China biotech: Elusive innovation?

"It is an important and strategic task to develop strategic emerging industries, particularly when the economy is facing increasing downward pressure," China's State Council said in May following a meeting chaired by Premier Wen Jiabao. It resulted in plans to launch 20 major projects across seven "strategic pillar" industries. Biotechnology, and biopharmaceuticals in particular, is likely to be a major beneficiary.

China's pharmaceutical sector has been enjoying rapid growth. On the demand side, rising disposable incomes driven by urbanization and an aging population have spurred healthcare expenditure. In terms of supply, waves of Chinese scientists who studied aboard are also returning home as Beijing ramps up funding and incentives for R&D. According to anecdotal evidence, almost all new university professorships in medical science go to returnees who bring best practices learned in the research ranks of multinationals.

Deloitte expects the country's life sciences and healthcare market to become the second-largest in the world within a decade. Biotech output, meanwhile, is on course to reach RMB4 trillion ($630 billion), 90% of which will come from biopharma.

It goes without saying that the country has set its sights on becoming a global healthcare pioneer. However, PE and VC players - which are responsible for a lot of growth funding entering the industry - question whether this is a realistic goal, even in the medium term. China has yet to show world-class credentials in developing biomedical and chemical-based drugs.

"In China, you see a number of high-class R&D experts at the top of the industry, as well as a many home-grown researchers, but what's lacking is the middle part of the pyramid: a group that can transform innovation into products that can be commercialized fairly quickly and can bring in steady cash stream to further support innovative research," Sunny Sun, managing director at CVC Capital Partners, tells AVCJ.

Appetite for investment

Private equity and venture capital investment in pharma and biotech reached $953 million last year, up 31.6% from 2010, according to AVCJ Research. This is equates to 3.3% of total China spending within the asset class. Investor appetite remains steady in 2012, with $620 million committed to eight deals in the first six months.

Recent transactions involving drug developers include: CVC's purchase of a 14% stake in Venturepharm Group for $105 million investment into Ventruepharm Group in April for a 14% stake; CDH Investment, CITIC Private Equity and New Horizon Capital's rare secondary buyout of MBK Partners' interest in Luye Pharma in March; and PAG Asia injecting $250 million in Bicon Pharmaceutical in February to become the company's largest investor.

A number of biotech-focused venture capital funds have also emerged. BioVeda, for example, has already launched three funds focusing on China's pharma, biotech and other medical sectors. Its second US dollar fund, which closed in 2008 at $90 million, was four times larger than its 2004 vintage predecessor. International Finance Corporation (IFC) and multinational pharma companies include Eli Lilly and Johnson & Johnson are among the LPs. BioVeda is currently in the process of raising a renminbi-denominated vehicle from high net worth individuals.

"China's healthcare market has been expanding at a double-digit growth rate and the government supports the emergence of private companies," says Zhi Yang, chairman and managing partner of BioVeda China Fund. "Ten years ago, nine out of the top 10 pharma companies were state-owned; now six out of the 10 are private players."

Despite this clear commitment to R&D and drug discovery evolution from both government and overseas returnees, the value of innovation to financial investors lies in drugs that offer patients something they can't get anywhere else and therefore command a premium price. But China's track record in drug development isn't long enough to demonstrate an ability to commercialize discoveries.

At the same time, the country's pharma industry as a whole is still dominated by generic drugs. Much like the broader manufacturing sector, scientists and medical professionals routinely rely on basic research already in the public domain to churn out treatments at a lower cost than the competition. Of the 1,300-plus synthetic medicines produced in China, more than 90% are said to be copies.

Chronic short term-ism

To the extent that there are Chinese companies discovering new drugs and launch them commercially, the majority are building their businesses based on one or two blockbuster medicines that have a 5-10 year lifespan. Investors question whether these R&D teams are capable of developing the diversified portfolios required for sustained success.
"There are a lot of indigenous innovations but of dubious quality," one global GP tells AVCJ. "Some companies are developing drugs that have only a small chance of winning regulatory approval and they simply don't know what they are doing. International companies, which have in some cases tried similar drugs many times, understand what will and will not work."

