CRO Consolidations - Does 1 + 1 = 3?
The CRO industry has undergone a great deal of consolidation over the last decade. Numerous transactions involving mid-size Clinical Research Organizations (CRO) have been completed:
INC Research acquired Kendle International
InVentiv acquired I3
Expected benefits of CRO consolidations include:
Increased scale and geographic presence
Access to additional therapeutic expertise and service capabilities
In today's article I am going to focus on Financial Synergies and explain why they are a compelling component of CRO mergers. I have personal experience as I was a synergy from both Chiltern's acquisition of Theorem and Bain Capital/Ricerca Biosciences's acquisition of MDS Pharma Services' preclinical/early stage CRO (I was also made redundant in Cardinal Health's acquisition of VIASYS Healthcare - so you may not want to stand next to me during a lightening storm).
Why Are CRO Consolidations Financially Compelling?
Let's walk through a simple example. Assume CRO #1 and CRO #2 have identical financial profiles - both have $100M in revenue, $45M of Gross Profit and $15M of EBITDA. As a side note, EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. EBITDA is a profitability metric that provides a company's earnings before taking interest, taxes, depreciation and amortization into account. Back to our example - let's assume that CRO #1 acquires CRO #2:
No rocket science here, consolidating the CROs creates a company that is double each of the CROs on a stand alone basis. What happens when $10M of redundant costs or synergies are taken out of the combination:
Profitability increases to $40M (up from $30M) and our EBITDA % jumps from 15% to 20% - now it really gets interesting. CROs tend to be valued as a multiple of EBITDA. Typical valuations range from 5x (for smaller, slower growing, riskier CROs) up to 14x (highly attractive desired assets). Mid-size CROs tend to be valued in the 8x-14x range. Let's assume that the owner of CRO #1 and CRO #2 paid 10x EBITDA for both companies, or $300M total. Let's also assume that the combined company after synergies would also be valued at 10x EBITDA.
After accounting for synergies the new combined valuation is $400M, or 10x our $40M EBITDA. Our return on investment is $100M or 33% of our initial $300M investment.
Our simplistic example shows a $100M increase solely from the elimination of redundant costs in the business. Like anything in this world there are more complex scenarios that could improve the overall return such as using debt to finance the transaction or selling at a higher multiple. Let's see the return if we could sell the combined business with synergies for a 12x multiple.
Now the combined value is $480M, a whopping $180M more than what we paid for both businesses on a stand alone basis. Our return on investment in this scenario would be 60%.
I want to stress that this is a simplistic financial example - is this scenario possible in real life? Yes, but likely only if the combined CRO's are:
Providing a high level of customer service
Delivering exceptional quality
Growing at or above market rates
Equipped with a strong management team
Seen as strategic by potential future acquirers
Putting together two poorly run companies will likely create a larger poorly run organization. However, consolidating and successfully integrating two well run companies can create the financial windfall described above.
Synergy is an overused buzzword for cost reductions. Due to the significant infrastructure costs of global CROs, consolidations quite often provide sizable cost synergies. I would classify CRO synergies into three primary categories:
3) Operating Expenses
Selecting the go forward management team is an important decision for the Board of Directors of the acquiring organization - that team will be tasked with making the transaction a success. The executives that aren't retained provide significant cost savings (could you imagine two CFOs to driving everyone crazy?). Here is a rough estimate of potential savings:
Per Chief Executive.net, the average CEO compensation of a privately held business with $59M-$99M of revenue is $400K+ (add roughly 50% more for a private equity owned healthcare/pharmaceutical business).
Per CFO Search Inc, the average salary for a CFO of a privately held business with $41M-$100M of revenue is $166,500-$262,500. Add in estimates for a bonus, taxes and benefits and the costs swell to $278,000-$438,000.
Becker's Hospital Review sates that in 2014, the average healthcare Chief Information Officer ("CIO") salary was $208,147. Let's assume $200,000-$300,000 with bonus, payroll taxes and benefits.
Inhouseblog states that Robert Half estimates that 2017 in-house counsel compensation will range between $137,500-$269,500 for experienced counsel. Let's assume $200,000-$300,000 with bonus, payroll taxes and benefits.
Let's assume compensation for a head of Human Resources is similar to a Chief Information Officer and Chief Legal Counsel at $200,000-$300,000.
Lastly, since compensation ranges for Vice Presidents of Sales vary greatly, let's assume a range between $300,000-$400,000 when taking salary, commission, bonus, payroll taxes and benefits into consideration.
Executive team reductions could result in annual cost savings of $1,600,000 to $2,250,000+. That comes to 1.6%-2.25% of revenue for a $100M revenue acquisition.
