China healthcare: Innovation issues

Cord blood might turn out to be the ultimate life insurance policy. Samples of around 60 milliliters are taken from the umbilical cord shortly after birth and placed into storage. Should the child later be stricken by a serious illness, stem cells extracted from the blood can be used to treat more than 80 diseases, notably leukemia, lymphoma and anemia.

Stem cell research remains a relatively nascent area of science and it is not certain that cord blood contains sufficient stem cells to be successfully used in treatment. Storage has also yet to become habitual for Chinese parents. Of the 60-80 million children born in the country each year, samples are collected in just 1% of cases, compared to 15-20% elsewhere in Asia.

The investors that have backed US-listed China Cord Blood Corporation (CCBC), the leading domestic blood banking operator, are betting on the long game. KKR committed $65 million in 2012, making its first foray into the country's health services sector. Hao Capital invested six years earlier, when the market was very much in its infancy.

Cord blood collection in licenses are closely held in China. The government only permits the practice in 10 provinces and municipalities and CCBC has exclusive rights in three of them. Elaine Wong, a partner and co-founder of Hao Capital, notes that these local monopolies were necessary to attract investors.

The PE firm fully exited its holding last year with a reasonably high return and can therefore endorse the business model. But the investment thesis has little in common with perceptions of Chinese healthcare.

"It's more of a consumer play - cord blood storage is like health insurance. The focus of the company was on storage rather than research and development of stem cell therapies," she says.

Hype and reality

China has become a magnet for healthcare investors, apparently at the expense of developed economies. According to London-based research firm GlobalData, PE investment in the sector came to $19.8 billion last year, well short of the 2007 peak of $57.7 billion. Activity in Europe fell by 30.5% year-on-year and North America saw growth of just 2.5%. Asia, on the other hand, has witnessed a 125.8% jump investment between 2011 and 2013, led by interest in China and India.

However, it is still unclear what form the China opportunity will take and how big it can become, and by extension, whether these investments will deliver the anticipated returns.

"Investing in China's healthcare sector is like wondering around in an antique flea market where it is difficult to tell if the products are real or not," says Dr. Zhi Yang, founder and managing director at BVCF, a China-focused life science PE firm. "People may regret over-blowing the market in the future, especially if they don't know the industry well."

AVCJ Research breaks down PE investment in the sector into three categories: service providers, pharmaceuticals and medical devices. Only the service provider segment saw an uptick in activity last year, with eight deals totaling $202 million, nearly double the 2012 figure.

The most dramatic shift was in commitments to pharmaceutical firms, which came to $441 million, compared to $1.6 billion in 2012 and close to $1 billion in each of the two years before that. This was the primary reason healthcare investment as a whole dropped to $688 million in 2013, from $1.8 billion the previous year.

The pharmaceuticals slowdown is blamed on two factors. First, the Chinese government launched an investigation into multinational pharma player GSK over allegations of bribery. This made PE investors turn cautious, for fear of inadvertent association with individuals and companies that may be sucked into the scandal.

Second, as part of broad healthcare reforms, more drugs are being added to the list of treatments deemed essential to meeting basic medical needs. Those drugs are made available to all grassroots healthcare services providers, with the cost fully reimbursed through the insurance system. As such, prices are set deliberately low.

In 2012, the list expanded from 307 to 502 products, including 317 conventional drugs and 203 traditional Chinese medicines (TCMs). It includes Bayer's Glucobay, Pfizer's Norvasc and Novartis' Diovan.

"The government's expansion of the essential drug list will inevitably put pressure on pharmaceutical companies' growth margins. Once drugs are on the list, price cuts range from 5% to even half the original level," says Nisa Leung, managing partner at Qiming Venture Partners.

Other options

In this context, investing in generic drugs manufacturers might not be as attractive as it once was. On the flip side, healthcare reforms have given impetus to PE firms looking at other parts of the sector, notably service providers. The government's decision to relax curbs on foreign investment in state-owned hospitals is seen as indicative of a more favorable environment.

Notable deals in the 18 months include: GIC Private and Goldman Sachs' $100 million investment in medical examinations provider iKang Healthcare, which recently listed in the US; the $49 million commitment to Meinian Onehealth Healthcare Group, a leading independent provider of preventive check-up services, by The Carlyle Group, Cathay Capital and Ping An Insurance; and Warburg Pincus' investment in the maternity-focused Amcare hospital chain.

"In the provider space, there are still some assets available in the market for financial investors to land on. Those specialty chains, such as dental care and eye care, are focused on the repeatable model. They are preferred to general hospitals in tier-one and tier-two cities because they are less differentiated and have a lot of complexities," says Phil Leung, a Shanghai-based partner with Bain & Company, who also leads the firm's China healthcare practice.

It is not for everyone, though. Public hospitals can be a turn-off because, without strong policy support or a clear turnaround opportunity, they are inherently low-growth and hampered by bureaucracy. Even the private specialty chains are generally off limits to VCs and mid-cap PE players because of the amount of capital required.

"The hospital sector is overheating and valuations are being pushed up," says BVCF's Yang. "Furthermore, some investors will come to regret their involvement if they don't have the right management skill sets. It isn't like investing in a hotel or shopping mall. You need capable professional skills to manage doctors and nurses, who are highly educated."

A model apart

In contrast to recent patterns in China, the pharmaceuticals segment has consistently been the most popular among investors in the US, followed by medical devices and providers.

The power of the US Food and Drug Administration (FDA) is the critical differentiating factor. Once a new drug receives regulatory approval, large-scale production usually begins and the technological and chemical patents that underpin and protect its value ensure high margins.

