This was originally posted on LifeSciVC.com.

Contract Research Organizations (CROs) have historically been sleepy fee-for-service partners for the drug industry, widely disregarded as not innovative, and their scientists certainly not treated with the same professional respect as their counterparts in Pharma R&D.

But this is clearly changing: CROs are now stepping up as important change-makers in the life science ecosystem and are helping drive the “Pharma R&D makeover”.

I was reading JPM analyst Tycho Peterson’s recent report on CROs after the Society of Toxicology meeting, and he highlights a number of interesting points.  While all of Big Pharma has to varying extents embraced the global CRO industry over the past decade, especially for clinical development, one of the most interesting observations was the impressive number and scale of the recent strategic deals with Pharma they’ve inked recently.  Here’s a subset:

• WuXi-BMS (Mar 2011): WuXi announced it will build and specifically dedicate a Shanghai-based facility GMP stability testing for BMS’ global NCE programs.  A core part of an FDA-regulated process moving to China.
• Takeda takes on Covance & Quintiles (Feb 2011): Part of the former’s decision to “move toward a fully virtual outsourcing model”, Takeda will partner with Covance and Quintiles across all therapeutic areas except oncology (which will continue to be led via their Millennium organization).  Takeda with its nearly $5B in R&D spend going virtual?  Probably a directional rather than specific comment, but interesting nonetheless.
• Pfizer & chemistry (2011): Pfizer has recently decided to break up its medicinal chemistry teams into“designer chemists” (thinkers) vs “synthetic chemists” (do-ers), with the latter being split between existing sites and offshore CROs like WuXi.  Wonder how long that cost differential for synthetic chemistry can be maintained.
• Covance-Sanofi (Sept 2010):  As part of a 10-Year, ~$2B partnership, Sanofi will transfer a set of sites/assetsto Covance in France & the UK, and get a set of outsourced functions in discovery support, tox, med chem, clinical, and central labs.  Looks like a great deal for Sanofi: site rationalization and “synergy capture” in tough labor markets, while locking in a fixed deal for 10 years.
• CRL-Pfizer (Feb 2011): Earlier this year, Pfizer contracted CRL to distribute 11 lines of genetically modified animal models covering CNS, diabetes, and CV.  Although a small deal, it’s interesting to see that Pfizer is actively monetizing its animal models.  Hard to imagine 5 years ago.

Those are just a few of the deals.   There’s a bunch more that have been inked in the past 1-2 years (e.g., PPD and GSK, ICLR/PRXL and BMS, Paraxel and Lilly, PPD and Eisai, etc…).

As expected, accessing talent and labor cost benefits by emphasizing China is obviously an important part.  Peterson notes:

“Although still only a small fraction (~3-4%) of the global CRO market, China-based CROs have grown 30% in the last five years, with the growth expected to remain >20+% for the next five years. Furthermore, while leading clinical-stage CROs have advanced in China (e.g., PPDI, Parexel, Quintiles, ICON), preclinical companies, including Covance and Charles River Laboratories, have moved more slowly, a trend that should continue to favor SHP and other China-based CROs”

People and talent are an important part of this transformation of the ecosystem.  Over the past decade, Big Pharma organizations have supported, willingly or not, a huge knowledge and talent transfer to CROs.  Many of the project leaders in offshore CROs are Big Pharma trained medicinal chemists.  Clinical trial management expertise has also flowed out of Pharma and into CROs.  Furthermore, many CROs have recently been attracting some very seasoned executive talent: Lee Babiss ran Roche Research and now running a division at PPD; Vince Aurentz was head of strategy/BD for MerckSerono and now with Quintiles; Rob Armstrong was leading external R&D for Lilly and recently moved to Piramal; even Biogen’s former CEO Jim Mullen has joined a Patheon, just to name a few.  This longer term trend of knowledge transfer and talent cross-fertilization between Big Bio/Pharma and CROs will further accelerate the trend toward greater ecosystem integration.

One reason why I think CROs are likely to be change-makers for the drug industry is their culture: they are by nature cost-conscious businesses.   According to Peterson, the business is incredibly tuned to its capacity utilization and small changes off of the ‘ideal’ of 85% leads to significant pricing pressure.  Taking capacity offline for a while makes a lot of sense for many CROs (btw, can you imagine Pfizer just temporarily taking Sandwich offline for a couple years?).  The CRO industry understands how to manage this pricing pressure: in 2009 pricing was at a 20-30% discount to the peaks of 2006-2007 for preclinical services, so they’ve been adjusting.  This is a business that watches its operating costs very closely, and the pressure to compete by ‘doing more with less’ is very much part of the CRO industry’s culture.

This stands in start contrast to Big Pharma: most firms have only functioned in a world of incredibly high operating and gross margins.  Hugh sums for R&D spending were easy to come by and a culture that ignored costs became embedded in the system.  Saving a little here and there in R&D made little sense if the next blockbuster spit off billions in profits.  Like any system with too much money and little incentive for cost-control, R&D costs have skyrocketed and all the components of the system extracted a ‘rent’ on this excess funding.   Like all things that can’t go on forever, this won’t (or hasn’t).

As a more general point, this lack of cost consciousness plagues advancements in healthcare.  Innovation in most other industries strives to take cost out of the system, even for direct costs (e.g., enterprise SaaS, personal mobile devices like iPads, etc…); all of this comes out of things like Moore’s Law of improving computer power and the commensurate reduction in cost.   In healthcare, however, for decades new innovations that have improved health outcomes have almost always added more direct costs (though ‘system’ costs may come down when looking at full pharmacoeconomic impact and such); drug costs have outpaced inflation for years. Its intriguing to entertain the idea that putting CROs closer to the center of the ecosystem could be a key ingredient in allowing the drug business to maintain its focus on innovating but doing it while reducing system costs. At the very least, I think they are certainly an important part of the solution.

An obvious ecosystem trend is that large pharma disgorges itself of more research sites and infrastructure, some of which will be shut down, others absorbed into existing CROs or spun-out into new ones.  I also think smaller biotech will follow the same trend: more and more virtual or semi-virtual biotechs will be funded that require less infrastructure and focus increasingly on an asset-centric model of innovation and less on platform-centric capacity building.  Equity and success-based collaborations with CROs will become commonplace for startups (it’s already being done, but not commonly).  These startup biotechs are only able to “go virtual” by leveraging the emerging breadth, expertise, diversity, and cost-consciousness of the global CRO industry.  And to help enhance their access the startup market, and leverage the efficiency of relationships, I also believe CROs will increasingly rely on ever tighter connections with biotech venture capital firms to access portfolios of assets requiring outsourced functions.  VCs successful at fostering these relationships will distinguish themselves over time.

The ecosystem is changing and CROs are both driving and benefiting from it.