Gil Y. Roth09.03.09
Newsmakers Interview: L. Lee Karras
AAIPharma Services’ CEO makes sense of the development arena
By Gil Y. Roth
In July, Water Street Healthcare Partners announced that it was acquiring the Pharmaceutical Development unit of AAIPharma, Inc. and converting it to a standalone company, to be known as AAIPharma Services. I spoke with L. Lee Karras, the chief executive officer of the new company, to discuss the transaction. Our conversation covered the business of pharma development services, the mega-merger wave and the venture finance crunch (and their potential impact on service providers), the CDMO phenomenon, and the perils of having a 26-page “company capabilities” profile.
If you have comments about what Mr. Karras had to say, drop me a line (and let me know if your comment is for public attribution)! —GYR
Contract Pharma: What does the new AAI include? What services are coming over from the “old” AAI to the new one?
Lee Karras: The new AAIPharma Services includes all of the CMC (chemistry, manufacturing and controls) assets of the “old” AAI. This includes all of the pharmaceutical drug product development and contract manufacturing-related businesses. Specifically, this covers analytical chemistry, the sterile and solid dose formulation development businesses, the GMP contract manufacturing plants for both clinical and commercial, including solid oral and sterile products, the clinical packaging and distribution business, the oral drug delivery franchise, including our ProCR™ controlled release technology and its associated IP, and our regulatory affairs and validation services businesses (our support services, as we call them).
So it’s all of the CMC-related businesses. We can think of AAIPharma Services as a company that takes an API that’s delivered to us and brings it all the way through packaging and distribution. What’s not included are all the clinical research businesses. Those remained with the parent company.
CP: Can you tell me how much Water Street paid? Just between us? (and our readers?) In the news announcement about the acquisition, Water Street said it would commit as much as $75 million to the deal, including strategic acquisitions.
LK: The $75 million figure includes the purchase price of the business.
CP: What was the rationale for this transaction?
LK: It was driven by management’s belief — and this is validated by the interest we had from the various constituents that were looking at the business — that the pharmaceutical development business was ultimately going to be more successful as a standalone. It has very different needs and customers from the clinical research portions of the parent company.
CP: What does the spin-off of AAIPharma Services indicate about the remaining units at the “old AAI”? Do you feel there’s an irreconcilability — or at least a lack of synergy — in having development services and clinical research under a single umbrella?
LK: There are three perspectives to keep in mind to answer that. The first is the customer perspective: despite being at the same company, the buyers of those disparate services — Pharmaceutical Development, Exploratory and Clinical Development — can be sitting in completely different geographies, different offices. The buyers may not even know each other. So there’s a segmentation to reckon with, and I think the model starts to break down there.
That said, this is the structure that the parent company had when it emerged several years ago. I understand how the original AAI got to where it was, but I think the fundamental issue to overcome was that the buyers of its services are segmented.
The second is that the capital needs of the businesses are vastly different. The geographical footprints required for those businesses are, too. You can’t compete in the CRO business unless you truly have a global footprint. Establishing that takes a big infrastructure. It’s not the same case in the PharmDev side. You don’t need to have a business in every region of the world; the business model doesn’t dictate that.
The third, from a marketing perspective, it’s hard to tell people what you do when you have such a diverse range of offerings. On one hand, it’s an opportunity to open a lot of doors and leverage those sales, but on the other, the segmented buyers make it hard to package those sales up from a marketing/messaging perspective. It’s hard to drive business in all segments that way, and that’s what you need to be doing in order for them all to be successful.
CP: I have to make a horrible admission: I’ve never had a clear grasp of what the old company actually does. I once picked up a “company capabilities” folder at a trade show, and discovered that it contained twenty-six sheets of capabilities. It occurred to me that if you need that many profiles to explain what you do, you may be better off explaining what you don't do.
LK: I think it’s going to be much simpler for us now to explain just what we do as AAIPharma Services. It is all centered around pharmaceutical drug product development and contract manufacturing.
CP: Once the decision was made to spin off the group, how long a process was it to decide on a buyer?
LK: It took about three or four months. There was an initiative to see if there was an interest in the market for a CMC-focused business. There was significant interest, both from private equity and strategic investors. We ended up with Water Street primarily because they’re a private equity group that focuses only on healthcare-related businesses. They understood our business well, had been following the pharma services space for some time and had been looking for an entry point. This opportunity presented itself and they liked what they saw, from a management team perspective, a profitability perspective, and from platform perspective.
CP: Platform?
