M&A In Biotech Industry

Determinants and consequences of M&A activity in the pharmaceutical вЂ" biotechnological industry

Alisher Saydalikhodjayev

March 30, 2008

Industrial Organization

Professor J. Likens

ABSTRACT

Traditionally, pharmaceutical firms with large R&D platforms dominated the space of drug innovation; however, the last 30 years produced a large number of smaller research-oriented biotech firms. Advances in the human genome project opened doors to the field of drug innovation to many new players. This event caused a change in the structure of the pharmaceutical-biotech industry, primarily through a hike in M&A activity during the 80’s and the 90’s. The examined study found that large pharmaceutical firms that had gaps in their drug development pipeline tended to engage in acquisitions, while small biotech firms that experienced financial trouble tended to participate in M&A as targets. At the same time, small biotech firms that had promising drug development pipelines and healthy financials chose to grow organically. No significant positive effects of the event of the merger on operations were found after controlling for company’s merger propensity score.

INTRODUCTION

“Formerly, when religion was strong and science weak, men mistook magic for medicine; now, when science is strong and religion weak, men mistake medicine for magic”

- Thomas Szasz

In the capitalist societies of the western world people have become increasingly aware of the importance of healthy life. Anecdotal evidence says that Americans spend most of their medical insurance funds during the last three months of their life. Thus, it’s easy to see why pharmaceutical and healthcare-related business would strive to deliver the best, most effective and reliable products to the consumers. Any proprietary or patented drug that battled cancer or any other feared disease could be sold at high markups in a state of inexhaustible demand. Focusing on life prolongation, healthcare-related industries boosted research in the field of medical science during the twentieth century. The germ theory of disease, which states that microorganisms are the causes of many diseases, was a highly controversial proposal at the beginning of the century but, eventually, it lead to the discovery of antibiotics and hygienic practices. Chemo-therapeutic revolution, which originated during WWII, has lead to major advances in cancer treatment. In the second half of the century, advances in synthetic organic chemistry allowed for controlled synthesis of complex molecular compounds and brought new opportunities to the field of pharmaceutical innovation. During each of these changes in the industry there were both losers and winners in the market, but generally, pharmaceutical firms with large R&D platforms dominated the space of drug innovation.

This status quo changed dramatically with the unraveling of the human genome research. The effort to identify all existing genes, along with their functionalities in human DNA, lead to many new research targets in drug development. Breakthrough in this field would allow scanning a patient’s genes in normal and damaged cells, delivering accurate diagnosis and prescribing customized medicines with a minimal amount of side-effects. Identification of these genes proved to be relatively easy; however, discovering their properties is much more difficult and costlier. Therefore, the immense breadth of possible research makes the investment in R&D a sizeable and very risky commitment. However, it also allows smaller firms to focus on one particular molecule or a set of molecules, which can be developed into a product (vaccine, treatment medication, etc.). Such firms have virtually no assets and consist of a very small management team along with a lab filled with the best researchers in the field. They start up with no sales force and no product. Their hope is to convert the research done in a lab into something marketable and producible at a larger scale. Because bigger pharmaceutical firms have established sales and advertising platforms, it seems reasonable to ask a question, whether some kind of a partnership between a small research-focused firm and a pharmaceutical power player would add value to both. Presumably, the bigger firm would benefit from the transfer of investment risk onto the research company and the latter would benefit from the growth opportunities through the established platforms of a bigger firm.

This reasoning seems to be supported by the consensus in the market: in general, bigger pharmaceutics yield lower valuation multiples than smaller research-oriented firms. This implies that the investors believe in stronger growth prospects of the latter and perhaps, factor a probability of acquisition by a pharmaceutical player in the price of a small firm. What other incentives may exist for small biotech firms to partner up with bigger pharmaceutical companies? Potential causes and effects of mergers and acquisitions in this developing sector are examined by Patricia Danzon, Andrew Epstein and Sean Nicholson (2004).

PAST LITERATURE

Danzon, Epstein and Nicholson argue in their paper that the determinants of M&A activity in the pharmaceutical-biotechnological industry are split between large and small firms. For the large ones, M&A is a primary answer to holes in the drug development pipeline; while for the small ones, it’s a primary exit strategy in situations of financial distress. The authors also criticize some common explanations for the M&A activity вЂ" economies of scale in research in development and desire to achieve higher market power. Moreover, as the authors analyze effects of mergers on future company profitability and operations, they find no significant difference in enterprise value, sales and employees among the firms that merged and the ones that haven’t. In fact, smaller firms have experienced a relatively slower growth in R&D expenses in the first year post-merger, which may suggest that the integration expenses due to the merger absorb the cash required to finance R&D among small firms.

As I go through a more detailed analysis of this work, I will also incorporate some case studies that were used by Louis Galambos and Jeffrey Sturchio in their study of strategic transition of pharmaceutical firms into biotechnology