Glen Giovannetti

Blogging about Biotech, Pharma, innovative business models & the future of Life Sciences

[glenlifesciences]

Sweat Funded Medical Research

This past weekend I joined over 20 of my E&Y colleagues and 5,400 other riders in the 2012 edition of the PanMass Challenge bike ride.  For those not familiar with the PMC, it’s an incredibly well organized, very fun 2 day ride from various points in Massachusetts to the tip of Cape Cod – 165 or 190 miles depending on where you start.  The PMC has raises an incredible amount of money for cancer research and care at the Dana Farber Cancer Institute in Boston.  In fact, the over $30 million raised each year makes the PMC the largest single-event sports fundraising event in the country and comprises over half of the Dana Farber’s annual budget.  While riding this year, I got to thinking about why endurance sporting events – be they walks, runs, rides or more creative varieties – are so popular and such an important source of fundraising for various medical conditions.  Fortunately, others have done research and writing on this topic including here: http://ow.ly/cMrde , here:  http://ow.ly/cMrIO , and from the perspective of evolutionary psychology, here: http://ow.ly/cMwdS .

The website www.runwalkride.com has some interesting stats about the top 30 largest fundraising events in the US in 2011.  At the top of the list is the American Cancer Society’s Relay for Life which brought in $416 million and incredibly involved over 3 million participants.  If one sorts the list by dollars raised per participant, the bike rides comprise the top 4 positions and 5 of the top 7 (with the PMC comfortably in the lead).  While runs and walks accounted for 78% of dollars raised, on average the bike events raise nearly seven times as much per participant.  I think one can safely presume that the average bike rider, having invested several hundred to several thousand dollars in equipment, has more financial resources and is likely older than the average walkathon participant (the average age of riders in the PMC was 45). Also bike rides tend to have capacity limitations - it is certainly hard to imagine the PMC with many more riders although the organizers have been creative in expanding the routes over time.  Over half of the total $1.6 billion raised in all endurance events went towards cancer research, with no other disease comprising more than 10% of the total, and only three of the top 30 events raise money for causes unrelated to disease or disability (hunger, youth programs). 

Part of the great feeling around the PMC comes from the number of individuals and teams riding in memory of a loved one, a friend or former patients.  For them, the motivation is clear and highly inspirational.  For many others – myself included – I think the motivation varies.  Like most, I have lost family members to cancer, but participation in the PMC is more about the challenge (including having a goal to motivate training), the camaraderie with teammates and other riders, and the experience of the ride.  That’s not to say that I am not a proponent of more cancer research - after all I spend much of my life working with life sciences companies that are pursuing cures and treatments - or of the mission of any particular institution like the Dana Farber.  It is more a case that if I ask myself objectively, would I be motivated to donate or raise the $4,500 PMC minimum fundraising total to Dana Farber absent the event, the answer would be probably be no.  I would certainly donate to medical research related causes, but more likely spread it around to different organizations.  Also, I don’t think I would be asking friends, family and colleagues to contribute along with me absent the event.  Thus these events are very powerful aggregators of donations – from those motivated to participate and for those that want to lend their support.  

Team E&Y and I will be back.                                                                                                                      

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Opportunities and Consequences: Tax implications of R&D financing structures

In an earlier blog post, I provided an overview of creative R&D financing structures utilized in the biotechnology industry over the years, and the related accounting consequences of such structures.  These structures normally involve the use of a special purpose entity (SPE) that licenses one or more product candidates from a sponsor company (which retains a buyback option on the products or on the entire SPE), raises capital from third party investors and then funds research on the licensed products.   The risk of development in these structures falls with the SPE, with a significant upside to the third party investors if the repurchase is eventually exercised.

Over the course of time in the biotech industry, these structures have been motivated either by profit and loss considerations (for example by recently profitable entities seeking to move some R&D expenses off the financial statements), or by purely the need to access capital (for example by loss making biotechs with reduced options for traditional fundraising).  From the perspective of the sponsor company, the income tax considerations of these structures has historically been, at most, a nominal consideration, and thus the structuring dialog has focused primarily on governance and financial reporting.

