China medical devices: Climbing the value chain
Author: Winnie Liu
Asian Venture Capital Journal | 17 Jul 2013 | 12:47

Driven by government policy, China’s medical devices industry is growing rapidly and VC capital is flowing in. Picking winners requires a keen eye for new technology and potential distribution obstacles.

Nurotron Biotechnology, a Hangzhou-based hearing aid manufacturer, is looking for global distributors. The company specializes in cochlear implants – unlike traditional hearing aids, these devices convert sound waves into signals sent directly to the brain; there is no reliance on the internal ear, so clinically deaf people can recover hearing.

As a concept, cochlear implants have been around for decades, but there are only three major manufacturers. One of them, Sydney-based Cochlear Corp, sells implants at an average $25,000 apiece.

Eight years ago, Nurotron founder Fangping Li met Fangang Zeng, director of the University of California’s Center for Hearing Research, who had participated in the research on cochlear implants. He won the rights to produce implants in China with a view to developing a cheaper alternative.

Clinical trials commenced in 2010 and government approval to sell nationwide came a year later. At $10,000 apiece, Nurotron’s implants are less than half the price of imported devices.

“Mainland authorities are willing to fast-track approvals of high technology medical devices, especially when it is supported by strong R&D,” says Nisa Leung, managing partner at Qiming Venture Partners, who sits on board of Nurotron. “We are the only offshore fund to invest in the firm, alongside with domestic VC players. This equipment is more affordable and has great potential to grow.”

For all Nurotron’s export ambitions, the main target market is clear: Around 30,000 babies a born each year in China with hearing difficulties, not to mention elderly who are hard of hearing.

It is a similar story for the bulk of China’s medical devices industry. Homegrown products are climbing the value chain – rising from disposable gloves to radiotherapy equipment – and the more advanced the technology the greater the chance of it prevailing in a competitive domestic market that has received a lot of capital in recent years. Exports, however, remain in the minority.

Hungry locals

Private equity and venture capital investment in the industry has soared since 2010, reaching $148 million, up from only $29.7 million in 2009.

The spike coincided with the Chinese government committing RMB850 billion ($124 billion) to the first phase of a three-year health sector improvement program. It announced plans to build more public hospitals and clinics, particularly in remote areas, and this inevitably leads to more spending on medical equipments, from consumables to imaging systems.

In addition, under China’s 12th Five-Year plan, the medical devices industry qualifies for state support as part of efforts to develop independent intellectual property.

The government has pledged to throw its weight behind 10-15 large-scale medical device conglomerates and 40-50 high-tech enterprises, as well as establishing 8-10 medical technology industry bases.

China healthcare spending as a whole is estimated to grow from $375 billion in 2011 to $1 trillion in 2020, according to McKinsey & Co. In 2011 alone, $20 billion was spent on medical devices and KPMG expects the industry to grow at annual clip of 13% over the next few years.

Venture capital investors are keen to ride this wave. The opportunity set ranges from low-cost but high-efficiency equipment for use in rural areas to medical imaging, CT scans and biochemical testing in top-tier hospitals. The risk factor is that medical devices are not classified as mainstream pharma products, which are often subject to government price controls.

“Domestic medical device manufacturers are investing more in R&D to improve their technology and become more internationally competitive with foreign players,” says Mei Dong, a partner at KPMG China. She adds that local firms also have an advantage at home due to their familiarity with customer habits, making them attractive partners for private and foreign investors.

For domestic VC player Kunwu Jiuding Capital, the industry is attractive by virtue of its fragmentation and reliance on overseas technology. Once consolidation kicks in, locally-made products with a lower cost base are expected to replace these foreign imports. After that, the next step is winning international market share.“We see opportunities in investing in Class III medical equipment, which has the highest entry barrier,” a spokesperson for the firm explains.

Another factor that potentially works in investors’ favor is the imbalance between pharmaceuticals and medical devices spending by Chinese hospitals. For every $1 that goes to devices, $5 is spent on drugs; in the US the ratio is closer to 1:1. The imbalance has its origins in hospitals’ traditional business model, with the bulk of revenues coming from the pharmaceuticals side. Efforts are being made to redress it.

“We are starting to see hospitals spend more on equipment for diagnostics and therapy, as they try to find other sources of revenues,” says Elaine Wong, co-founder and partner at Hao Capital. “At the same time they are trying to provide a better service and so investing massively in healthcare technology.”

Two years ago, Hao formed a joint venture – TCL Health – with mainland consumer electronics leader TCL Group to provide high-tech diagnostic imaging equipment. The market for x-rays, ultrasound, CT and MRT devices is dominated by multinationals with the likes of General Electric (GE), Siemens, Phillips and Toshiba holding a 75% share. No Chinese medical equipment company is said to have a full product line in this area.

Operational challenges

Medical device manufacturing requires strong R&D teams with a variety of technical skill sets. However, the key issue is the length of time required to registration of Class III medical devices – it can easily take 2-3 years for most orthopedic devices. Prior to launch, a manufacturer must submit the product to China’s State Food and Drug Administration.

If core changes are required, the manufacturer must implement them and re-apply for a license. Industry participants have voiced their dissatisfaction with the delays and the regulatory environment continues to evolve. But it remains to be seen what this means for hospital budgeting and procurement, and by extension, downstream demand.

VC-backed companies must also deal with fragmented distribution networks and the at times excessive commissions demanded by agents. Transparency is noticeably lacking and under-the-table dealings are commonplace, local fund managers add.

“With much of the growth coming from provincial and township hospitals in tier three cities and below, the biggest challenges for medical devices companies, in addition to offering products at the right price point, is how to access and penetrate new channels and establish contacts with new customers,” says Carl-Johan Sköld, director at consultancy firm Stenvall Skoeld & Company.

In theory, the more high-tech and unique a product the more successful it will be in penetrating new markets. However, industry participants struggle to identify devices that have nationwide appeal – local requirements, and budgets, vary – while there is always the danger that technology will simply be copied.

China’s weak intellectual property regime is a widespread concern, particularly as hospitals may be located away from large cities and therefore beyond the highest levels of scrutiny. Sam Olsen, head of the Asia security practice at Kroll Advisory Solutions, argues that relying on legal recourse alone is unwise. Investors should ensuring portfolio companies have adequate operational and cyber protection systems in the facilities where critical IP is stored.

Many of these challenges will ease in the long term as the industry consolidates. Venture capital investors hope to see the beginnings of this trend within their current holding periods.

“In five years time, while the medical devices industry will still be fragmented, a new breed of increasingly competitive domestic companies will have emerged in a wide range of product categories,” Sköld says. “Many of these domestic companies will be able to benefit from PE capital and strategic guidance.”

For portfolio companies that reach a certain level of scale and technological expertise, there is also the prospect of exits to global strategic investors seeking to expand in China. According to AVCJ Research, medical devices M&A reached $1.1 billion last year, up from $763.4 million in 2010. Most deals involved inbound acquisitions.

However, some China-focused fund managers, still see IPOs as the best option. “We won’t take trade sales as an exit approach,” says Guoping Tang, healthcare investment director at Shenzhen Fortune Capital. “The key factor when choosing an investee company is whether it has the potential to become and industry leader and list in the local market.”