BB&T Washington Editor

IPOs are still in neutral, but venture capitalists remain big on med-tech

WASHINGTON – It seems fairly likely that a number of med-tech companies watched with dismay as initial public offerings (IPOs) sagged over the past year or so, but these firms need not abandon any thoughts of an exit strategy, two analysts with Ernst & Young (New York) said at AdvaMed 2008, eld here in late-September.

The two team leaders – who spoke at the second annual med-tech conference hosted by the Advanced Medical Technology Association (AdvaMed; Washington) – also indicated that while the rate of venture capital investment has slacked a bit from its torrid pace of earlier this year, the strong start at the beginning of the year may provide enough of a base that total VC investment may end up matching the record-setting clip of 2007.

Richard Ramko, U.S. medical technology leader at Ernst, said last year's "record-breaking venture capital was up to $3.7 billion." The size of the average investment also rose, from about $9 million in 2004 to about $14 million in 2007. "We've seen the average deal size go up" in recent years, Ramko said, but investors "want a clearer [regulatory] path" for their money. However, the trend on average VC investment seems to be reversing slightly this year, falling from $1.4 million to $1.3 million for the first half of the year.

Ramko showed a chart that depicted the effect of the greater interest on the part of VC money in products that are closer to showing a profit, hence putting more money into late-round companies and less into early-stage companies. He said "this trend has been going on for a while. The challenge is that if you do that for a number of years," the pipeline of new products will tend to run dry.

Ramko described 2007 as "the best IPO market since the mid-90s," but 2008 is shaping up as a tougher environment for going public. Ramko said the number of firms that have gone public has ebbed from 13 last year to three thus far this year, and he said he does not expect to see any more successful IPO offerings this year.

Ramko pointed out that the definition Ernst & Young used to define a med-tech company required that the company be headquartered in the U.S., and was limited to firms "that primarily design and manufacture medical technology equipment and supplies." Contract research organizations and contract manufacturers are not included.

According to Ramko's numbers, total financing for med-tech firms is off in 2008, partly because of the drop in IPOs, but also partly because of a stiff drop in convertible debt, which is defined as loans that can be converted into stock. Convertible debt last year ran toward $2 billion, but only to about a quarter of that sum in the first six months of this year.

Ramko said VC investors will stay involved in med-tech, but opined "it will be the latter part of 2009 . . . before the public market opens up" for IPOs. As a result, "you'll see companies going public later in the life cycle." Private equity (PE) investors are also expected to stay active, giving device makers an exit strategy, but acquisitions or mergers that come in at a value above $1 billion will be tough to put together until the current debt mess settles.

The numbers offered by Ramko indicated no buy-outs of device makers by PE firms in 2005, but indicated a spike the following year to almost $13 billion. This number is slightly skewed, he said, by the purchase of Bausch & Lomb (Rochester, New York) by PE firm Warburg Pincus (New York) for almost $3.7 billion. PE purchases last year fell to roughly $10 billion, and the first half of 2008 seemed to keep pace.

According to Ernst's global biotechnology leader, Glen Giovannetti, who appeared with Ramko, PE investors are of the view that "med-tech lends itself to their model . . . because they're buying cash flows." This does carry the condition that these investors are more geared toward "middle-market transactions" and less interested in start-ups and mature companies, such as the purchase of Chrysler (Auburn Hills, Michigan), which Cerebrus Capital Management (New York) bought last year.

The Ernst numbers included a breakdown of revenues for companies that are not part of a conglomerate such as Johnson & Johnson (New Brunswick, New Jersey). According to Ramko, independent device makers enjoyed a 6% boost in revenues in 2007 over the previous year despite a 3% decline in the number of firms occupying this territory.

Venture capital's impact on healthcare remains significant, Ramko noted, making up 33% of all healthcare investments. That number has held more or less the same level since 2003. However, VC has a more prominent place in the device and diagnostics industry, making up only 5% of all med-tech investment in 2001 but pushing to a high of 12% of all such investment last year. That ratio is expected to hold steady this year.

While the short-term outlook is mixed, the current situation is expected to have little impact on the longer market, which Ramko said bodes well because of the impact of an aging America on co-morbidities. However, he also cited greater access to healthcare in the developing world – much of which has its own baby boom to deal with – as another source of customers in the decades ahead.