Creative financing structures for the biopharma industry provide a plethora of tax challenges and intricacies that venture capital (VC) and private equity (PE) investors must consider.  Some of the more common tax considerations encountered by US based VC and PE investors include management of the business onshore versus offshore, current and future use of tax attributes (i.e. the net operating losses generated by the SPE), minimizing unrelated business taxable income (UBTI) for tax-exempt investors, minimizing effectively connected income (ECI) for foreign investors, and minimizing the impact of the US anti-deferral rules (i.e. Subpart F).

There are several different variations of the SPE structure that can be used to maximize its tax efficiency.  Perhaps the biggest tax consideration is what legal form the SPE will take.  Commonly, third party investors want to avoid multiple levels of tax on any income realized by the SPE.  Thus, an LLC or domestic partnership vehicle would be the most beneficial.  However, if the third party investors include either tax-exempt or foreign investors, then a flow-through structure can present special tax problems to those investors, including UBTI or ECI, which is generally precluded by most VC/PE partnership agreements.  Therefore, despite the second level of tax, investors often create the SPE as a C corporation to “block” any potential UBTI or ECI, as all investment activity is reported at the corporate and not the investor level.  Importantly, using a corporate entity limits the investors’ exit strategy to a sale of the shares of the SPE, as an asset sale is usually cost prohibitive from a tax perspective.

Another way around the UBTI and ECI concerns is to create the SPV as a foreign entity.  The SPV may achieve an income tax rate lower than a domestic C corp. through lower statutory tax rates and use of debt financing, while avoiding the UBTI and ECI issues encountered by flow-through domestic investment vehicles.  Consequently, a foreign SPE often allows the investors to sell assets more tax efficiently than could be achieved with a US C corporation.

However, foreign SPEs present their own problems.  A foreign SPE will need “substance” in the local jurisdiction to be respected for US and, sometimes, non-US tax purposes.  This can involve management and operation functions being performed locally.  Additionally, the US anti-deferral rules might require the US taxable investors to currently recognize income regardless of whether any funds are repatriated, creating “dry income” (an income tax liability for which no cash has been provided from the venture to satisfy).  And of course, the complex withholding tax rules and applicability of income tax treaties must be fully examined and complied with, which can be burdensome on the SPE and investors.

Ultimately, the makeup of the third party investors, the stage of development of the R&D, and funding needs of the biopharma sponsor company will all play into the tax analysis, which can interact in novel ways.  Only by closely considering all of the facts and business objectives of the specific investors and the sponsor can the most tax efficient structure be chosen and executed.

Thanks to my E&Y tax colleagues Blair Murphy, Mike Jacoby and Jonathan Guin for sharing their knowledge of these structures and their experiences helping private investors navigate the complicated tax rules that may apply.

[glenlifesciences]

BIO Boston and Beyond Borders

Summer is here and with it a chance to reflect on a very productive last six months that culminated with the release of our the release of the 26th edition of Ernst & Young’s Biotechnology Industry Annual Report, Beyond Borders, at the BIO International Convention on June 17.  Beyond Borders came together later this year, in part because our team needed to catch its collective breath after the February release of Beyond Borders sister publication, Progressions.  While we were still fortunate enough to have contributions from many industry executives and investors – including Moncef Slaoui, Chairman R&D at GlaxoSmithKline, and Tony Coles, CEO of Onyx Pharmaceuticals - we had far less of an opportunity to “test and validate” our points of view with market participants as they were evolving.  As such, it was particularly gratifying that the key themes of the year’s report – how biopharmaceutical R&D needs a new model, based on holistic collaboration between players from across the healthcare ecosystem and perhaps beyond – was very aligned with many  of the panel discussions and hallway conversations at BIO.  As one of SuperSession panelists, Joshua Boger, put it – we seemed to have “captured a bit of the meeting zeitgeist.”

I will be blogging about Holistic, Open, Learning Networks (or what we call HOLNets), and how models based on these principals could transform the way R&D is conducted in the biopharmaceutical industry today in future posts – both here and on a blog on Ernst & Young’s Life Sciences webpage which is launching later this month (www.ey.com/lifesciences).  

