Investment opportunities in life science industry

An estimated US$ 10 billion worth of investments were made by PEs in 2010. Out of this investments of around US$ 500 million was in the life sciences industry. This was a significant jump in comparison to the investments made in 2009, both in terms of value and number of deals. It is expected that this trend will continue in 2011 as investment companies are sitting on a large amount of capital, ear-marked for investment in the Indian economy. Industry experts estimate this idle capital to be in the range of US$ 25 billion to US$ 40 billion. Also, the number of secondary PE deals in India is on a definite rise.

While the ongoing economic turmoil, with fears of a double-dip recession, might make foreign investors cautious and lead to them deferring their investment decisions, we believe that there is a higher probability of capital flows to India increasing as it remains a stable and high-growing economy.

Also, returns from PE deals in India are set to improve going forward as the market fundamentals are strong and domestic entrepreneurs mature. The bottomline remains that, there is no shortage of capital, but there seems to be a shortage of suitably strong investment opportunities, for the traditional deal-sizes and industry segments most preferred by investors over the last five years. For identifying the best available investment opportunities in the life sciences industry, investors need to alter their usual models and adopt a newer perspective.

Key investment trends
Mid-sized deals offering high-growth potential
Private Equity firms traditionally buy a controlling stake in struggling, mature corporations and then try to turn them around. But in emerging economies like India, these firms act more like venture capitalists. These funds are on the look-out for promising companies which they can help grow by injecting capital for expansion providing strategic guidance to the management.

Such deals can have far-reaching consequences for certain life sciences segments in India which are still in the nascent stages, like drug-discovery, stem-cells, informatics etc and lead to the formation of industry segment leaders, in a short span of three to four  years.

Investors on an average are looking to invest US$ 5 to 15 million, for a stake size of around five  to 20 per cent, in a mid-stage company which is already accruing revenues of around US$ five  million. Investors are highly optimistic regarding their investments in the Indian life science industry and expect returns in the range of three to four  times their original investment, within a four years time-frame.

High valuations a deterrent
The strong and active participation of old generation PEs encouraged the entry of new players into the field which has resulted in lot of capital supply and have driven valuations upwards.

Current valuations are very high in certain sectors like pharmaceuticals, due to hype surrounding a few recent deals, mainly acquisitions made by large global companies. For example, in 2010, Abbott paid Piramal around nine  times their annual sales value for their domestic formulations business. Also in the first quarter of FY12, JB Chemicals and Pharmaceuticals sold its Russia-CIS business and prescription products to Dr. Reddy's Laboratories for over US$ 30 million, and the OTC products to Johnson & Johnson's subsidiary, Cilag for US$ 250 million, this was around 70 per cent ofJB Chemical's total market capitalization at the time.

Investors believe that these high valuation expectations are deterring several deals which are in the discussion and pipeline stages. Even MNC companies, who are looking to boost their Indian portfolio and businesses inorganically, are wary of paying such high multiples going forward.

Focus increasing on early-stage funding
The prevailing high valuations for mid and late-stage companies are leading to increasing interest for start-ups and early-stage companies.

In the last few years, availability of seed capital for start-ups has improved significantly with the setting up of various Angel Investor networks. Even growth-stage funding is easily available through PE players and from established life sciences players who are looking to enhance their existing products and portfolio through novel technologies. But one area where funding availability has been highly constrained is for early-stage companies.

This trend is set to change, as investors in India are finding it difficult to identify good suitable mid-stage opportunities as several entrepreneurs have to shut-down due to lack of early stage capital. Established PE/VC Investors now prefer entering at an earlier stage, to have a better chance of developing a promising start-up and to be in position for raising subsequent second and third rounds of funding and gaining a meaningful stake in these companies. For example, Sequoia made eight  early stage investments over the last 18 months, and they are planning to make 15 new investments by the end of 2012.

However, this trend is very sector and company-specific and according to some investors mid-stage deals might still be the preferred option for certain segments of life sciences industry, like drug-discovery and innovator companies, as there is a very high degree of risk associated with these activities.

Differentiated investment models
The private equity landscape is seeing a high degree of churning in the last one year, with PE players selling their stakes to each other and entering and exiting companies in shorter time-frames than usual. This primarily is because of indifferent and low returns from certain investments. Investors are now trying to experiment with differentiated models and are trying to expand their scope to cover the range from high-return investments (returns of 100 per cent and over) to mode rate-return investments (returns of around 25 per cent). Investment amounts also range across the spectrum from an average of US$ 50 million to US$ one miIlion. One established investment company has even setup a dedicated mezzanine fund to do quasi-equity structures targeting returns of around 20 per cent, so as to be able to utilize various capital structures and deal sizes, to target opportunities at all deal sizes.

Investors now look to actively help their companies in terms of strategic focus and in facilitating various deals and expansion plans. For this, they are increasing their focus on evaluating business models with the intention of identifying areas where they can add value to a investee company's growth plan and by establishing a connect with the management in terms of common vision and goals.

Non-lPO backed exits on the  rise
Investors are increasingly realizing that they can no longer be dependent on markets to establish a high value for their companies. Further, with the economic upheavals since 2008, it has become difficult to release IPOs successfully and often there are long delays and even termination of the IPO listing.

This has led to the rise of secondary deals between PE investors as a means of profitably exiting their investments. The Indian PE secondary market is evolving at a fast pace, but  still has a long way to go. Till recently there were limited PE deals in India and even rarer were secondary equity deals. Now investment funds which are focusing only on secondary deals have started establishing their base in the country. Another form of exit increasingly being adopted is selling the investor's stake or the entire company to players in the same industry.

Credit outlook for Indian life sciences industry
Around 300 life sciences companies have their credit facilities rated by RBI recognized agencies, CARE, ICRA, Fitch and Crisil. Of these, only four  (i.e. one per cent) have the highest rating of AAA, but around 175 more (59 per cent) have good credit -worthiness and are fundamentally sound.

Credit outlook for most of the mid and large size pharma companies have remained stable in the last few years. However, business risks have increased significantly due to the companies' rapid global expansions for capitalizing on the large generics opportunity in the regulated and semi-regulated markets. The credit risk profiles of domestic players have been supported by the strong profile of their global partners and parents, which in many instances are Big Pharma companies looking to increase their presence in India. Indian pharmaceutical companies have undertaken several strategies to mitigate their risk along with global collaborations, like increasing focus on contract manufacturing, strengthening risk management policies, curbing R&D to avoid drain on resources, avoiding costly litigations, etc.