Portfolio: CDH Investments & China Grand Pharma

Stories of this kind are rooted in the demonstration of value creation. They lend themselves to buyouts where the private equity investor has free rein to replace management and implement its own agenda.

China Grand Pharmaceutical & Healthcare Holdings does not conform to type. It is Hong Kong-listed and CDH Investments holds a 10% stake. Yet the private equity firm might claim to have played a decisive role in the company's development as collaborator in a string of bolt-on acquisitions that have redefined China Grand. The more than 300% increase in China Grand's share price since CDH's investment goes some way to quantifying the value created.

"We see many promising start-ups, but sometimes they don't fit our investment strategy – ticket sizes generally have to be above $50 million – or our risk appetite," says Minfeng Wu, a managing director at CDH. "When a portfolio company is making investments, there is a completely different mindset. For us, it's an equity investment. For them, it might be seen as an R&D expense that brings in new talent or product development synergies."

Revolmmune Therapeutics, a Shanghai-based start-up that specializes in oncolytic viruses used to kill cancer cells, is a case in point. CDH introduced the investment opportunity to China Grand, which paid RMB30 million ($4.7 million) for a 9.7% stake last year. As part of the deal, the portfolio company secured exclusive global development and commercialization rights to one of Revolmmune's pipeline drugs and preemptive rights to cooperate on other products.

The payoff for CDH is indirect and potentially long-dated. It benefits if China Grand benefits and may find other investment opportunities based on the knowledge and networks accrued via association with Revolmmune. "Some private equity investors only look at listed companies as an exit channel, but CDH invests with us and introduces attractive targets to us," says Frank Zhou, executive deputy officer – and soon-to-be CEO – of China Grand. "We have deep trust in each other."

Tough beginnings

Over the course of a relationship that began seven years ago, China Grand has evolved from a pure-play drug ingredients maker into a pharmaceutical preparations business and then into global healthcare company with a portfolio encompassing medical devices and innovative drugs. Its market capitalization has risen from HK$3 billion ($386 million) to HK$23 billion, while revenue has more than doubled to HK$6.4 billion and net profit has increased tenfold to HK$1.78 billion.

But the story had a rocky start. In 2014, CDH invested about $40 million at a valuation of HK$2.6 billion (and put in another $20 million two years later). Around the time of the initial commitment, it introduced China Grand to Beijing Jiuhe Pharmaceutical, manufacturer of oral cough medicine Qie Nuo. The company also produced all the active pharmaceutical ingredients (APIs) that went into the medicine, so it had the equivalent of an exclusive product with no patent term.

CDH and China Grand eventually talked Jiuhe into an acquisition, only for an obstacle to emerge. Jiuhe was involved in a patent dispute with its main competitor, a major global pharmaceutical company. China Grand's mainland parent, China Grand Enterprises, was reluctant to proceed with the deal, but CDH held firm. Given Jiuhe's R&D was led by the Chinese Academy of Sciences and had won national-level awards, it reasoned that the competitor was unlikely to prevail in a legal action.

The private equity firm took the lead and became Jiuhe's controlling shareholder. Several months later, once integration was completed, its shares were transferred to China Grand. The transaction was structured as a bridge loan, so China Grand only paid interest on the loan, making it a very low-cost arrangement.

The competitor's patent challenge was thrown out and Qie Nuo became a dominant force in the China market. Sales grew from about RMB100 million to RMB794.6 million in 2020. Qie Nuo is now the biggest seller in the entire respiratory treatments category in China and the single largest revenue contributor to China Grand.

"The Jiuhe deal was the first time we cooperated with China Grand and through this transaction, our teams built a deep understanding. It laid solid foundations for future cooperation," says Wu.

Since then, CDH has involved in all China Grand's M&A activities in one way or another. The diversification drive has relegated drug ingredients, previously the company's core business, from 60% of revenue to 12.1% in 2020. Biotech and healthcare products accounted for 23.7% with the remaining 64.2% coming from pharmaceutical preparations and medical devices.

Drama down under

The acquisition of Australia-based Sirtex Medical in 2018 was vital to the development of the innovative therapies business. China Grand had been exploring the area – including treatments for cardiovascular and cerebrovascular diseases – and high-end medical equipment for three years. The objective was to fill the oncology-shaped gap in its product portfolio.

"We want to be a platform company like Johnson & Johnson. Following discussions with CDH, we decided this wouldn't be possible without proper oncology coverage," Zhou explains.

Most of the major areas of immunotherapy, such as immune checkpoint inhibitors, were already crowded. Sirtex offered something different. The company manufactured devices for selective internal radiation therapy, a minimally invasive surgical technique that it claimed could double the rate of liver tumor shrinkage and cancer remission. Moreover, the technology had high barriers to entry and there were few meaningful competitors.

CDH's intervention was dramatic. Four days before Sirtex shareholders were due to vote on an acquisition by US-listed Varian Medical Systems, the private equity firm stepped in with a A$1.87 billion ($1.4 billion) buyout offer, representing a 78% premium to the last close before Varian's interest became known and a 20% premium to Varian's bid. Sirtex's board switched allegiances.

CDH and China Grand made equity commitments of A$493.1 million and A$473.7 million, respectively, while Bank of China provided A$933.3 million in debt funding. The deal was put together in two months. CDH became the controlling shareholder – with 51% to China Grand's 49% - because it had received US security review approvals on previous deals. The Committee on Foreign Investment in the US (CFIUS) signed off on the transaction in March 2019.

