Suggested callout sentence:  While the contract research industry has become increasingly attractive to private equity investors seeking growth opportunities and stable cash flow, investors and acquirers should not lose sight of the importance of conducting effective due diligence with regard to potential or planned transactions.

With an increasing focus on managing costs and shortening time to market, many pharmaceutical companies now outsource their clinical trials to contract research organizations (CROs).  CROs are hired by drug developers and medical-device makers to provide research services such as overseeing preclinical and clinical testing.  The CRO industry has experienced double-digit annual growth in recent years and is increasingly relied on to perform clinical trials in countries with more diverse populations and less stringent regulations, including China and India, and nations throughout Central America.  Such dramatic growth and consistent cash flows have recently drawn private equity investors to this niche industry.

Background

The growth of CROs has arisen, in many ways, out of necessity.  Globally, the number of clinical trials is on pace to reach nearly 150,000 each year.  The sheer volume of trials makes it prohibitive for pharmaceutical and medical-device companies to perform these trials exclusively in house.  Furthermore, stagnant research and development budgets have led pharmaceutical companies to cut costs wherever possible. 

In response to these realities, many CROs developed niche practices to focus on specific types or stages of drug development.  This specialization enables clinical trials to be performed at a lower cost and over a shorter duration because CROs can leverage their preexisting client base and accumulated knowledge to deliver superior value and quality. 

While the growth of CROs has been significant, it has not come without growing pains.  Many firms have shifted to a full-service model that enables them to play a part in each step of the drug-approval process.  This shift has been accompanied by increasing consolidation of larger-market participants—in the most recent (2010) data, the six largest publicly held CROs made up 41 percent of the market.  Furthermore, this market concentration is forecast to increase due in part to big pharmaceutical companies wanting a single provider for all their CRO needs. 

However, the trend does not signal the death knell for niche players, since they still offer value for smaller start-up companies.  In addition, the overall market structure will likely experience upheaval in the coming years as larger CROs gain more market share.

Recent Deals

Quintiles

Quintiles has played an important part in the development of the 50 most-successful drugs on the market.  It is the largest CRO, with annual revenues in excess of $3.7 billion.  The company has shifted from privately to publicly held on two occasions and, in May 2013, was brought to market again in a $947.9 million initial public offering (IPO) that far exceeded market expectations. 

Quintiles illustrates the growing influence of private equity firms in the CRO marketplace.  The reason CROs have become a popular point of entry into the life sciences industry is that they generally boast consistent cash flows and are not subject to the boom or bust realities that accompany pharmaceutical drug producers seeking FDA approval.  This enables private equity funds to structure leveraged buyouts with significant debt loads and benefit from future appreciation of the underlying asset as well as dividend recapitalizations.

TPG Capital and Bain Capital LLC, two private equity funds that led a $3.8 billion buyout of Quintiles in 2008 from One Equity, have implemented the strategy.  From 2009 to 2012, they received almost half of the proceeds of the roughly $1.5 billion in dividends that were paid.  Each of the funds profited handsomely from the recent IPO of Quintiles, reducing each of their individual stakes to 18.6 percent, but taking over half of the $269.4 million in proceeds allocated to the private equity investors.  The IPO proceeds will be used to extinguish existing credit facilities and to take advantage of strategic growth opportunities in the form of specialized businesses that offer the potential to deepen their scientific, therapeutic and technical expertise.

PPD

Another market leader, PPD, was acquired in mid-2011 for $3.9 billion in cash in a leveraged buyout led by private equity giants The Carlyle Group and Hellman & Friedman.  The buyout represented a nearly 30 percent premium over the stock price at the time of announcement and involved one of the five-largest CROs globally.  The acquisition resulted in the previously publicly held company being taken private and in the appointment of a new CEO. 

While the acquirers have been understandably tight-lipped regarding their future intentions for the firm, the company seems an ideal candidate for an IPO or sale down the road if capital markets are receptive.  Tight lending standards at the time of the buyout resulted in a decreased selling price due to a lack of other viable bidders, a fact that may allow Carlyle and Hellman to turn over the asset at a favorable price in a short investment period.

Medpace, Inc.

Consolidation and strategic relationships are key drivers of growth in the small to mid-size segments of the CRO marketplace.  In November 2012, Medpace, Inc., a privately held CRO based in Cincinnati, Ohio, and with offices across the globe, acquired MediTech Strategic Consultants B.V., a European CRO that focuses on medical device clinical trials.  The deal expanded the influence and scale of Medpace in the growing European CRO marketplace without subjecting the company to the difficulties of establishing new offices in the target markets. 

The MediTech deal is the most recent in a string of acquisitions of smaller CROs that present strategic fits and synergies for Medpace.  Some of their other recent acquisitions include a late-2009 deal involving a Swiss CRO that focused on oncology drugs, and an early 2010 deal involving a Germany-based CRO that focused on regulatory consulting and drug safety.  The transactions are an attempt to achieve a level of scale and breadth of service that would allow Medpace to secure CRO contracts with larger pharmaceutical companies that provide more consistent and less piecemeal business than niche pharmaceutical companies.         

