Andrew Jones and Leo Gribben at Ernst & Young suggest steps to overcome partnership and transaction challenges in the latest pharma business model
Pharma’s old business model has expired and companies are being reconfigured for more sustainable growth. Corporate transactions and partnerships will be critical in enabling and accelerating this change. However, powerful trends are setting the stage for a new healthcare environment and new business models. This new paradigm threatens to take business development functions out of their comfort zones and into uncharted territory.
Business development functions will have to make valuation, business modelling and due diligence core competencies if they are going to successfully create value and manage risk in the future. This article sets out the landscape and explores the new normal ‘Pharma 2.0’ and the trends that brought us to this point. It will also examine the next new normal – ‘Pharma 3.0’ – and the reasons why this model will reshape the partnering and transaction landscape.
PHARMA 1.0 – OUT WITH THE OLD
Pharma’s old business model, ‘Pharma 1.0’, was all about the blockbuster. The top-line was dependent upon a small number of products generating multiples of $1 billion each year with sales concentrated in the primary care markets of North America and western Europe. Small molecules dominated R&D pipelines and product portfolios. Innovation was all too often incremental, generating third, fourth and fifth in-class, clinically undifferentiated ‘me-too’ products. The entire operational apparatus to discover, develop and commercialise new drugs was fully-owned ‘in-house’ and budgets expanded year-on-year. This budgetary growth was in-line with market growth driven by the rapid expansion of national healthcare expenditures and a relative lack of restrictions on pricing and reimbursable access – the physician was the decision-maker.
A sustained R&D productivity depression, a burgeoning and aggressive generics sector, a global proliferation of pricing and access controls, and payer dissatisfaction with paying over-the-odds for incremental innovation have sent a strong signal that Pharma 1.0 has been living on borrowed time. Today, the prognosis for Pharma 1.0 is clear: the model is dead.
Weak revenue growth, shrinking margins, earnings volatility and declining reputation across the entire spectrum of stakeholders have created the momentum for change and the new faces that have taken up CEO and CFO roles at the largest companies are now driving this change. Decisions are being made about how to transform Pharma 1.0 businesses to ensure they are fit to compete today and in the future. Ultimately, these are decisions about how to allocate capital to deliver improved and sustainable returns on investment. We see capital allocation considerations driving strategic shifts along four key axes.
Segment Shift
The cyclical boom-bust nature of pharmaceutical R&D and the earnings volatility that arises from sector-specific risks have raised questions about whether capital should be focused purely on patented small-molecule prescription pharmaceuticals. Many companies have determined that a more diversified business mix, which gives broader exposure to growth occurring in the global healthcare market, can produce smoother, more sustainable earnings. Increased investment and acquisitions have resulted in the revenue contribution from ‘diversified’ segments growing at a faster rate than the core prescription businesses of the world’s largest companies over recent years (see Figure 1a).
Market Shift
Over the past five years, the rate of sales growth from outside the US and Europe has exceeded that of these traditional markets. This trend is expected to continue, with emerging markets forecast to achieve double digit annual growth until 2014 and deliver aggregate sales growth of more than $120 billion (source: IMS Health). Unsurprisingly, companies have been reviewing how capital is being deployed across the globe. In many cases, costs have been cut in traditional geographies and the saved capital reallocated to growth markets.
Value Shift
Payer dissatisfaction with clinically undifferentiated drugs and the saturation of markets by patented and generic products are forcing companies to reconfigure R&D to deliver better value to consumers and greater return on investment. Reducing investment in saturated indications and redeploying capital to underserved disease areas, prioritising breakthrough innovation (new targets and new interventions) and aligning investment with priority epidemiological challenges are key features of this reconfiguration. Recent announcements from some of the largest companies and the changing composition of R&D portfolios highlight these trends.
Sourcing Shift
With the aim of reducing costs, freeing capital and improving return on investment, the pharmaceutical value chain is under intense scrutiny to determine what is a core competency and needs to be fully-owned and what is noncore and can be outsourced. Increased scrutiny coupled with a rapidly maturing outsourcing services sector means that few components of the value chain remain sacred. Companies are increasingly sourcing from outside their corporate walls and from emerging economies, and this includes high value R&D.
