Outsourcing Landscape

Companies are facing challenges in adopting and implementing integrated and more strategic relationships. While organizations have embraced these relationships as strategically critical to their long-term viability, and adoption has increased substantially in the last year, it has progressed in unexpected ways, leaving the outsourcing landscape misshapen and unstable.

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A bird's eye glimpse of today's outsourcing landscape reveals:

• Small and mid-sized contract research organizations (CROs) have largely been left behind while major CROs—the only organizations with sufficient scale and diverse talent—service a growing number of integrated relationships.

• Many smaller and mid-sized CROs have looked to joint ventures in order to scale up and jump on board in servicing integrated relationships of their own.

• Sponsors have compelled their preferred CROs to customize each integrated relationship in order to accommodate company-specific systems, processes, and cultures.

• For these CROs, customization means higher costs to service integrated relationships and lower operating margins.

• In response, large CROs are poised to continue reducing fixed infrastructure costs and to move into more profitable service areas along the R&D continuum.

For industry insiders and observers alike the coming 18 months will be anything but smooth sailing, as sponsor sourcing requirements diverge from the operating needs and long-term strategies of the major CROs.

In addition, the suboptimal implementation of integrated relationships during the past two years has prompted many sponsors to modify their governance practices and to rein in their collaborative control.

New strategies, poor execution

Global operating conditions during the past five years have prompted pharmaceutical and biotechnology companies to seek new approaches to contain costs, improve infrastructure utilization, and facilitate operating efficiencies.

Weak consumer demand and restrictive price controls have dampened revenue and profitability. Facing an unprecedented near-term $125 billion in revenue at risk due to patent expirations and competition from generic drug equivalents, sponsor companies are aggressively reducing fixed costs and vying for ways to develop drugs more efficiently.

Clinical and nonclinical services outsourcing have been essential solutions, helping companies achieve their operating and economic objectives. Without exception, pharmaceutical and biotechnology companies have increased their use of and reliance upon CROs to secure project-specific niches and full services as well as portfolio-wide functional service, multi-functional service, and alliance-based service support.

Figure 1

Smaller and some mid-sized pharmaceutical and biotechnology companies are primarily using transactional relationship outsourcing to augment capacity for a specific task in support of a given project. This approach affords small and mid-sized sponsors variable multi-functional capacity to support the peaks and troughs of their portfolio resource requirements.

The largest and some mid-sized sponsor companies are actively using more integrated and strategic relationships (e.g., functional service providers (FSP) and alliances). These relationships offer major sponsors the opportunity to transfer operating risk to better leverage their internal resources, and to streamline select non-core functional areas. Integrated functional and alliance relationships also permit CROs to become essential to, and embedded within, sponsor company portfolios.

For sponsors with large and very active development portfolios, FSP and alliance partners hold promise in establishing longer-lasting relationships that benefit from strategic insight into and engagement in future portfolio needs. Under these relationships, sponsors partner with a much smaller number of contract service providers. They gain the assurance of dedicated global capacity and expertise under shared governance, coordinated communication, and issue resolution, and integrated operating processes and systems. Integrated relationships also offer higher revenue per client to CRO partners.

Recent published reports affirm this promise: Pfizer and Eli Lilly, two of the earliest adopters of integrated alliances, report that their three-year-old relationships have resulted in significant cost savings, cycle-time improvements, and fewer contract delays. Eli Lilly, for example, has reported 20% cost savings on data management and monitoring and a 93% improvement in monthly patient-enrollment volume. Pfizer has reported saving $20 million annually through consolidating its vendors from 150 to 17; a 26% reduction in enrollment cycle time, and an 80% reduction in the number of contracts delayed by more than 120 days.

