Report from: India

Bangalore-based biotech firm Biocon is the new kid on the block with a plan to transfer its research and development (R&D) arm to a new company. Biocon is reportedly transferring all of its molecules under development into a firm that will serve as a wholly owned subsidiary.

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Transferral trends

Biocon joins the list of luminaries such as Mumbai-headquartered Sun Pharma, Wockhardt, and Piramal Healthcare, and Delhi-based Ranbaxy, who have divested their R&D business into new companies to attract strategic investments in the high cost-burden drug development sector.

In India, this trend has been gaining momentum as a strategy to de-risk the core business model, secure funding via the demerged R&D entity, and thereby unlock value for shareholders. With the introduction of the product patent law in 2005, several domestic pharmaceutical companies have been compelled to increase their R&D focus to counter the likely slowdown of reverse-engineered products (Before the patent law was enacted, companies were allowed to copy new medicines to produce generic drugs. Today, the creation of new processes to produce generic versions of drugs is allowed, but companies cannot simply copy the drug product).

However, the huge cost involved to bring a new molecule to market is daunting. The Tufts University Center for the Study of Drug Discovery recently estimated that it costs an average of $900 million to bring a new drug to market. A biotech drug costs even more, $1.2 billion on average, and typically takes 12–15 years to get approved.

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Because Indian pharmaceutical firms do not have this kind of access to funds, many have latched onto the transferral strategy to de-risk their business. R&D firms can then focus on basic research and raise funds through private equity or venture capital, or by way of an independent listing. The interests of shareholders who may be risk-averse are protected, while options are provided to those with a larger-risk appetite.

The numbers game

Indian drug companies typically invest 7–9% of annual revenue in new drug research, well below the international average of 14%. A KPMG study pegs R&D investment by Indian companies at $500 million in 2010 and $1.2 billion by 2015.

Some analysts, however, are watering down the excitement with reservations over the generic-skewed pharma industry's capacity of discovering the next big drug, or new chemical entity (NCE). (The fact that India has still not launched its first NCE has led many industry experts to be skeptical of the trend of transferring R&D units. Companies such as Mumbai-based Glenmark Pharma have divested their generics business instead, and retained the R&D business, expecting better valuations.)

Although there are no clear-cut solutions, Poonam Bhana, an analyst at ValueNotes, a leading provider of business intelligence and research, believes that demerging R&D units is a judicious decision. It gives shareholders of the existing company an option to exit the risky R&D business while unlocking value of the R&D pipeline in the new company and also attracting investors that are prepared for a long wait before revenues flow in.

Others allude to the fact that if India's top 10 pharmaceutical firms transfer their R&D divisions, the collective market capitalization of new research entities is expected to touch $120 billion in less than a decade.

Apoorva Shetwankar, group managing director of Veedra Sciences, a clinical research organization based in Mumbai, says selling off R&D is also being done because companies recognize that "research is a business in itself and should be treated so. It's not a bottomless pit. One has to invest in R&D and only then you can expect results that are measurable in financial terms."

Although Hyderabad-based Dr. Reddy's took the lead in this regard when it formed India's first integrated drug development research company in 2006—Perlecan Pharma, Sun Pharma Advanced Research Company (SPARC) became the first pure research company to be listed on the Indian stock exchange. SPARC was created when Sun Pharma transferred its innovative R&D development undertaking, including new drug delivery systems, to a separate company.

Other firms such as Hyderbad's Aurobindo Pharma, Ahmedabad's Zydus Cadila, and Mumbai's Lupin have either deployed or are thinking of deploying similar de-risking strategies. Analysts maintain that this initiative can help reduce pharmaceutical companies' R&D costs and improve the margins of their standalone business by as much as 3–4%.

They also argue that the move may fetch greater returns in the long run. "Once [the transferred companies] start developing innovative products, the management may choose to unlock the value of these separated entities. The [combined] market value of these companies will be higher than the book value in the years to come and consequently, the parent companies can make money by diluting stake to strategic investors like private equity firms and venture capitalists. They can easily recoup the initial investments for the new R&D ventures," says Sadashiv Gopalan, senior pharma analyst at a foreign institutional brokerage house in Mumbai.

Kiran Mazumdar Shaw, chairman and managing director of Biocon, ruled out the possibility of raising funds by diluting a stake in the new arm. "The motive behind the hive-off strategy is to minimize the increasing tax burden to the company caused by our R&D activities," she said. The new arm is to be set up this year.

In 2007, Biocon sold its enzyme business to Danish firm Novozymes for $115 million. The company has various molecules under development, including a molecule for Type II diabetes, rheumatoid arthritis, psoriasis, and non-small cell lung cancer. Taking these drugs to Phase III trials would be an expensive proposition.

There could be some dropouts too. Perlecan Pharma, the integrated drug-development company set up by Dr. Reddy's Laboratories in September 2005, has dropped a second blockbuster candidate from its drug-development portfolio. "Two new chemical entities have been dropped and work on two more is going through some processes," G.V. Prasad, CEO and vice-chairman of Dr. Reddy's, said. Work on a cardiovascular drug has been discontinued, as has a molecule to treat diabetes and obesity.

For some firms, separation angst appears to have worked. Kotak Private Equity Group, part of the financial services firm Kotak Mahindra, and MPM Capital, the US-based global investment management firm focused solely on healthcare investing, are reportedly in talks with Piramal Healthcare to acquire a minority stake in its recently sold R&D arm, Piramal Life Sciences.

Kotak and MPM are eyeing a 10% stake in the R&D arm. Financial research firms have valued Piramal Life Sciences between $480 million and $540 million. Piramal's R&D arm has 14 compounds in its research pipeline in various areas such as cancer, diabetes, inflammation, and infectious diseases. Global investor groups such as Carlyle and Blackstone are also said to be interested in claiming a stake.

Firms such as Wockhardt and Panacea Biotec, however, are not even open to the transferral option. Says Wockhardt Chairman Habil Khorakiwala, "Our board of directors has never considered this option." Adds joint managing director of Panacea Biotec, Rajesh Jain, "Our core strength is R&D and the products the company innovates would help growth."

A. Nair is a freelance writer based in Mumbai, India.