China healthcare: Technology transfer

The "Bridge" in Ally Bridge represents just that - a private equity firm that wants to serve as a link between Chinese and global companies, bringing new healthcare technologies to the former and opening up new customer markets for the latter.

The firm, set up in 2010 by Frank Yu, was originally known as Themes Investment Partners. It targeted Chinese companies in healthcare, environmental technology and agri-business. The healthcare portfolio performed particularly well, generating an approximately 3.1x return on investments worth $60.4 million.

Forging a new path as a healthcare specialist, Yu saw the cross-border M&A angle as a means of differentiating his strategy. The rebranding as Ally Bridge soon followed in 2013. Fund I, now fully invested, backed healthcare technology start-ups in the US and helped them enter China. In June, the firm reached a second close on its second fund. For this vehicle, the one-market strategy has evolved into a fully-fledged cross-border strategy, with investments in the US and China.

"China healthcare has matured to a level where the more progressive companies are looking internationally. They want to source world-class technologies in order to address unmet needs in China and also access overseas markets," Yu explains. "Simultaneously many global companies look favorably on the continued strong growth of China's domestic healthcare sector. These are two factors generate cross-border opportunities."

In July Ally Bridge sealed a partnership between Shenzhen-based LifeTech Scientific and US-listed Medtronic to produce pacemakers and other cardiac devices for the Chinese market. LifeTech will develop the devices with Medtronic providing technical support.

Ally Bridge is not the only PE firm to recognize the potential of the cross-border healthcare investment thesis. Life sciences specialist BVCF, Fiderlity Growth Partners, Silicon Valley-based healthcare investor Essex Woodlands, and newly-formed GP Aequus Asia Capital Partners are also keen on deals of this nature. But why now?

Drivers of demand

According to Preqin, 41 Asia-focused funds that claim an interest in investing in healthcare are currently in the market, seeking to raise $24 billion between them. It runs the full gamut from large pan-regional players to small sector specialists. The total is some way off the 2005 peak, but it compares favorably with recent years. Last year 55 funds were targeting $11 billion.

AVCJ Research breaks down private equity investment in healthcare into three categories: pharmaceuticals, service providers and medical devices. While each segment has seen an uptick in activity this year, the latter two categories have generated the most interest.

A total of $403 million have been committed to 12 medical devices manufacturers so far this year, the most since 2010 when $189.5 million went into 14 deals. Meanwhile, on the service provider side $554.7 million has been deployed across six deals, more than double last year's figure.

China wants to climb the value chain all along the industrial manufacturing spectrum, including healthcare, and develop technologies that can be exported overseas. At the same time, the country needs better hospitals with better equipment to meet rising domestic demand.

Healthcare expenditure - state-led and private consumption - reached to RMB3.2 trillion ($523 billion) in 2013, up 14% from 2012. Spending is expected to grow at 20% per year, driven by macroeconomic factors like urbanization and rising disposable incomes, but also by the fact that China's population is ageing.

Chronic conditions such as diabetes, cancer and respiratory disease are becoming more prevalent. China accounts for one in five of the world's population and one in three of its deaths from lung cancer. Liver cancer is the fifth most common form of cancer globally and the vast majority of sufferers are in China, yet it remains underdiagnosed and inadequately treated.

For these reasons, healthcare is a key tenet of the 12th Five-Year Plan, which covers 2011-2015. Earlier this year, the government unveiled its latest policy initiative by relaxing rules on private investment in public hospitals and also fast-tracking approvals for the sale of innovative foreign medical devices in China.

"Over the last 10 years, real estate development was one of the key drivers for GDP growth in China, but over the next 10 years it will be healthcare. There are greater internal needs around healthcare service provision, health and wellbeing, medical devices, elderly care and pharmaceutical development," says Jenny Yao, a partner in KPMG's healthcare consulting practice.

Carving a niche

As a result of the recent reforms, the hospital space has turned into a sellers' market, with a large number of private equity and strategic investors flocking around the limited number of facilities put up for auction.

In April, a consortium led by Fosun Pharmaceutical Group and TPG Capital agreed to buy hospital operator Chindex International for $433 million, after seeing off a counter bidder, while in October Hony Capital purchased Shanghai Yangsi Hospital, the largest privately-owned hospital in the city. Hony wants to acquire 10-15 hospitals over the next three years.

