What Drives Mergers & Acquisitions in the Pharma industry?

The pharmaceutical industry probably sees more merger and acquisition (M&A) activity than any other industry, both in the number of deals and the amount of money spent on acquisitions and mergers. No other industry can compare when it comes to M&As; large, game-changing deals continuously and profoundly change the competitive landscape, while smaller yet still significant transactions are an integral part the of operations of pharma companies.

Below we describe key drivers that force pharma companies to redefine themselves, and why large M&A is the preferred way to do so. We continue by describing why M&A is a standard component of the pharma business model. Finally, we conclude by showing M&A transaction patterns in strategic business areas, which corroborate our concepts and hypotheses.

Key factors triggering changes in the pharma industry
The single most important driver for changes in the pharma industry is the ever-increasing cost of drug development. Most companies can no longer afford to carry out R&D to find innovative compounds.

The most-quoted study of drug development costs states that on average, the development of a new drug—a new active pharmaceutical ingredient (API)—costs around $1.4 billion, if pipeline failures are factored in. It usually takes ten years from synthesis to approval, thus $1.2 billion capital costs accrue the to the figure below, which results in average total cost of $2.6 billion to develop a new drug.

One fundamental reason behind the growing costs is the advancement of medicine. To create value, new drugs need either to solve a problem which has previously been intractable, or be significantly better than what already exists on the market. The other driver for the development costs is the ever-increasing regulatory requirements.

Today, a company needs to invest between $2-4 billion per year in R&D to have a meaningful portfolio of drug development programs. Putting this in perspective, in the long-term, pharma companies spend 20% of their revenue from high-margin original drugs on R&D. Thus, only companies with revenue of $10 billion or higher from originals can afford to have a substantial drug development program.

Meanwhile, payors and regulators strive to replace as many off-patent original drugs as possible with generics. Reimbursement prices for generics have been lowered everywhere, leading to major consolidation among generic drug providers.

Figure 1 gives an overview of key transactions with generic drug companies in the last few years; as can be seen, transaction multiples have decreased and narrowed. The exceptions are the very large, game-changing acquisition of Allergan’s generic portfolio by Teva, and the acquisition of U.S. special generics provider Par Pharma by End. By now we know that TEVA massively overpaid for Allergan. More relevant is the observation that in January 2018, Mallinckrodt apparently failed to find a buyer for its generic portfolio at a valuation of 0.6x sales.

The third classical segment of Pharma—consumer health/OTC—recently also saw large, industry-shaping transactions involving Novartis/GSK, Merck & Co./Bayer and Boehringer/Sanofi. After a pause in 2016-2017, consolidation is picking up again, with Merck KGaA and Pfizer trying to divest their OTC operations.

Four strategic archetypes emerge
In this changing environment, we can observe four distinct strategic archetypes emerging. Originators, the classical pharma model, focus on financing the development and marketing of new drugs. Generic drug providers excel in producing and delivering drugs at a low cost and as a result are fully backward integrated. Consumer health companies promote drugs directly to patients, using mass-consumer marketing techniques, whereas point-of-call specialists are well established in a specific indication or with a specific group of doctors such as Novo Nordisk for diabetes, Lundbeck in psychiatry, Leo Pharma in dermatology, or Norgine in gastroenterology, and by definition, all orphan drug companies.

As the term itself implies, “archetypes” are strategic focal points companies coalesce to, yet organizations rarely meet these pure definitions. Practical experience however shows that one organization cannot successfully combine several archetypes—a company cannot be a generic drug provider and an originator at the same time, for example. The required business cultures—e.g. fostering innovation by originators vs. controlling costs by generic drug manufacturers—are incompatible.

Our model is not applicable to emerging markets, and has some limitations for countries with strong local pharma industries such as Japan, Italy and Spain. Also, in the U.S., the regulatory and pricing framework allows for a fifth archetype—developers of advanced generics. Biosimilars are also not discussed as those have their own, emerging market rules.

Why M&A is used for strategic repositioning?
There are three basic reasons why pharma companies resort to M&A to implement strategic changes. First, the critical size requirements in each market segment increased much faster than the companies could grow. M&A was unavoidable to build today’s originators and generic drug providers. None of the players from 20 years ago could have succeeded on their own. The second reason is the fundamental nature of the required changes. Large mergers allow bundling of sub-critical businesses, to change the culture and to build new platforms.

The third reason is that, except for the effects triggered by a patent cliff, changes in the pharma market are glacial compared to other industries. Hence the top tier of the industry is remarkably stable. Of the 10 largest pharma industry players by sales, only one (Gilead) has roots of less than 100 years. On the other hand, there are a few biotech companies who became firmly established as originators—Amgen, Biogen and Gilead.

M&As for efficient capital allocation
The other driver for M&As is efficient capital allocation across the industry, which applies to two areas: R&D and manufacturing.

The large, complex organizations of the originators are unsuited to fostering innovation. An ecosystem of venture capital and entrepreneurs has proven much more effective in selecting early-stage biomedical research opportunities and allocating money to those opportunities. Essentially, venture capitalists today pre-finance the early-stage development for pharma companies.

At the other end of the value chain, originators have started to use M&A to outsource manufacturing, selling plants to contract manufacturing organizations (CMOs) in combination with long-term manufacturing and supply agreements. Besides the cost benefits which these deals typically entail, they also increase the return on capital by reducing the asset base of the originator. The expected return on capital in the relatively stable, low-margin, and capital-intense manufacturing activity is distinctly lower than for the more volatile and more profitable development and marketing of drugs.

Looking at the big picture—M&A activity pattern
In Figure 2 we mapped M&A transaction activity over five years from 2013 to 2017 with targets in Western Europe, Canada and the U.S. to the four archetypes and associated business areas. The resulting patterns confirms the trend to be expected based on the above comments. Most activity is seen with innovators as targets. But also manufacturing assets and contract development and manufacturing organizations (CDMOs) have gone through many transactions in this period, which is the result of the fundamental rearrangement of pharma manufacturing and pharma service providers.

Conclusion
In conclusion, M&A is a fundamental tool for strategy implementation in the pharma industry. Deal-making is essential to implement game-changing strategic moves to build companies fit to master future challenges. But M&A is also a standard element of the business model for pharma companies to get access to innovation, but also to streamline operations in manufacturing or to prune business portfolios. 

---

Christoph Bieri is managing partner with Kurmann Partners, a Swiss-based M&A boutique focused on mid-market transactions in the pharmaceutical and medtech industries and adjacent segments. Christoph has led numerous buy-side and sell-side international transactions concerning targets based in Europe and North America. Prior to joining Kurmann Partners, Christoph was chief executive officer of a venture-financed R&D technology company for biotechnology, and before that a consultant with The Boston Consulting Group.