Capacity investment opportunities in European APIs

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By Abhishek Patel, Associate; Adam Scott, Senior Partner; Dr Victor Chua, Senior Partner

Mansfield Advisors

August 2022

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Introduction

COVID-19 has unveiled the fragility of supply chains in many sectors, and API (active pharmaceutical ingredient) production is no exception. The Medicines and Healthcare products Regulatory Agency (MHRA) estimates China alone manufactures ~40% of global APIs, yet lockdowns and government restrictions have meant over 40 Chinese companies were effectively non-operational during the pandemic. Consequently, pharma companies, both large and small, have recognised the need for local alternatives to mitigate the risk of over-reliance on any single region. This has created opportunities for European players, particularly within patent-protected ‘originator’ APIs, to expand their capacity and capabilities.

In September 2021, we reviewed the strong argument for investing within the CDMO sector [insert link to previous article]; since then, the case for pharma companies to outsource API production has only strengthened, driven by surging demand and price hikes in a capacity-constrained market.

PE investors have already begun to realise these opportunities, with several recent transactions:

• Corden Pharma, a global API and drug product manufacturer, was acquired by Astorg from International Chemical Investors for an estimated €2.5bn recently in May 2022.

• Bridgepoint-owned Pharmazell, a European specialty API manufacturer, merged with Novasep (April 2022), and acquired complex small molecule and antibody-drug conjugate (ADC) capabilities.

• SK Capital Partners acquired a majority stake in SEQENS, and merged this with Wavelength Pharmaceuticals to create an integrated global API CDMO leader in October 2021.

• This followed the high-profile acquisitions of Pharmathen by Partners Group (July 2021, €1.6bn) and Recipharm by EQT ($2.8bn, February 2021) last year.
However, capex alone is not enough to win; success very much depends on picking the right specialist technologies and people in place to execute. In this article, we review some of the key trends in the European outsourced API market, with a deep dive on cancer, recent price hikes, and where equity investment can make sense.
Market trends

The global outsourced API segment is valued at ~$85bn, and is forecast to grow at ~7% CAGR. This is slightly faster than the 6% for all CDMOs (contract development and manufacturing organisations, which include pill manufacturing and packaging.) One of the key growth drivers in recent times has been a favourable regulatory environment, both in Europe and the US, with drug approvals surging particularly for biological APIs (Exhibit 1). With ~50 approvals each year on average, this has created demand for greater development and manufacturing capacity.

It’s not just a question of greater volume; a closer look at the therapeutic indications for new drug approvals by the EMA (Exhibit 2) indicates a mix shift towards cancer and infectious diseases. These therapeutic areas include a high proportion of biological drugs and complex small molecules (such as high potency APIs), which in turn require more specialist manufacturing capabilities and technologies. This has led big pharma to lean on the expertise of CDMOs more, and even if they develop their own internal manufacturing capabilities for ‘blockbuster’ drugs, they frequently dual source and retain the outsourced API developer to mitigate supply risk.

Biologicals in Cancer

Biologicals, currently ~40% of API revenues, are growing faster than small molecules (11% vs 9% CAGR respectively). This is partly due to that rising prevalence of cancer, with ~20 million new cases worldwide each year. This, in turn, supports increased R&D on cancer-specific biological APIs, with the aim to uncover more targeted treatments. Indeed, the current biological API pipeline has ~50% of all drugs in clinical trials are cancer-specific (Exhibit 3). Other research efforts have shifted towards specialty products with complex formulations; for rare diseases, orphan drugs and personalised treatments.

Taken together, this provides excellent value creation opportunities for investors. The cost of production of a new biologic is $100-200 per gram, compared to less than $1 for a small molecule generic such as simvastatin. Therefore investors can help to build out the property, plant and equipment needed to manufacture these biological cancer drugs at industrial-scale volumes, and hire the necessary expertise to successfully design and execute the most complex manufacturing process.
There is also a strong consolidation thesis; whilst individual CDMOs often cover the full spectrum of basic small molecule techniques, they often specialise in a specific technology (such as flow chemistry, chromatographic separation, controlled substances, peptide synthesis…) Therefore there are opportunities to build a pan-European platform and differentiate from the leading players like Lonza, Recipharm and Patheon (owned by Thermofisher) by combining a basket of capabilities into a broader offering.

Price hikes

Capacity constraints in Europe and the US were already present before COVID-19, and have only been exacerbated. China’s manufacturing appeal has been hampered by high freight and logistic costs, which has only got worse with Beijing’s ‘zero-Covid’ policy and rising global oil and gas prices. Energy rationing and political uncertainty has resulted in a lower cost advantage from manufacturing in China (only 10-15% cheaper compared to 35-40% 3 years ago).
European demand for API production is expected to increase by up to 10% per year for the next 3-4 years for both small molecules and biologics. Consequently, annual price rises have been reported of 8-10%, compared to 3-5% for recent years; this is even before the more recent signs of the return of general inflation which would feed through in higher costs of inputs like fine chemicals, wages and energy. The true impact of these price hikes is difficult to ascertain as contracts between CDMOs and pharma companies remain bespoke and confidential, but we see supply constraints and resultant high prices persisting, given the trend for shorter supply chains.

Challenges and risks

API development and manufacturing is an expensive business, with greater risk for more complex molecules. Both biological and complex small molecule production require high manufacturing quality standards to be met, with major consequences if things go wrong. Therefore, building production capacity is not just a question of cost (~€20-30m) and time (2-3 years to build a new facility to commercial capacity), but also building reputation. This takes time to build, and requires the right people with relevant expertise to handle the complexities of the manufacturing and engineering process, and there is a steep learning curve to scale.
Barriers to greenfield entry are therefore high, which puts an emphasis for investors on understanding the specific capabilities of existing players to build a platform that makes sense through a complementary portfolio.

Conclusion

Biological and complex small molecule APIs carry a greater inherent level of complexity, so equity investment makes sense where debt providers fear to tread. Succeeding in a capacity constrained European market is not just about building a new factory, but finding the right management team and having smart equity is essential. Investment does not come without execution risk, but the fundamental trend towards high volume, high value products is promising. Moreover, there are attractive forecasts for high volume uptake of new cancer drugs, with favourable reimbursement in most European countries allowing for pharmacos whose prime concern is not drug price but reliability and security of supply. Biologicals are also better protected in the long-term, owing to their market longevity compared to small molecules, where easier entry for generics destabilises markets and make production far less predictable. Taken together, there is a compelling long-term case for capacity investment opportunity in European APIs, with potentially high exit multiples once smart equity has been willing to take on the work of providing development capital.