Jurisdiction - China
Reports and Analysis
China – Trends And Best Practices In R&D Strategic Partnerships.

30 April, 2012



Most of us engaged in the pharmaceutical, biotechnology, and medical device industries in the U.S. and Europe are well aware of the seismic changes occurring in the worldwide marketplace in these sectors, driven by the relentless pressure from most governments for cheaper and cheaper pricing of generics. Almost daily, there are reports of the occurrence of this from countries including, recently, Germany, Spain, the U.S., China, and other locations. In contrast, other changes are only occurring on a regional basis, such as the downsizing of sales forces in the U.S. and Europe, countered by a significant increase in sales forces in the Asian markets, particularly China. Where changes are regional, there is the possibility of arbitrage, and here we propose to examine the possibilities for this in the area of research and development in these sectors.

Leaving to one side the investment of the major pharmaceutical companies inR&D (and in many such companies there have been cutbacks in R&D spending either in terms of absolute financing numbers or as a percent of revenue over the past several years), there has been a growing realization, first in Europe and now in the U.S., that 10-year venture capital investment funds are not always appropriately suited for investment in companies focused on earlier-stage pharmaceutical or biotechnology R&D. If the history of investment in the sector from such funds in the U.S. and Europe is closely examined over the past 10 – 15 years, one can see that many did not meet their investment expectations and projected IRRs. The venture capital community investing in earlier-stage pharma R&D has been decimated in Europe and, to a lesser extent, in the U.S., with the exception of a small number of specialist venture capital firms with a track record of excellent exits, and even they are finding it as difficult as it has ever been to raise new funds. This has caused a crisis in the funding of earlier-stage R&D, and, although the pharmaceutical majors are aware of this and need collaborative partnering more than ever to bolster their pipelines, they cannot fill the void created by this harsh financing climate. There are some examples of the major pharmaceutical companies striking alliances with 
universities or other institutions doing very early-stage research, one recent example being the partnership between the University of California, San Francisco, and Abbott Diagnostics. But generally speaking, there has been a serious decline in the funding of translational research in Europe and the U.S.
Although the emerging markets, and especially the BRIC countries, are demonstrating rapid annual growth in the size of their pharmaceutical markets, caused by a heady mix of rising middleclass affluence, a desire for better health care, the treatment of newly prevalent on communicable diseases arising due to changes in lifestyle, and, in some communities, the problems of a significantly aging population (e.g., China and Japan), this has not yet really driven significant investment in earlier-stage pharma R&D. Indeed, in many of these locations there is a desire by local and international companies to acquire the rights to “ready-to-go” assets that have marketing approval in the U.S. or Europe and can be made available in these new markets relatively quickly, possibly with a small level of additional clinical trials. In addition to the focus on “ready-to-go” products, there is also considerable interest in the broad bio-similar/bio-better space because of the extremely high prices being paid by emerging-market governments for the existing incumbents supplying blood products such as Factor VII or high-price monoclonal antibodies products such as Herceptin or HUMIRA. The Latin American and Russian focus is on stimulating local manufacture and providing incentives for such manufacturing initiatives. For example, in the deal conducted by GlaxoSmithKline (GSK) for vaccines in Brazil, GSK was given preferential long-term supply agreements in the Brazilian market in return for considerable technology transfer by GSK of its vaccines-manufacturing technologies. 
There is, however, one market where there is a stand-out difference, and that is China. The Chinese government is vigorously pursuing policies and implementing long-term funding arrangements to promote the conduct of earlier-stage pharmaceutical R&D in China, with the ambition of transitioning from “Made in China” to “Discovered in China” (for China and the rest of the world). Indeed, both biotechnology and intellectual property research have been identified as “Strategic Emerging Industries” in China’s 12th Five-Year Economic Development Plan (2011 – 2015), which calls for heavy government and private investment by Chinese enterprises to promote “indigenous innovation” in the fields of innovative biotech products, high-end medical devices, and patented medicines, coupled with a major modernization of China’s health care and pharmaceutical distribution industries.
