Private equity investment deals in the pharmaceutical CDMO industry. Separating the best from the rest. A fictitious story that teaches a lot.

Spring and summer is a great time to spend in Southern Europe, especially when all expenses are paid and you have given pocket money to spend. It was some years ago, when one family owned pharmaceutical CDMO, decided to change its ownership status from family to capital equity owned. And as it often happens, the private equity firm called the experts to have their say about the strategy to be followed and what should be expected.

The outcome of the first reviews and calculations was that this CDMO did not have a cost issue, it had a pricing issue. So, there was no need to visit the manufacturing sites, they would just take a look in the corporate functions and build the strategy. And specific attention should be paid to Business Development and Procurement departments. And this is what two well-known management consultants did. They spent their summer in Southern Europe and focused their attention to the corporate functions.

Long office hours, endless meetings, dozens of excel files, and the result was just great! A more than one hundred and thirty pages’ study and a more than one hundred pages new 5 years’ business plan were ready!

The Normalized cash EBITDA of the CDMO could fly from €10mio EBITDA, to €50-€60 million in just 5 years. The experts “sized a potential EBITDA upside of a great significance in 5 years from now”.

How? Very simple by approaching big pharma not yet in the CDMO’s portfolio, by finding additional opportunities among mid-sized pharma, by expanding in other geographies and technologies by saving in raw and packaging material cost due to higher annual volumes coming from new business, and the list goes on including other cost out initiatives of central management such as centralization of OPEX.

And of course, some prerequisites would support further the success story that was about to evolve in front of their eyes. A new pricing process, a new market intelligence team, new systems and tools, etc.

So, the solution was clear. Don’t change anything in the efficiency and the cost structure of the manufacturing sites, follow the above, and fasten your seat belt, you are ready for take-off!

So passengers sit, their seat backs and tray tables were placed in their full upright position and their seat belts were fastened. The flight attendances gave their guidelines for the take off and they… left the plane! The consultants were the first to leave.

The consultants left in the beginning of autumn and the same people in the middle management working only some months before for the family, were asked to begin transforming the company. The new owners, a big private equity venture, were happy and the journey began.

So, after the departure of consultants, people in the company started translating the business plan into actions. They started with the easy ones. And what is easier than kicking out some unprofitable business?

They started with a product which was well known of having negative EBITDA. And when someone from the top management raised the question how much is the positive impact that we have by discontinuing the specific unprofitable product, the answer was direct. “We earn the amount of EBITDA that we were losing before discontinuing itSo if we were losing €1 mio euros each year, the positive impact to the EBITDA is this amount”. Well… not exactly…

First of all, before answering this question, you need to understand in depth what does it mean “unprofitable product of €1 mio per year”

The second information you need to know to answer this question is what will happen to the costs associated with this product as soon as it is discontinued. Especially the fixed costs. Will they stay or they will be out too?

And this is where politics entered into the game. Business Development was arguing to operations that “I made what I had to make, I kicked out the product, now it’s your turn. Start cutting your costs linked with this product”. Operations did not want to cut their costs and finance was asking alignment between the functions for a common figure when it came to how much is the impact of the discontinuation.

Meanwhile the guidelines were clear. it’s OK to lose business, as long as they are not profitable.

To make the long story short, after two years, EBITDA was not increased and this was due to the fact that some business was discontinued, costs did not decrease and there was no time for new business to enter into the business. In the pharmaceutical CDMO industry, it takes time to quote, agree and transfer-in new business. And because of the new pricing policy dictating to quote with higher prices in order to improve profitability, it was getting more and more difficult to bring in new business.

And of course if two years from day 1 you are still on the same EBITDA level, with very limited new business agreements, there is no way to reach the 5 years target on time. As soon as it became clear to the top management and to the private equity investors that the target could not be met, pressure started to raise, the blame game began and of course the story could not have a happy ending. People in the top management, started one by one leaving the company and eventually the time came for the investors to start considering their exit with the minimum possible loss.