When asked about any difference in healthcare spending depending on which candidate wins the presidential election in November, Ramko declined to attempt a forecast, but said that regardless of who wins, "clearly the pricing pressure" is something that will continue to increase.

He said "companies will have to continue to address that" in their attempts to obtain a national coverage decision from the Centers for Medicare & Medicaid Services. Any product that turns a procedure from an inpatient to outpatient procedure, or trims the amount of time a patient spends in the hospital, "will be very valuable."

Ramko said the take-home for those seeking reimbursement is that the offering "has to be better [than the competition] and it has to reduce cost."

Scrutiny of cardio devices to continue

A conference session addressing the future of cardiovascular devices painted a complex picture. While sheer demographic trends promise a robust market, concerns over the appropriateness of the use of many cardiovascular devices hint that getting a device accepted by the market will require more work.

Another problem is that patients have a tough time deciphering the data behind the devices, but one panelist said that the doctors have almost as much difficulty making sense of those numbers.

Session moderator Peter Groeneveld, MD, assistant professor of medicine at the University of Pennsylvania (Philadelphia), said the standard of care for infarction in 1965 did not include many things taken for granted today, such as defibrillators and stents. Even beta blockers, which were available, were not typically used.

"The 30-day mortality rate for [infarction] patients over 75 has been halved" in the interim, Groeneveld said, which nonetheless came at a cost. The advent of Medicare, which he characterized as "the most important event in healthcare history," occurred at a time when healthcare spending "represented less than 1% of GDP." However, that number has risen to 3%, despite substantial economic growth.

"It really is new healthcare technologies . . . which are driving the coming fiscal challenge," Groeneveld said, adding that the situation "presents a value imperative" that will incur either "policy changes . . . or differential access to care."

David Magid, MD, director of research at Colorado Permanente Group (Denver), said the current approach to translating the latest data into clinical practice "takes too much time and is too expensive." He said that the Cardiovascular Research Network (CRN), a Kaiser effort, is looking into costs and outcomes to establish value.

Fourteen of the 15 participating healthcare centers "have electronic medical records," Magid said, but added that "one of the challenges of working together is to take these 15 healthcare systems' data" and reformat all that data "into a common data dictionary" that permits useful analysis.

"Each of the organizations was not thrilled with the idea of just sending their data to a repository," Magid said, so the data are stored behind a firewall so as to ensure patient privacy.

CRN is only a year old, but its coronary stent analytical effort "indicated that outcomes were better with DES than with bare-metal stents" with regard to infarction and death, Magid said.

The network has a grant to look at anti-platelet therapy in conjunction with DES use, and a project on ICD use "based on eligibility criteria" also is in the works. CRN also is hoping to extend the ICD effort to look at quality of life.

"Standardized data formats have really been the key to our success so far," he said, but he also acknowledged that definitions of a disease state – which vary between organizations, often depending on severity – is an issue "that goes beyond the standardization."

Magid said CRN found it had to adopt a uniform definition for disease states because otherwise "you can make errors in your interpretation" and potentially invalidate the conclusion. However, he said the data format question looms larger, stating that CRN has spent "a huge amount of time standardizing the format."

Sarah Goodlin, MD, president of Patient-Centered Education and Research (Salt Lake City), said about 6 million persons in the U.S. are diagnosed with congestive heart failure. She acknowledged "clear geographic variations in approaches to [medical] management" and rates of implantation of implantable cardioverter defibrillators (ICDs) and cardiac resynchronization therapy (CRT) units, the latter of which combines pacing and defibrillation.

Goodlin referred to well-known data that indicate "a substantial disparity in ICDs for black men versus white men [and] for women versus men," adding that "the lowest proportion receiving ICDs were black women."

However, she said there is little or no data on comparing outcomes, which might clarify the question of which patients are not good candidates. She said the data indicating the low rates of fire for most such equipment suggest that most patients are "clearly not even meeting the criteria.

"Many issues influence the way decisions are made," Goodlin said, adding "we know very clearly that people's choices are clearly influenced by the way the choice is anchored." There is a difference, she said, when a doctor says 30% of patients survive compared to telling the patient that 70% of patients die.

