Return on Innovation, Part 2: Contract Research Organizations

A Multi-Part Series on Outsourced Pharmaceutical Services

Pharmaceutical companies are increasingly using outsourcing to be more efficient and effective in drug development, help reduce time-to-market and boost the ongoing commercial success of their products. This shift is accelerating M&A across many segments of outsourced pharmaceutical services.

Contract research organizations (CROs) are of particular interest to strategic buyers and investors. In this article, Paul Hepper, a managing director in the Harris Williams Healthcare & Life Sciences Group, discusses investor opportunities within the CRO segment of outsourced pharmaceutical services.

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Key Takeaways:

  • CROs have evolved from being providers of additional research capacity to being integral partners to pharmaceutical manufacturers in the drug discovery and development process.
  • With its power to help pharmaceutical and biotech firms manage costs and drive new drug candidates through the development process, the U.S. CRO market is expected to reach $21.9 billion by 2023.1
  • Five factors set leading CROs apart: customer profile, therapeutic areas of focus, capability across trial phases, geographic reach and growth.

Strategic partnerships, and a mid-market gap

Across the pharmaceutical value chain, outsourced services are gaining traction, from drug discovery, contract research and contract manufacturing to commercialization services, safety and risk management and pharmaceutical IT. (See Return on Innovation, Part 1: Commercialization Services.) For their part, CROs outsource components of the R&D functions of pharmaceutical, biotechnology and medical device companies, particularly pre-clinical and clinical trials. 

From an investor perspective, there is strong interest in those CROs that focus on clinical, or in-human, testing. These CROs generally employ an expertise-driven, project-based consulting model that requires strategy and capability around managing complex trials. Most importantly, while there are some large service providers in this segment, significant consolidation opportunities exist. In comparison, the pre-clinical CRO market is more mature and consolidated.

Over the past five years, many large pharmaceutical and biotechnology manufacturers have moved from working with a set of preferred providers to forming strategic partnerships with only one or two CROs, says Hepper. “Around 70% of biopharmaceutical companies now use five or fewer clinical CRO vendors,” he says. “These tend to be ‘sticky’ relationships, with contract terms ranging from three to five years. This provides CROs the benefit of greater revenue visibility and margin protection.” 

To win such strategic partnerships, larger CROs are expanding their offerings to include regulatory affairs, medical communication and writing, pharmacovigilance, post-approval services, health economic outcomes research and other capabilities. Some have achieved this goal through M&A, adding service lines as well as greater geographic coverage.

Hepper points out that the move to strategic partnerships between large manufacturers and larger CROs has created a gap in the market: Some small and midsize pharmaceutical companies are being underserved.

“That bifurcation in the segment creates a growth opportunity for smaller and midsized CROs focused on small and midsized pharmaceutical and biotech companies,” says Hepper. “As private equity investors go after these opportunities, we expect to see more midsized platforms emerge.” 

Strong tailwinds driving CRO growth

CROs address a critical and increasingly prevalent set of business challenges: the loss of blockbuster revenue streams, rising drug development costs, increasing complexity and pressure on pharmaceutical pricing. Exacerbating those challenges is the well-known “patent cliff.” From 2016 to 2018, approximately $110 billion of branded drugs came off patent protection.2

Another dynamic is increasing specialization. With many large therapeutic areas—cholesterol treatment, for example—largely addressed, manufacturers have to find more specialized therapeutic frontiers. In fact, the specialty share of net spending on drugs nearly doubled from 2011 to 2017 (Figure 1).  

Figure 1: Soaring Spending on Specialty Drugs

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Source: IQVIA Institute

How does this create growth opportunities for CROs? Specialty drugs require highly tailored clinical trials and specific scientific expertise, which increase costs. A major cost factor is that patient populations are smaller and more complex. 

“If you’re targeting a rare genetic disease that has a small population diagnosed annually, then you might need 50 clinical trial sites globally to get enough people,” says Hepper. “The complexity of managing 50 sites and the costs associated with that are drastically different than the approach for testing a drug that addresses a common health problem. These more niche trials may also require more tests on patients, which adds to expense.”

The net result, says Hepper, is that the outsourcing of research will be more important than ever to pharmaceutical companies. Hepper adds that the FDA is making regulatory requirements more stringent, which forces pharmaceutical companies to perform more tests, collect more data and meet higher levels of statistical significance – all of which increase drug development costs. 

Despite those more stringent requirements, pharmaceutical companies are experiencing an uptick in new drug approvals. This rise, along with a strong sales forecast, is allowing pharmaceutical companies to allocate more capital to R&D spending. In fact, as shown in Figure 2, global prescription drug sales growth is driving 4% compound annual growth in R&D spending, from $149 billion in 2015 to $188 billion in 2021.3

Figure 2: R&D Costs Continue to Climb

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Source: EvaluatePharma

Leading CROs stand to benefit from these tailwinds—the U.S. CRO market is forecast to reach $21.9 billion by 2023 (Figure 3).4

Figure 3: U.S. CRO Market to Reach $21.9 Billion

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Source: IBISWorld CRO Industry Report

Five factors that set leaders apart

As Hepper explains below, five key factors drive value for CROs: customer profile, therapeutic areas of focus, capability across trial phases, geographic reach and growth.

1. Customer profile

Hepper notes that, as with any business, being too reliant upon one or two large customers increases risk. “Given the size of large pharmaceutical manufacturers and their outsourcing budgets,” he says, “it is common to see CROs with customer concentration issues.”

Conversely, customer diversity – particularly a mix of large, medium and small pharmaceutical manufacturers and biotech firms – enables CROs to take advantage of upticks in each segment and protects against the vulnerability associated with serving just one.