PHARMA 2.0 – TRANSACTING IN THE ‘NEW NORMAL’
Transactions and partnerships have a central role to play in enabling and accelerating the strategic shifts occurring across the industry and recent corporate transaction history reflects this. Yet these strategic shifts are in themselves creating challenges for the business development functions tasked with deal execution. Business development functions currently face three important challenges: demand for assets is intense, deals are becoming more complex, and assets often exhibit a high degree of novelty.
Demand Intensity
Pharmaceutical companies are currently hungry for value enhancing deals. This is creating strong market demand for high quality or unique assets and the internal resources required to process and project manage transactions and partnerships. Two distinct sets of challenges are produced as a result.
The first set of challenges relate to valuation. Competition for what are often scarce assets is inflating prices at the negotiation table. High pricing coupled with greater capital constraints means that now, more than ever, valuation must be regarded as a critical competency. Business development teams cannot afford to simply go through the motions but must bring discipline into the valuation process by identifying the key drivers of value and ruthlessly interrogating the assumptions surrounding them. Business modelling can play an important role here by supporting the development and testing of multiple possible future states with regard to factors such as the future performance of the asset, the achievement of post-deal synergies and pay-back periods. It is also important to recognise the downside risk events or outcomes which could lead to overpayment, and capture these in the modelling process. One approach that can drive additional rigor into valuation is to validate ‘top-down’ valuations against ‘bottom-up’ elements of value, as is common in pre- and post-deal purchase price allocation. By providing a greater range of perspectives on value, this ‘bottom-up’ approach enhances the decision-making process, supporting optimal pricing judgements. Ultimately, the valuation process needs to determine the upper price limit that will be paid for an asset and companies must have the discipline to walk away from a deal when price thresholds are exceeded.
The second set of challenges relate to the volume of deal opportunities that business development functions must process. If transactions are critical to supporting corporate strategy, then the capacity to assess, negotiate, execute and integrate deals is a key factor in determining success. Failure to move fast in this environment can result in missing out on the next big opportunity and a key piece in the strategic jigsaw puzzle.
As a consequence of demand intensity, business development functions are coming under pressure to assess deals quickly, progressing to go/no-go decisions as fast as possible to free up resources and move to the next deal. This requires business development functions to maintain a delicate balancing act – moving at full-tilt to process deals quickly, while taking the extra time when necessary during the valuation and due-diligence process to manage risk to the business. Achieving the right balance is made more challenging by increasing deal complexity and uncertainties arising from asset novelty.
Deal Complexity
In the past, the high profit margins offered by blockbusters meant that companies could rely on a portfolio approach to transactions and partnerships. After all, one or two successful blockbuster products arising from a portfolio could pay many times over for the failures. In addition to this ‘profit buffer’, assets were plentiful and prices low compared to current market values. Today, while facing greater capital constraints, companies are also paying high prices for scarce assets that, in many cases, will find it harder to reach the market and are less likely to match the profits generated by yesterday’s blockbusters. The one success in a portfolio can no longer be guaranteed to pay for the failures – the profit buffer has gone. While a portfolio approach remains important for spreading risk, we are now seeing greater discipline and creativity in deal-making, particularly with regard to structuring deals to minimise downside risk.
For pre-market assets, for example, companies are making fewer outright purchases and instead are taking options over assets which can be exercised or left to lapse, subject to success at pre-defined milestones. Structured acquisitions undertaken in phases, also subject to milestone success, provide another way for companies to manage downside risk. This optionality and contingency increases the complexity of all aspects of a deal, from valuation and negotiation to day-to-day management. On-market risk factors further compound deal complexity. Clinical efficacy is no longer the sole determinant of a product’s success and value, as factors such as pricing and reimbursement are now also critical to determining commercial value. As such, commercial uncertainty is increasingly influencing deal terms and contingent structures. For example, the headline value of licensing deals is often split between development and commercial milestones, the latter being tied to actual sales or profits. Such back-loading of contingent payments means that companies are in deals together for longer, not only navigating discovery and product development together, but also the commercialisation of products – once again, compounding deal complexity.
Companies are also learning to collaborate where they might once have competed. This collaboration often occurs via joint ventures with complex, risk-reward sharing structures. Similarly, what were once tactical service provider outsourcing agreements are now becoming strategic long-term risk-sharing agreements, transforming relatively simple relationships into ones that are inherently more involved.
