The Outlook for R&D Outsourcing
What trends will impact growth and innovation in the medical device business landscape? Recent research may provide some insight.
Five years ago, medical device research-and-development (R&D) outsourcing was growing despite a poor initial public offering (IPO) market, a recent recession, a war in Iraq, a strained healthcare system and a large dose of risk aversion from the “dot com” fallout. Today, many of the drivers behind outsourcing have not changed (aging population, need for R&D efficiency, shorter development cycles, access to technology, etc.), but the business landscape looks entirely different. How does today’s business environment affect venture capitalists’ and OEMs’ decisions to invest their profits in R&D, whether it’s performed internally or externally?
First, let’s look at some of the recent economic changes. Since the beginning of the year, the nation’s unemployment rate has been rising, jobless claims are at their highest since hurricane Katrina and unemployment roles are at their highest since July 2004. Recently, there has been a housing collapse, a credit crunch, rising fuel prices and a turbulent financial market. During the first quarter of 2008, merger and acquisition (M&A) activity slowed and hedge funds retreated from medical device investment. Usually a slowing economy signals conservative business practices, whether it’s less hiring, less spending or reduced capital investment.
But this year also marks the first year that many baby boomers will reach an early retirement age of 62. As they begin claiming their Social Security benefits, other consumers also are demanding more from the healthcare system. In three years, boomers begin eligibility for Medicare. This year, however, Medicare begins paying out more in benefits than it collects in payroll taxes, thereby reducing the reserves in the Medicare trust fund. In addition, consumers are spending more of their own dollars on healthcare while also increasing their demand for elective procedures.
According to the Centers for Medicare and Medicaid Services, national healthcare expenditures are projected to nearly double between 2006 and 2015. At that point, the national healthcare expenditure is projected to account for 20% of gross domestic product (GDP). Presently at 16.5% of GDP, the United States outspends on a percentage basis of GDP all other countries in the world by more than 25%. During the last five years, national healthcare expenditures have grown an average of 6.8% per year and consumers today are paying 15% more in out-of-pocket expenses.
Besides the enormous challenges faced by the government to fund its existing commitments, there is a growing need for more inclusive and affordable healthcare. Regardless of the upcoming election results, we are seeing renewed pressure to enact broader healthcare coverage. This type of coverage should translate into more demand for medical devices. Affordable healthcare may translate into something else.
At the present time, there is a push toward more evidence-based medicine. Unfortunately, despite our higher healthcare costs in the United States, Americans don’t receive the commensurate quality. According to the World Health Organization, infant mortality in the United States ranks a poor 28th compared with other countries. And research from the journal Health Affairs shows that every year, more than 100,000 deaths in the United States are a result of medical mistakes or medically preventable deaths. This number puts the nation in 19th place among industrialized nations. Furthermore, data from the Organization for Cooperation and Economic Development show that numerous European countries have higher cervical cancer and breast cancer survival rates than those in the United States; meanwhile, mortality due to asthma in the United States is twice that of Germany or Sweden.
Therefore, while the United States spends more than any other country on healthcare, it’s not getting the best return on its investment. US lawmakers are preparing legislation for studies that would compare specific treatments—the idea is to have the federal government fund independent comparative studies on the effectiveness of drugs and medical devices (for more information about “comparative effectiveness,” see “On the Hill” on page 20). Having to prove effectiveness—versus conducting protracted clinical studies or having products compared in independent studies—may or may not be beneficial to the healthcare system. If treatment or approval is denied on the basis of debatable studies or relative effectiveness, innovation in the healthcare industry could suffer. Medical device companies need to see a path to market without additional unpredictable processes. It has always been difficult to legislate efficiency into the market.
As cost containment becomes one of the major driving forces in our healthcare system, we are bound to see changes. There could be increased pressure to make our system more market driven, to use funds wiser or to have consumers pay more out-of-pocket expenses.
Medical Device Venture Capital in the Past Five Years
While government wrestles with healthcare funding, there has been steady investment in medical devices from the private sector over the last 5 years. In fact, according to data from the National Venture Capital Association’s Money Tree survey, venture capital spending in the United States last year was the highest in six years. In the life-sciences sector (biotechnology and medical device), investment was at an all-time high at $9.1 billion in 2007 versus $7.6 billion in 2006. In addition, 2007 was a record year for medical technology investment. Medical devices saw $3.9 billion invested in startup company funding, a 40% increase from 2006.
Since venture capital funding is at an all-time high in medical devices, it’s safe to assume that future investments may not continue at their present rate. Despite any corrections we may see this year due to venture debt’s ties to the banking industry, there are a number of large funds focused on the longer term. Another reason to expect investments to moderate in the medtech industry are the lower returns medical device start-ups have produced compared with their biotech counterparts. Device IPOs need to prove predictable revenues and show profitability to be successful. During the last several years, it has taken an increasing investment to get to that inflection point, while valuations are not commensurately larger. Still, the life-sciences market in 2007 represented 31% of all venture capital investments, making it the top-ranked sector last year.