“If the CRO is not focused on large pharmaceutical firms, then showing that it can sell to and service both small and midsize pharmaceutical and biotech companies is important,” says Hepper. “If all clients are biotech, for example, and that funding dries up, the CRO is vulnerable. At the same time, if the CRO is serving small and midsize pharmaceutical companies, and biotech R&D funding is growing, it wants to take advantage of that. So, having the ability to sell to multiple customer types makes the CRO more attractive.”

Being a value-added partner to customers is important too. The broader the CRO’s capabilities, the more likely it can be a one-stop shop for its customers and the larger its market opportunity. Services such as medical writing, FDA consulting, regulatory affairs consulting, commercialization services and, broadly, any type of post-approval services are all opportunities to be a more strategic and value-added partner to customers. (See Return on Innovation, Part 1: Commercialization Services.)

2. Therapeutic areas of focus

Certain therapeutic areas are receiving greater R&D investment or require scientific expertise or specialization, says Hepper. These areas include oncology, infectious diseases, central nervous system (CNS) disorders and cardiovascular health. Hepper calls out oncology as a great example of an area receiving significant R&D investment: “There’s immense complexity, driving the need for very specific expertise in different types of cancer.”

Scientific expertise and demonstrated thought leadership in these areas can meaningfully differentiate CROs. For example, Harris Williams recently advised Evolution Research Group (ERG) on its sale to Linden Capital. According to Hepper, “In that sale, ERG’s expertise in recruiting and retaining the difficult CNS population was very important. As a clinical trial site business, ERG was adding tremendous value to pharmaceutical manufacturers by speeding up the execution of clinical trials.”

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3. Capability across trial phases

Buyers will place a premium on companies with balance across clinical trial phases.

Non-diseased safety trials (phase one) are conducted with small populations of normal, healthy patients. There is less value-add to provide as a CRO, and specializing in this phase provides less differentiation.

In comparison, phases two and three are conducted on diseased populations, and often have stringent requirements that make it difficult to recruit and retain patients in trials. A CRO’s proven ability to access, recruit and retain these difficult patient populations is valuable to customers and can be highly differentiating. In addition, latter-phase trials are longer in duration, and therefore result in more revenue potential and more predictable multi-year revenue for the CRO. A CRO that can manage many phases of the trial has greater opportunity to work with the pharmaceutical company from end to end. 

Hepper is quick to point out that “some CROs focus on early-stage trials, as they lack the global reach and the capabilities to complete a phase three study. There’s nothing wrong with that strategy, but you do have less visibility into future earnings, and have the potential to be disintermediated by a bigger CRO that can run all three phases. Having the capability to do all phases is preferable.”

4. Geographic reach

Clinical trials are increasingly becoming global, placing a premium on CROs that have global capabilities to serve their clients’ needs across geographies. The combination of global populations being served by the drugs (and therefore the need to incorporate different ethnicities into testing), and increasing specialization of drugs, which requires more legwork to secure enough patients for trial, are raising the importance that CROs have broad geographic reach. 

“If a CRO has access to a geographic area that very few others do and a proven ability to recruit patients from that geography, that’s valuable,” says Hepper.  

5. Growth  

Clearly, buyers are interested in looking deeply into growth indicators. Buyers will be focused on customer tenure, retention rates and the ability to gain new customers. Backlog is also a key growth indicator. Can the CRO demonstrate a strong, growing backlog and a history of consistently converting backlog to revenue? 

“Consider a CRO that is doing a few large multi-year phase three trials, versus one that is doing many phase one trials,” explains Hepper. “From an investor’s perspective, the former has more visibility into its growth, but likely has a higher level of customer concentration. The latter has less visibility into future growth, but less risk from customer concentration. A balance between the two is ideal.”

Five Factors in Action

Evolution Research Group (ERG)

evolution-research-group.gifERG includes ten wholly owned and operated clinical research units (CRUs), Thievon-Wright Consulting Group and an established network of affiliated clinical research sites. The company is an industry leader in  the $2.2 billion central nervous system segment. It conducts a wide range of complex trials focusing on therapeutic areas that include:

  • Behavioral (schizophrenia, depression, bipolar disorder)
  • Neurological (Alzheimer’s disease, Parkinson’s disease, pain)
  • Addiction, sleep disorders, and renal/hepatic disorders

ERG attracted strong interest from the market, and ultimately was acquired by Linden Capital Partners. Harris Williams provided advisory services during this transaction.

Buyers were excited by ERG’s leading position and scale in a fragmented market, deep expertise in complex study execution and superior patient recruitment and retention. ERG’s customers span small, midsized and large pharmaceutical companies, and it had a strong track record of executing trials in the attractive central nervous system therapeutic area thanks to strong community relationships and its multi-pronged approach to recruitment. ERG also boasts impressive financial performance and a proven acquisition platform. In fact, it completed and integrated three acquisitions in the twelve months prior to closing, including one during the process.  

Conclusion

As CROs become more integral to successful, efficient and timely pharmaceutical and biotech R&D, the segment is well positioned for growth. Market dynamics signal the opportunity for investors to gain entry into the segment and build platforms that can provide an array of services across a broad spectrum of customers, therapeutic areas and trial phases. CROs that can demonstrate solid growth supported by strong customer metrics, geographic reach or capabilities stand to be highly valued.

1. IBISWorld CRO Industry Report

2. Equity research, EvaluatePharma, and FDA

3. EvaluatePharma

4. IBISWorld CRO Industry Report

Published June 2019