As global pharmaceutical companies grapple with the high cost of research and development (R&D), attention is beginning to shift toward China as a potential hub for innovation in biotechnology.

As a growth area for biotech development, China has several cards stacked in its favor. The country has a sizable scientific workforce, thanks to decades of government support for research institutes and science education. Tax incentives and other concessions are available to encourage R&D. The regulatory environment is more relaxed, which could fuel development of innovative drug therapies that are expensive to develop and test in the West.

Furthermore, the Chinese market for prescription drugs is growing: within four years, the country is poised to become the world's fifth-largest market for pharmaceuticals, with likely annual sales of US$25 billion, according to the Boston Consulting Group.

While much of the biotech industry in China is funded and run by the government, companies have been cropping up in the private (including foreign-funded) sector to leverage Chinese scientific talent and low research costs. Many of these private biotechs have been founded by returnees - Chinese scientists who have come back to China after stints working or studying in the United States or Europe.

"During their startup phases, these companies are being funded by angel investors, venture capitalists or wealthy families. However, funding for the next phase of development is often a challenge," said Carol Liao, a vice president and director at Boston Consulting Group.

Accessing capital
For small and medium-sized companies that want to grow, access to capital can be the single most significant factor that will determine success or failure. The problem for biotech companies in China is that the public markets are not robust enough to raise substantial amounts of capital, and other financing options are limited, said George Bickerstaff, former Novartis Pharmaceuticals chief financial officer and current managing director at CRT Capital Group LLC, a US-based investment bank.

"Chinese companies that are frustrated by a lack of funding in China may want to consider international sources of financing and advice. With the right mix of financing vehicles, they will have a better chance of seeing their innovations reach patients worldwide," said Bickerstaff, who was responsible for investing in biotech products and companies as CFO at Novartis.

"Investors in developed countries, meanwhile, are looking to boost their returns through risk-adjusted investment opportunities, and are growing increasingly more receptive to opportunities in China," said Bickerstaff. "With improved information flow out of China, investors are feeling more confident about seeking investment targets there."

There are several ways a small or medium-sized biotech company can raise money, through venture capital, private equity, capital markets or hedge-fund investment.

Identifying the "flavor" of financing that is appropriate - equity, debt or convertible debt - can be the key to growth. "Often, the answer is a combination of multiple financing sources. For instance, many banks have capital they can invest themselves, side-by-side with another investor such as a hedge fund," said Bickerstaff.

Companies should seek out advisers with experience in global capital markets to determine which type of offering is best suited to their needs. Public market financing alternatives include initial public offerings (IPOs) of shares, reverse mergers and private investments in public entities. Another way to raise financing is through a special-purpose acquisition company, a relatively new blank-check investment vehicle.

The Alternative Investment Market (AIM) in London is an example of a successful capital markets fundraising vehicle for emerging-market companies. The AIM exchange is available to smaller-growth companies from any country and industry sector. Since its launch in 1995, more than 2,400 companies have listed on the exchange, raising more than $50 billion in a combination of IPOs and follow-on financing.

Hedge funds, which previously only invested in the public marketplace, are also now considering private and, in some cases, "almost public" investments. "Hedge funds can be a good source of financing for an emerging-markets company," said Bickerstaff. "A hedge fund might invest in a company if it likes its business plan, management team and board. Unlike a private-equity firm, however, a hedge fund invests for shorter periods of time and does not usually get involved in management of the firm. This can be appealing to many management teams."

Companies can get advice as well as financing from global banking firms. Managements with little fundraising experience may benefit from counseling on how to present themselves when meeting with investors, or on how to make contacts in the global banking world. Depending on the relationship, international financial advisers can also offer regulatory advice and other strategic guidance to company principals.

Bickerstaff contends that a significant challenge for emerging-markets companies can be understanding and complying with the market regulations, governance, reporting and internal control requirements associated with operating in the international capital markets.

"For example, the US Securities and Exchange Commission's Sarbanes-Oxley regulations require companies to implement specific reporting standards, audit schedules and corporate governance practices. Implementation of these financial controls and compliance procedures is a legal prerequisite for global capital raising. It can also go a long way in boosting investor confidence in a company," said Bickerstaff.

Tomorrow's cures
Biotech innovation is the key to continued profitability in the global pharmaceutical industry. For large pharmaceutical companies, keeping the pipeline full has become ever more challenging. R&D is a risky business, with expensive clinical trial processes and lengthy product cycles.

Although China's intellectual-property regulations are not yet up to Western standards, the potential for lucrative biotechnology development is there. In a recent report, the Boston Consulting Group notes that almost every major global pharmaceutical company is already conducing R&D in China to some degree. As intellectual-property protection advances, the pharmaceutical companies will be in a position to form natural alliances with small and medium-sized biotech companies, just as they do in the West, said Josh Lerner, professor of investment banking at the Harvard Business School.

Bickerstaff said the important thing for private biotechs to do now is to seek out expertise in global capital markets to find the appropriate mix of financing for their companies. "By bringing their financial and regulatory processes up to Western standards, these companies will be far more attractive to strategic investors, and ultimately to large pharmaceutical companies that can sell and distribute their products."

Patty Buchanan is a freelance financial writer based in New Jersey.