Unleash the Dragon 2

September 1, 2008

Pharmaceutical Executive

Volume 0, Issue 0

Concerns over quality? It's not stopping Big Pharma outsourcing and venture capital.

If last month's Olympics marked China's "coming out" in the global media, last year saw a similar (if less extravagant) emergence of China's pharmaceutical industry. Insiders took note of two signal developments: WuXi Pharmatech's IPO on the New York Stock Exchange in September, and the R&D collaboration deal between Hutchinson Medipharma in Shanghai and Eli Lilly. The largest China-based contract research organization (CRO), WuXi has seen its stock value climb as high as $40-plus per share since its IPO at $14. Hutchinson Medipharma's partnership with Lilly, focusing on oncology and inflammation, is the first "rich deal" between a Big Pharma and a China-based drug R&D shop.

In fact, with its explosive economic growth and increasing influence on world affairs, China has emerged as one of the last remaining superpowers, and experts predict that China will surpass the United States as the top pharmaceutical market worldwide in the next two decades. Accordingly, the Chinese government has designated the life sciences as one of its "pillar industries" to fuel growth. Various incentive programs were created to attract overseas commercial entities to establish Chinese operations and entice "sea turtles" to return to the homeland as entrepreneurs. (Why "sea turtles"? "Overseas returnees" and "sea turtles" are pronounced the same in Mandarin Chinese: hai gui.) Increasingly, US and European venture capital (VC) funds are looking to China for new life-sciences investment opportunities.

According to a May 2008 Citigroup report, the global CRO market is estimated to be US$15 billion, and growing 15 to 16 percent annually. China's share is growing well above that rate. Despite fears about quality control—mainly in manufacturing—Big Pharma's outsourcing of R&D is only accelerating. Chemistry and small-molecule compounds lead the way, with biology and protein-based work gaining fast. And preclinical safety research is just starting, with initiatives from Charles River and Covance/WuXi Pharmatech.

Big Pharma has understandably tended to take a one-toe-at-a-time approach to sourcing in China, especially when it comes to cherished R&D activities. Roche Research China went at it more ambitiously, working with a wide range of partners—academic groups, biotechs, and CROs—and integrating them as much as possible into Roche's own drug discovery teams. "We are seeking the optimal balance of how much we do in-house and [what we do] with external partners," says Li Chen, head of research at Roche China R&D Center. "We expect to approach a 50/50 ratio by the time we run a full portfolio, from lead generation to Phase IIa clinical trials." The Swiss giant is now collaborating with its Chinese partners on translational research and looking into the clinical trial design for new medicines discovered in China.

The Question of Quality

The recent heparin panic—the likely result of a sophisticated contamination upstream from the plant processing the anticoagulant for Baxter—has apparently not dampened Big Pharma's enthusiasm for outsourcing to China. "I don't see much of a difference between running an operation with internal staff and external staff," says Roche's Chen. "It's all about leadership. If you look at the quality of the science itself, Chinese chemistry is always good. DMPK [drug metabolism and pharmacokinetics] and safety operations can be standardized in China just as in any other part of the world. Research biology and pharmacology require knowledge and expertise, and they are still evolving. The redistribution of talent is now happening—from Big Pharma to CROs/biotech, and from West to East. The challenge is to translate individual excellence to an institutional and industrywide practice in China."

If anything, the heparin contamination revealed failures of oversight and accountability on the part of both the US's Food and Drug Administration (FDA) and China's equivalent agency, the State Food and Drug Administration (SFDA). After a congressional comeuppance, FDA is scheduled to open foreign drug-inspection offices to improve safety monitoring in this new age of outsourcing; the first three are planned for China, in Shanghai, Beijing, and Guangzhou, and will be staffed by eight FDA employees and five Chinese nationals. As for SFDA, agency officials have retreated from their longstanding refusal of even nominal oversight of drugs being manufactured for foreign companies or foreign consumption.

For James Cai, vice president of healthcare policy and former head of R&D China at AstraZeneca, R&D outsourcing is a no-brainer for most big pharmas. "We outsource wherever we determine the work can be done at faster speed, lower cost, and similar or better quality than in-house," he says. "Our internal audit shows that the quality of Chinese CROs we have used is comparable to that of our internal-generated data. That is why AstraZeneca is growing its China outsourcing significantly in all areas." Cai says he has heard a similar assessment from his Big Pharma colleagues.