With hospital deals fast-becoming a large funds' game, mid-market investors are looking for other entry points where valuations are lower. Medical devices and pharmaceuticals are obvious targets and their cross-border strategies leverage the still huge innovation gap between China and developed markets, chiefly the US.

"Healthcare investing is definitely heating up, trying to catch up with internet investing and this means valuations are rising every day," Yu told the AVCJ Hong Kong Forum in November. "We don't chase valuations by getting into crowded deals. Instead, we have our own niche, acting as an enabler of cross-border M&A to cement partnerships between Chinese and overseas healthcare companies."

Industry participants note that the valuation situation isn't just more favorable for cross-border deals than domestic hospitals; in some cases it is turned completely on its head.

Still suffering the after-effects of the 2000 biotech boom and more recent moves by the US government to reduce funding, a number of US and European companies distressed, desperately in need of capital to continue development programs. However, their technologies retain intrinsic value and this could be exploited to the full by bringing them to China.

Although biopharmaceuticals and medical devices are both present in the Ally Bridge portfolio, Yu sees investments in the latter as easier to manage given the regulatory risks. This view is echoed by Weiheng Chen of law firm Wilson Sonsini, who claims to have seen more deals in medical devices over the last two years.

Medical devices will also be a strong investment theme for Aequus, which is preparing to launch a $200 million healthcare-focused fund. The firm is looking for disruptive medical technologies that are established in the US and can be rolled out in China, and then elsewhere in Asia. Technologies used in the diagnosis or treatment of cancer and diabetes are of particular interest.

"Those products could work well in diagnostic centers and patient specialty clinics, complementing existing equipment such as CT scanners and MRI systems. The idea is that patients wouldn't have to go to 4-5 places for imaging, diagnostics and treatment; everything could be done in a single center. It is close collaboration between technology and the healthcare service delivery model," says Amit Kakar, co-founder and partner at Aequus.

The private equity firm would acquire full distribution rights for medical devices in China and then leverage its working relationships with the Chinese government to secure regulatory approvals. It would seek out joint venture partners for distribution or invest in companies that are building specialist diagnostic and disease treatment centers, and sell equipment to them.

"The application process for a license to build a large hospital is lengthy. It is also difficult to get quality doctors to work in private hospitals. And then, most importantly, it is easier to scale smaller facilities - you can open a new center within six months," Kakar adds. "We could also differentiate ourselves from regular check-up centers by focusing on diagnostics and treatment."

In this context, the steps taken to simplify approvals for overseas-developed medical devices are significant. Previously, it could take 4-5 years for a new product to be fully licensed; now, technologies deemed sufficiently innovative should be able to sweep through the process in less than two years.

However, greater access to the China market also presents market-positioning challenges for foreign companies. A multinational can roll out premium brands at high prices and see little but lucrative take-up, or team up with local players to develop affordable brands. This is the essence of the LifeTech Scientific-Medtronic partnership.

"By working with a local champion, international players can deploy their proven and innovative technologies while also leveraging local brands and distribution channels, and establishing a pricing structure that reaches a larger addressable market," says Ally Bridge's Yu.

The discovery angle

Multinational drug developers are also becoming more open-minded in licensing treatments for clinical trials in China. Again, the driver is China's scale.

According to Chinese Academy of Social Sciences, the domestic pharmaceutical was worth RMB93 billion in 2012 and it is expected to reach RMB2.3 trillion by 2020. The earlier a company starts clinical trials and wins local approvals, the sooner it gets access to this market.

Government efforts to reduce the prices of essential drugs have made the generics space less attractive than it once was. Meanwhile, the general quality of domestic drug development has improved as waves of Chinese scientists who studied aboard return home, encouraged by increased state funding and incentives for R&D.

"More and more talents trained at world-class Western companies and institutions have returned to China to lead clinical development projects, many of which have reached global standards," says Jonathan Wang, senior managing director at OrbiMed Asia. "Global investment firms like us have also served as a bridge between East and West to facilitate cross-border partnerships. Through their networks and resources, these returnees are bringing advanced Western technologies to local companies in Asia."

