Pharma APIs, once a sleepy sector, is the flavour of the season

“Not just one, but multiple funds reached out to buy a controlling stake," said a member of the promoter family, speaking on the condition of anonymity.

“In the last 12 years, the API industry has never received so much interest from the investor community as it does today… all because of the momentum that the covid-19 pandemic has created. We thought about it (the offers) and decided that there couldn’t be a better time to exit in case we wanted to do that."

This mad dash for a footing in the API business, even at eye-popping valuations, is not a one-off. Indian API manufacturers have never been as loved by the PE industry as they are now.

APIs are the biologically active component in a drug that produces the desired effect. It is mostly a low-margin business, since these basic chemical components are often outside the realm of patent protection.

Until quite recently, China had an almost unshakable hold over the global API trade, and the few Indian companies who had a foothold in the business had been reduced to pariahs.

However, suddenly, Indian API makers are on everyone’s radar. Global PE giant The Carlyle Group’s acquisition of Sequent Scientific Ltd, Advent International Corp.’s acquisition of RA Chem Pharma Ltd and ZCL Chemicals Ltd, and PAG’s acquisition of Anjan Drug Pvt. Ltd are just some of the marquee deals that PE investors have struck in recent months.

What is behind this sudden craze? And is the Indian pharma industry at yet another major inflection point?

The China factor

The reason why we didn’t care about it (pharma API firms) until now is very simple. It was a low RoCE (return on capital employed) business, so everybody used to look at the capital-intensive nature of the business and say, why am I getting into this?" said Amit Varma, managing partner and co-founder of Quadria Capital, a healthcare-focused PE investor.

“Secondly, the Indian firms were basically overshadowed by their Chinese counterparts. A lot of players were just competing on price and that was leading to a drop in margins," he said.

According to an analysis done by the consultant PwC, as of 2020, 50% of India’s critical API requirement was being met via imports and almost all of it originated from China. Domestic firms catered to the remaining 50%, but even in this segment, the key starting materials (KSMs) for most APIs were still being sourced from China.

Chinese API makers had many advantages, which skewed the market in their favour. “The Chinese API industry has an inherent advantage because of economies of scale and support from the Chinese government," the PwC report noted.

“The presence of large special economic Zones (10-15 times the size of Indian SEZs) lowered the capex requirement, borrowing costs were lower (5-7% in China vs 11-14% in India) and logistics costs are lower (1% of total costs in China vs 3% for India)" the report added.

All of this meant that over the past decade Indian API manufacturers steadily lost their competitive edge, particularly at the lower end of the API spectrum where cost is the only factor. The business environment steadily deteriorated for Indian players and some firms like Orchid Pharma Ltd and Sterling Biotech Ltd even ended up in bankruptcy courts.

So, what changed for the API industry suddenly in the past one year? And what has made them so attractive to investors?

Pandemic effect

Ask anyone what’s changed the fortunes of the industry and all fingers will point to one common factor: Covid-19.

“The pandemic led to a sudden spike in the consumption of medicines, which was enabled by a variety of factors like self-medication, precautionary purchases, and an expansion in the alternative medicines category. This led to an overall expansion of the market," said Quadria Capital’s Varma.

“Besides that, a new need to manage a predictable and stable supply chain which can counter any potential geo-political challenge has arisen," he added.

With several global clients relocating a part of their business away from China and India’s own need to localize giving that shift further momentum, India’s drug and pharmaceutical exports shot up to $24 billion in FY21—a growth of 18%.

“The Indian domestic pharma market is going nuts," Varma said. “By 2024, we will be at almost $65 billion (in exports) and reports say by 2030, it will almost be $120 billion. Now, that growth has obviously brought PE interest. So, almost $1.5 billion has already gone into this market over the past year. And PE and VC investments are up by five-fold."

To be sure, while many investors may have woken up to the changing winds after the pandemic made things quite apparent, others believe that things were beginning to fall into place for Indian manufacturers even before the pandemic, and that the pandemic has only accentuated this trend.

“Even pre-pandemic, before this supply chain rebalancing concern, the Chinese pharma industry was going through a bit of a churn. A lot of the domestic capacity was being diverted to cater to the local Chinese healthcare market as they shifted from traditional Chinese medicine to allopathy," said Hari Buggana, chairman of pharma and healthcare-focused PE fund InvAscent.