"Besides shortage of experienced leaders and mid-level managers, the top challenge in China has to do with the regulatory hurdle in terms of capability and capacity," Cai says. "At the SFDA, up to 20,000 new applications a year are reviewed by only 120 staff. Innovative products that have not been approved by the US FDA or European EMEA may face additional challenges in the review process, as the SFDA may find it hard to set the standard for safety and efficacy, not having prior experience with these novel products."

A Pioneer's Point of View

The growing demand for CRO services ranging from preclinical to manufacturing and the surging influx of entrepreneurial sea turtles have combined with the unfavorable US stock market and narrow IPO window to produce a new wave of Western VCs investing in China. Among the first on the life-sciences scene was Fidelity Asia Ventures, the Asian VC arm of the Fidelity Investment Group, beginning in 1995. Its most celebrated investment was co-leading the series A round in WuXi Pharmatech in 2004.

Norman Chen, an entrepreneur who founded Asia Renal Care, a regional chain of kidney dialysis centers, first met Ge Li, WuXi's founder and CEO, in 2002. At the time, WuXi was a relatively new company, but it had already signed major Western pharmas and biotechs as clients. "WuXi has strong leadership, an excellent track record, and extensive customer relationships from Ge Li's Pharmacopeia days," says Chen. "With the growing need for outsourcing and the predictable CRO business model, I thought WuXi was the clear leader in that space—and a compelling investment." WuXi's pathbreaking success has marked Fidelity Asia Ventures as a leading Western VC in the Chinese life-sciences.

Looking ahead, Chen is concerned about the high valuation of certain Chinese deals, exacerbated by the influx of Western venture capitalists who may be unfamiliar with the local landscape or unschooled in healthcare. He cautions against inflated expectations of the new generation of Chinese entrepreneurs. "I am always concerned about a 'bubble'—with too much money chasing after too few good deals, though I think we are not quite there yet," he says.

High Tech Hot Spots

China's central and regional governments have invested quickly and heavily in hundreds of biotech/life-sciences startups clustered in a few dozen R&D parks in Beijing, Shanghai, Suzhou, Tianjin, Taizhou, and elsewhere. Says Charles Wessner, director for innovation and technology at the US National Academy of Sciences: "The Chinese government has succeeded in creating an environment that provides the incentives, infrastructure, and personnel to conduct world class research. The level of investment in first class facilities is especially impressive." Meantime, high-ranking government officials representing top-notch life-sciences parks have gone on "road shows" to pitch to talent pools at US biotech hotbeds such as San Diego, San Francisco, and Boston. (See "Right on the Rim")

Right on the Rim

How bountiful the harvest will ultimately be depends not only on the quality of these new companies but the sustainability of the government support.

The undisputed champion among Chinese life-sciences hubs is the Shanghai Zhangjiang Hi-Tech Park in Shanghai's Pudong district—a bustling research nerve center built in the early 1990s on former rice paddies. The gross fixed asset investment in the park through 2006 was 81.9 billion yuan (about $11.7 billion), according to official sources. Since its inception in 1992, seven Big Pharmas—Lilly, Roche, Novartis, Pfizer, AstraZeneca, Abbott, and GlaxoSmithKline—have established R&D centers or forged alliances with local CROs to do drug discovery, translational medicine, and clinical trials.

The Shanghai Zhangjiang cluster, with its focus on attracting top level talent, maintaining a desirable work environment, and offering the benefits of the Shanghai lifestyle, represents a new level of commitment to developing Chinese biotech. "The scale and focus of this park on global talent is most encouraging," says Wessner.

The investment in China has already paid off for at least one Big Pharma. "We are very pleased with the progress we have made developing our concept for doing R&D in China," says Lee Babiss, global head of pharma research at Roche, the first multinational to establish an R&D center inside the Zhangjiang Hi-Tech Park, in 1994. "The scientists have contributed to a large number of programs in the Roche pipeline, and have created important intellectual property for our company. We are now evolving our model in China to create a new innovation hub, where the scientists will work with our colleagues in pharma development to bring first-in-class therapeutics to the clinic, with the intent of local and global product launches." Roche also was responsible for recruiting other large-caps, biotechs, and CROs to Shanghai. "We wanted to have a strong community of drug discovery efforts and know-how in close proximity," he says.