Although many sponsor companies have embraced strategies to establish integrated outsourcing relationships, most sponsors have executed these strategies poorly during the past 24 months. Interviews with, and anecdotal reports from, sponsor companies indicate a large number of implementation shortcomings, including:

• Coordination and communication problems among local affiliates and lower-level management—parties who have had limited to no involvement in establishing integrated relationships—and CRO project teams

• Failure to communicate the new outsourcing strategy to support functions, resulting in confusion and inefficiency

• Organizational commitment to integrated relationships has waned as governance roles and responsibilities of personnel at varying levels in the sponsor organization have not been clearly defined

• Realization that too much responsibility has been transferred to CRO personnel, resulting in more strained relationships between sponsors and their valued investigative sites and subcontractors

• Senior management at both sponsor and CRO companies has failed to adequately convey relationship expectations to study teams, resulting in redundant activities and poor communication

• Failure to communicate the rationale for the new strategy throughout the enterprise—forcing staff at the execution level to establish their own practices and processes, resulting in inefficiency

Challenges and sponsor response

The results of a 2011 survey conducted by CenterWatch echoes these anecdotal reports on the challenges of implementation. Conducted between March and June, 134 respondents from CRO companies evaluated 52 FSP and alliance relationships and reported that sponsors were having major difficulties providing adequate oversight, clearly defining governance team roles, and establishing efficient issue-resolution processes. With experience under their belts, having now recognized that the implementation of their new outsourcing strategies was weaker than expected, sponsors are modifying and adjusting governance structures and collaborative processes and practices.

Figure 2

A number of sponsors are exploring ways to empower internal staff at the execution-level, more actively manage communication and coordination processes and systems, and more effectively measure collaborative performance.

Sponsors are also closely watching regulatory agency response to integrated sourcing relationships in anticipation of tighter scrutiny of clinical trial oversight and issue resolution. FDA and EMA have both signaled strong interest recently in understanding how integrated outsourcing relationships impact global clinical data quality and compliance.

CRO customization and eroding profitability

As sponsors move to adjust—and in many cases increase control over—their integrated relationships, CRO partners appear to be moving in the opposite direction. Many top CROs are consolidating assets; subcontracting non-core capabilities that are a drain on their profitability; and looking to tie into more variable approaches to accessing a diverse pool of talent specializing in a wide variety of drug innovation areas.

Regardless of the types of relationships that sponsors and CROs form, contract services profitability is being challenged. Sponsors want more flexible and fluid drug development operations at lower relative cost. Pharmaceutical and biotechnology companies are requiring CROs to provide more favorable preferential pricing for both project-based tasks and portfolio-based services. This practice alone is putting downward pressure on CRO company margins.

Integrated relationship customization is also deeply squeezing large CRO profitability. No two sponsor-CRO relationships are the same. Every sponsor wants to establish relationships that uniquely suit their culture, their operating style and practices, their systems, and their management models. Those CROs that have entered into a number of FSP and integrated alliances have had to increase their own operating capacity, infrastructure, and capabilities in order to service the unique demands of each partnership. Customization cannot be scaled. It demands more infrastructure and management and eats into the CRO's ability to operate efficiently.

Sponsor company adoption of FSP and alliance relationships has pushed CROs of various sizes to pursue widely different strategies:

• Small CROs are focusing on servicing transactional relationships and subcontracting out their capacity and capabilities to larger CROs. This segment has reported relatively strong performance during the past several years.

• Mid-tier CROs have been blocked out of the outsourcing market's movement toward more integrated and strategic relationships. These companies lack sufficient operating infrastructure and expertise to secure and support integrated relationships. Mid-tier CROs have turned to the private equity markets to build through acquisitions and mergers—resulting in more capacity and capabilities to compete with the market leaders and play in the integrated relationships arena.

• The largest CROs—those uniquely capable of providing the depth of capacity that sponsor portfolios require—have been the primary recipients of integrated relationships. The vast majority of newly established FSP and alliance models have been awarded to the top 10-largest CROs. According to investment banking firm Fairmont Partners, the market for integrated alliances may be even more lopsided. The top five-largest CROs alone have entered into more than 100 alliances during the past several years.

According to CenterWatch, the majority of revenue for leading CRO companies now comes from strategic integrated relationships (e.g., functional and alliance relationships). Among the top 10-largest CROs, one third of their reported revenue comes from functional service provider relationships, 39% from integrated alliances, and 29% from transactional relationships. In contrast, the majority (60%) of revenue for niche and mid-sized CROs comes from transactional service relationships.

In addition, CenterWatch reports that an overwhelming number of CRO professionals (80%) expect sponsor use of integrated alliances to significantly increase during the next three to five years. Almost half of the 134 respondents believe that the predominance of transactional and functional service provider relationships will either decrease or not change during that same time period.