"In the face of uncertainty, people tend not to follow logical decision making," she stated, noting that most patients experience "substantial difficulty understanding numerical data."

On the other hand, "we also know that clinicians [also] have difficulty understanding numerical data," which makes it tough for docs to advise their patients, Goodlin said. And since "we don't have a good way to predict the course of heart failure," and "many heart failure patients are unaware of its life-limiting potential," the decision-making process is further muddied.

The situation calls for "clear information, and tools to facilitate patient selection and comprehension" as well as "education for clinicians in participatory decision making." There are other issues from within the clinical setting, but she made the case that unlike a drug, which can be stopped at any time, "a device is likely to take someone down a path from which they cannot simply turn back" on short notice. Consequently, burdens and benefits have to be explained in terms that make sense to the patient.

Part of the problem is that "there clearly are benefit for cardiologists who implant ICDs to implant more ICDs," and while "there are some very clear guidelines on how long someone should be on optimal [medical] management" before referral, "those guidelines are often not followed," Goodlin said.

She said that she sees patients aged 80 and older who get ICDs despite profoundly complicating co-morbidities and "who don't understand what [the device] is." Some such patients are completely taken by surprise when the ICD shocks their heart, she said.

Patents now will be tougher to defend

Observers of the legal turf that device makers call home have had a lot to look at over the past year, including the case of Riegel v. Medtronic and the subsequent legislative proposal to end federal pre-emption of liability for pre-market approval (PMA) devices, but another set of developments have reshaped the way that patents are obtained and held.

The proliferation of devices for cardiovascular use, including stents and catheters, have been an especially ripe source of patent conflicts, with Abbott Laboratories (Abbott Park, Illinois), Medtronic (Minneapolis) and Boston Scientific (Natick, Massachusetts) all in court with one other and with other manufacturers pursuing remedies for allegedly infringed patents.

At the AdvaMed conference, several attorneys in both academe and in practice took to the microphones to give a roundup of those recent developments.

The session's moderator, Brian Hopkins, a partner working out of the New York office of Mintz Levin (Boston) pointed out that one recent issue was settled in a lawsuit filed by GlaxoSmithKline (London) against Jon Dudas, director of the U.S. Patent and Trademark Office (PTO), over rules changes that the firm alleged were of sufficient importance that they went beyond the agency's authority.

PTO made the decision last year to limit the number of continuations a patent holder could apply for in connection with a patent. Hopkins noted that the agency lost that suit because "they were substantive changes, not procedural," but noted that PTO's appeal is pending. One of the factors behind the court's ruling was that PTO wanted to apply the rules change retroactively.

John Thomas, a professor of law at Georgetown University (Washington), said he is "one of four or five people who actually liked the rules," except for retroactivity. Nonetheless, he said the federal appeals court will probably uphold the district court's ruling.

William Murray, divisional counsel at Abbott, said some of the rules in question "are procedural in many aspects and have merit." However, he said retroactivity is "what the court went off on." He said that for biotech and pharma, it is nearly impossible to predict which compounds that are in development will go into trials, which makes it difficult to know how much effort to put into any given patent application.

Joe Havrilla, senior VP for innovation at Medrad (Warrendale, Pennsylvania), described retroactivity as "a problem and a misstep," but said "to limit patentees ability to file continuations later not only limits ability to invent, but also put a higher burden and higher cost . . . on inventions that otherwise might not warrant that kind of investment." A patentee will have to predict how to structure claims, which "will ultimately hurt innovation and the patentee." He said the limitation on continued claims is helpful from an administrative standpoint, but not a good idea for device makers.

Hopkins asked if the administrative headaches associated with continuances could be dealt with by boosting the related fee. Thomas replied, "Congress has already thought about this," but took no action. He also said PTO proposed six or seven years ago to boost the fees but the idea "got shot down by the independent inventor community."

The European Patent Office has not been sitting idly by, either, Hopkins noted, and among the provisions of recent regulatory changes is one that allows applicants to file their patents in English only, rather than file in the languages of each of the 27 member nations. While this seems to promise much greater convenience, the panel stated that this can be a hazardous route to take.