The park now boasts more than 290 life-sciences companies. Having created an environment fostering innovation, Shanghai Zhangjiang Biotech & Pharmaceutical Base Development (BPB)—the company that oversees the life-sciences cluster at the park—is currently planning for its next phase of growth, focused on building an incubator for the seeding of innovation. "Our vision is to build a life-sciences cluster with a stellar worldwide reputation," says Lanzhong Wang, BPB general manager.

Venture Capital's Big Adventure

As mature CROs and the nascent life-sciences industry churn out research talent and skilled management, VCs from the US and Europe are looking for a piece of the action. CROs, in particular, are attracting US investors whose traditional business is outside of the life sciences. IDG Ventures, an IT-focused publisher/VC was among the first non-healthcare VCs to invest in a Chinese life-sciences startup. In 2005, IDG put money into Sundia MediTech Company, in a series A round less than a year after the CRO was founded by Xiaochuan Wang. Unlike a traditional life-sciences VC, for which the quality of the science and technology are the most important part of the due diligence, IDG's interest originated in the high quality of Sundia's management team. Says IDG Ventures general partner Suyang Zhang: "Xiaochuan Wang struck us as sincere and truly dedicated to building a successful long term CRO service company in China. She and her management team respect one another's opinion and have complementary skill sets. They also seem to have a good grasp on future trends in the industry."

Xiaochuan was one of the first sea turtles to land at Shanghai Zhangjiang Hi-Tech Park. She left her job at Neurocrine Biosciences in San Diego in 2003 to set up Sundia, and has convinced more than 20 other sea turtles with deep industry experience to join her there. "I am grateful to my partners who share the same vision and passion that I have about building a world class CRO company," she says. "Professional management, excellence in R&D, and good communication are the big factors to win customers." Sundia now has some 300 scientists toiling in over 150,000 square feet of lab space and in such high tech areas of drug discovery and development as custom synthesis, library production, medicinal and process chemistry, API manufacturing, bioassay, pharmacology, and PK studies.

Another IT-focused VC fund interested in healthcare deals is Shanghai-based Qiming Venture Partners, which closed its second fund, Qiming Venture Partners II, at $320 million in May 2008. Qiming is a joint venture established in 2006 by the Seattle-based VC firm Ignition Partners, former director of Intel Capital China, Duane Kuang, and founder and former managing director of Mobius Venture Capital, Gary Rieschel. This fund will continue the firm's early-stage investments in healthcare, among many other sectors. Recent investments included preclinical research company Crown Bioscience, founded by sea turtles Alex Yue Wu and Yiyou Chen and headquarted in Silicon Valley, with its main operations in Beijing.

Eli Lilly was the first and remains the only large-cap to launch a corporate venture fund in China, opening an office in Shanghai in November 2007. Says Darren Carroll, senior managing director: "Establishing Lilly Asian Ventures is consistent with Lilly's overall strategic move from a fully integrated company to a fully integrated network model. The new opportunities in China—and later on in other parts of Asia—will allow us to expand our network."

Lilly Asian Ventures, which typically initially invests $3 to $8 million per company, does deals in three areas: CROs that offer preclinical, clinical, and other services; companies that are developing innovative drug molecules or platforms; and China-centric opportunities that aim at the domestic Chinese market. "Since the China VC market in life sciences is only developing now, we believe it is very innovative for a major pharmaceutical company to stake out this kind of position," Carroll says.

HBM BioMed China, a $100 million China-focused fund affiliated with the Swiss HBM Bioventure (the largest European life-sciences VC fund), invests up to $15 million per company from startup to pre-IPO stage. The fund, with management based in Shanghai, has made three investments since its inception in April 2007, and has a number of additional investments in the pipeline. Says Kevin Li, a partner: "This is a natural evolution of the nascent life-sciences business in China."

A Changing China's Challenges

Greg Scott, co-founder and president of Life Sciences Angels, came to China in early 2007 seeking early-stage life-sciences investments. He found 4,000 companies, but few met the typical US investment criteria. Most early-stage life-science companies in China are founded by returnees who have R&D experience in the West, but are novices in the entrepreneurial realm, with little experience raising capital or building companies that can compete in the global market. This can create a challenge for Western investors accustomed to companies born in the more structured environs like Silicon Valley.

