M&A Expected to Pick Up in 2014; Private Investment to Be a Challenge

By nearly all calculations there was nothing exceptional regarding the number of transactions or the value of merger and acquisition (M&A) deals in the diagnostics space in 2013. Companies and investors played it safe while trying to forecast the financial impact of the industry’s two most pressing challenges—the uncertainties surrounding the Affordable Care Act (ACA) and reimbursement. For 2014, though, most industry watchers are buoyed by slight optimism, believing that as more late-stage diagnostics companies reach commercialization, buyers may be enticed by efficiency gains from newer platforms and the high growth potential of emerging clinical technologies, including molecular diagnostic-related products. A 2013 Recap The headline-grabbing announcement of Thermo Fisher Scientific’s pending $13.6 billion purchase of Life Technologies sent excitement through the industry last spring but failed to trigger a hoped for series of follow-on acquisitions. According to research from Ernst & Young and Dealogic, insecurity regarding the impact of the ACA kept the broad category of health care-related deals slightly below 2012 numbers, but by some measures deal value was up slightly for life science transactions. “Global life sciences M&A deal values hit $131.8 billion in 2013 in 203 transactions with disclosed deal values greater than or equal to $20 million. That compares to $108 billion in total deal values for 211 transactions in 2012,” writes Marie Daghlian, in a Jan. 6 entry of the Burrill Report. “Although 2013 total deal values were 21.3 percent higher than in 2012, the number of deals was down by 3.8 percent.”  

Completed Diagnostics IPOs in 2013
Company	IPO Date	Amount Raised
Oxford Immunotec Global	11/2013	$64 million
Veracyte	10/2013	$65 million
Foundation Medicine	9/2013	$106 million
NanoString Technologies	6/2013	$54 million
Cancer Genetics	4/2013	$6 million
LipoScience	1/2013	$45 million
Source: Burrill & Co.

  Rather than bold expansions into new business lines, the M&A activity in the laboratory and diagnostics segments reflected the “substantial” pressure the industries are under to reduce cost and drive greater operational efficiencies. Reimbursement challenges, increasing provider consolidation, shrinking preferred networks, and consumer price sensitivity, are hitting reference lab margins and leading to laboratory consolidation and pricing pressure that in turn puts pressure on in vitro diagnostics manufacturer margins and drives consolidation there, as well. The result is that some players will leave the space by spinning-off or divesting noncore assets, underperforming units, or more commoditized lines so that they can focus resources on higher-margin, more core segments. A prime example of this is Quest Diagnostics (Madison, N.J.), which undertook a five-point strategy to refocus on its core diagnostic information services business, drive operational excellence, restore growth, simplify the organization, and deliver disciplined capital deployment. As a result, the company divested its OralDNA dental diagnostics business, HemoCue diagnostic products business, Ibrutinib royalty rights, and its Enterix colorectal cancer screening test business, which generated combined gross proceeds of approximately $800 million. “Big service providers and large life sciences companies (pharmaceutical and medtech) alike will divest and spin off business lines that are non-core or low-margin in order to be more nimble,” write Ernst & Young Capital Advisors in a forecast of 2014 deal activity. “All participants in the continuum of health care are streamlining the business to prepare for the changes happening now and the expectations of continued shifting regulatory landscapes.” On the acquirer side, Soren Peterson, Ph.D., a senior analyst with the consulting firm Health Advances, says acquisitions were targeted to products of demonstrated value that in many cases improve workflow efficiency. Peterson cites Roche’s (Switzerland) $220 million purchase of Constitution Medical Investors as an example. Constitution, which developed the Bloodhound complete blood count testing instrument, received a high valuation, Peterson says, even before regulatory approval or commercial validation, because of the system’s potential cost savings for laboratories through a reduced need for technicians with the automated system. With a slow pace of acquisitions of venture-backed biotech companies, companies turned to the public markets to access capital and provide some return to investors. Initial public offerings (IPOs) were unusually active for biotech, with 52 U.S. life science IPOs in 2013 versus 16 in 2012, according to the Burrill Report. Experts don’t expect this pace to continue in 2014, so eyes will once again turn to see if M&A activity will pick up, or if softer alternatives to outright acquisitions, such as licensing agreements and partnerships, will be more attractive this year. Looking Ahead: M&A “Multi-billion dollar trades have occurred because innovation is and will continue to be the lifeblood of this industry,” said Ben Perkins, U.S. Life Sciences Sector leader for Ernst & Young Capital Advisors, in a statement about industry mergers and acquisitions. “Research and development groups will return to the era of going where the science takes them and allowing internal programs to cross over into other disease areas. High quality assets are difficult to find, and we will continue to see high-priced acquisitions and robust valuations for unique assets.” However, experts caution that those products and companies able to attract high valuations will be very select. Broadly, products and services that are immediately accretive financially or add substantial technical advances will be favored, while those without commercial validation will be of less interest to buyers. “Payers and providers will no longer accept a slightly better product; innovation under the Affordable Care Act will mean producing products with demonstrable improvements in quality of life and life expectancy, which could drive M&A activity,” write Ernst & Young Capital Advisors. “Specifically, medtech and pharma subsectors will see a tectonic shift in how drugs and devices are being reimbursed and each product will be more closely scrutinized to understand the price to value benefit.” Peterson, with Health Advances, tells DTET that technologies that drive down costs by increasing lab efficiency and increase retention of provider contracts will continue to be in demand as labs continue to face an increasingly difficult landscape.  Assets, such as those in health IT, that assist labs in demonstrating their value to providers, are expected to be in demand in the coming years.  Peterson also says that, driven by labs’ scramble to improve margins, higher value and more efficient molecular diagnostics such as multiplexed and automated molecular diagnostics have played an outsized role in M&A deal volume. In 2013 the buyers of diagnostics companies tended to be more traditional players, reversing a trend towards nontraditional buyer activity seen in the previous few years.  In the several years before 2013, nontraditional buyers, such as life science tool companies, industrial onglomerates, and non-health care companies, accounted for a substantial share of molecular diagnostics deals.  However, given integration troubles, uncertainty surrounding diagnostic reimbursement, and a decreasing number of nontraditional buyers, who themselves have been acquired, Peterson expects the appetite for nontraditional buyers  to enter the diagnostics space will be “tempered” in the coming years. Pharmaceutical companies, for example, have preferred lower-risk partnerships for the development of companion diagnostic products. While some buyers such as tools companies like Illumina will likely continue to penetrate the clinical diagnostics market through acquisitions, core diagnostics players will likely continue to be key players in deal activity as they seek to increase scale and breadth of product lines and private equity firms look to leverage debt financing to acquire companies with strong cash flow.  With a longer time to exit than other life science companies, emerging diagnostics  companies will need to continue looking for additional private investment to get them to the late-stages of development associated with more lower-risk and attractive acquisition targets. Looking Ahead: Private Investment “Private financings of U.S.-based companies grew 4.5 percent to $8.9 billion, [but] early-stage financings continued to be constrained for many start-ups, which turned to non-traditional sources including angel investors, philanthropic groups, disease advocacy organizations, and corporate venture,” writes Steve Burrill, CEO of the life sciences financial services group Burrill & Co. “At the same time, Big Pharma and Big Biotech increased their venture activities in early-stage financing through centers of innovation and partnerships with venture capitalists, incubators, and research institutes to launch companies. Expect corporate venture to take a more active role in 2014, especially in early-stage deals. Early-stage capital will remain tight with a handful of companies raising large initial rounds.” Despite the challenging fundraising environment, Burrill sees a brighter year for the diagnostics industry. “Diagnostics will grow in value in 2014 as increased pressure from payers to pay only for those drugs that work will demand defining the patient population most likely to benefit from their use,” writes Burrill. “At the same time, diagnostics companies will have to demonstrate to payers their tests’ effectiveness in reducing overall costs and/or improving outcomes in order to get them reimbursed. . . . Expect to see insurers embrace value-based pricing in the United States, much as it has been embraced in European countries and elsewhere.” Takeaway: Signs point to a rebound in M&A in the laboratory and diagnostics segments in 2014. With tremendous pressure to reduce costs, technologies that drive greater operational efficiencies will be acquisition targets for traditional buyers. Side Box: 2014 Acquisitions Start Quickly Deals in 2014 got off to a quick start with several large deals announced in early January.  