LK: That is, the ability to plug other assets into the already established pharmaceutical drug product development business and to build a leader in the space. It’s their perspective — and my belief — that we haven’t seen a true leader in the pharmaceutical development and CMC services space. You’ve got the big-scale CMOs that serve a certain niche, and they dabble to a certain extent in product development, but their bottom lines are moved by large commercial manufacturing agreements. Then you’ve got the middle-tier group of companies that do what we do, and we don’t feel that there’s a real leader in the space. So there’s an opportunity for someone to become the platform company and stand above the rest.
It is my belief that there’s going to be consolidation in the space. Much like we’ve seen in the large-scale CRO business, where a few companies like PPD and Quintiles have bubbled up to the surface, and as we’ve seen on the CMO side with the Catalents, Patheons, and Baxters, I think you’re going to see a similar move in the pharma development and clinical manufacturing segment. Having a leadership position is a good thing when a consolidation movement is underway.
CP: What form do you think that consolidation is going to take? Will it be driven by technologies, geographic coverage, marketshare push, or something else?
LK: I think a lot of it will be driven by large pharma’s spend in the space. Historically growth in the segment was driven by biotechs and emerging pharma companies, which don’t have the infrastructure. I believe large pharma is looking more and more at getting away from clinical-scale product development and manufacturing. They want to bring more molecules to the forefront faster. I think there’ll be a big push from big pharma.
Further, it just doesn’t make sense for them to invest in assets that support that level of product development. Their efforts are going to be focused on what they’re good at: the “R” in “R&D,” and sales/marketing. What happens in between creates a great opportunity for companies like ours.
CP: Can you describe the strategic acquisitions you’re looking at?
LK: We’re going to stick to the core business. Any M&A that happens is going to have to be a fit with our pharma development and contract manufacturing businesses. We might look at companies that have broader toxic and potent compound manufacturing assets, or companies that have a different geographical footprint when it comes to clinical packaging. On the analytical side, we might look at companies that have a different therapeutic specialization, or ones that have assets on the ground in inhalation-based analytical chemistry. Specific analytical plays such as spectroscopy-focused companies are an interesting area of specialization: we’ve mainly been a chromatography shop, so spectroscopy is an area where we could add strategically to our core business. These are all things that could plug in logically to the current AAIPharma Services business.
CP: And the “buying a big pharma manufacturing facility on the cheap in exchange for a supply agreement” model? Not so much?
LK: I previously managed a large CMO before this [Baxter in Indiana], and seeing what capacity and demand is like out there for large-scale manufacturing, the model of acquiring a soon-to-be-closed pharma facility for a few years of backlog is not a model I embrace. Others may feel differently, but it’s certainly not a model that I think is going to stand the test of time.
The one exception to that is if an asset is available where there’s a more novel dosage form that isn’t currently offered, or is only in very limited supply. In that case, we may take a look. Blow/fill/seal at a large scale is an example that we’d consider, because of its novelty. But tablet or capsule large-scale manufacturing, large-scale pre-filled syringe manufacturing, vials, lyophilization: I think those fields are already well covered.
CP: What’s your take on the CDMO phenomenon? Do you think commercial CMOs can compete in the development space?
LK: They consume a portion of the development market, and they have business development professionals who can use it as an additional selling point. So it is competition, but I don’t think they’re nearly as good as we are, as a focused company in this particular segment.
From an economic perspective, what it takes to “move the needle” at a major manufacturer like the ones I mentioned earlier, adding development services is just not enough in terms of revenue growth. So there’s not a significant economic driver.
Some of them say they do it because “it’s our pipeline to the future,” but that’s not really true. They do it because it’s opportunistic and they happen to have an available asset.
I don’t think it’ll move the needle enough as they try to grow their business, because they best grow their business by adding large-scale, multi-year contract manufacturing agreements. That’s a completely different focus. In development services, it’s more than just executing a recipe. Our team get intimately involved — almost down to a consulting level — with making recommendations on how to proceed from a drug product profile perspective to match the clinical needs of the customers’ product. It’s a whole different business model.
CP: Are you doing or planning any IP sharing or royalty-based work?
LK: We’re a services business; the only IP we have and feel passionate about is our oral drug delivery franchise, especially our ProCR™ controlled release matrix tablet technology. It’s a technology that offers a low-cost, traditionally manufactured, dry-blend, direct-compression tablet that really rivals osmotic systems when it comes to controlled release. We’ve been able to tailor drug substances to release anywhere between 6 to 24 hours. It’s very flexible and applies to a whole host of APIs of varying solubility. To clarify, we are not looking at doing basic research, so much as development services.
