Avoiding Subprime Contractors and Contracts

This summer's crisis in the financial markets is a timely reminder of the costs and disruptive consequences of sloppy due diligence. Biopharmaceutical and pharmaceutical companies as well as contract manufacturing organizations (CMOs) would do well to heed the lessons of the mortgage meltdown.

The root cause of the debacle in the financial markets was the poor due diligence practices of mortgage lenders and of the institutions that invested in mortgage-backed securities. Mortgage brokers and packagers were most concerned with maintaining the high volume of originations, which generated a lot of fees for them. Knowing that the mortgages would be packaged and sold to investors, they had little concern for the ability of borrowers to sustain payments on their loans, and made little effort to check the veracity of income and other credit information that borrowers provided.

Jim Miller

Although the subprime mortgage sector itself is a small part of the overall financial market, its problems had implications across all financial sectors. It made investors appreciate that they had undervalued risk in their rush to chase high returns, and caused them to make terms on higher-risk assets more onerous. It also made them look more closely at the creditworthiness of those assets.

Effect on companies

What can pharmaceutical companies and CMOs learn from this? Our experience has been that both parties to contract manufacturing transactions have been remarkably lax about their due diligence practices. While pharmaceutical companies will send armies of quality assurance staff to audit a CMO's operations, they seldom put much effort into reviewing its financial status. In the 2005 edition of the PharmSource–Pharmaceutical Technology Outsourcing Survey, only 17% of pharmaceutical company respondents said they reviewed their contractor's financial statements at least annually.

Companies need to remember that adverse business developments at their CMO are likely to be more catastrophic than compliance or technical problems. Even when a CMO receives a warning letter from the US Food and Drug Administration, it is usually able to continue shipping product while correcting deficiencies. However, a client may be forced to take drastic measures if its CMO is facing financial distress.

A clear case in point occurred this summer. In July, Inyx (New York, NY), a contract dose manufacturer, had its United Kingdom operations placed in receivership, and its US subsidiary filed for Chapter 11 bankruptcy protection. The actions came after Inyx's principal lender, Westernbank Puerto Rico, declared the three UK subsidiaries in default of their loan covenants and demanded repayment of the $120 million loan outstanding to the company. Inyx had nearly $80 million in revenues, and clients have included Merck Generics (Darmstadt, Germany), NovaDel Pharma (Flemington, NJ), Kos Pharmaceuticals (now owned by Illinois' Abbott Laboratories), Genpharm (Quebec), and UCB (Brussels).

Inyx has been supplying product to UCB, from which it acquired operations in 2005, and Aventis, whose Puerto Rico facility was also acquired by Inyx in 2005.

Proper due diligence could have alerted these companies to Inyx's highly leveraged financial situation, and to its management's association with a previous CMO's business failure. As a public company, its precarious balance sheet was readily available to potential clients. Now, these companies are dealing with a potential interruption of product supply and having to consider a takeover of facilities they had previously sold.

Impact on clients

A CMO faces a different and more complex due diligence problem. It must deal with at least three dimensions:

1. Does the client have the financial means to pay for our services?

2. Will the client's product achieve the projected manufacturing volumes if the product is approved?

3. Does the client have the management and technical expertise and experience to get the product to regulatory approval?

Of the three dimensions, the second—validating the client's volume projections—is probably the most daunting and most crucial. When a CMO signs a contract with a client, it is committing a certain amount of its manufacturing capacity to a client's product beginning at a projected date. The business development team is committing to company management and stockholders that, at a certain point in the future, it will be generating a given amount of revenue.

There is a big opportunity cost associated with that commitment: if the client's product is delayed or does not get approved, the CMO is not likely to be able to use the capacity for another product—revenue and profits will be permanently lost.

Realistically, due diligence on a client's volume projections can be very difficult and, if done properly, expensive. It requires knowledge about the product's pharmacology and about sales of products currently in the market for the given indication.

Market sales data from sources such as IMS or Wolters Kluwer can be very expensive, as is scientific and market knowledge about trends in a given therapeutic class. Even with good information, sales projections are a crapshoot: Major pharma companies with plenty of resources and experience cannot necessarily predict clinical and commercial success with great certainty.

The risk to CMOs when projecting client sales volumes was underscored in September when a prominent research institution reported that rates of success for cancer drugs are only 40% of the success rate for all drugs. According to Tufts Center for Study of Drug Development, only 8% of cancer candidates entering clinical development in the mid-1990s won commercial approval in the United States, compared to 20% of candidates overall. This is critical to CMOs because cancer drugs represent a significant share of all drugs in the pipeline, especially injectable drugs.

Despite the challenges validating client projections, it is worth doing because the stakes are high: a commercial manufacturing contract can be worth $10–50 million or more during a five year period.

Yet, CMOs do not seem to be making a big investment in this area: there is a lot of pressure to sign new business, and the current state of the new product pipeline is providing numerous opportunities to close new contracts. Incentives not to do a deal are minimal. CMOs, however, will end up paying the bill for failing to carry out adequate due diligence in 3–5 years when projected sales fail to materialize.

Jim Miller is president of PharmSource Information Services, Inc., and publisher of Bio/Pharmaceutical Outsourcing Report, tel. 703.383.4903, fax 703.383.4905, info@pharmsource.comwww.pharmsource.com