sector should the anemic funding environment continue on a protracted basis. Last year, we reported that emerging pharma was sitting on about 2-3 years of cash. According to KPMG and CapIQ (Figure 8), the U.S. emerging pharma cash runway is just under two years (20 months), down from over 36 months in Q1 2021.

Implications for CROs and CDMOs
The protracted, weaker VC funding environment, and a clogged IPO exit funnel has led emerging pharma companies to continue to focus on managing cash burn. According to Pitchbook’s European Venture Report for H1, 2023, they have seen VCs work with their portfolios to restructure operations in-house and extend cash runways as far down the line as they can given current funding environment. This has translated into a continued softening in demand for pharma services, particularly in the early and mid-phases of development where most emerging pharma companies engage with the pharma services sector. With some exceptions, the general consensus among most of the CRO/CDMOs we’ve spoken to is a broad softening of the market, with most citing a softening in demand from emerging pharma.

What’s going on at Big Pharma?

While much attention has been paid to VC funding and emerging pharma, Big Pharma has been going through its own reinvention. Big Pharma is operating against a backdrop of continuing inflationary pressures, rising capital costs, patent expiries, ongoing Federal Trade Commission (FTC) transaction scrutiny, and the impact of the Inflation Reduction Act (IRA) in the U.S. In a recent survey by PwC, 90% of executives said they were worried about the macroeconomic environment, with many already taking action to adjust strategic plans.

M&A picking up
In 2022’s CPHI report, I predicted M&A to likely increase significantly as Big Pharma’s balance sheets were robust, patent cliff’s coming, and value buying opportunities with emerging pharma accelerating. What happened in 2023?

According to Goldman Sachs (Report July 6, 2023), pharmaceutical companies are sitting on $700 billion for acquisitions and investment. Larger strategic consolidations have picked up in the past year, with a number of notable deals including Pfizer-GBT, Amgen-Horizon, GSK-Bellus, Merck-Prometheus, and Pfizer-Seagen. It is likely that these larger consolidations will continue for the foreseeable future. As Big Pharma continues to shore up gaps in therapeutic areas, and as it looks for new technology areas emerging earlier in the discovery pipelines.

Big Pharma’s M&A of smaller emerging pharma companies (values <$1Bn) has been more muted than expected for the past year, although there were signs of acceleration over the first two quarters of 2023. With IPO exits clogged, M&A activity should continue to increase, and value-buying opportunities of pre-IPO emerging biopharma should accelerate given the capital supply/demand dynamic currently ongoing in the private funding market.

Streamlining for the future
As Big Pharma deals with increasing costs, recent government intervention around mega M&A deals and drug pricing controls, and a changing macro environment, it is beginning a phase of structural change to proactively get in front of the changing dynamic. One area that gained much attention in 2023 was announced layoffs within the industry. According to a Fierce Biotech analysis, as of mid-August 2023, layoffs industrywide (119) eclipsed all of 2022. While understandable for emerging pharma, several Big Pharma companies including Novartis, Biogen, BMS, J&J, Genentech, Takeda, Novo, Eisai, Merck KGaA all announced planned layoffs last year. A notable example was Biogen’s “Fit for Growth” program where president and CEO Christopher A. Viehbacher mentioned, “We have taken a bottom-up view to shift our resources to the areas of greatest value creation.” In August, Biogen announced ~11% reduction in workforce (~1000 employees) over the next three years.

Implications for CROs and CDMOs
Big Pharma Streamlining – Enhances Demand for Services: As Big Pharma streamlines its resources to areas of greatest value creation (shedding people and assets) the need for outsourced providers of research, development, and manufacturing services will be needed more than ever, which should bolster demand for CROs and CDMOs.

Big Pharma M&A – Enhances Demand for Services: Increasing M&A volume provides an outlet for the clogged IPO funnel currently observed in the emerging pharma sector. This keeps the flow of capital to support development programs and commercialization of new therapeutics innovated by emerging pharma, and bolsters demand for CROs and CDMOs. This also helps fix the capital supply/demand imbalance in the emerging pharma sector by reducing the number of companies. Currently there are too many companies chasing too little cash.