• GE Healthcare (United Kingdom) agreed to buy three business units from Thermo Fisher Scientific(Waltham, Mass.) for roughly $1.06 billion. The deal, announced Jan. 6, includes a gene modulation business for drug discovery, magnetic beads business for protein analysis and diagnostics, and the HyClone cell culture business. The divestiture will allow Thermo Fisher to overcome antitrust concerns in the European Union regarding its pending acquisition of sequencing firm Life Technologies. For GE this acquisition represents further expansion of its life science businesses, which John Dineen, chief executive of GE Healthcare, says is the company’s fastest-growing business area. Together the three units, Thermo Fisher said, had estimated combined revenue of $250 million in 2013.

• Johnson & Johnson (New Brunswick, N.J.) announced the sale of its Ortho Clinical Diagnostics unit to private equity firm Carlyle Group (Washington, D.C.) for $4.15 billion on Jan. 16. The divestiture allows J&J to reallocate  resources from a slow-growing, non-market leader business segment to more lucrative products. According to a report by Reuters, Carlyle believes that Ortho Clinical Diagnostics, which includes equipment for laboratory diagnostics and blood transfusion screening, has growth potential in emerging markets.

Side Box: Domain Associates’ Fund Invests in Diagnostics Among the venture capital funds committed to investing in diagnostics companies is Domain Associates (Princeton, N.J.). In 2009 the firm raised DOMAIN VIII, a $500 million fund. The fund’s most recent diagnostic placements include: Xagenic (Toronto; December 2013). Domain led a $20 million series B round for point-of-care developer Xagenic. The company is developing lab-free molecular diagnostics platform with 20 minutes time-to-result based on patented nanostructured microelectrodes that allow for direct nucleic acid detection from clinical specimens without the need for extraction. BioNano Genomics (San Diego; follow-on October 2013). BioNano Genomics completed a $10 million follow-on round of funding that will allow for further development and commercialization of its automated, benchtop IRYS system that can identify genomic structural variation. Applied Proteomics (San Diego; August 2013). Applied Proteomics will use its $28 million series C round to begin commercializing protein-based diagnostic tools. The company is building a CLIA-lab that will use an MRM mass-spectrometry-based platform for its first blood test that detects precursors to colorectal cancer.