Therefore, almost uniquely in relation to China, there is the possibility to strike deals marrying Western products and technologies with Chinese partners and financial investment. The Western products can either be a company’s lead product—where it needs contribution of finance to conduct expensive clinical trials—or it can be in relation to technology that is perfectly good but effectively “on the shelf” for want of investment dollars. The U.S. and Europe are awash with such products and technology that have reached a certain point of development but that have been shelved in some sort of portfolio review. There is a growing realization amongst mid-sized life science companies in the U.S. and Europe that it is possible to do deals in China for pharmaceutical R&D at an earlier stage than in most other emerging markets, and we predict a wave of such deals over the coming years, driven by the deficit of financing of early-stage R&D in the Western markets, combined with R&D development lag time in this area facing the leading Chinese companies. These Chinese companies have distribution networks in place to penetrate the growing Chinese market for health care spending, but lack a pipeline of value-added products and technology. Although the last few years have seen a steady flow of Chineseborn but Western-educated research talent back to China (the so-called “sea-turtles”), the very long lead-in times required to produce mature products mean that they are facing a 10 – 15 year period of R&D to develop solid pipelines and fulfill local R&D and innovation targets. To meet their aspirations (and the 12th Five-Year Plan), these Chinese companies need to build pipelines at various stages of development fast, just like the Western major pharmaceutical companies, and an ideal way to do it is by the acquisition of the rights to Western products and technologies. 
This trend of strategic partnering between Western companies and Chinese partners and investors is at its inception. We have been advising in some of these pioneering deals and are pleased to offer our readers some of our observationsof the best practices for getting these transactions done.
Identifying the Partners: The Role of Intermediaries
Some of the largest Chinese pharmaceutical companies, especially the pharmaceutical arms of key State Owned Enterprises (SOEs), are still organizing themselves to conduct international business development, including establishing business development groups with English-speaking capabilities and developing intellectual property departments, licensing departments, and other assets necessary to conduct international transactions. At present, they do not tend to participate in international partnering sessions in force, nor even to attend partnering sessions in China that are largely conducted in English. Therefore, 
accessing these companies who want to do deals can be difficult. Generally, it is better, for the time being, to approach these companies through an intermediary with Chinese-language capability. Obviously, the intermediary needs to know the decision makers at these companies and their decision-making processes. Many intermediaries claim to know many of the key players, but the reality is that their contacts may not be with the right people within the organization, or the contacts may be superficial. Therefore, to establish good contact, it will be important to carefully research the potential intermediaries, and to use two or three intermediaries in order to triangulate on the right persons in such organizations. With the right intermediary, the whole process of communication between the Western rights owner and the Chinese company may be greatly facilitated. Realizing this, some of the key intermediaries are seeking remuneration through finder’s fees or other successbased compensation, along the lines of boutique investment banks. Quite clearly, it is necessary to approach Chinese companies with interest in the relevant technical area. Some Chinese companies are more small-molecule driven, others more biologic- or medical-device driven. We deliberately refer to “interest” here rather than experience, because a particular Chinese company may have a strategy for investment in a particular type of technology that is prevalent in the West, but has no real presence or availability in this area in the Chinese market as yet. An important component of these deals is that the Chinese companies are very anxious to learn, and so a high level of ongoing technology transfer is required, along with assistance with the design and conduct of preclinical and clinical trials. Armed with the design, the Chinese companies are more than willing to organize trials to be carried out at Chinese centers, because this takes them up the experience curve
Identifying Contributions and Financing needs
Just as in any transaction, once there are interested potential partners, this leads to discussions about the nature of the opportunity. In our experience, it is advisable for the parties to try and work up a business plan, including the plan and budget for the conduct of the research and development envisaged. Agreeing in some detail what is required to get the products onto the Chinese market, how long it will take, its phases (e.g., import initially, with a local manufacturing capability established later), and what will be the contribution of the parties (including the financial contribution) are key components of these deals. There are likely to be many contributions in kind, with the Western company providing intellectual property, technology transfer, and possibly some equipment, and the Chinese party providing resources, such as land and/or buildings, manufacturing capabilities, distribution networks, and/or financing. This planning exercise will also focus minds on the financing required to achieve the strategic goal. If, on a gap analysis, it appears the project requires more investment than the parties are willing to contribute, this will identify the need for the involvement of third-party investors. There are a number of private equity, venture capital, and strategic investor groups in China that are anxious and willing to participate in these projects.