CP: In which dosage forms do you see the most demand?
LK: Most of our services are on the parenteral and solid dose side, so that’s where we see demand. With parenterals, you have subsets: suspensions, freeze-dried products, and microemulsions. We may be the only CMO in North America that has a significant amount of sterile emulsion manufacturing expertise. This helps with insoluble compounds that need to be taken up in a water-in-oil matrix for IV administration. We have not only formulation scientists, but manufacturing professionals in our Charleston facility that understand that technology well enough to produce a pharmaceutically elegant product. Along similar lines, we are seeing a fair number of sterile suspensions. One the solid dose side, potent and cytotoxic compounds seem to be more prevalent now I think as a result of the growing oncology market.
CP: I don’t recall seeing that in the 26-page corporate capabilities folder. . .
LK: That’s probably why we’re talking today. It was hard to get a message that you could drill down to. That was just inherent in the nature of being one-third of a company that was two-thirds clinically focused.
CP: Did you make any expansions recently prior to the Water Street acquisition?
LK: We installed an Xcelodose® 600S system in our solid dose facility and interest in that has been fantastic. We’ve had huge takeup for Phase I powder in capsule clinical supplies since we introduced it. I think the interest ties into our strong analytical franchise and our ability to complement the manufacturing with analytical support. It also is very synergistic with our clinical packaging Business. We’ve made other investments, including UPLC technology and new analytical detection techniques. But moving forward, the level and number of investments will increase, especially in those core areas I mentioned earlier. We’re going to be installing some small-scale syringe filling in our sterile facility. We get calls for that quite often and think there’s a niche for both clinical and small-scale commercial prefilled syringe parenteral manufacturing.
All of our investments center in the near term will center around organic expansion opportunities.
CP: What impact do you think the pending pharma industry mega-mergers will have on your space?
LK: I think there’ll be more demand for pharma development services as companies look to optimize their pipelines. They may move products up in the queue that were in the “backroom” of one company or the other, as they try to find out if they have some hidden gems. New management means there may be a fresh look at existing libraries and compounds. I think that’s going to result in more work.
It probably won’t result in more large-scale manufacturing in the near-to-mid-term, but I think it’ll be a boon for the product development and clinical manufacturing segment as people try to shake loose a lot of these compounds upon further review by the acquirer.
Further, for some time now, many of these consolidating companies have been in stasis, sort of locked in, pending a formal close of a sale. Decisions don’t get made in a timely manner when there’s a major change afoot. I think as soon as a merger announcement is made, you see people saying, “Oh, my gosh, we need to get all this stuff going!” And they’re behind the eight-ball because of that previous indecisiveness.
So I’m actually very bullish on our space. I don’t think M&A in the pharma/biotech space is going to result in less outsourcing for our segment.
CP: How has the finance-crunch among startups and VC-backed drug companies affected your space?
LK: We were already doing a lot of work for big pharma, so we weren’t as reliant on biotechs and emerging pharma companies as many of the other development providers and CDMOs. When VC funding dried up, a lot of that demand went by the wayside. We were affected, but nowhere near the extent of what we heard from some of our competitors. We were fueled by — and continue to be fueled by — the large pharma business. We’re very fortunate that our customer segmentation enabled us to weather the storm. We don’t have a single customer that accounts for more than 7% of our total revenue; we have a pretty diverse base and that insulated us from the VC downturn to a large extent. That said, we are bullish on biotech and emerging pharma making a comeback as that will be a future push to our business.
CP: What do you think Water Street’s long-term strategy is, and why did it choose to enter the pharma services space?
LK: There hasn’t been that well-run of a company in this space, in terms of being able to handle the volatility of the business and delivering a continued growth trajectory. The sustained growth that our business has had in the past three years has been pretty spectacular, and we have one of the most tenured groups of scientists and professionals in our space. The average tenure in our formulation and analytical lab is 10 years; our turnover is less than 2%. There was a consistency here that really assuaged their concerns about long-term growth prospects.
At the same time, the exit strategy is all for the future. Both we are Water Street are working hard to get out of the gate fast with the transaction and we haven’t really spent time on the exit as you can imagine.
CP: What’s Water Street’s history with company ownership? Does it have an average turnaround time to watch for?
LK: They’re a growth-based private equity firm. Not only are they healthcare-focused, but they have a 5- to 7-year investment horizon and aren’t interested in a quick flip. So there’s no impending timelines that we’re terribly worried about. Those discussions will take place down the road.
They understand the space well enough to understand that there are peaks and valleys in demand and the long view is the most important.