Regulatory environment / Inflation Reduction Act

While government price controls have been the norm in many countries around the globe, the pharma industry in the U.S. has relied on the ability to fuel the heavy cost of innovative drug development (now >$2Bn per new drug launched) by playing in an environment of limited price controls. This has enabled an environment of hyper-fueled re-investment of pharma profits back into R&D or M&A, and many argue has been the catalyst for the explosive decades of innovation centered in U.S.

The Inflation Reduction Act
In August of 2022, the Inflation Reduction Act (IRA) was passed in the U.S. Among other things, the IRA requires the U.S. government to negotiate prices for the top-spending Medicare drugs. In August 2023, the first 10 drugs up for price negotiation were announced, and notably, the number of drugs eligible for government price negotiations will increase to 60 drugs by 2029. The law sets the drug price ceiling at between 25% and 60% of its list price, with no price floor.

Another element of the IRA is the timing of when a drug will be eligible for government price negotiation. Under the IRA small molecules can be selected for government price negotiations 9 years after approval, while biologics selected for price negotiation will be implemented 13 years after approval.

It is estimated that tens to hundreds of billions of future profits could be wiped out based on the passing of this law alone. Industry trade groups like PhRMA and Big Pharma have pushed back on the IRA citing its potentially negative impact on drug innovation, given the billions in future profits that could be wiped out as a result. It is unclear how this will all shake out, but generally this will put negative pressure on demand for CRO/CDMO services should the price controls lead to a slowing of investment in future innovation.

Enhanced oversight of mergers
Over the past year, the U.S. Federal Trade Commission (FTC) and Department of Justice (DOJ) has signaled deeper scrutiny of merger activity in the pharma industry which could slow down or halt certain mergers going forward. In the U.S. Omnibus Spending Package passed in 2022, increased filing fees for M&A will be used by FTC and DOJ to increase enforcement actions in mergers deemed anticompetitive. The fees went into effect in 2023.

As part of the increased scrutiny, the FTC and DOJ may consider changes to how they define “anticompetitive behavior” for pharma which will extend beyond competition as it relates to specific drugs or therapeutic indications.

They are also considering reviewing mergers that span across markets, as well as impacts on future innovation. Scrutiny could also extend to clinical trial design, drug delivery and how platform technologies could have wider applications in field beyond what they are currently being used for.

One high profile example of enhanced scrutiny is Amgen’s merger with Horizon which was halted in May 2023 with a lawsuit filed by the FTC. The case against Horizon and Amgen did not hinge on claims of competition (current or future), but rather focused on the possibility for Horizon’s blockbuster drugs to be included in Amgen’s rebate program. In a settlement on September 1, 2023, the FTC dropped its case, and the merger was allowed to proceed.

Implications for CROs and CDMOs
Price Controls and the IRA – Potential to Decrease Demand for Services: Increasing government pricing controls generally puts downward pressure on CRO/CDMO demand since the fuel for innovation in new therapeutic development has largely come from profits from commercial drug sales. This ultimately impacts negatively on future demand for pharma services.

Increased Government Scrutiny of Mergers – Neutral Effect on Services: Increased government scrutiny on mergers can cause more uncertainty, slow down the process, and cost billions to litigate which is money/resource not spent on pharma services and innovation. On the other hand, the true intent of anticompetition laws is to help foster an environment of diverse innovation and competition which can have a positive impact on demand for pharma services.

Regional capacity and the onshoring conundrum

In 2022 we reported that the onshoring phenomenon had been maintaining the momentum gained from the pandemic due to additional geopolitical concerns surrounding Russia/Ukraine, China/Taiwan, and growing political tensions between the U.S. and China. In the past 12 months, those concerns have been dampened somewhat, and generally speaking, the momentum towards onshoring seems to have lost some steam. While onshoring continues to be a significant topic for discussion, with few exceptions our conversations with many CROs and CDMOs in the U.S. and EU have not revealed widespread evidence to support a consistent and material increase in business attributed to onshoring. This is particularly true in our discussions with smaller pharma services companies, and those participating earlier in the drug development process. Hyperbolic talk of widespread onshoring does not seem to match the reality on the ground. Why is this?