Scott founded ChinaBio Accelerator specifically to get China's biotech entrepreneurs up to speed. "Through our ChinaBio Investor Forum, and by working directly with Chinese entrepreneurs, we have helped 11 companies secure funding," Scott says. "We also created our first spinoff from Accelerator, ChinaBio Therapeutics, to develop novel drugs more quickly and at lower cost in China."

Scott has had a front row seat for the rapid increase in VC interest in China life-sciences. While the numbers are still small relative to the US's, investment in biotech grew to $400 million in 2007, according to Zero2IPO, an organization that tracks VC funding in China. Perhaps more importantly, the portion of VC funding going to healthcare doubled in 2007, while that going to IT decreased by almost a third. Scott expects this trend to accelerate. "We just met with a new fund that has over $700 million to invest in China, one-third of which will go to life-sciences companies," he says. "And now we're beginning to see money come into drug development companies, which wasn't the case even a year ago."

Performing due diligence on China biotech companies can also present some interesting puzzles. One of the most challenging is the intellectual property (IP) review. Patents are ultimately the key to the value locked in a promising molecule or novel biomarker. "We have seen a few cases of very exciting technologies, but weak patents killed the deal," Scott says. "Chinese companies and scientists are still learning how to build IP portfolios that provide global protection. The best patents are still being filed and prosecuted by Western firms."

Another due diligence issue, according to Scott, is corporate structure. "It's standard practice in China to create relatively complex, multilevel, off-shore companies to take advantage of potential tax benefits. But this can be a turnoff to investors," he says. "It's sometimes difficult to determine who owns what, and where the IP resides. This has caused us to pass on more than one opportunity."

Wei Zhou, a Chinese native who did his postdoctoral research at Emory Medical School, and received a JD from Stanford University, joined the law firm Wilson Sonsini Goodrich & Rosati (WSGR) to lead its efforts in corporate financing, M&A, licensing, and intellectual property strategy for life-sciences entrepreneurs in China and the US. WSGR opened its first China office in Shanghai in 2007. "It is exciting to see the tremendous interest from international venture capital investors in the emerging life-sciences industry in China. However, they will need to quickly adapt to the business environment in China, where deals will likely look different from what is typical in Silicon Valley or San Diego." Recent changes in regulations have, for example, challenged the traditional model of investment and exit strategy. In some cases, new regulations make it more difficult to obtain approval for investment and foreign listing via offshore special-purpose vehicles—the customary approach for investing in China. But Zhou says he has found that China-based companies are fast learners on patent portfolio strategy. "With the aggressive patent filing strategy of some Chinese companies, I think that freedom-to-operate issues will become more critical for international companies, with long-lasting impact in the future," he says. "As Chinese firms become increasingly sophisticated in their IP strategies, they will not hesitate to enforce their patents against competitors in China and overseas, and will be more active in licensing transactions."

"Hidden Dragon" No More

The early phase of the Chinese CRO scene was flooded with chemistry-based companies because of the nation's large chemist talent pool—and the clarity and ease of assessing the quality of the deliverables by their Western customers. As we have seen, opportunities are now emerging for new CROs that provide preclinical, animal model, and clinical trial services. But the hurdles are higher due to the complexity and difficulty in quality control. Big Pharma and large biotech companies in the West have been more cautious in using these services, but outsourcing will likely increase with experience. "Quality is always the key, and we have had great success outsourcing chemistry in China," says Roche's Babiss. "However, many areas of drug discovery that span the value chain are being developed in China, with a primary emphasis on quality, and we are continually testing the capabilities to see if we can then establish longer term relationships."

One company that has established its presence in systems biology and analytical services for preclinical and clinical is ShanghaiBio, originally the contract research division of Shanghai Biochip, at the Shanghai Zhangjiang Hi-Tech Park. ShanghaiBio expects to double its revenue in 2008—from $3 million in 2007, according to Jason Gang Jin, executive vice president for global technology and business. The company develops cell, tissue, and protein arrays internally for Western pharmas and biotechs. "With the recent, drastic restructuring at many Big Pharma companies in the US, we expect the prospect for growing and expanding our preclinical and biology services to be excellent."