The largest CROs have highly diverse revenue portfolios. Many of these companies have recently reduced headcount and consolidated infrastructure (e.g., PAREXEL, Kendle, Covance, and PPD) to meet short-term profit objectives.

Many of the largest CROs have turned to the private equity markets to get out from under public market scrutiny and visibility. Doing so allows them an opportunity to "fix" their revenue mix quietly, with less transparency. It provides longer time horizons free from outside influence and reactive public market pressure to change and eliminate holdings.

Indeed, publicly traded CROs seem to be a dying breed. During the past eight years, 13 contract clinical research service providers that were formerly public companies have moved into the private equity markets.

Much to the confusion and surprise of many professionals in the clinical research enterprise, some of the largest market-leading CROs— including Quintiles, PRA International, and PharmaNet—have transitioned out of the public markets. The recent acquisition of Kendle International by privately held INC Research and the acquisition of PPD by The Carlyle Group and Hellman & Friedman continue this trend.

Poor global economic conditions for drug developers and unforgiving and intensifying investment community scrutiny have made the public markets less attractive to CROs. In the coming years, behind the veil of the private markets, large private CROs may look to sell off under-utilized and low-margin-producing assets. Some may seek to expand their offerings to include novel, high-growth, and higher-margin services, such as R&D and health service technologies; nonclinical services; clinical supplies; regulatory sciences; and R&D and health consulting services. These novel service areas extend the integration of CROs into all areas of R&D. Long-term interaction between these areas in a more coordinated and integrated fashion promises to drive higher levels of drug development performance and efficiency.

Private equity investors, in turn, appear to be bullish about the life sciences industry in general, and they find the CRO market to be particularly attractive. CROs now double the global capacity of drug development professionals and play a critical and essential role in supporting pharmaceutical and biotechnology company R&D operations. Sponsor company reliance on CROs is certain to grow. CROs typically generate strong cash flow, manage their operating expenses prudently, and most have taken on minimal debt to fund their growth. Private equity investors will help reshape the CRO landscape and create substantial value through—in many instances—the eventual sales of CROs via initial public offerings.

Poised for change

The market for contract clinical services is changing profoundly. On one side are small and mid-tier CROs servicing primarily niche and full-service transactional relationships. The top mid-tier and market-leading CROs are concentrating on large pharmaceutical and biotechnology companies to obtain and establish more integrated relationships. Mid-tier CROs appear poised to continue to consolidate the outsourcing market in order to supplement their capacity and capabilities. Market-leading CROs will continue to pursue higher-margin businesses, expand their portfolio of service offerings, and increase their client base of integrated relationships.

Although FSP and integrated alliances offer the largest CROs continuity, upfront planning, and stability during periods of global economic growth, these same relationships can be more volatile as portfolio-wide delays and cancellations tax CRO operations during global economic downturns.

Large CROs that had established a diverse client base now face increasing client concentration under integrated relationships. Fairmont Partners has noted that ICON's 10-largest clients, for example, generated 50% of their revenue in Q2 2011 versus 43% in the same quarter a year earlier. PAREXEL's 20-largest clients generated 71% of their revenue during the same 2011 period versus 42% in the prior-year period. Client concentration will present higher levels of volatility that must be managed carefully and nimbly—perhaps through more variable operating models.

All CROs must manage their profitability as sponsors demand lower pricing. Larger CROs managing portfolios of FSP and integrated alliances also face the difficult challenge of running up fixed infrastructure costs to service client customization requirements.

Ultimately, these CROs will be forced to shed fixed costs and underutilized assets and to establish more flexible, integrated relationships with traditional and non-traditional parties. Private equity will continue to play a key role in supporting this movement.

Many sponsors may find it hard to accept alliances with large CROs that are structured more like virtual general contractors than primary service providers. Other sponsors will be very receptive to more open, virtual innovation models offering flexible access to diverse, global talent; shorter cycle times; and higher levels of efficiency.

In short, the adoption of integrated alliances is driving profound change in the outsourcing landscape. Among these changes are consolidation and leaner fixed infrastructure; expanded CRO portfolios offering contract services across a spectrum of R&D functions; and more elaborate and open partnering models comprised of service providers of varying sizes and positioning.

Kenneth A. Getz is a Senior Fellow at Tufts CSDD. He can be reached at kenneth.getz@tufts.edu.