The current onshoring climate is really a battle of competing forces. Those forces that originally ignited the supply chain re-alignment surge (Covid, Geopolitical tensions, other risk mitigation) have been partially offset by calming geopolitical tensions, easing supply chain disruptions, and the current funding challenges prompting renewed focus on cash management (i.e., re-considering lower cost regions for outsourced services). There is also the realization that disentanglement from off-shore sources such as China is exceptionally complex, and many supply chains ultimately lead back to China-made raw materials.

In spite of this apparent softening in the onshoring rhetoric, a recent report from Cytiva (2023 Global Biopharma Resilience Index) cited just under half (44%) of pharma leaders feel that their supply chains are more robust than they were one year ago, and only 19% of pharma executives say that increasing supply chain resilience is a domestic priority for the next two years.

What is clear from this report is that if supply chain realignment (onshoring) is going to systemically take hold, there needs a sustained, long-term industry and governmental prioritization to create a climate that supports such a complex initiative. Otherwise, it ebbs and flows with the political cycles.

CRO/CDMO valuations & the M&A climate

CROs and CDMOs have generally seen valuations continue to modulate over the past year, but appear to be at, or near a trough (Figure 9), and flattening out around levels seen just prior to the pandemic which is about 20-25% below the peak seen in 2021. TTM July 2023 shows only marginal declines in public valuations versus 2022.


According to Bain Capital’s Global Private Equity Outlook 2023, private equity managed to post its second-best year ever in 2022, riding a wave of momentum coming off the industry’s record-breaking performance in 2021. However, inflation and related interest rate hikes caused a sharp decline in deals, exits, and fund-raising in the second half of 2022.

The number of private equity healthcare services platform deals (LBOs) saw a steep decline starting in Q4 2022, extending through Q1 2023, and modestly picking back up in Q2 2023 (Figure 10). Interestingly, according to KPMG (Biopharma Services Update H1-2023), while overall PE deal counts are down, the sector has continued to witness strong participation from the private equity community as nearly 68% of all M&A deals were PE-backed. This level is consistent with the level seen in 2022 70% and represents a marked increase from the 2019 (pre-pandemic) level in which 44% of transactions were PE-backed.


It should be noted that while there has been a significant decline in the number of deals executed, the amount of PE dry powder continues at historically high levels and the need to deploy capital remains high. However, given the broader economic landscape, and dampening valuations, sellers continue to sit on the sidelines waiting for the right time to go to market. We have heard consistent feedback from the investment banking community that they expect deal volume to pick up later in 2023 into 2024. This will coincide with continuing improvement in biotech funding/valuation climate, and a stabilization/improvement in inflation and interest rates.

Summary

The long-term demand drivers for the pharma services sector are strong, driven by strong pipelines of both small and large molecules across the entire drug development cycle, and a macro environment that favors more outsourcing. However, over the past year the CRO/CDMO sector has gone through a period of realignment. While pandemic and geopolitical pressures have subsided, inflation, higher interest rates, a capital supply/demand imbalance in emerging pharma, and a clogged IPO funnel have marshalled in a period of softening demand for services generally across the industry. As a result, emerging pharma generally have migrated towards cash preservation mode. There are signs of an improving VC funding environment, but this needs to coincide with increasing pharma M&A and a healthier IPO environment. We believe softer demand, particularly from emerging pharma and in earlier phases of development, will extend for a period of 12-18 months.

Concurrently, CRO/CDMO valuations have modulated a bit, but appear to be stabilizing at levels prior to the pandemic (versus the highs of 2021). PE-backed deals and exits have slowed in the sector due to market conditions and buyers waiting on the sidelines. Noteworthy is that PE is participating in nearly 70% of the deals getting done, and the investment banking community is signaled a pickup on deal activity starting late 2023 into 2024. 

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Brian Scanlan leads Edgewater’s Life Science practice and is engaged with several portfolio companies in advisory roles spanning commercial, operational, and board advisory. Brian has spent nearly three decades in the pharmaceutical services sector, developing and growing companies offering highly differentiated technologies and services. For more information visit EdgewaterCapital.com.