This was clearly an unsuccessful exit that was partly created by the unrealistic scenarios assumed in the first place. If the consultants that create the strategy do not have the expertise on the specific industry, and if the investors lack this expertise as well, it is easy to believe in something that an expert in the pharmaceutical CDMO industry could tell that is based on generalities and finally it is unrealistic.

It is no secret that private equity investors ideally look for high returns as soon as possible, but this has to be combined with the specific industry peculiarities. Of course there are opportunities for successful deals in the industry within 5 years window but specific market experience is required.

In order to create a successful exit strategy you need to have a realistic business case that convincingly answers the questions WHAT, HOW and BY WHEN and take actions that do not undermine the future of the company. In our case above, these questions were answered in an incomplete way.

  • WHAT: the general directions provided by the Consultants were not broken down to details.
  • HOW: not really touched upon.
  • BY WHEN: CDMO market peculiarities had not been taken into consideration.

It is not realistic for example to assume that unprofitable business (that cover part of the fixed costs and overheads) will be discontinued and the financial picture will get better. If you remove the revenue and you keep the cost, the picture will be worse.

If you increase your overheads because you need to make a more professional business development and finance team, you need to consider that you cannot wait for improvements in EBITDA in the first years. On the contrary, profitability may go down before it goes up again due to some preparatory work that might be needed. And before you decide to increase your pricing levels for new business, you probably need first to take into consideration the market that you operate. If a CDMO manufactures conventional tablets (along with hundreds of other CDMOs in this world) increased prices will lead to lower success rate in the new quotations, meaning less new business for the same level of submitted offers. If the strategy involves increased prices to existing customers (without considering contract clauses in place) it should also assume that some of those customers will decide to leave. And if this happens, a cost adjustment should take place, not only in direct but also in fixed costs. (in order for EBITDA to remain untouched)

Creating a business plan that sounds attractive to investors is easy. The difficulty lies on creating a business plan (including an exit strategy) that is aggressive but also realistic both in terms of financial expectations and timing.

Before suggesting to invest in a new technology, you need first to understand the competition and the overall market of this technology. It easy to suggest investing in soft gelatin capsules or blow fill seal but the proposal should include what is the competition of the specific market, what are the difficulties in the manufacturing process, how many potential customers are out there and what are they ready to pay for these technologies.

Do they currently outsource their products to other CMOs, do they produce them inhouse or they have in-licensed the products and they keep the production to other pharma companies which out-licensed the dossiers to them?

Before suggesting increasing the price level or the profitability expectations, a strategy should consider what type of products the CDMO offers and what is the market average in terms of price level and profitability for these products and not just for the technology type i.e. tabs or amps. In general, before estimating the growth potential of a CDMO, deep knowledge of the industry is required.

And the same goes for cost reduction opportunities. Even if many times neglected, cost is one of the primary factors for near future business sustainability, especially in technologies with increased competition. It is common that CDMOs see their profitability decreasing year after year. The main reason for this is poor cost management and limited or no actions taken addressing cost increases. Identifying the cost level through benchmarking, determine the reasons for cost increases and suggest procedures and actions for efficient cost increase management is necessary. This will illustrate where room of improvement lies, what and how much benefit could be targeted and what expectations investors should have before proceeding with the deal.

And of course business development mentality is also core to achieve growth. Industry experts can tell if a specific business development team works according to best practices and what (and if) room for improvement is there. Current processes and way of working, understand how customer focused the Bus Dev team and the supporting organization is, RFQ management and lead identification processes are items that is difficult to be evaluated by investors without the support of industry experts.

Separating the best from the rest when it comes to business strategies creation that will be followed by private equity investors is straightforward as long as people involved in their creation know what to look for. Part of the job of those who consult private equities is to manage their expectations and explain to them the real picture in order to avoid future disappointment. You cannot expect from investors to know everything about the business, but you should expect it from the market experts.