For now here are some links:

www.ey.com/bb12

  The media release which summarizes key findings is here

An interview I did at BIO with Chris Morrison of Elsevier and the InVivo Blog on the HOLNet concept is here

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Behavioral Economics in Health – Continuing the Conversation

In the recent Ernst & Young Life Sciences Annual Report Progressions (found here: www.ey.com/p12 ), my colleagues and I argue that the single biggest opportunity to improve health outcomes and reduce the growth in healthcare expenditures is behavior change.  As a result life sciences companies, and indeed all players in the health ecosystem, must consider themselves in the business of helping patients change their health behaviors.  We further make the case that as companies adapt their business models, much can learned from the emerging field of behavioral economics in designing effective solutions (product, service, education) that seek to improve patient behaviors.

To explore these concepts further, on June 4th we hosted an interactive client seminar that featured Dr. George Lowenstein from Carnegie Mellon University, and Dr. Katrina Firlik and Tom Kottler, founders of the start-up company Healthprize.  Dr Lowenstein, along with colleagues at UPenn, Harvard, MIT and elsewhere, has conducted some of the foundational research in applying behavioral economics principles to health.  The team from Healthprize has launched a business that seeks to leverage some of the techniques that have emerged from this research to impact the “real world” issue of drug adherence.  

Dr. George Lowenstein, Carnegie Mellon University

Dr. Lowenstein picked up the dialog by explaining that traditional economics is not well equipped to deal with problems caused by self-destructive behaviors because it assumes that people know what is best for themselves and are able to act on that understanding.  As such, economic theory holds that there is little need for intervention and the focus should be on providing information so that people can make informed choices that they believe are in their best interest.  In fact, the reality is quite different and Dr. Lowenstein  went on to explain how studies have shown that providing more information, for example on diet – from food labeling to calorie counts on restaurant menus – has had little impact on dietary choices , or at times has proven counterproductive. Why?  Because the big problem is not information (we usually know what the right choice is) but lack of self-control. 

Behavioral economics, on the other hand, starts from the premise that people often don’t know what is best for themselves or if they do, can’t implement.  The trick is to leverage the biases we all have – a bias for the present over the long-term, overweighting small probabilities, loss aversion, regret aversion etc. – to design programs that both engage individuals and nudge them towards improving their behaviors.  Dr. Lowenstein walked us through several case studies from his research (including a Warfarin adherence that is described in Progressions).  The findings to date are very promising and have generated a lot of interest, but from the overall discussion it was also clear that there are still many unanswered questions in applying the knowledge to the health space – for example do these techniques lead to habit formation or must they be continued in perpetuity?  Dr. Lowenstein commented that he was surprised how little of this type of research is conducted in a formal way (i.e. randomized trials) by companies in the industry.  This lead to a discussion of research priorities and how companies could productively reallocate a relatively small portion of their R&D budgets towards testing various techniques to modify patient behaviors that might late be scaled to have a meaningful impact on outcomes.  While there is perhaps an opportunity to include testing of behavioral economic techniques on patient behavior in drug clinical trials, a more practical approach would be to conduct such trials with approved products in “real world” settings, uncoupled from the structure of an FDA approved trial design.  Such an approach would allow for more adaptive approaches that extend beyond drug adherence to more holistic view of the patient.

The team from Healthprize then walked through their approach to improving drug adherence which employs multiple techniques designed around the known biases.  The basis of the program is self-reporting by patients that they have taken the medicines or refilled their prescriptions, tasks that earn the participants points towards various rewards.  The patient dashboard below provides other ways to earn points and to compete against other participants (see www.healthprize.com). Importantly the Healthprize system incorporates multiple techniques into the design of their system to maximize patient engagement (i.e a immediate feedback, point lotteries that play on our bias towards overweighting small probabilities, loss aversion, etc.).

All in all, it was a very engaging afternoon of discussion and learning. The techniques covered in the session have great promise to improve outcomes and reduce costs by encouraging patients to focus on effectively managing their conditions (or preventing them in the first place).  However, it is also clear that we are in the early days of understanding how best to implement this knowledge and the ultimate impact and sustainability of the resulting programs. Academics and companies across healthcare – life sciences companies, pharmacies, payors and providers – must continue to do research to better understand the patient and which techniques and approaches are truly scalable.  Ultimately, these players may find it necessary to collaborate to have the desired impact – both during the research and implementation phases.

We are also committed to continuing the conversation regarding this approach and to that end, Gautam Jaggi will be launching a dedicated Behavioral Economics in Health Blog in the next month.  Stay tuned.