Growth and Innovation Outlook
For investment funds to continue providing dollars to start-up companies in the medical device space, there needs to be a liquidity event or exit strategy, whereby there is considerable return on their investment to mitigate portfolio risk. M&As are one of the most common exit strategies for start-ups. In 2007, we saw robust acquisition activity for medical device companies, with about 80 companies being acquired. On the IPO side, the public markets opened a few years ago and, during the last four years, there have been at least 15 medical device IPOs per year.
The fact is, venture capital investment in life sciences has been increasing during the last five years as National Institute of Health (NIH) funding has been decreasing. Why should we care about NIH funding levels? The NIH is responsible for nearly 80% of all federal support for the life sciences and nearly 90% of the biological sciences. The NIH is one of the key drivers of healthcare innovation in the United States. In the last couple of years, NIH spending has been flat or declining, when compared with inflation.
Despite the effort to double NIH funding from 1998 to 2003, today more than two-thirds of all US R&D spending is industry funded. In our global economy R&D can be performed in a number of countries, many of which have more generous tax treatment. Today more than ever, we should be encouraging government and private investing in the United States. This would induce economic growth and strengthen our competitiveness in the years to come.
Last year, the medical device industry’s top 25 companies reported revenue increases of 9.7%, with 15 companies posting double-digit gains. By all accounts the medical device industry continues to grow as does medical device outsourcing. According to Frost & Sullivan’s US Medical Devices Market Outlook, revenues of $76 billion in 2006 should reach about $139 billion in 2013. With double-digit growth in healthcare and medical device outsourcing, medtech developers and manufacturers should be in an excellent growth position. Traditionally, medical device companies invest about 9% of their revenues in R&D.
For medical device OEMs to increase investment in R&D, there needs to be healthy demand for medical products, reimbursement or self-pay revenue models, as well as a growing economy. When Hillary Clinton’s healthcare plan was proposed in the early 1990s, demand for medical products—especially capital equipment—dropped off dramatically. Anyone in the medical device industry knows how essential reimbursement or FDA approval is for a product. And according to the National Science Foundation’s annual “Survey of Industrial Research and Development,” the 2002 decline in R&D spending was the largest single-year reduction since the survey's inception in 1953. Whether it’s demand, the economy or the government, medical devices can be just as vulnerable as other industries.
Medical device innovation has been a driving force in the United States and remains one of the country’s core competencies. The US advantage, of course, is the value we place on ideas and innovation, our law’s treatment of intellectual property rights and our understanding that innovation gives our country an edge. This is apparent in our system, which encourages higher education, research at medical schools and specialization in hospitals. Besides a system that rewards successful entrepreneurs, it also encourages a strong base of related industries, such as suppliers, designers, technologists, clinicians and attorneys. But innovation alone is not the goal; unless innovative technology reaches the patient, significant benefits are realized and investors (internal or external) are rewarded on a timely basis, the model is not sustainable.
Fiscal pressures may drive better processes, market efficiency or leaner organizations in the future, but they also may lead to healthcare rationing. Will an economic slowdown or the Medicare trust fund drive innovative healthcare solutions or stifle them? Medical devices are now the darling of the investment community, but can investment levels be sustained?
A number of exciting technological advances are in the medtech pipeline. Some of the innovations involve cross-disciplinary approaches including science, engineering and biology—eg, artificial retinal implants to restore sight, artificial nerve implants and stimulators, wireless wearable sensors, image-guided therapies, robotic surgery, accommodating intraocular lenses, spinal implants, deep brain stimulation, the artificial pancreas, liver dialysis and wearable kidney dialysis systems. These innovations hold great promise, but how do we continue to stimulate the medical device industry?
An example is the R&D tax credit. Created in 1981 when the government and industry spent about the same on R&D, it was designed to help the United States maintain its lead in innovation. Today, despite the fact that industry expenditures on R&D are more than twice that of federal expenditures, the R&D tax credit is not permanent. R&D leads to future innovation and economic growth. Many of our global trading partners, including Japan, China, India, Canada and Australia, exceed the United States in R&D tax credits. According to the Information Technology and Innovation Foundation, “while we provided the most generous tax treatment of R&D in the late 1980s among OECD nations, by 2004 we had fallen to 17th.” This has led some US companies to increase R&D spending overseas rather than domestically.
To encourage medical device investment and innovation, the R&D tax credit should be made permanent and competitive with our global trading partners. We should insist as government looks to cut healthcare costs that we don’t institutionalize disincentives to invest or innovate. We also should be more open to market regulation of the healthcare industry.
Increasingly, a number of US companies are exploring development overseas as a way to cut costs. Another trend over the last five years has been the rise of US service providers in the US outsourcing development and clinical services—not just locally but globally. Aside from software and clinical trials in India, mechanical engineering, design for manufacturing and tooling are being outsourced to China. As China expands, it has its eye on innovation.
Today, we see high-volume disposable manufacturing in Asia and clinical trials outsourced in India. We see growing R&D efforts in Asia, while China is graduating increasing numbers of engineers in an effort to innovate from within. But US medical device innovation involves a complex system of support from the government, industry, healthcare and the sciences. The technology is cross-disciplinary and the support system interrelated. As the medical device industry relies on expertise from abroad, we need to stay focused on innovation from within. Outsourcing will continue to expand, as will healthcare in general, but efforts to contain cost do not need to stifle growth or innovation.