The ability to commercialize drug discoveries is not the only concern. The development process requires deep capital reserves and much patience. Even for multinational pharma companies like Eli Lilly, Pfizer and Merck, see only one out of 100 medicines that enter clinical trials make it through the approval process. The development of a single drug - from identifying potential elements, getting approvals to launching the final product - might require 10 years and $1 billion or more in funding.

Production in China requires less capital, but expenditure is nonetheless substantial, particularly given rising labor and raw materials costs. Established in 2001, Shanghai Genomics spent close to $100 million on drug discovery before finally breaking into sales side relatively recently.

Ying Luo, director and general manager of Shanghai genomics, notes there is a disconnect between investor expectations in Asia and the fact that biotech or early-stage drug discovery companies cannot deliver substantial profit until 10 years after inception.

"It comes down to how people value the company," he says. "On NASDAQ, for example, investors bet on the future potential of technology and they allow innovative companies to be listed once they reach a certain stage. In Asia, all they are interested in is profits."

From a VC perspective, approaches to China biotech are influenced by the maturity of the market. While in the US they back early-stage companies, in China there is tendency to target players that have either reached a critical mass or received approvals for product launches.

Qiming Venture Partners, for example, has an average ticket size of $5-25 million and looks for minority stakes in proven companies. When it invested in Tigermed, a leading Chinese contract research organization in 2008, the firm already had 11 offices nationwide. Two years later, Qiming committed $14.5 million to Gan & Lee Pharmaceutical, which claimed to operate Asia's largest recombinant insulin manufacturing site. Both companies are planning to list on the A-share market in the next year or so.

"It's a step-by-step process. China's pharma industry is undergoing a familiarization process before large-scale innovations become available," says Nisa Lin, head of Qiming's healthcare practice. "The first job of the government is to build up a large generic market with affordable drug prices. Then sizable drug companies will have the capability to develop more advanced medicines or discover new drugs ."

As part of wider healthcare reforms, the government has sought to make key treatments affordable, introducing a national essential medicines list comprising drugs that should be widely available. Qiming has responded by investing in companies that target international approvals in order to ensure better profit margins outside China.

One of its portfolio companies, Jiangsu-based Novast Pharmaceuticals, claims to be the first Chinese pharma player to develop drugs that have been approved by the US Food & Drug Administration for sale in America. Novast also counts BioVdea, New Enterprise Associates and Lilly Asian Ventures, the VC arm of Eli Lilly, among its backers.

Big pharma moves in

Eli Lilly is the only global pharma company with a corporate venture capital presence in China, actively cultivating early- to mid-stage firms. It is an interesting anomaly given that one of the primary concerns how local players can best position themselves for acquisition by larger industry participants.

In more developed markets, trade sales are a well-used exit route for private equity and venture capital investors with healthcare assets. It is increasingly the case in China too, for several reasons.

First, there are more than 5,000 pharma companies nationwide, with the top 10 players accounting for less than 30% of the market, so there is a clear need for consolidation, Second, weak IPO markets in the mainland and Hong Kong have denied investors and entrepreneurs their preferred exit channel. Third, multinationals are keen to establish an R&D presence in China where real estate is relatively cheap and labor is affordable and comparatively skilled.

"That means the same amount of money can be used to develop 10 as many drugs," Shanghai Genomics' Luo says of the cost arbitrage opportunities. "Drug development is a probability game, and the more you work on it the higher the chance of success."

Almost all the big pharma representatives are now setting up their own research facilities in China. In 2009, Novartis announced plans to invest $1 billion in R&D over the next five years, including a significant expansion of the Novartis Institute of BioMedical Research in Shanghai. Last year, Merck & Co also rolled out a five-year $1.5 billion project that will see the construction of a new facility in Beijing for 600 researchers focused on drug discovery and translational research.