Asset Novelty
The pharmaceutical industry is R&D intensive and growth has historically been driven by incremental and breakthrough innovation. The latter in particular can generate assets which exhibit novel qualities and characteristics with which companies have little or no experience. The emergence of recombinant biologics in the 1980s is one example of how advances in technology can give rise to asset novelty. Today is no different. As companies reconfigure R&D to deliver greater value to patients and payers, they are investing in identifying new drug targets and technologies that will support and drive the next wave of products.
However, technology is just one driver of novelty. In the current environment, pharmaceutical companies are also regularly entering business segments and geographies which are novel to them. In some instances, assets demonstrate novelty across multiple dimensions. Much recent deal activity, for example, has occurred in emerging markets where buyers have had to get to grips with local market dynamics, political, regulatory and legal systems and business practices, as well as the operations of a new business segment and new product lines.
Asset novelty can throw up a host of challenges, not least how to value assets in the face of the uncertainty. Conducting due diligence in unfamiliar territory can also be difficult, making it harder to uncover and manage risks. This is because mitigating risk is often more about past experience than simply following a process.
PHARMA 3.0 – THE NEXT NEW NORMAL?
If Pharma 2.0 is challenging business development functions, then it is just a taste of things to come. Just as the industry is in the midst of its Pharma 2.0 journey, powerful trends within healthcare threaten to reshape the transaction environment further still.
The reconfiguration of healthcare systems that have traditionally been input-focused to being outcome-driven, the rise of consumerism and the maturation of enabling technologies are the forces of change setting the stage for a new model. If Pharma 1.0 and Pharma 2.0 were all about developing and marketing drugs, then Pharma 3.0 is a reconfiguration of the model to focus on health outcomes where the traditional product – a drug – is only one part of pharma’s value proposition.
At the same time, many non-traditional players in healthcare (e-health firms, consumer electronics companies, large retailers and medical technology firms), are mobilising resources to capitalise on the new opportunities presented by a consumer-driven, technology-enabled, outcome-focused world. These new entrants have the potential to reshape healthcare delivery and pharma cannot afford to be absent from the coming revolution.
The emergence of non-traditional players is creating new opportunities for partnerships that can combine and utilise respective core-competencies to meet the needs of the healthcare market. It seems highly likely that in many cases, these partnerships will combine assets and capabilities to co-develop products and services.
While the pharmaceutical industry has become increasingly fluent in executing traditional research and development collaborations, partnerships with nontraditional players will take business development teams into uncharted waters and out of their comfort zones. From managing differing goals, operating principles and cultures, inter-industry collaborations will face challenges at every stage of the process.
The themes of demand intensity, deal complexity and asset novelty are likely to continue and be accentuated in a 3.0 world. According to a recent Ernst & Young survey of business development leaders at major pharmaceutical companies and non-traditional entrants, 50 per cent of respondents indicated that deals will become more challenging, while only two per cent expect deals to become less challenging. The survey also indicates that there are potentially significant gaps in the preparedness of companies to deal with these challenges, particularly in areas such as valuation and modelling and due diligence (see Figure 2).
It is expected that many Pharma 3.0 partnerships will focus entirely on new product and service offerings and that this will give rise to uncertainty around the key variables required as inputs for valuation: the probability of a project’s success, the timeframe to success or failure and the size and timing of future revenues. Consequently, the complexity of the valuation and business modelling challenges are expected to increase.
The mainstay of valuation and value modelling in the pharma industry remains discounted cash flow (DCF) analysis, primarily due to its familiarity and relative practicality. As companies enter deals with high degrees of uncertainty, they may need to look to more sophisticated methodologies to support valuation and decision-making. Monte-Carlo simulation, for instance, offers a more sophisticated approach to handling uncertainty by producing a probability distribution of possible outcomes (as opposed to a single point estimate) to support decision-making.
Due diligence is also expected to become more challenging. While asset novelty can present due diligence challenges for 2.0 transactions, partnerships, related assets and capabilities are still typically drug-centric and therefore executed within the realms of relative familiarity. Pharma 3.0 partnerships on the other hand will seek to develop entirely new products, services and business models from scratch and will take pharmaceutical companies into unfamiliar territory. Corporate agility in a 3.0 world might therefore be highly dependent upon the ability to move from the type of scientific due diligence process used to assess drug assets to one capable of conducting due diligence evaluations within technology, retail, consumer electronic, telecom or health insurance environments.
