CRO Sector Fundamentals Remain Hot for M&A Consolidation

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Contract Research Organizations (CROs) provide outsourced research and development services, regulatory and scientific support, and infrastructure and staffing support to the life sciences industry. CROs have evolved over many decades from limited clinical trial services providers to fully outsourced providers of drug development from preclinical and discovery services, to clinical (often referred to as Phase I-III), to Phase IV/post-approval monitoring and commercialization.

The therapeutic, regulatory and clinical expertise of CROs helps to improve the cost of development and improves the speed at which clinical trials can be completed.

Sponsors of such CRO services include biotechnology, pharmaceutical, and medical device companies. The sponsors choose to outsource drug and device development capabilities to CROs for a variety of reasons including access to capabilities not found in-house, shift fixed costs to variable costs, and achieve greater global reach and scale. Small and virtual life sciences companies need to outsource nearly every piece of the drug and device development process. Other companies, such as large pharmaceutical manufacturers, maintain their own research and development capabilities in-house and may choose only to outsource very specific components of the development process in a functional service provider (FSP) relationship due to resource constraints, specialized expertise, or a lack of required geographic footprint. Companies that outsource a portion but not all of their development work to CROs have the benefit of choosing projects based on the value they provide and also may benefit from economies of scale if they are willing to commit to outsourcing a certain amount of work over a longer period of time (strategic partnerships).

 

The CRO Industry Landscape

The CRO industry is estimated to be $30B and highly fragmented with over 1,000 entities globally, though relatively few of full scale and breadth of service.

Consolidation in the space is relatively common, though recent M&A among CROs has been around building out capabilities either in data analytics (Quintiles / IMS Health, PRAH / Symphony) or in key CRO functions such as patient recruitment (PPD / Acurian) or site management (Parexel / Fomativ, PPD / Synexus). Much of the growth has been concentrated in the large full-service players as well as the small/niche CROs, while mid-size full-service companies have generally trailed market growth, which is where a lot of the consolidation has been happening. The largest services provided by CRO’s are site management, study monitoring, and data management comprising 22%, 20%, and 12% of total industry revenue, respectively. Many of the largest outsourced services are generally mature and to an extent, commoditized. The CRO industry is expected to grow ~6%, driven by ~2%-3% from increasing R&D spending by the biopharma industry and ~3% from increased penetration of drug development budgets. The industry remains fragmented in 2019 and look to see continued opportunity for value-accretive M&A.  

 

Fragmented Market

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Growth Rates

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Demand Trends

Several key positive trends that are driving CRO industry growth include robust biopharmaceutical funding, accelerated drug approval rates, growing number of clinical trials, proliferation of biopharmaceutical companies without internal research and clinical capabilities.

According to a recent study in March 2019 from the Tufts University Center for the Study of Drug Development (CSDD), leaders in the analysis of the CRO industry, the top 10 largest CROs, according to CSDD, controlled 57% of outsourcing spend in 2018, a 12% increase from seven years ago, suggesting the top CROs, with geographic scale and broad therapeutic expertise are taking share. Of note, in a previous survey, R&D projects managed by CROs have shorter cycle times, with study initiation duration 39 days faster for established CRO relationships (77 days faster for new relationships) as compared to sponsor-run trials. The dynamics further emphasize the value proposition of clinical trial outsourcing, helping to offset the growing complexity of clinical trials and expanding scope of studies. It also noted that sponsor layoffs alongside building R&D pipelines as well as sustained biotech demand continue to support R&D outsourcing penetration.

Biopharmaceutical fundraising is also at record highs. Robust capital markets have driven increased biopharmaceutical R&D investment. A key driver of increased large molecule spending has been record high capital market funding for the biotechnology sector in recent years. The success of key pipeline drugs such as in the immuno-oncology (IO) area have been a key component of this heightened sentiment for the sector.

Improving review times at the FDA have contributed to an increased pace of drug launches. Robust funding and improving review times at the FDA have in part contributed to a healthy rate of new drug launches, which itself has been driving an even better funding environment. The FDA approval process has historically been a bottleneck for new drug launches. The rise of biologics (and more recently, biosimilars) has only made the approval process more complex. With increased resources at the FDA, time to approval trends have been improving. Given how critical to drug candidate value is a shorter timeline from early development to launch, this development at the FDA has been a positive. In fact, the volume of new drugs launched has been robust in part due to this.

Lastly, the number of biopharmaceutical companies with active development pipelines has been increasing and this has benefitted CROs as redundancies in R&D programs are likely to be more prevalent when compared to if the pipelines were housed within a concentrated number of entities. Increasingly, the role of small and mid-cap biotechs is becoming like an outsourced development hub for traditional pharma, which seek to acquire biotechs with programs that they deem attractive or of strategic fit with existing development pipelines.

