On this episode of The Capital Corner, McGuireWoods' Geoff Cockrell sits down with Dr. Bijan Salehizadeh, Managing Director at NaviMed Capital, to discuss what is happening in the pharma services space within healthcare private equity.

The pharmaceutical services industry has piqued the interest of private equity investors over the last five to ten years as more drugs move into development and high quality science continues to grow. An impressive 500 IPOs were filed from biotech companies last year alone. 

So what attracts private equity firms to invest in pharma services? And what can we expect in 2022? 

“The benefit of pharmacy services is you're not subject to government reimbursement. And Pharma is a good payer and a fast payer. You also have pretty good pricing power,” explains Bijan in relation to what attracts investors to pharmaceutical services. 

Despite a turbulent start to 2022, Bijan doesn’t see the interest in pharma services slowing down. In fact, he describes the industry as being “recession resistant” compared to many other areas of healthcare. 

Featured Guest

Name: Bijan Salehizadeh

What he does: Bijan has over 20 years of healthcare operating and investment experience. At NaviMed, he sits on the firm’s Investment Committee and is responsible for leading investments and overseeing portfolio companies with a particular focus on healthcare providers and pharmaceutical services. Prior to co-founding NaviMed Capital, he was a General Partner at Highland Capital Partners, where he focused on growth stage healthcare investments.

Organization: NaviMed Capital

Connect: LinkedIn

Notes From the Capital Corner

Top takeaways from this episode

★     Structural change is driving growth in pharma services. Over the past 5-10 years there has been a lot of growth in pharma services within the healthcare private equity space. Structural changes have driven a lot of this growth, including having more drugs in development and a growing need to outsource the commercialization of drugs to third-party companies. 

★     Private equity firms see the appeal in backing pharmacy services. Despite the risks of the FDA stopping a trial or discovering that the science didn’t work, pharma services remains an attractive investment for private equity groups. Investors appreciate not being subject to government reimbursement and the strong gross margins present in the industry. 

★     Niche companies are especially attractive. Strategies for attractive deals within the pharma services space can include working with very specialized companies who have found success in their specific niche — including finding sales synergies and cross selling opportunities to help these smaller companies grow. These once niche companies then grow to a size that other companies and investors begin to pay more attention to. 

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is the Capital Corner, a McGuireWoods podcast, exploring investment strategies, capital structures, and topics relevant in today's middle market private equity. Join McGuireWoods partner Geoff Cockrell, as he and specialists share practical insights to inform your deal work.

Thank you. This is Geoff Cockrell. I'm glad you could join us with another episode of The Corner Series, where we bring together thought leaders, deal makers and professionals in the healthcare private equity investing arena to talk about more specific and nuanced aspects of investing. Today, we're thrilled to be joined by Bijan Salehizadeh from NaviMed Capital. NaviMed is a middle market investor in private equity and life science businesses. Bijan, maybe give a little bit of introduction of yourself and what you all are doing at NaviMed Capital.

Great. Thanks, Geoff. Happy to be on and really a big fan of the podcast that you're putting together here. So as you said, NaviMed Capital is a healthcare only private equity investment firm. We're based in Washington, DC. We are in the lower end of the middle market. Typical entry point for us is one to 10 million of EBITDA. We have invested across the healthcare landscape, payer provider, but also pharmaceutical services. Firm's been around for eight or nine years, and we're investing our second fund, which is about a $300 million fund, which is right sized for the kinds of investing opportunities. I'm one of the co-founders of the firm. I got to private equity by a little bit of a circuitous background. Trained as a physician up in New York. Worked in industry for a few years in the healthcare industry. And then after more grad school, I got into the private equity investment business about 20 years ago.

Bijan, one of the areas where you're spending some time is in pharma services. I'm always interested to hear from investors the investment thesis and maybe how you're segmenting that sector.

Yeah. Thanks, Geoff. Pharma services has been, I think really one of the, I wouldn't necessarily call it hidden, but really one of the growth sectors within healthcare PE for the last five to 10 years, I would say, and really is just as much so here at NaviMed. The things that are driving that growth of interest from private equity are really structural things that start first and foremost with the growth in high quality science. Science leads to more drugs in the pipeline, more cures. Let's just frame what pharma services is. It's the outsourced services that the pharmaceutical and biotech industry use to get their drugs through the FDA approval process, and often after the FDA approval process in getting those drugs commercialized.

It used to be 30, 40 years ago, all of that was done inside the bio-pharma company itself. There was very little outsourcing. And really over the last 20 years or so, there's been this rapid move from the large pharmas and the small ones to outsource a bunch of their key functions. Up to 30, 40% of the R and D budget now is outsourced to outsourced providers and an increasing portion of the commercialization budget for new drugs is outsourced to outsourced providers, the exact type of providers that private equity firms are buying and consolidating and then selling up the chain.