Duplicative Non-Billable Management
A great number of management roles below the executive management team will become redundant. Examples would senior leaders such as Vice Presidents or Directors of Finance, Proposals/Contracts, Clinical Operations, Human Resources, etc... While this article discusses the financial implications of a CRO consolidation, in reality many of these reductions would be necessary from an organizational impact. For example, let's assume both companies have a VP of Clinical Operations, going forward it would be healthier for the organization to have one leader making decisions for the clinical operations team. Multiple leaders could result in confusion and a less effective integration post closing. I think it's reasonable to assume $100,000-$150,000 of savings per person between salary, benefits, payroll taxes and potential travel. Cost synergies could be very significant, especially for larger CROs.
Positions that are driven by work volume should not be eliminated during a consolidation. A great example would be the billing/collections staff. Ownership groups should be assuming growth for the combined entity and eliminating staff that is built around work volume would be a mistake (assuming the teams are already appropriately staffed). Reducing staff in this example could result in longer lead times to deliver invoices to clients, increased time to collect cash and unhappy customers from receiving invoices later than usual. Mitigating or improving client impact during a merger should always be a priority. Other examples of volume driven positions would be the contracts and proposals development team, recruitment staff and help desk support.
Excess Billable Capacity
Excess billable staff are typically the smallest amount of labor related cost synergies. Staff expertise is the most important asset acquired in a CRO acquisition so most billable staff are "ring fenced" - meaning they are protected from any cost reduction measures to minimize operational disruptions (to limit customer disruptions). However, there may be situations where each company has functional staff that is only partially utilized in a particular country where it may make sense to reduce staffing. An example would be if both companies are paying full time salaries for CRAs only 1/3 utilized (in a particular country) and if the sales pipeline isn't expected to result in additional work, it may make sense to reduce one CRA position. The end result would be one CRA 2/3 utilized and with annual cost savings of one employee.
Facility reductions are a no brainer - truly low hanging fruit. Every country where the CROs have overlapping operations is an opportunity. I always look for facility savings as I am a big proponent of:
Preserving jobs by eliminating as much non-labor cost as possible
Making investments in people rather than bricks and mortar
From my experience clients are usually more concerned with the quality of a CRO's staff rather than how big or nice their facilities are in every country. For example, if two merging CROs both have an office in Paris, France, consolidating into one office can provide big savings. The more countries that overlap, the greater the opportunity to save. Consolidating corporate offices could provide huge savings, but that discussion is only relevant as long as the employee base isn't disrupted. More often than not, I see companies end up with a corporate and regional offices so key talent is retained
Assessing facility footprint is an exercise all companies should undergo periodically. We didn't make any acquisitions during my time at Theorem, but saved over $1,000,000 annually by reducing our facility footprint around the world. We saved money and created flexibility by moving out of traditional leases and into Regus type offices. The biggest win was buying out our corporate headquarters lease and moving into a smaller, nicer and better utilized footprint - saving us $500,000 annually. Savings from those facility reductions allowed us make investments needed to grow the business.
Operating expense savings come from economies of scale generated by being a larger enterprise or just activities that going forward will be redundant. Examples are:
Annual financial audit
Healthcare insurance (great because could be savings for the company and employees)
Tax services consulting costs
Legal entity governance cost
Telecommunication fees (resulting from less facilities)
It's no secret that technology can help make a company more efficient and cost effective. However, many companies disregard potential technology improvement due to cost. A consolidation can make it financially possible for the combined entity to take on projects that previously may not have provided the financial rate of return necessary. Large scale system implementations such as a new Enterprise Resource Planning (ERP) system or a Clinical Trial Management System (CTMS) could provide not only operational costs savings, but improved efficiency for employees and service to customers.
A theory used for most CRO transactions is that increased scale and geographic presence creates the opportunity to win larger (i.e. higher priced) clinical trials, creating the opportunity to quickly grow revenue. I wouldn't recommend financially justifying a CRO merger based on this theory, but I believe the concept to be true as long as the combination delivers world class customer service and continues to target customers that make sense.
Mergers in any industry are difficult to undertake - in fact, Forbes magazine reported via a KMPG study that 85% of all mergers failed to deliver expected shareholder value. CRO consolidations can be especially tricky when considering cultural differences, IT considerations when consolidating clinical trial systems and the legal entity and tax work required when consolidating international entities. There is also that small point of executing clinical trials and satisfying customers during a merger - no small feat. The industry has proven that CRO mergers when integrated effectively can add significant value. INC Research successfully integrated both MDS Pharma Service's Late Phase Business Unit and Kendle International along with numerous small acquisitions over the last decade. INC is now one of the world's largest, most respected and profitable CROs. So to answer my own question "Does 1 + 1 = 3 when it comes to CRO Consolidations?" - yes, as long as you do it right.