“The Chinese labour cost arbitrage compared to southern European countries like Italy and Spain was also shrinking. The Chinese environmental regulations had started to become more stringent at the same time. So, a number of advantages that Chinese firms enjoyed from 2005 had started shrinking because of the changes in Chinese policy and its domestic economy," Buggana noted.

“So, a lot of the Indian API companies were already sitting pretty and looking forward to healthy growth. Now, the pandemic may have given a bit more tailwind… because some of the European and American customers are now even more seriously thinking about rebalancing the supply chain and maybe sourcing more from ex-China," he added.

The government’s production linked incentive (PLI) scheme is also expected to boost the sector. The PLI schemes were first announced last year with an aim to create global manufacturing champions in India by removing sectoral bottlenecks and creating economies of scale in order to develop complete ecosystems for components.

In February, the Union cabinet had cleared the PLI scheme for the domestic pharmaceutical sector for fiscal years FY21 to FY29. About ₹15,000 crore worth of incentives will be provided under the scheme, with total incremental sales worth ₹2.94 trillion and incremental exports of ₹1.96 trillion expected during the six years. A total of 46 applications, with committed investment of ₹5,355 crore, have been approved by the government so far under the PLI scheme for bulk drugs (KSM, intermediates, and APIs).

Investor over-enthusiasm?

This unfolding gold rush moment for the API industry is raising a few eyebrows. Is the sector another flavour of the season that investors don’t want to miss out on? Are valuations running ahead of fundamentals? Will these bets return money in the typical five to seven year exit horizon that a PE fund usually targets? There are several unanswered questions. Meanwhile, the dollars keep pouring in.

“What I find with generalist, sector agnostic funds is that there’s a bit of opportunistic behaviour. And the tendency is to try and spot the wave and ride it. So, microfinance was the flavour of the season once, business process outsourcing (BPO) was a flavour, and then gold loans, and so on. So, this is yet another wave," said InvAscent’s Buggana.

To understand the rationale behind the voices of concern, take a look at the listed stocks in the sector. Firms such as Hikal Ltd, Neuland Labs Ltd, Aarti Drugs Ltd, and Solara Active Pharma Sciences Ltd have seen their stock price multiply between three to seven times from the time the market crashed in March 2020.

“Today, I am not getting a single deal at a discount. But if we are able to go in and prove that we can help a firm achieve a broader goal, we are getting deals at reasonable levels," said Quadria’s Varma.

“If you look at publicly listed peers in India, the good ones are always trading in the high 20s to even mid-30s (price multiple) depending on market segment."

“I think deals in India can be done in the high teens, if you can show a value proposition which makes sense to all partners. They’re still steep. If I compare it to my US and Europe counterparts, they’ll still think we are crazy paying such a high price to get into companies," he added.

There are others who believe that even high teen multiples may be difficult to justify. “Unless they have some exceptional capability, paying double-digit multiples is not justifiable," said a PE fund manager, who did not wish to come on record.

“You cannot peg to public market multiples because there is a scarcity premium. Take Divi’s Laboratories Ltd. They are a completely different beast in terms of their product mix, their scale, their cost advantage. Now, if people are willing to pay in (the) high teens hoping that five years from now they can take them public at higher multiples. Who knows? Eighteen months ago, nobody saw this IPO market developing the way it did," he said.

“It’s a great time to sell. Some family-run firms are getting the next 10 years of profit today. It’s an easy call to take," he added.

Essentially, while there are sufficient tailwinds that are driving the domestic pharma market’s sudden growth, the excess liquidity that is flowing through the global financial markets has created a potent mix.

“To say that valuations are frothy is an understatement," said Vishal Nevatia, managing partner at True North, a home-grown PE fund. “The key call that people need to take is how long will the liquidity that has been pumped in by the US Federal Reserve and other central banks continue. If inflation in the US picks up and interest rates increase, then there will be a huge question mark on valuations. That is a very difficult call because nobody knows what will happen. We are in uncharted territory," Nevatia said. “This kind of stimulus, both fiscal and monetary, has never been seen before."