Working Through Transaction Structure Drivers
As much as it is commercially desirable to agree upon the relative contributions of both parties, the form and magnitude of the contributions (e.g., cash vs. in-kind consideration) will help inform the ideal structure of the proposed transaction, as well as the government approvals that will be required in order to implement such a transaction. In addition to the type and magnitude of the contributions being made by each party, the specific characteristics of the Chinese partner (e.g., private vs. publicly traded, onshore vs. offshore incorporated, SOE vs. private sector), and the specific technologies being developed (e.g., whether they are activities that are encouraged, permitted, restricted, or prohibited for foreign investment in China), may dictate the recommended structure of the strategic transaction. In this regard, it is important to be aware that Chinese law places strict requirements on the types of intellectual property rights that can be contributed, and the extent to which such in-kind assets can be used to fund the capital requirements of onshore entities. The complexity of the approval process and the time it may take should not be underestimated, and it may be desirable to the have some initial approval in principle even before the letter of intent is established, particularly if arms of local 
government are going to be providing a grant or other cash contribution to assist with the development of the project. 
Due Diligence, Documentation, and the Pacing Items 
There is a considerable amount of work to be undertaken before the documentation of a deal is sensibly generated. It is very common in these deals to aim first for a term sheet, letter of intent, or memorandum of understanding that sets out in some detail the nature of the project, the contributions of the parties, and their key objectives (e.g., achieving a given exit). In the discussion of the letter of intent, it is critical that allowance be made for a number of face-to-face meetings, possibly including the intermediaries we have mentioned, so that everyone becomes comfortable with each other. Sometimes, Chinese companies want the letter of intent to be binding and, although this is not customary for international transactions (with certain carveouts), it may be possible to mitigate the effect of accommodating such demands in relation to certain provisions (e.g., designating a short longstop date, pursuant to which the letter of intent and its binding nature terminate if the definitive agreements have not been entered into by such long-stop date). Once the letter of intent is executed, there still needs to be time properly allocated to engaging in due diligence on both parties’ proposed contributions, as well as a means of integrating the internal and external approval processes and generating the definitive agreements, which will almost inevitably generate timing issues due to the need to produce initial, interim, and final drafts of each agreement in both Chinese and English. In some cases, the Chinese party is not as experienced with these types of deals, and as it really begins to understand the proposed terms of the transaction in detail, it may well seek to renegotiate the terms of the transaction. In addition, the Western party (or certain groups within its organization) may not be familiar with Chinese foreign investment and technology import regulations. As a result, additional time and energy may be needed to educate and reach internal consensus on regulation-driven structures and terms, which may be more rigid and less favorable, respectively, than those adopted by the Western organization in its domestic or other international collaborations. There needs to be understanding on both sides about this. By this point, however, when the parties are feeling more comfortable with each other, more can be potentially handled through the exchange of drafts, and the need for face-to-face meetings may diminish. There must also be adequate time and resources set aside for government and third-party approval processes, many of which occur from the date the definitive agreements are signed until the closing of the proposed transaction. 
Overall Timing
The message from all of this is clear—getting a deal done in China is going to take considerable time, commitment, and patience. For years now, business development folks have debated how long it takes to get these strategic partnering deals done in the West from inception to conclusion, and quite frequently it is in the region of 12 – 18 months. In relation to China, it is possibly a little longer, and so the Western rights holder wanting to announce a deal to sustain its share price and to bring in money for underutilized assets should be under no illusion that trying to carry out a deal in China will be a short-term panacea. Indeed, the Wester company needs to have the commitment and drive to see things through. Over the next several years, we anticipate these timelines shortening as the Chinese companies get more and more experience with such deals. 
In our next issue, we will further examine the details of these deals and look at some of the key structural, regulatory, and commercial issues parties face when negotiating these deals.


For further information, please contact:


Julian Thurston, Partner, Morrison Foerster


Thomas Chou, Partner, Morrison Foerster


Gordon Milner, Partner, Morrison Foerster


Homegrown Corporate/M&A Law Firms in China


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