Follow us on Twitter to stay up to date with our most recent blog posts: @Glengiovannetti @GautamJaggi @BE4HC

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PharmaVoice: New Course for Biotherapeutics

I recently contributed to an article published in the current May issue of PharmaVoice Magazine entitled “New Course for Biotherapeutics”. The article features various subject matter experts who cover details around the future of biotherapeutics from collaborations to the funding environment. “Companies developing biotherapeutics are beginning to study indications beyond cancer and autoimmune and infectious diseases and are researching how antibodies and proteins can be used to treat other conditions, such as pain and cardiovascular conditions, that have traditionally been treated with small molecules…” 

To read the full article, see PharmaVoice pages 18-20

Also notable in the May PharmaVoice issue is an article featuring Yazaki-san, E&Y Japanese Life Science Leader. This piece, “The Sun Keeps Rising on Japan’s Pharma Industry”, (page 26) discusses Japan’s “hallmarks of a leading market for the pharmaceutical industry”. This article was especially interesting having recently gathered my own new insights on the market following a visit with clients in Asia last month. 

[glenlifesciences]

Reflections from recent visit to Brazil

Along with several colleagues from the US and Europe, I had the opportunity last week to visit Sao Paulo and to spend time with our Brazilian Life Sciences team and with the Brazilian management teams of several of our global pharma clients.  Sao Paulo is a very dynamic city and one certainly cannot miss the hallmarks of a rapidly growing economy which are present in there, including an incredible amount of construction and completely unpredictable traffic.  It is almost impossible to leave too early to travel to the airport as one never knows if it is going to take one hour or three.  I was fortunate enough to have a “creative” driver who got me there in 90 minutes by traversing most of the city.  

E&Y colleagues from L to R:  Transaction Advisory Resident Andrew Forman, Brazil Life Sciences Leader Frank de Meijer, Glen Giovannetti, and Brazil Chairman Jorge Menegassi

Beyond the broader economic trends, Brazil is also a key focus for global pharma companies seeking growth because of an aging population and an increased incidence of chronic disease (see chart below for diabetes as an example).  The elderly population is growing at nearly triple the rate of Brazil’s overall population and by 2050 at least 30% of the population will be at least 60 and life expectancy will reach 81 years of age.

Source: International Diabetes Federation

As a result, Brazil’s Pharma industry growth remains robust and is expected to continue at a CAGR of over 13% thru 2015. With the advent of austerity programs in Europe, Brazil could move past Italy and France to the #6 market in 2012 (2 years ahead of expectations).  Compared to the anemic growth expected in the developed world as a result of the combination of expiring patents and pricing pressures, it is no wonder that most global pharma companies see Brazil as key to hitting their global growth targets.  At the same time, the market presents many uncertainties.  Some themes that emerged from our discussions included:

How best to align product offerings to the purchasing power of the population.  Generic drugs have grown from only 5% of total pharma sales a decade ago to in excess of 20% today – a figure that is expected to increase to 33% by 2014.  While companies can sell “developed world” products to the A/B class that can afford these medicines, the growth opportunities in the C class and below require a generic or branded generic portfolio. For companies lacking this portfolio, or the means of distribution to a fragmented market of pharmacists, acquisitions of a local generic player is a logical step.  However these transactions are few in number, Sanofi’s 2009 acquisition of Medley and Pfizer’s minority stake in Tueto being among a limited number of examples.  The challenges to completing deals mirror those of other emerging markets – a lack of targets with sufficient scope/scale and concerns about the quality of reported revenue due as a result of sales practices that do not match the compliance standards of the multinationals.  In addition, the Brazilian government would like to reduce the dependence on imported drugs by encouraging the development and consolidation of its domestic companies and can be expected to carefully review any proposed transactions.

Market access is also a challenge – especially for high price oral medicines that are administered outside of the hospital setting and therefore not reimbursed by the government.  Many of these novel medicines have not yet been introduced in Brazil because of the need to secure a price that is reasonable and also conforms to global pricing regimes.  In our discussions, companies are open to the idea of discussing creative, risk sharing pricing arrangements with regulators, however the practical ability to implement such arrangements is unclear.  We found great interest the outcomes-focused business models we have discussed in Progressions the last few years (the latest edition can be found here www.ey.com/p12).