This kind of product innovation is one area in which China is decidedly lagging. While TCM and biological pharmaceuticals are faring well, chemical drugs represents the problem area, with generics manufacturers seeing slower growth as a result of the essential drugs list. It is suggested the Hony Capital-backed management buyout of US-listed generics player Simcere Pharmaceutical Group last year was in part driven by expectations that American investors wouldn't respond well to more moderate growth.

However, Bain & Co's Leung notes the slowdown in investment is going to be temporary. He foresees a wave of industry consolidation, especially when new regulations come into force.

"Injectable drug manufacturers must implement a revised set of good manufacturing practices (GMPs) by January 2014, and the manufacturers of other drugs must do so by January 2016," Leung says. "That will be a milestone or hurdle and some local pharma firms will actually need either to shake-up or get out of business."

This may well result in opportunities for financial investors to partner with managers of renminbi-denominated funds, creating reasonable size generic pharma companies through series of roll-up investments.

Regardless of whether or not roll-ups prove to be strong investment thesis, a dependency on generic drugs manufacturing does not represent an attractive long-term goal for China's pharmaceutical industry. The product innovation issue must be addressed with a view to generating higher value, patent-protected treatments.

"There is a lot of talk about innovative drugs. However, few people know how to be innovative and even fewer people understand the value of being innovative. Finding good projects in China is like looking for a needle in a haystack, taking a lot time to find," says BVCF's Yang.

His firm recently reached a final close of $200 million on its third China life sciences fund. The portfolio already includes Kunshan RiboQuark Pharmaceutical Technology, a joint venture established by US-based Quark Pharmaceuticals and Suzhou Ribo Life Science, and MicuRX Pharmaceuticals, a biopharma firm developing next-generation antibiotics.

Yang expects cross-border transactions - using joint ventures with overseas pharmaceutical and medical devices companies to bring innovative products and technologies to China - to feature strongly in the fund. BVCF also hopes to generate deal flow through partnerships with US venture capital firms.

Positive signs?

BVCF's activity is representative of more VC money flowing into early-stage companies. It didn't happen much in the past because the development cycle is long and risky and regulatory barriers are high.

Taking a new drug from clinical tests to commercialization often takes 7-10 years and the success rate in China is less than 1%. For investors to consider such opportunities, a product pipeline should already be in place.

"In our experience, even though a product may have received FDA or Europe's CE Mark licensing in other geographies, it can still take several years to obtain China Food & Drug Administration licensing. Very few venture capital funds have the fund life and expertise to invest in new drug development," says Hao Capital's Wong.

She sees the biotech ecosystem evolving in China, with increased demand for pre-clinical medical equipment and services indicated a higher level of interest in early-stage drug development. But the market is still very small. Joint venture-type investments like those endorsed by BVCF are only just moving from thought to execution and no one is anywhere near producing the next blockbuster treatment.

"R&D has become an area of focus for Chinese companies, but it is not yet comparable to Western countries," says Mei Dong, a partner with KPMG China. "Meanwhile, I think most of the Sino-foreign joint ventures may only focus on domestic market. When a foreign firm comes in, it needs local distribution channels - that is the main purpose of forming a JV."

These firms come with drugs ready to sell, not awaiting development. It is a model comparable to that of China Cord Blood: an investment in the consumer, rather than technology itself.

SIDEBAR: TCM - A local cure

Traditional Chinese medicine (TCM) was identified as one of the nation's seven strategic industries under the 12th Five-Year Plan, a document outlining government policy for 2011-2015. Buoyed by this support, the industry is expected to grow from $18.6 billion last year to more than RMB550 billion ($87 billion) by 2015.

TCM remedies now account for 203 of the 502 drugs on the list of treatments deemed essential to meeting basic medical needs. This is a reflection of the government's desire to support the use of TCM in lower tier cities and rural areas where it generally popular. Drugs on the list are available to grassroots healthcare services providers at low prices, with costs reimbursed through the insurance system.

TCM providers are also being encouraged to expand globally, with 10 companies expected to set up such branches in Southeast Asia, Europe and the US by 2015. However, given alternative treatments are less recognized in Western countries, how far can these drug makers go?

"There is no standard procedure to produce Chinese medicine and so it will be a challenge expanding TCM globally. A lot of lobbying work should be done with regulators such as the US Food & Drug Administration to prove that TCM actually works," says Mei Dong, a partner with KPMG China. "I think TCM will be more focused on Asia because people here understand it more."

Indeed, it is the domestic strength of TCM that is attracting private equity investors.

Shandong Buchang Pharmaceuticals, a TCM manufacturer specializing in heart disease formulas, has received several rounds of funding from Morgan Stanley Private Equity Asia, AIF Capital, TDR Capital, ARC Capital and Hao Capital.

Having developed strong local distribution channels, the company has started supplying foreign traditional drugs, such as those developed in Japan, says Elaine Wong, a partner and co-founder of Hao Capital.

Foreign strategic investors are also interested. Two months ago, Germany's Bayer HealthCare bought Dihon Pharmaceutical Group, a TCM manufacturer based in Yunnan province. The deal facilitated the exit of Legend Capital, an investor in the firm since 2010.

The acquisition is part of Bayer's ambition to become the leading multinational in the Chinese over-the-counter market, of which TCM accounts for about half. Several other multinationals have also expressed an interest in herbal treatments, with Sanofi buying BMP Sunstone for $520.6 million in 2010.

"We're optimistic on the growth prospect for TCM in China. Since it has a long history in Chinese culture, many people believe in its pharmacology and will combine Western and Chinese medicine to recover from sickness," says Nisa Leung, managing partner at Qiming Venture Partners.

The VC firm committed a Series A round for Jun He Tang last October with a view to scaling up the company's chain store business. "Jun He Tang provides standardized services and operates in the same business model as Western clinics, which is easier to expand and manage," Leung adds.

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• Topics
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• Greater China
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• BVCF
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