They are also developing local drugs for local patients. For example, Hepatitis B is not a life-threatening condition in the US and therefore not a focus for multinationals; in China it is undertreated, with 100 million people afflicted by the disease. So not only is there domestic demand for treatments, but also a large base of patients for clinical trials. This is important given patients from different geographies have different genetic backgrounds.

Zai Lab, a clinical trials company set up by Samantha Du, former CEO of Hutchison Whampoa subsidiary Hutchinson MediPharma and a healthcare partner at Sequoia Capital, is one of a number of start-ups looking to license overseas treatments and conduct R&D in China.

The company, which is backed by Qiming Venture Partners and several other venture capital firms, recently obtained a license from Sanofi for two novel compounds that could potentially be used to treat chronic respiratory diseases, including chronic obstructive pulmonary disease (COPD) and asthma. This is a common condition in China due to worsening air pollution.

Although no one is close to producing the next blockbuster treatment, the biotech ecosystem is evolving, which is in turn driving the contract research organization (CRO) industry. These groups provide outsourced clinical-trial services, enabling drug sponsors to save on costs. They are getting more business from US players.

As success rate for new drug development is relatively low, most of the products brought into China by cross-border funds have at least reached Phase II clinical trials in the US. This minimizes the technology risk but the regulatory hurdles are still significant compared to medical devices, where companies can at least rely on improved intellectual property rights protection.

"Even if a drug candidate has been in clinical trials overseas, which means that it has been tested on humans, the developer must still gain investigational new drug (IND) approval from the China Food & Drug Administration to conduct clinical trials in China. The IND approval process typically takes 1-2 years," OrbiMed's Wang says.

It can be a daunting and time-consuming process but it is not the biggest challenge facing private equity firms when pursuing cross-border healthcare strategies. The most important consideration is whether an investment team has the skills and background to identify and source advanced technologies outside of China that can work in China. For example, Ally Bridge has 20-strong team, split between China and the US, all of whom have biotech experience.

"Having industry expertise is critical for medical devices and biotech investments," says Wilson Sonsini's Chen. "Few China-based private equity funds have actually built up professional teams to look at global disruptive technologies in areas such as life sciences. Most of local GPs are still chasing healthcare consumer players like generic drugs and hospitals."

SIDEBAR: Regulation - Doors opening

Medical devices

The Innovative Medical Devices Special Licensing Procedure, introduced in February, is a fast-track approval process that allows manufacturers, including those from overseas, to get their products to market in double-quick time. Qualification rests on being able to demonstrate that the medical device in question is more innovative than existing models in its category.

Jenny Yao, a partner in KPMG's healthcare consulting practice, says it is part of a wider effort by Beijing to promote locally-made medical devices, with considerable resources devoted to helping companies establish brands and improve quality.

"Not only private equity firms, but also some medical devices companies in China are trying to acquire overseas targets. The trend has emerged over the last couple of years but the market has become especially active this year," she explains.

China's medical devices market was worth an estimated RMB170 billion ($27.7 billion) in 2012, a tenfold increase on the 2001 total.

Hospitals

Another significant policy change came in August when the government announced that it would allow foreign investors to take full ownership of hospitals in seven cities and provinces, including Beijing, Tianjin and Shanghai.

The move has further opened up China's fast-growing private hospital sector, but Yao warns that investors should be aware of the variety of risks and challenges that may await them. Above all, the prospective investor must answer two questions. How is the target company going to attract high-quality doctors? And what can be done to boost patient numbers?

"I have many clients saying this is a hot area with much potential, but the more they know about this sector the more cautious they become. Some of them have even decided not to go in at all because they don't have robust solutions for all the issues," she adds.

On the recruitment side, a lot of professional doctors eschew opportunities with private hospitals because they see a clearer path to promotion in the public healthcare system. Many public hospitals also have ties to universities, and this presents teaching opportunities as well as the possibility of getting government funding for research.

Earlier this year, the government allowed doctors in public hospitals to work part-time in the private sector, but as a result of time management issues, the initiative has yet to catch on.

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• Topics
• Healthcare
• Greater China
• Expansion
• Venture
• Technology
• healthcare
• China
• Growth capital
• M&A
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• OrbiMed
• Aequus
• Technology