Demerger or the spin-offs of research and development (R&D) unit has become a new trend in the Indian pharmaceutical industry.
Post 2005 era, Indian pharmaceutical companies are concentrating on drug discovery activities. The entire process of drug discovery, starting from target identification to marketing, can cost anywhere between $ 500 million to a billion (depending on the drug's use and therapy area) and extend from 10 to 15 years or more.
Also, there is a high probability of failure. Out of thousands of molecules screened in discovery process, only one finally succeeds in entering the marketing phase. With years of expensive research, the success ratio is still small.
In addition to investments, R&D also puts forth requirements in terms of infrastructure. About one to two million is required for lab equipment alone in early part of drug discovery for scale up. However, the scale up process may cost about 20 to 40 million.
These issues make it particularly difficult for pharma companies to drive the entire process of drug discovery all the way to the stage of marketing.
Despite such high risks, we see several companies investing in research as the gains from possible blockbuster are colossal. Investing in R&D also gives an edge over others, in this highly competitive market.
Since the drug discovery process is essential (yet heavy-duty financial activity), several companies are experimenting with various R&D collaboration frameworks like in-licensing and out-licensing. Big pharma is now looking at commercialising R&D earlier in the cycle.
One such attempt towards mitigating the risk involved in drug discovery is by spinning off the R&D unit into an individual entity.
Demerger advantage
Quite a few companies are carving out their R&D entities into a completely focused and a separate company. The new company does not rely on the parent company's balance sheet but incubates the new chemical entities (NCEs) and associated R&D expenditure. This allows the spinout to focus on developing its own technology and business independent of the parent's strategic constraints.
Spinning off non-core assets allows the core company to better focus on their continuing activities. Any savings on R&D expenses previously invested in the spinout can be redirected toward retained R&D efforts. A spin off can also mitigate the technical and commercial risk exposure of the parent company by isolating high-risk activities within the new entity.
In addition, spin-offs also give an edge for companies to procure strategic investments and collaborations without having to struggle for attention from the parent company. New entity can now reap the benefit of a dedicated venture capitalist or a private financier, who may want to finance only R&D activity and may not be interested in the whole basket of pharma activities being carried out by the parent company.
Any product or alliance revenue generated by the new entity will now go directly to the spin off for it to use as it sees fit. Since spin-off discoveries often transforming and generate intellectual property in areas outside the parent company's core interests, a spin off may be better positioned to work with the best partners to expand its licensing business and to leverage new business in ways that might not have been possible as a neglected business unit of the parent.
Recent spinouts in India
DRL: This phenomenon of separating R&D activity was triggered off by Dr Reddy's Laboratories (DRL), which formed an integrated drug development company called Perlecan Pharma Pvt. Ltd. in May 2005, with a 14.3 per cent stake and managed by an independent board.
This specialised R&D venture has an equity capital commitment of $52.5 million from Citigroup Ventures, ICICI Ventures and DRL. In addition, Perlecan Pharma will issue the company warrants to purchase 95,000,000 equity shares of Perlecan Pharma, the exercise of which will be contingent upon the success of certain research and development milestones. If the warrants are fully exercised, then the company will own approximately 76.9 per cent of the equity shares of Perlecan Pharma.
The new entity has four of DRL's NCE assets in its kitty. Perlecan will also have the first right of refusal on future NCE pipeline products of DRL at a fair market value.
Sun Pharma: Sun Pharma de-merged its R&D business as a separate entity in last February. It formed Sun Pharma Advanced Research Company (SPARC) in a bid to de-risk its business and strike innovative alliances to support its research and litigation spends.
De-risking the company's R&D efforts was another important motive behind the demerger. The newly-formed entity was listed on the Indian stock exchange last month.
NPIL: NPIL too has followed the footprints of its domestic rivals and hived off its R&D unit into a separate entity under the leadership of Somesh Sharma, Chief Scientific officer of NPIL.
Drug discovery and development of New Chemical Entities (NCE) and herbal products would be a separate company with a product pipeline of 13 molecules. Of these, 4 drugs are in clinical trial stage. Research supporting NPIL's custom manufacturing business and generic formulations business, would remain with NPIL.
NPIL will hold 18 per cent in the research company, promoters 41 per cent and the rest will be public. NPIL will initially invest Rs 4.55 crore in the new company and transfer the novel drug research business assets worth Rs 185 crore at book-value (including cash of Rs 95 crore) to the new firm. The new research company is expected to get listed on the bourses by June 2008.
Spin off of the unit could help Piramal Healthcare reduce risks related to drug development costs and unburden the core company from R&D costs - thus giving a positive boost to the earnings per share (EPS). Currently the firm devotes around 5 per cent of its total revenue - which was $600 million (€439m) last year - in R&D, and over half of this is spent on the NCE research unit.
Spin off will allow direct participation by strategic and financial investors. Spin off will also give shareholders an exit option from the riskier R&D business.
Ranbaxy: Ranbaxy Laboratories could be the next one on the list of large Indian pharma companies to opt for a similar strategy. Ranbaxy Laboratories may dilute 60 per cent stake in new research company, which will be formed by hiving off its R&D unit into a separate entity in 2008.
Disadvantages of de-merger
In return for all potential benefits, the new entity may have to let go of its established brand equity associated with the parent company. It may call for giving up a substantial 'safety net' previously afforded to them by the parent company.
The new entity formed out of spin off could also lose access to key infrastructure such as a broad base of scientific colleagues, complementary technologies, future core technology improvements made by the parent, product development capabilities, manufacturing capacity and distribution channels or market access.
The spin off may start off as a research unit with little internal manufacturing capability or development expertise. However, to fill these gaps the new entity may require to maintain an ongoing relationship with the parent, cultivate new partners to fulfil its immediate infrastructure and capability needs, or use its own funds to build development and commercialisation capabilities as it goes forward.
Finally, if the new entity is the latest child of a long pedigree of successful spinouts, then it may have to deal with a 'legacy challenge' of either resting on its predecessor's historical laurels or garnering valuation expectations which it cannot fulfil.
(The author is associate director of pharmaceuticals & life sciences with Pricewaterhouse Coopers)