The other thing that's been driving all of this ... Why has this been happening? There's been a lot of money inflow into the pharma industry itself, into those molecules. That's not where private equity invests. That's more of a venture capital IPO market thing, but it's been dramatic. Venture funding has been really growing over the last 15 or 20 years into bio-pharma. Behind tech, it's number two. And the IPO market starting in 2013 through last year, there's been 500 new biotech IPOs, companies that have gone public on the NASDAQ or NYSC, and that's almost as much as went public in the prior 20 years have gone public in the last eight years.

So there's just a lot of supply of companies with a lot of cash, developing a bunch of exciting science, and they've all realized that we don't need to hire. In fact, we can't hire the best and the brightest people to develop our drugs, which means how do you make them? How do you test them and get them through the FDA mandated clinical trials? It's hard to get those people hired internally. So let's outsource that to a specialist who will do that on our behalf, and that has really driven the growth of this space, and now, exactly what happens in lots of other industries like payer provider, a bunch of small outsourcers are consolidating, driven by private equity and being bought by strategics and bigger private equity.

It's also interesting to me, and it has some similar dynamics to provider services in the sense that we're both with bio-pharma and provider services. They're big markets, big sectors that investors would like to have investment access and exposure to, but they have some characteristics that are challenging for them. On the provider services side, a lot of investors might be spooked a little bit by government reimbursement and the liability and risk that comes with that aspect of it, but if they can find an adjacent business that supports them, they can get access to the growth trajectory of that primary sector while avoiding some of the characteristics they don't like. And in bio-pharma there's characteristics that can be challenging with bio and pharma dominated by large players. A lot of the access points have binary outcome risk.

If you can park yourself a little bit adjacent, now all of a sudden you're in a cash flow business that's more typical for a private equity investor and getting exposure to that primary sector while avoiding some of the characteristics that they don't like. And that opens up investment to a much wider array of types of investors. Is that consistent with what you're seeing as far as investment participants?

Yeah, that's exactly right, Geoff. In fact, I think so much so that at least some, a good chunk of the money from private equity, we notice that goes into outsourced pharmaceutical services, not just from healthcare groups or historical healthcare investors who've invested in payer or payer provider, but also from generalist business process outsourcing because at the end of the day, pharma services is a business process outsourcing type of investment. A lot of it is project based businesses because you don't know what's happening with the pharma company's pipeline. They can wake up tomorrow morning and say, "The FDA said our trial has to stop," or the science didn't work. So, that's the risk of pharma services.

But the benefit of pharma services is you're not subject to government reimbursement, and pharma's a good payer and pharma's a fast payer and you also have pretty good pricing power, which I think in these inflationary times, a lot of the provider businesses don't have because the way Medicare and reimbursement tends to work in the provider side of the world is there's a lag behind your cost structure as a provider to what Medicare's willing to reimburse you. Pharma has a lot more pricing power, given most pharma companies, when they're commercial are driving 80, 90% gross margins. So they have pricing power in how they want to deploy that capital into their R and D spend, which is often the budget that the kinds of businesses private equity invests in outsourcing, that's where the budget comes from.

What are some of the economic growth thesis that you think about in pharma services? In provider services, it might be multiple arbitrage of buying smaller things and putting them on a platform that then will trade at a higher multiple, or bringing in other ancillary services that a smaller organization couldn't fully tap into. What are some of the economic growth theses that you think about in pharma services?

Yeah, I think first and foremost, we tend to think of it, and different firms probably have different theses, but ours at the small end of buyout, lower middle market, is a lot of revenue and cross sell synergies. There are relatively few economic buyers inside the pharmaceutical company, and yet they have to outsource many different kinds of functions to get that drug approved, a whole bunch of buzzwords I won't use around the manufacturing process and the FDA and the clinical trial process. One of the things that I think has held, a thesis that has held true in terms of the economic expansion potential is you buy different areas within that and you try to make the economic buyer inside of the bio-pharma company have the classic one vendor, one stop shop thesis. So that's worked out pretty well for us and for a lot of other investors in this space.

The other driver here is there are a lot, and I mean, a lot, this is what's similar to the provider business, there are just a lot of small outsource providers that grew up with a niche. Almost think of them as little consulting firms that grew up with a niche. They're really good at this kind of trial or this kind of manufacturing process or this kind of commercialization process, and yet they can't scale above a certain level. So putting together a best of breed type of offering, getting sales synergies and cross sales is a really big economic driver.

And then you get those things big enough at a scale that larger private equity in our world at NaviMed or the strategic buyers, which are what's called the CROs, the clinical research organizations, the publicly traded guys like IQVIA and some others want to buy because they make economic sense. That's the rinse and repeat cycle. And when those things get bought, sometimes the founders of those things spin out, start all over again and do another small little niche vendor. And that rinse and repeat cycle's happened now for almost 20 years. The industry tends to replenish itself in this world quite often.

For you and at NaviMed, what's your entry point from a size and scale perspective?