"We have different cooperation methods for different projects. For all late-stage buyout deals, our funds are more likely to participate directly as the controlling investor," says Wu.

Sirtex was not only revelatory for China Grand in terms of what it could achieve through M&A. It gave confidence to other listed healthcare companies, not least those under the China Grand Enterprises banner. Later the same year, Shenzhen-listed Huadong Medicine bought Sinclair Pharma, a UK-based medical aesthetics specialist, for RMB1.49 billion.

Run the gauntlet

In retrospect, Wu feels CDH was fortunate to act when it did. Should a similar acquisition be pursued today it might not be successful, he contends, because of geopolitical tensions between China and the US as well as COVID-19-related uncertainty. Zhou adds that competition for assets has heated up. Any viable overseas target is likely to attract two or three Chinese bidders, pushing up the price. The stream of Hong Kong IPOs by pre-revenue biotech players has also created a valuation bubble.

"Some investors just want to buy a foreign company and bring it back to list in Hong Kong," he explains. "They are not thinking about when products will be launched or commercialized. They are thinking about how to increase the stock price after the IPO. Their thinking is completely different to ours and the prices they quoted might be highly irrational."

For Sirtex, the biggest benefit has been China market access. China leads the world by number of liver cancer patients; it is home to more than half the global patient population of advanced liver cancer sufferers, and liver cancer ranks in the top three by number of deaths of all cancers in China.

However, prior to the acquisition, the US accounted for 70% of demand for Sirtex products. The company had tried to enter China but failed, largely due to a quirk in regulation. While Sirtex's radiation therapy technology is classified as a medical device in most foreign countries, it falls under the drug category in China.

After closing the deal, China Grand submitted a new drug application (NDA) to domestic regulators and the technology is likely to be exempted from clinical trials in China because there is sufficient overseas data. Zhou expects it to start generating sales revenue next year. China Grand has suggested that China revenue could reach RMB5 billion by 2026, nearly three times Sirtex's current global revenue. China would represent 70% of sales.

"The greatest value for Sirtex is in China. Its period of explosive growth in overseas markets has passed, but we don't want to move too quickly," says Zhou. "We will take our time examining the market and the impact of pricing and inclusion in the medical insurance coverage list."

Sirtex's freedom to exercise patience is a byproduct of privatization. Wu argues that too many companies listed overseas are preoccupied with short-term stock performance and lose focus on long-term goals like R&D. "If Sirtex were listed today, it might be facing post-pandemic layoffs," he suggests. "But we still support the management to invest in next-generation projects."

China Grand dismissed the company's incumbent CEO because he focused on cost-cutting and didn't discuss the strategy with shareholders. A five-person transitional management committee was organized to make collective decisions, comprising the sales director for North America and the heads of human resources, finance, legal affairs, and production. The sales director was subsequently promoted to CEO.

Quality counts

The leadership solution is representative of how China Grand addresses post-deal integration with offshore assets, relying heavily on local management talent and giving them a reasonable amount of autonomy. For domestic acquisitions, three key roles – general manager or chairman, financial director or CFO, and human resources head – are assigned to existing China Grand executives.

"When we go into the acquisition process, we think about the future operation plan and integration matters in advance," says Zhou. "The future general manager appointed to the acquired company participates in the entire process. In this way, the new management team develops a familiarity with the company in advance and works out the business plan before the deal is completed."

Even though innovative technologies and treatments now feature in China Grand's portfolio, the company has never aspired to be seen as a typical biotech player. Internally, the preferred designation is pharmaceutical industry enterprise, in reference to the strong foundations – from production systems to quality assurance to registration – required to deliver genuine and lasting technological innovation.

According to Zhou, these qualities are not pursued by the new generation of Chinese biotech companies, which rely on third-party service providers to fulfill different functional capabilities. As a result, these capabilities have become undervalued in the market. CDH's Wu endorses this view, simply observing that ingredients are no less important than drugs.

"Let's take India as an example. There was a huge shortage of vaccines because most of the raw materials are controlled by America. When supply chains are loose, medical ingredients are readily available. As soon as there is an extreme supply chain event, they become strategic materials," says Wu.

With interests that span the healthcare industry supply chain, China Grand can be difficult to understand compared to specialists in areas like biotech. The company is considering a restructuring that would see Sirtex and other oncology-related assets spun out through an IPO. The idea is to simplify the corporate structure, while facilitating an exit for CDH.

China Grand would retain its stake, with Sirtex continuing to function as a key subsidiary. There are no plans to spin out any other assets. Zhou points to the increased compliance requirements that come with a public market listing, adding that the costs are prohibitive.

"As a shareholder, normally you cannot interfere much with the operations of an independent listed company. I think this leads to weak management of listed subsidiaries," he says, making the case for continuing centralized control. "We've acquired many companies over the years, and we haven't exited anything, but CDH needs to exit."

There is a logic to the extended supply chain exposure in that it brings diversification and reduces market risk and policy risk. In contrast, a single research failure could have severe ramifications for the future of a biotech company. Regulation becomes an issue when centralized procurement brings down the market price of a product, to the point that it no longer offsets the R&D expenses.

Wu cites heart stents as an example. A combination of abundant supply and high-volume purchasing sent the average sales price plummeting from RMB10,000 to RMB700 last year, completely undermining the investment thesis of anyone active in the space.

"They just changed the valuation model for heart stent companies, reclassifying them as metal processing businesses rather than high-end medical device manufacturers [and the valuation difference between the two is enormous]," says Wu.

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• Topics
• Greater China
• Healthcare
• Australasia
• GPs
• CDH Investments Management
• China