"Multinationals prefer to develop drugs on their own rather than investing into someone else because they have enough resources and they can have all the profits to themselves," says Christina Zhang, Cooley's life sciences practice partner who previously worked at Merck. "But the reality is that over the last few years, new challenges have emerged and they need to look beyond their own world by collaborating with other companies, including Chinese companies."

Although multinationals are trying to reach out, they are cautious about investing in Chinese companies. Entrepreneurs - who are often just in their 40s or 50s - are rarely willing to give up control of their businesses while big pharma, with rigid processes of its own, finds it difficult to adjust to Chinese management styles.

Market integration is another challenge. Global players focus on high-end products, but their local Chinese counterparts remain rooted in the lower tier. It takes a considerable amount of time and effort for multinationals to source a company that has complementary capabilities and quality management, and then familiarize themselves with market segments in which they have little experience.

"As venture capital investors, we don't marry our portfolio companies, we are just lovers," says BioVeda's Yang. "For this reason we need to understand the specific needs of multinationals, which often favor category leaders with good governance."

From generics to the world

Whether or not big pharma because a key force in Chinese M&A, local firms will continue to devote resources to developing better quality drugs that might be able to compete with the world's best. CVC-backed Venturepharm, focused on doing contract research for multinationals before starting in-house development about five years ago.
It is looking into local solutions to local problems, notably anti-allergy and central nervous system drugs, where demand is driven by urbanization, allergies and stress - side-effects of China's rapid modernization.

In much the same way, companies that have generated strong cash flow through existing generic capabilities are now well positioned to more to next stage and become local innovators. For private equity and venture capital, the priority remains identifying industry participants with a competitive advantage.

"I am encouraged by innovation in China," says CVC's Sun. "My two cents advice is be that researchers should assess in advance whether the specific fields they choose to work in are likely to see approvals and whether international companies already have similar products."

 

SIDEBAR: Big pharma goes VC

With pharmaceutical industry research budgets shrinking globally, large pharmaceutical companies are instead looking to support early-stage biotechnology startups. Eli Lilly, Novartis and GlaxoSmithKline have all set up their own corporate venture capital arms. Last year, Merck followed suit, establishing the Merck Research Venture Fund with $250 million to invest globally, as well as a separate Global Health Innovation Fund with another $250 million.

However, Eli Lilly is the only one of these companies whose corporate venture arm is active in China. Established in 2007, Lilly Asian Venture focuses on phrase two or three life science and healthcare companies, with an average ticket size of $10 million.

Chinese pharma giant Sinopharm has also recently joined the corporate venture capital party. In June, the drug distribution conglomerate announced Sinopharm Capital, a RMB1 billion fund that will invest in different segments of the healthcare industry. Initial LPs include Sinopharm itself and Fosun Pharmaceutical, the listed medical arm of China's largest privately-owned investment firm.

While many industry participants say that innovative drug development in China has yet to reach a stage where it can compete with the multinationals, Lilly Asian Venture operates in the country under the premise that it can achieve financial returns for itself and strategic benefits for its parent.

In 2008, Eli Lilly made an initial investment in Novast Pharmaceuticals through the VC unit. Just two months ago, the company announced plans to expand its manufacturing capabilities in China through a broader collaboration with Novast. As part of the agreement, Eli Lilly - not the VC unit - will inject $20 million into the drugmaker directly from its balance sheet. Novast will set up a platform to support Lilly-branded generic products. Manufacturing capacity will increase over the next several years with Eli Lilly providing technical support to enhance quality standards.

"If Eli Lilly did not invest ino Novast through its corporate venture capital arm several years ago, there may not have been an opportunity to discover and then partner with a company that has such strong potential," Yi Shi, managing director of Lilly Asia Ventures, tells AVCJ.

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• Topics
• Greater China
• Healthcare
• China
• healthcare
• CVC Capital Partners
• PAG
• CDH Investments Management
• New Horizon Investment Advisors
• Citic Private Equity