Opportunity for further outsourcing / CRO penetration

In the US, the biopharmaceutical industry accounts for ~90% of total R&D spend on clinical trials according to PhRMA. Recent EvaluatePharma estimates for R&D spending is ~$170B and is projected to increase 2% – 3%. The forecasted growth is lower than the average for 2010 – 2017, which is in part due to improving trial efficiencies through better use of data and predictive analytics. There is also a component of expected reduced pharmaceutical spend due to revenue pressures from generics / biosimilars as well as uncertainty around pricing given the recent political and regulatory climate in the US. Of the development spend, it is estimated that the addressable preclinical market is 10% – 15% and the addressable clinical market is 60%-70% (which is the primary addressable market for most CROs). Current estimates of CRO penetration of the addressable clinical development spend are ~45%. Development spend is expected to increase commensurately with total R&D spend (2% – 3%) while increasing CRO penetration of development budgets will provide for an incremental ~3% of growth to the CRO industry growth.

Industry Margin Dynamics

Typically, CROs use a cost-plus pricing model, where all costs related to the clinical trial is billed to the client, with CROs realizing a margin on top of project costs. In 2017, IQVIAintroduced the fixed pricing model. Currently, it employs some element of its fixed pricing strategy across ~30% of projects. Further shift towards a fixed pricing model may pose a challenge for CROs with more limited data assets to properly determine and set achievable timelines while taking into account the considerable risks, such as patient recruitment bottlenecks, site identification, increasingly complex trials, and clinical trial design. The cost-plus model provides CROs protection to such dynamics, though it may also limit realized margins on projects. Hybrid outsourcing models are becoming increasingly common, and as a result of this dynamic, clients become more reliant on a provider’s full-service solutions, leading to strategic partnerships that are longer and stickier in nature. FSP offerings continue to gain favor amongst large sponsor customers, which can retain certain functions internally while choosing to outsource others. Overall, FSP is a faster growing sub-segment for CROs, albeit lower margin relative to full-service. As a result, CROs that provide less FSP work compared to their full-service offerings will sustain higher margins (e.g. IQV & MEDP).

2019e CRO Operating Margins

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Business Valuations

According to Pitchbook data, business sale median valuations of publicly traded CROs range from 11.75x to 15.6x EBITDA (earnings) and 2.88x to 4.77x revenue multiples. Valuations within this range are influenced by revenue size, competitive environment, growth rates, margins, the strength of the management team, and buyer motivations. The multiple valuation approach for precedent transactions is relevant as well, however, market data indicates it is a less informative valuation measure with a significantly wider range since much of the business sale transaction data is not known or published. What can be observed, and a key takeaway is that there is much deal activity in the sector.

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Final Thoughts

Although the CRO market is still a relatively fragmented industry, biopharmaceutical and medical device companies have increasingly turned to CROs in the past five years to stay competitive, improve their efficiency and therapeutic expertise, while adding more widespread geographic capabilities. Many mergers and acquisitions have occurred over the past several years that continue the trend of consolidation in the CRO space, as demand for these services has continued to heat up. Consolidation will, in turn, have a beneficial impact on the bottom line for many CROs. In the past, CROs have been formed by life science entrepreneurs, but as CROs continue to grow and merge, it’s likely that more private equity investors will buy these companies. As a result, CROs will have more financial resources as well as more business discipline that will appeal to their clients.

If you are trying to explore either a sale of your CRO company, valuation of your business, or are interested in looking at opportunities for growth, our Life Sciences & Healthcare Practice Group is happy to assist you with your goals. Contact Life Sciences and Healthcare Managing Director David H. Crean, MBA Ph.D at (858) 461-9490 or reply directly to [email protected].

Disclosure

Objective Capital Partners is a leading investment banking advisory firm whose Principals have collectively engaged in more than 500 successful transactions serving the transaction needs of growth stage and mid-size companies. The executive team has a unique combination of investment banking, private equity, and business ownership experience that enables Objective Capital Partners to provide large enterprise caliber investment banking services to companies with annual revenues up to $500MM. Services include sale transactions, partnering/ licensing, equity and debt capital raises, valuation and comprehensive advisory services. The firm uses a proprietary process to work to achieve maximum company valuation, premium pricing, and high client satisfaction rates post-sale. The firm’s industry expertise is focused on 5 verticals including healthcare, life sciences, business services, technology, and consumer products. Additional information on Objective Capital Partners is available at www.objectiveibv.com.

This article is provided for informational purposes only and does not constitute an offer, invitation or recommendation to buy, sell, subscribe for or issue any securities. Securities and investment banking services are offered through BA Securities, LLC Member FINRA, SIPC. Objective Capital Partners and BA Securities are separate and unaffiliated entities. While the information provided herein is believed to be accurate and reliable, Objective Capital Partners and BA Securities, LLC makes no representations or warranties, expressed or implied, as to the accuracy or completeness of such information. All information contained herein is preliminary, limited and subject to completion, correction or amendment. It should not be construed as investment, legal, or tax advice and may not be reproduced or distributed to any person.

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