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Pharma: Hiving off R&D...

Sep 4, 2007

The introduction of the product patent law in the country has compelled domestic pharma companies to increase their focus on R&D - to counter the likely slowdown of reverse engineered products in the future. Having said that, given that R&D is a high risk, costly and time consuming affair, many domestic pharma companies are adopting a host of strategies to mitigate the risks involved in the same. The most recent trend that has been observed is the hiving off of the new chemical entity (NCE) research into a separate company. In this article, we shall take a look at the rationale for this strategy and how does it benefit the investors going forward. Rationale for the hive off
The entire drug discovery process is time-consuming, expensive and risky. With molecules becoming more complex and approval criteria becoming more stringent, the cost incurred to develop a drug right from its inception to commercial launch has risen sharply to around US$ 1 bn, which is by no means a small sum for domestic pharma companies. Besides this, clinical trials form a larger chunk (around 43%) of the total R&D investment putting a strain on the profitability of the companies.

Hence, in a bid to mitigate the high risks involved in discovery research and at the same time keep the discovery programme intact, domestic pharma companies are looking to hive off the NCE R&D business into a separate company. This also helps the companies focus on their core business, which is relatively less risky and perk up margins going forward.

Companies at the forefront
Dr.Reddy's took the lead in this regard when it formed India's first integrated drug development research company in FY06 - Perlecan Pharma Pvt. Ltd - by roping in Citigroup Venture Capital and ICICI Venture Capital and transferred 4 NCE assets for clinical trials to Perlecan. Dr. Reddy's currently holds 14% stake in Perlecan and will gradually hike it to 62% depending upon the success of certain research and development milestones. Perlecan reimburses Dr.Reddy's for the clinical costs incurred for these 4 NCE assets.

Similarly, Sun Pharma hived off its innovative R&D business into a separate listed company called Sun Pharma Advanced Research Company (SPARC) in a bid to unlock value from its R&D assets and enable the former to concentrate on its core generics business, which has a relatively stable revenue stream. The most recent company to take this route has been Nicholas Piramal, which last week, announced its plans to list its R&D business by forming a separate company in a bid to secure finding for the same in the longer term.

It must be noted that since the molecules are yet to be commercialised, these de-merged R&D companies would report losses in the initial years, as there are no revenues to offset the R&D expenditure. Thus, while in the initial phase, the respective pharma company would infuse capital into the de-merged company, the latter is expected to generate resources either by out-licensing the molecules or roping in strategic investors after a certain time. Another point to be noted is that Dr.Reddy's and Nicholas Piramal, for instance, have continued to retain a stake in the de-merged R&D companies to capitalise on any upside potential from the molecules in the longer term.

What's in it for investors?
While Perlecan Pharma formed by Dr.Reddy's has not been listed on the bourses, both Sun Pharma and Nicholas Piramal have hived off their NCE R&D into separate listed entities. This provides an exit option for the investors if they do not want to invest in this high risk-high reward business. This also provides some semblance of certainty to the overall business of the domestic pharma companies, leads to margin improvement and enables them to deploy the cash generated into growing their respective core businesses.

At the end of the day, considering that Indian companies do not have the resources and the money required to invest in the entire stage of development of the molecules, we remain positive on the partnership strategies followed by these companies, despite the fact that the upside, if any, will have to be shared.

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