PRA International

A $1.3 billion deal involving the acquisition of PRA International by Kohlberg Kravis Roberts & Co. LP (KKR) is set to close in the third quarter of 2013.  The deal illustrates the potentially lucrative investment opportunities presented by CROs.  PRA was purchased by middle-market private equity firm Genstar Capital, LLC, in 2007 for $797 million in a take-private transaction.  After appointing a new CEO and management team, PRA was able to significantly increase revenues and outperform the industry over the past six years. 

The investment strategy implemented by Genstar is becoming increasingly common amongst private equity funds.  Many seek investments that have an approximately five-year holding period and expected annualized returns in the 30 percent range.  However, these deals are not always well received in the marketplace.  For example, Genstar attempted to sell PRA in 2011, but was unable to find a suitable bidder.  In response to more receptive equity markets, Genstar filed an IPO for PRA a more attractive 2013 target for potential bidders such as KKR.

Key Considerations

The top five key due diligence and deal structuring points to consider in the acquisition of a CRO are as follows:

1. How Secure is the Cash Flow? 

Different CROs have varying levels of security in their contracts.  Most enter into long-term agreements and statements of work with clients, an arrangement that provides some clarity into the CRO’s cash flows in coming years.  On the other hand, CROs that have direct contract relationships with sponsors are less replaceable and are often included in FDA dossiers and approved clinical trial plans.  Those that act as subcontractors or have indirect relationships are less secure. 

Customer concentration can be a key concern.  Some niche CROs rely heavily on a small number of customers to drive a large percentage of cash flow.  To help identify potential risks of over-concentration, funds should closely examine the CRO’s client relationships and contractual obligations to gain a clear picture of their strength and reliability. 

2. FDA Oversight of CROs 

Although CROs are not bound to perform research within the regulations of a device or pharmaceutical company, the FDA may still oversee their activities.  Pharmaceutical and device companies transfer certain FDA-mandated clinical trial obligations to a CRO pursuant to a written agreement.  According to the FDA Compliance Program Guidance Manual, “When operating under written agreements, the CROs are subject to the same regulatory actions as sponsors for any failure to perform any of the obligations assumed.” 

In November 2009, the FDA sent its first warning letter to a CRO citing infractions observed by the FDA during two clinical trials that were sponsored by Johnson & Johnson.  Prior to this, it had been their practice to only send such letters to the sponsors of clinical trials and not to the CROs who may have actually committed the violation.  This evidences a trend of greater scrutiny of CROs’ compliance efforts. 

At least one private-equity funded CRO has experienced serious quality issues that led to FDA scrutiny and loss of business resulting in bankruptcy.  Cetero Research was built and funded by KRG Capital Partners through a roll-up involving a number of separate CROs.  Between 2009 and 2011, Cetero had significant issues with the FDA related to recordkeeping compliance at one of its main laboratory facilities in Texas.  Subsequently, the FDA took the unprecedented step of publicly declaring all research conducted during a nearly five-year period at the Cetero laboratory as “unreliable.”

The Cetero Research experience shows that CROs expose private equity investors to very material quality and compliance risks that cannot be ignored. 

3.  International Opportunities and Risks 

Many CROs increasingly have foreign operations or partner with CROs operating outside of the United States to conduct clinical work overseas.  For example, INC Research, Covance and ICON perform research throughout Asia, Central America and South America.  While the ability to identify patient populations in diverse areas does create a unique offering, it also exposes the investment to the risks of international regulation and international taxation.  CROs with international operations should be reviewed for tax compliance and for compliance with international bioresearch laws and regulations. 

4.  Sales and Marketing Personnel 

CRO business is built through relationships with sponsors of clinical trials.  This requires a robust sales and marketing team that can build long-term relationships with large and small pharmaceutical and device companies alike.  In order to ensure proper protection of intellectual property and corporate relationships, employment agreements, non-competes and confidentiality agreements should be closely scrutinized.  The deal should be structured so that the buyer can assume and enforce existing agreements in the event of a dispute with a former employee. 

5. Collections Risk 

Certain CROs will do business with early stage biotech and medtech companies.  This business model exposes the organization to much greater collections risk when compared with CROs that do business with global pharmaceutical conglomerates such as Pfizer or GSK.  Attention should be paid to accounts receivables management and to the structure of payment for services under the CRO’s contracts.  Some CROs may propose aggressive payment terms to woo business from early stage, cash-strapped development companies.  This approach, however, may have a negative impact on cash flow and expose the company to credit risk. 

The CRO market provides an interesting opportunity for private equity investors of all sizes.  However, it is important to use caution in due diligence to ensure continuity of cash flows and compliance with regulatory requirements.  Given continued consolidation in the industry and predicted growth, it is likely that the boom in CRO investments by private equity funds will continue for the foreseeable future.