The Active Pharmaceutical Ingredient (API) sub-segment is at the core of the pharmaceutical industry in India. Most of the large pharmaceutical firms in India started at some time or the other as API manufacturing units, building their expertise in the underlying chemistry and integrated forward into formulations over a period of time. India's global leadership position as a manufacturer of low cost medicines comes, in a large part, from our strength built over the last 30 years in manufacturing high quality APIs in a cost effective way.

With several blockbuster drugs going off patent in the next five to seven years, the future holds a lot of potential for this industry and several companies are likely to witness strong growth. This growth will have its own funding needs and require entrepreneurs to make critical balance sheet decisions. The scope of this article is to discuss the changing landscape of these funding options and, in specific, look at private equity funds as a fast emerging option of preference.  

Ten years ago the API industry was focused mainly on serving the domestic market or less regulated markets, a product portfolio which comprised of low complexity products and limited competition from China. The end-markets also exhibited relative stability in terms of pricing and product life cycle which resulted in stable and predictable cash flows making the risk-return profile amenable to financing by debt. Consequently, most entrepreneurs funded 95 per cent of their growth through debt finance of various types.

Over the last decade this risk-return profile has changed dramatically. The industry has witnessed significant competition from Chinese peers in the simpler molecules which has eroded profitability for many in those products, the opportunity has shifted from the domestic to developed markets of US & EU where regulatory requirements are more stringent and require higher capital investment. It is imperative today for an API company to be a scale player to remain market relevant i.e. offer complete basket of products in a therapy area as well as operate at large volumes to enjoy economies of scale and drive cost curve in the face of severe margin pressure. This entails investment not only in physical infrastructure but also investment in knowledge infrastructure like a strong R&D and regulatory affairs function. The capital needs are further compounded by longer working capital cycles in some of these developed markets. With increasing generic competition product life cycles have shrunk. The risks inherent in the business have increased and so has the likelihood of return with windfall gains for companies who establish themselves as preferred sources of API in a product category. It is undoubtedly a higher risk-return business today.

In terms of external equity participation entrepreneurs, could, in the past go, for public equity markets but were limited in their ability to access this source of funds meaningfully as it would be difficult to attract investors to a smaller company or impress upon them the full potential of their business given that this is not an easy industry for a general investor to understand. It also created unwanted stress on the business system by focusing more on meeting short -term quarterly targets by under-allocating capital towards investments, expenses needed for the long term success of the business. Private Equity (PE) funds are emerging as an increasingly preferred choice for entrepreneurs in this context as these funds do not have the above mentioned limitations.

PE funds by design are aligned towards building businesses that are successful in the long term. They typically have a long term horizon of five to seven years and look at return potential of the business over that time frame. Their investment approach involves spending significant time with entrepreneurs understanding the finer aspects of their business, distilling key value drivers as well as growth constraints so that the entrepreneur at the end of the process not only has access to source of funds but also a partner, co-owner in the business who can help in realizing their vision while improving the risk return profile.

PE funds assist in this by helping plug gaps in the management team if required, by introductions to relevant stakeholders in their global networks, by highlighting key changes in the overall macro-economic environment, sharing trends in industry structure and migration of profitability based on their investment insight and a whole host of factors which puts the business on a very strong footing. The cost of raising PE capital is also lower than accessing public markets for most mid-size companies and it is easier to meet future capital needs by follow on funding from the same PE investor. Given these strong pull factors, an increasing number of progressive minded entrepreneurs and family businesses in API are today looking at partnering with PE funds as they embark on their next cycle of growth. PE funds are a recent phenomenon on the evolving landscape for funding API firms but given the strong fitment with the changing risk return profile of the API business they will be a permanent feature as the sector realizes its potential in the years to come.

The author is Head of Investments-Pharma and Healthcare, Baring Private Equity Partners India