Thomas said language is "a very emotive subject" and that "on the one hand, most of these translations are never read," but "on the other hand, English is not that commonly spoken" in many EU nations, at least outside their national capitals.

Abbott's Murray said, "you really have to think through the invention . . . and if you think there's a chance you're going to have to litigate it, you should bite the bullet" and get the original application translated. He said this allows more control over the accuracy of translations, and the problem is not limited to Europe. "The translation problems in China are just huge."

Panelist David Schramm, a senior IP litigation attorney at Medrad, also recommended getting translations checked by a third party. "Multiple firms have told us they lost [patent cases] because of the translation."

The Supreme Court decision in KSR v. Teleflex, which the court ruled on in April 2007, also is seen as having a wide-ranging effect on patent law. The case arose when KSR connected an adjustable vehicle control pedal to an electronic throttle control. KSR's position was essentially that this combination of elements was obvious and hence deserved no patent protection.

The justices decided the case on the language of the related law, which states that "a person of ordinary skill in the art" is protected when to making a thing that is covered by a patent when that item is, in a word, obvious. Justice Anthony Kennedy wrote in his opinion that the phrase "a person of ordinary skill" entails the notion that such an individual is "also a person of ordinary creativity, not an automaton."

Thomas said, "When you read the opinion, it's earth-shaking. It turns obviousness on its head" and "dispenses 25 years of opinions." He warned that "now marketplace forces are supposed to dictate" the question of obviousness.

The court's unanimous opinion also states that a test of obviousness is whether "there existed at the time of invention a known problem for which there was an obvious solution encompassed by the patent's claims." The court also stated that the proper question "was whether a pedal designer of ordinary skill, facing the wide range of needs created by developments in the field of endeavor, would have seen a benefit to upgrading [a prior art patent] with a sensor."

Murray said, "The biggest impact of KSR is prophetic inventions" that have been granted, but which have not been put into play. Schramm said the decision means "now you're going to have to argue around" a previous explanation of a patent, should the holder of a patent attempt to file an infringement suit.

Contract manufacturing often seen as an essential

The 11 letters forming the word "outsourcing" have not deterred some from seeing it as a four-letter word in recent years, but that word will come to occupy a larger place in the lexicon of device makers in the coming years, even when the outsourced function is done in the U.S.

While documentation snafus have peppered recent warning letters in connection with outsourcing – aka, contract manufacturing in this context – the speakers at a conference session all said that this problem is easily overcome if an appropriate mechanism is put in place early in the contract manufacturing agreement.

According to the announcement for the meeting, research done by Covington Associates (Boston) indicates that a fifth of all manufacturing described as original equipment manufacturing "was outsourced to third-party vendors in 2005, resulting in annual market growth of 26%, to $4.4 billion." This is double the $2.2 billion spent on contract manufacturing three years earlier. Covington's report apparently also made the claim that the ratio of devices made by third parties will rise to about 40% by 2010, a scant year and a half from now.

Presenting a real-world scenario for outsourcing were Chris Oleksy, president of ATEK Medical (Grand Rapids, Michigan), an outsourcing firm, and Bryan Szweda, the director of OEM transfer for Boston Scientific (Natick, Massachusetts). The two teamed up on a presentation that described how to go about making such a collaboration function well.

Oleksy said that a contractor needs to clearly understand where the client company wants to go. "It doesn't start with me coming in telling him 'what ATEK can do for you,'" he said, but starts with asking the customer where they are trying to go.

"You'd be surprised at how many people fail" at the effort because of erroneously proposing a direction instead of getting the customer's input first and then suggesting a way to get there.

Szweda noted that he and his employer had at least one thing in common with many companies looking for outside manufacturing. "We don't want a partner for the next year or two," he said, noting that a longer-term perspective is mandated by the fact that many prospective customers have more than one product line in mind when they think of contract manufacturing.

One of the essential questions about a company, Oleksy said, is "where is it and what is it based on?" Firms can usually do pretty well on two out of the three of the measures of operational excellence, customer intimacy and product leadership, but doing all three well is quite a tall order. Most med-tech companies with a portfolio want to focus on the second and the last, in part because there is "quite an overlap between those spaces," e said.