Yeah. Our entry point is single digit EBIDA, we call it. So, often we're creating a platform by putting together two of those small one to $5 million EBITDA businesses that might have the same economic buyer inside of pharma, but on their own can't expand to the others area. We often, but not always, bring in a new management team, CEO, CFO had a sales to run that effort. Our formula, if you had to sum it, up is put things together that aggregate to somewhere between five and 10 million of EBITDA that have the right growth dynamic that we're looking for, the right double digit growth dynamic, and hope to grow them with new management and the founders together working and other add-on acquisitions over time, just things that are in the 20 plus million EBITDA range that fit nicely inside of the larger PE firms who have the exact same thesis that we have, but want to take things with a bow on it that we've done the business building professionalization part, because we're only buying founder backed founder owned businesses here at NaviMed.

We're not buying things that have been previously taken over by private equity and cleaned up. So we're doing a lot of that business building. I almost call it seed stage private equity, because there's a lot of building that has to go on cash base financials, no CFO, the idea of finance is owner tax. There's no sales, there's no CRM like Salesforce. It's all been done by the owner in all these small size businesses and we've got to come in and really make it look like the kind of KPIs, dashboards and business processes that we all are used to in PE.

What are some of the risks in this sector as you're investing? Is it re-vertical integration by the bio-pharma companies? Is it finding out you had greater exposure to binary outcome risk? What are some of the risks that are inherent in this type of investment?

You named two of the big ones. I think right now we might be entering this stage. We had a decade of lots of IPOs and lots of budgets to spend on outsourcing, and obviously the public markets have turned today as we record this in mid 2022, to mid 2022. I think that there will be a wave of M and A as the stock prices of the bio-pharmas. It's just part of the cycle. And that M and A might mean that there'll be vendor down select or vendor re-competes, and the vendors, of course, are the kinds of companies that PE funds are backing. So that's something that's a risk.

The biology is a risk. As I said, if the FDA or science says, "This molecule can't go on," well you lose your budget. We try to account for that in the way we do backlog and pipeline. We put a discount factor. Historically, that's been about 20% of your projects go away in a given year for reasons that are entirely out of your control. And then the other risk that we always look at, especially at the size where we enter, is concentration risk. A lot of these smaller businesses is consulting type businesses that have been formed around an outsourcing vector on behalf of pharma have started with one or two key relationships and have grown inside that particular client. And of course, that's something you have to think hard about because things happen to clients. So we try not to take anything greater than 10 or 20% customer concentration risk in any given business that we buy.

That's probably also an opportunity too, because those concentrations impact valuation, and a high degree of concentration in a small target once they're folded into you probably doesn't pose the same kind of concentration risk. So there seems to be probably opportunities in that arena as well.

Real opportunities for the add-on acquisitions that we make around that concentration, because as you said, that exact dynamic plays itself out once you fold it into the larger thing.

Super interesting area. Bijan, any other aspects of investing in pharma services that we haven't touched on that you want to raise?

Yeah. I mean I think the only thing I would add to this, Geoff, is that I think we always think of pharma investing, and I think it's generally true, as relatively recession resistant. I wouldn't say recession proof because I think nothing is really recession proof, but it's something we think about here in the middle of 2022, as the macroeconomic conditions seem unstable. The march of science goes on. The question is what's the access to capital for the smaller biotech companies? And of course it's not just small companies. The large companies like Pfizer and Johnson & Johnson also outsource a lot of things. You would think with all the people these companies employ at a Pfizer size company, they wouldn't outsource, but in fact they're some of the biggest users of outsourcing for some of the reasons I mentioned earlier. So, that puts in some of the recession resistance.

And then the other thing I would say is we lived through a recession in the great financial recession of 2009, and the part of pharma services that usually is challenged first is what I call the earlier stage projects, the higher science stuff that's years away from being revenue for your client, if you're the outsource vendor. The stuff that tends to get cut last is the stuff they have in their projections, the client has in their projections as being next year's revenue. So the things that focus on running your phase three, your last phase of clinical trials, the things that are around outsourcing commercialization services around once a drug's already been approved, those are the things that are the least likely to be touched by a pending recession.

Of course, if the recession's long enough, the problems will work their way through the snake as it goes. But we hope that those recessions aren't too long and too lasting. But I do think as I look ahead over 10 and 20 years that this trend to outsource in this space, the dynamics that we talked about of private equity finding this space attractive, not just healthcare private equity, but financial services and business process outsourcing generalist PEs find it attractive and are investing, and that's moving up the chain from small vendors consolidation to folks spinning back out after they're acquired, doing it all over again. It feels like a good long run space, and certainly is here at NaviMed, is to continue investing through the cycles.

It's a fascinating sector and your insights on it have been super interesting and a ton of fun. Bijan, thank you for joining us in this episode and hope you listen to the next ones coming out.

Thanks so much, Geoff. Appreciate it.

Thank you for joining us on this installment of the Capital Corner. To learn more about today's discussion, please email host Geoff Cockrell at GCockrell@mcguirewoods.com. We look forward to hearing from you. This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuireWoods makes no warranty, guarantee or representation as to the accuracy or sufficiency of the information featured in this installment. The views, information or opinions expressed are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.