InSight: Mansfield Advisors assesses capacity investment opportunities in European APIs

Covid-19 has unveiled the fragility of supply chains in many sectors, and API production is no exception. Associate Abhishek Patel, and senior partners Adam Scott and Victor Chua, of Mansfield Advisors assess the trends and opportunities for investing in European APIs

Broken China

The Medicines and Healthcare products Regulatory Agency (MHRA) estimates that China alone manufactures around 40% of global APIs (active pharmaceutical ingredients). Yet, during the pandemic, amid all the lockdowns and government restrictions, more than 40 Chinese companies effectively became non-operational, severely disrupting global supplies.

Pharma companies, both large and small, have reassessed the reliance on China and recognise the need for local alternatives to mitigate the risk of an over-dependence on any single region. This has created opportunities for European players in the sector to expand their capacity and capabilities, particularly within patent-protected ‘originator’ APIs.

Strong case

In September 2021, Mansfield reviewed the strong argument for investing within the contract development and manufacturing organisations (CDMO) sector. 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 the 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 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 (US$2.8bn, February 2021)

Capex alone is not enough to guarantee success. Realising the potential very much depends on picking the right specialist technologies and having the right people in place to execute on the strategy.

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 identify where equity investment can make sense.

Market trends

The global outsourced API segment is valued at around US$85bn and is forecast to grow at approximately 7% CAGR. This is slightly faster than the 6% for all CDMOs, including 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 (see Figure One). With an average of about 50 approvals each year, this has created demand for greater development and manufacturing capacity.

Greater volume is not the only contributing factor to rising capacity demand; a closer look at the therapeutic indications for new drug approvals by the European Medicines Agency (EMA) (see Figure Two) indicates a 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 increasingly rely on the expertise of CDMOs.

Even if pharma companies 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

The biologicals sector, currently around 40% of API revenues, is growing faster than small molecules (11% vs. 9% CAGR respectively). This is partly due to the rising prevalence of cancer, now standing at approximately 20 million new cases worldwide each year, which in turn supports increased R&D on cancer-specific biological APIs aiming to uncover targeted treatments. Indeed, of the current biological API pipeline, about 50% of drugs in clinical trials are cancer-specific (see Figure Three). 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 for a new biologic is US$100‒200 per gram, compared to less than US$1 for a small molecule generic, such as simvastatin. Investors can, therefore, help to build out the property, plant and equipment needed to manufacture these biological cancer drugs at industrial-scale, and hire the necessary expertise to successfully design and execute the most complex manufacturing process.

There is also a strong consolidation thesis; while individual CDMOs often cover the full spectrum of basic small molecule techniques, they might specialise in a specific technology (such as flow chemistry, chromatographic separation, controlled substances, peptide synthesis). That presents an opportunity to build a pan-European platform by combining a basket of capabilities into a broader offering, which would be a major differentiating factor in comparison to the likes of leading players like Lonza, Recipharm and Patheon (owned by Thermofisher).

Price hikes

Capacity constraints were already present in Europe and the US before Covid-19. The situation has been exacerbated by the pandemic. China’s manufacturing appeal was already waning due to high freight and logistic costs, but its attraction has deteriorated further due to Beijing’s ‘zero-Covid’ policy and the rise in global oil and gas prices. Energy rationing and political uncertainty have chipped away at the cost advantages previously found by manufacturing in China (now representing an estimated 10‒15% saving compared to 35‒40% some three years ago).

European demand for API production is expected to increase by up to 10% per year for the next three to four years for both small molecules and biologics. Consequently, annual price rises are reported as rising by 8‒10%, compared to the 3‒5% increase of recent years ‒ and that’s before the impact of a new bout of inflation is felt on 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. Building production capacity is, therefore, not solely a question of cost (around €20‒30m) and time (two to three years to build a new facility to commercial capacity), but also reputation. And a good reputation takes time to build. It requires having the right people with relevant expertise involved to handle the complexities of the manufacturing and engineering process. There is a steep learning curve to scale.

Barriers to greenfield entry are high, which places the emphasis on investors to understand the specific capabilities of existing players if building a rational platform 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. 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 the existence of pharma companies where the 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 makes production far less predictable.

Taken together, there is a compelling long-term case for capacity investment in European APIs, with potentially high exit multiples once smart equity has been willing to take on the work of providing development capital.