It can also be expensive to operate in Brazil and the Brazilian currency, the Real, remains very strong. According to The Economist “Big Mac Index” which seeks to measure relative purchasing power as compared to the dollar, the Real trailed only the Swiss Franc in terms of being overvalued as of January 2012.  In addition, imported drugs are also highly taxed - at approximately 35% as compared to a global average of 6.1% - due to a complex cascading tax applied in the import cost calculation, involving an inter-correlated system of federal and state taxes.  This requires the multinational companies to carefully consider how best to structure their supply chains for maximum efficiency and to carefully examine other costs in order to grow profitably.

All in all, a great week and I offer congratulations to our EY Brazil team, lead by Frank de Meijer, who has been doing a terrific job helping our clients address these and others issues as they seek to capitalize on growth rates that no longer exist in the developed markets.

[glenlifesciences]

Innovative R&D Funding - The Rules Matter

The biotech industry has a long history of creative financing structures - proving the point that necessity is the mother of invention.  A common structure that has existed in some form or fashion since the early days of the industry involves the use of a special purpose entity to fund the development of a particular product or set of products.  Simplistically, this involves the licensing of products or technologies under development to a new entity that is controlled and funded by investors.  The sponsor company is typically hired to perform some of the R&D and retains an option to acquire the newco at a pre-established price.  The risk of the development is transferred to the investors - albeit with a built-in healthy return if the option is exercised.

These structures have come in an out of use over time due to changes in tax laws and accounting rules and the funding needs of the various participants. The initial version of the structure was the R&D Limited Partnerships used by Genentech in its early years.  These partnerships provided a new source of capital to fund innovation and immediate tax deductions for the investors.  Tax law changes made the structure obsolete (although, interestingly, BIO has recently proposed amendments to the US tax law that would permit a similar structure for defined types of R&D based on provisions that exists in the code today for oil & gas exploration).  

The next evolution, the so called, SWORD or SPARC transactions, often involved companies that had access to capital but were reaching profitability and were seeking a measure of P&L relief by moving certain projects "off balance sheet."  The idea was that the market was beginning to value these companies on earning multiples, constraining R&D investment for the future.  I had the opportunity to be involved with a couple of these at ALZA Corp., but many companies including Elan, Genzyme, Centocor and others executed similar transactions.  The same basic structure was used by Symphony Capital, whose founder Mark Kessel has played a role in most of these transactions over the years.  The Symphony structures were directed at biotech companies that had robust pipelines and were seeking capital to fund development.  There was also a value arbitrage thesis in play - if the underlying products worked, the value of the company would presumably increase, allowing the biotech the capital necessary to exercise the option with lower dilution than if they raised the capital along the way from public investors. Unfortunately for many of these transactions, the value arbitrage concept ran into the financial crisis and a stock market that was no longer rewarding companies for their pipeline progress.

Over the last couple of years, interest in these funding models has moved from biotech to the pharma industry.  We have been involved in numerous discussions with private equity and venture capital firms, and large and mid-sized pharmas exploring this type of structure to address more constrained R&D budgets and the reality that the companies cannot afford to develop all of the assets in their pipelines.

The accounting rules related to these deals - in particular around consolidation - have also moved over time.  For biotechs involved in the Symphony structure, who did not trade based on their financial results, consolidating the losses of the newco was not important.  For Pharmas considering versions of this structure, a primary reason for doing the deal is to reduce consolidated R&D expense (along with sharing R&D risk), so the consolidation answer is critical.  Getting to that result requires the sponsor company to give up important control and decision making authority over the newco and the programs within the newco, which can be a difficult trade-off.  For those considering navigating these rules, a more in-depth discussion of the accounting considerations can be found here.  

While the accounting answer is normally a driver for the sponsoring company, investors are often interested in tax efficiency.  In future posts, I will discuss the tax considerations for investors.  

[glenlifesciences]

A Sustainable Biotech Path

I recently wrote an article for PharmTech Magazine discussing some of the challenges Biotech faces in light of ongoing industry financing constraints. The article outlines four complementary approaches for biotech companies to sustain innovation as discussed in EY’s annual biotech report, Beyond Borders.

Ways to sustain innovation:

Prove it or lose it

Do more with less

Build new competencies

Collaborate for coordinated action

For more details, see the Pharmtech article: A Sustainable Biotech Path