Szweda made the case "that you cannot afford to be a leader in all three." Describing a guidebook to the relationship, he said "the owner's manual is more important than the contract" because the former provides a detailed map as to who will do what. Putting this into a contract makes the contract a rather huge document. Furthermore, a contract fixes some functions that may need more flexibility than a contractual definition would allow. "As you move into the relationship, there may be something that needs to be altered" in order to deal with the rapidly changing landscape of device manufacturing.

David Busch, a principal at the management consulting firm PRTM (Boston), confirmed the notion that device and diagnostics firms want to move to a variable supply chain. "They may be in China today, but when will they be in Vietnam?" he asked. He also predicted that Africa will soon become a source of low-cost labor.

Busch said a device maker can trim its cost of goods sold by as much as 50% over five years by outsourcing "if you build a good model and are working with your partner appropriately." He reminded the audience that "the auto industry is transforming itself from an offshore model to an outsource model" in that it will buy parts from manufacturers rather than locate its own facilities in other nations.

The first step a firm might take is to "triage your [product] portfolio: what has to stay in house, what has to go out of house, what has to go offshore," Busch said, making the case that "huge cost savings are available." He said he is aware of one firm that shaved $60 million from a half-billion-dollar tab for cost of goods sold.

"Part of your rationalization is moving to where you have an attractive market," Busch said, saying that Shanghai, China and Singapore are attractive as both markets and places to locate manufacturing plants. China "typically comes out on top" in such an analysis, he said, and while Brazil is an attractive market, it is not great place to locate. Romania, in contrast is an unattractive market, but potentially good for a sourcing location.

However, Busch advocated a long-term strategy. "If you don't have that in China and India, you're going to get slaughtered," he said.

When asked to comment on recent warning letters that address contract manufacturing, Oleksy said some customers "will throw the ball to the supplier and say 'it's yours.'" In such a case it is very easy for contractor and contractee to get out of sync in GMP terms.

This can be handled with matching compliance software, Busch said, but he said that contractors often operate with more sophisticated software than their OEM clients, so "data is not collected [by the client firm] as regularly as it should be." He said "IT is a huge part of" the transition, but routine updates to data files are often the last thing the client bothers to think about.

Private equity firms like contract manufacturers

Another of the panelists on contract manufacturing was Philip Borden, a principal at private equity firm Riverside Partners (Boston), who said his firm has invested about 25% of its capital in this industry after talking to executives at about 50 contractors and client companies. "So far, we've made two large platform investments," namely New England Precision Grinding (NEPG; Holliston, Massachusetts), and J-Pac (Somerset, New Hampshire), both last year.

He said "the growth in contract manufacturing has been astonishing," forecast to rise from $2.2 billion in 2002 to a forecast of $8.9 billion by 2010. "There's a broad recognition in the industry" that manufacturing is not what a lot of potential clients want to continue to do, and "clearly, cost is another key component" due to capital costs, among other things.

A steady customer base is another reason private equity likes contract manufacturing. "Switching from that contract manufacturer is very difficult" and expensive, and tough to justify if the contractor is doing a good job, Borden said. He said it costs as much as $1 million and the effort can devour a year.

Also, "the customers are relatively price-insensitive" in part because "the margins medical device makers are making" are fairly healthy, he said. Hence, there is "a little less sensitivity to price, with quality and time to market" being the prime motivators.

"One of the weaknesses [of the large contracting firm] is the lack of responsiveness, particularly for smaller medical device firm" clients, Borden said, adding that one comment he has heard more than once is "we can't get the time of day" from the contractor. He said customer service "has suffered" despite economies of scale and good capital and professional skills sets.

Small players in the contract manufacturing business are responsive, but not a one-stop shop for the most part, which many manufacturers want. Mid-size players tend to "focus on a niche," he said, and develop skills that are not easily replicated. They do not compete on price, but on service.

Borden said Riverside picked up NEPG because the company has "the ability to get in early and form a tight relationship with customers," which he said "is absolutely critical." NEPG, like most successful businesses, "knows what it does and what it doesn't do well," and hence is a well-focused business.