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What the current lack of venture capital means for the CRO market.
Venture capital is the lifeblood of early-stage biopharmaceutical companies. Start-ups and companies with promising preclinical drug candidates rely on venture funding to get them to proof-of-concept—that point, usually after completing a successful Phase 2A clinical study, where companies can expect to get a big licensing deal or be acquired outright by a major biopharmaceutical company.
In the wake of the current global financial crisis, venture capital has become increasingly hard to come by, however, and the situation could get worse in 2009. The problem has been especially difficult for biopharmaceutical companies looking for new investors: venture capitalists (VCs) are holding on to their cash to make sure their current portfolio companies have adequate funding to advance their most promising compounds. Further, the VCs are reluctant to allow new investors into their current portfolio companies because at the low prices at which early-stage companies are being valued these days, their current equity positions would be diluted too much.
Still, the biopharmaceutical industry could fare better than some other sectors in 2009, according to the National Venture Capital Association (NVCA). In a survey of its members conducted in late November and early December of 2008, the NVCA found that 92% of VCs expect total venture investment to decrease in 2009 versus 2008. However, 58% of VCs expect investment in biotech to either grow or remain stable next year, while 42% expect it to decrease.
VCs will face problems raising funds and liquidating investments, according to the NVCA survey. Most expect institutional investors to reduce their commitments to venture capital in the coming year, and there is concern that some limited partners will not be able to meet current commitments. An overwhelming majority of respondents (72%) expect the IPO market to remain closed in 2009 and 87% expect transaction values to decline. Most expect returns on VC investing to decline over the next 10 years.
Because early-stage companies are dependent on contract research organizations (CROs) for most of their development activity, and because they typically take compounds only through proof-of-concept, the venture capital downturn will hurt service providers that focus on preclinical and Phase 1 services, including toxicology testing, process development, and small-scale manufacturing. This is especially true for the many small- and mid-size CROs whose customer base is comprised primarily of the venture-backed companies. Even market leaders in early development are feeling the pinch. In late December, Covance reported that its fourth quarter 2008 toxicology and clinical pharmacology revenues were down from what was expected.
Covance blames two developments for its disappointing outlook. One is a slowdown in new projects coming from smaller biopharmaceutical companies. Projects from smaller biopharmaceutical companies are usually one-off engagements, and they depend on the flow of new projects to replace completed projects. With funding down, those replacement projects aren't forthcoming. Those engagements only account for 10–20% of Covance's volume, but the slowdown is enough to hurt the company's overall performance.
The bigger concern for Covance are the project delays coming from what the company termed "strategic clients," i.e., the major biopharmaceutical companies, some of which have dedicated space contracts with Covance. Although the company expects many of the delayed projects to proceed in 2009, it does not expect its dedicated space clients to exceed their contract minimums in 2009 as they have in past years.
Despite the near-term uncertainty, large CROs and contract manufacturing organizations (CMOs) like Covance and Lonza are well positioned in the long-term. That's because their core customers are increasing the share of their development activity that is outsourced. In 2008, for example, Eli Lilly and Company effectively outsourced all of its toxicology testing to Covance while Novartis outsourced much of its biopharmaceutical process development and clinical manufacturing to Lonza under long-term contracts.
Most major pharmaceutical companies have established global sourcing units that are pursuing strategies to reduce outsourcing costs by standardizing processes and reducing the number of vendors that must be qualified, audited, and managed. These programs started five years ago and resulted in companies reducing the number of CROs they work with by as much as 80%. The major CROs and CMOs are well-positioned to be selected as preferred providers thanks to their large-scale, abundant capacity, and financial strength.
Things don't look so good for the small- and mid-size CROs and CMOs, however. With the major biopharmaceutical companies consolidating their vendor base and the early-stage companies having trouble raising cash, the small service providers are facing a rapidly shrinking market. Many entered the market only recently, attracted by the growing pipeline and ample funding for early-stage companies. They have minimal business development and marketing experience, haven't created brand equity and long-term relationships with better-funded companies, and are not well-capitalized. We expect a number of them to disappear in the downturn.
What is normal in the foreseeable future is likely to be very different from what was normal in the recent past. The global financial crisis has changed investors' perception of risk and undermined their confidence that they can manage it. Major institutional investors are indicating that they plan to reduce their allocation venture capital in coming years. VCs will have a tougher time getting an attractive return on their investments so long as IPOs remain scarce and valuations are low.
The new normal will consist of somewhat fewer opportunities than the industry has been used to, but it will lead to a smaller but healthier and more capable CRO and CMO industry.
Jim Miller is president of PharmSource Information Services, Inc. , Springfield, VA, 703.383.4903, firstname.lastname@example.org