ShanghaiBio was funded initially with $45 million, most of which came from the Chinese government, its venture funds, and local universities and research institutes. The company has attracted a number of potential US-based investors, including major private equity funds, and Big Pharmas are already using its services. Jin's goal is to have a ShanghaiBio IPO in the next two years.

Another China-based CRO company that garnered significant government support is Fountain Medical Development, one of the few Chinese CROs focusing on clinical trial services for biotechs and pharmas outside China. Armed with an MD degree from the top-ranked Peking Union Medical College, and with hands-on experience in launching Quintiles Transnational's greater China business, Fountain's CEO Dan Zhang says, "With our co-founders' extensive knowledge of designing and managing clinical trials within multinational pharmaceutical companies, Fountain is uniquely positioned to serve our clients' clinical research needs in China. Our Phase I and central lab facility in Tianjin is the only one in China to provide one-stop, integrated service for our global clients."

As the SFDA allows more clinical trials in the country, the test run of a special-approval, or fast-track, channel for first-in-class compounds is a likely innovation. Fountain's collaboration through Tianjin Binhai Biomedical Industrial Park provides a potential platform for the new approval mechanism. "Several US-based VCs approached us to get in the seed round, but we eventually had to turn most of them away because we only needed a small amount of funding at the beginning," says Zhang. "One important factor to keep in mind is the unique political environment of China. Building a healthy relationship with the government when a project is first initiated becomes essential. The effort spent in collaboration with the right partner at the beginning will translate into significant value." With a better understanding of China's political system, a drugmaker can take advantage of policies encouraging pharma R&D and gain government support.

As for China's infamous reputation for corruption among its countless local and regional officials, Dan Zhang insists that most such officials in the life sciences were removed following the criminal prosecution, resulting in the execution or jailing, of numerous high-ranking drug safety officials in recent years. A new generation of regulators is putting a system in place to prevent the recurrence of corruption. With revised SFDA regulations on drug review and approval—and increased accountability and transparency—the overall development time in China is set to shorten.

To realize the vision of turning the Chinese life-sciences industry from "an outsourcing provider" to "a sourcing destination of resources," Julius Li founded AutekBio, in 2006, a US front-end and China back-end therapeutic biologic contract manufacturing organization (CMO) for mammalian cell-based recombinant protein and monoclonal antibodies. According to Li, who worked at Roche and studied under Professor Yunde Hou, the "Godfather of Interferon," in China, AutekBio is the first and only FDA-compliant professional biologic CMO in China. "Our mission is to make China a manufacturing hub of high tech biologics for the world. In three to four years, we hope to turn the company into an important link within the entire global biotech value chain, with revenue topping $60 million," Li says. To achieve this growth objective, Li and his team have secured half of the $12 million to $15 million series B financing from prominent US and Chinese venture funds.

US angel investors and venture capital funds are also interested in cross-Pacific plays with China-born entrepreneurs who have founded companies in the US and are expanding to China. One such company is BioMedicure, founded in San Diego by Yong Qian, a US-educated Chinese-American researcher who was determined to develop cures for cancer patients after he witnessed the death of a good friend. Qian's new drug, Tumorase, works like a "molecular knife" that cuts away cancerous tissue without harming the surrounding normal tissue. Tumorase has proved efficacious in eliminating 135 solid tumors originating from seven types of human cancers in animal models. Qian is now attracting life-sciences angel groups, US VCs, and a number of Big Pharma and biotech firms for investments, and estimates that BioMedicure will complete all FDA requirements for filing an IND to initiate Phase I trials for broad solid tumor elimination in a little over a year.

All these cross-Pacific life-sciences trends demonstrate the China biotech industry's vitality, with prominent CROs, CMOs, and novel drug development companies attracting investment from the Chinese government as well as venture capital funds from the West. The new companies will likely play an increasingly important role in reshaping the future of global drug discovery and development efforts. Many more licensing deals will be consummated as the quality and quantity of desirable novel compounds improve in China. The sea turtles will continue to lead the way in starting exciting new companies in novel therapeutics development and CRO services that will be snatched up by savvy investors as they proceed down the life-sciences "Silk Road."

Zhu Shen is CEO of the consulting company BioForesight and vice chairman of SABPA. She can be reached at bioforesight@gmail.com