Reverse Distributors: A Case Study in Alternative Opportunities in Healthcare Private Equity | Waller Lansden Dortch & Davis, LLP

In the face of a looming probability of recession, many private equity investors are looking to healthcare as their strongest defensive strategy.  For that reason, we continue to see robust interest in the traditionally dominant provider and pharmacy sectors.

But healthcare investment opportunities are diverse and present ripe opportunities for the application of non‑healthcare industry experience, too.  For example, optometry, medical spas and infusion are all areas that are in the process of rapid acceleration and growth which are poised to benefit from an influx of non-healthcare expertise in consumer retail and marketing.

Reverse distributors – companies that help hospitals, pharmacies and other drug dispensers process returns of pharmaceuticals back to the manufacturer – present another example of the diversity of healthcare opportunities and a unique opportunity for investors with deep experience in logistics and B2B.  We highlight reverse distributors as just one example, among others, that are worth exploring, particularly for those who are newer to healthcare.

Overview of Reverse Distributors

Historically, the pharmaceutical industry has consisted of three types of companies: pharmaceutical manufacturers, distributors of pharmaceutical products, and dispensers of these products, primarily pharmacies and hospitals.  Pharmaceutical products are of course unusable after their expiration date and generally unsellable within six months prior to expiry. 

Reverse distributors (also known as return processors or reverse logistics providers) serve a niche, and overlooked, role:  they facilitate the return of unusable and unsellable drugs from the dispensers back to the manufacturers for refunds or trade credit, a process known as reverse distribution.

Patchwork of Regulations

One of the benefits of existing inside a niche specialty is that it attracts less regulatory attention.  The other side to that sword is that, in the absence of focused attention, reverse distributors have become subject to a patchwork of overlapping federal and state regulations.  Just for flavor, these include:

• Particularized DEA registration requirements
• Specific record-keeping requirements, imposed either by governmental authorities or by manufacturers (see below)
• State licensing requirements with unexpected variance – from a waste permit being required in one state, to a food and drug permit in another, to third party accreditation in others still

As in all healthcare segments, these barriers to entry present both challenge and opportunity.  Investors who do not have a strong team of advisors often flounder, rushing into states without having accounted for the regulatory reality in designing their business strategy and modeling outcomes. 

The more successful healthcare companies, however, understand that regulatory compliance and business strategy go hand-in-hand.  Said differently, compliance is not a limit on business; rather, it is the game board that enables better businesses to beat inferior ones. 

In the case of reverse distribution, management teams should adopt a continuous process that includes monitoring changes in regulations, ensuring that proper policies and procedures are put in place, and training employees to ensure ongoing compliance – all with the goal of being market leaders who can influence the direction of regulatory consolidation in a patchwork environment, rather than merely react to it.

Recent Sector Trends Create an Opportunistic Environment

In recent years, reverse distributors have found themselves under increasing pressure from drug manufacturers to strictly comply with their specific return policies and procedures.  One case currently being litigated before the U.S. District Court for the Southern District of New York, Chartwell RX, LLC vs. Inmar Inc., illustrates that drug manufacturers are not afraid to play hardball with technical requirements in their return policies.  This is an area that is ripe for dispute – and one that private equity investors with logistics and distribution experience would recognize from other industries.

In the Chartwell lawsuit, Chartwell (a manufacturer) alleges that Inmar, a reverse distributor, did not strictly comply with some of its return policy terms, such as including the product expiration dates on return submissions. While the specific details of the case are technical, the gist is not:  it’s a case of a manufacturer wanting to ensure that faulty returns do not generate erroneous credits for distributors/dispensers. 

Pulling from experience in both healthcare and, separately, logistics and distribution, we see a number of ways that drug manufacturers might seek to achieve this goal:

• Tightened enforcement of return policies, or more aggression in denying customers refunds or credits for faulty returns (or only offering partial credit)
• Leveraging of commercial relationships with distributors/dispensers to force reverse distributors – who normally contract with the distributor/dispenser, and not the manufacturer – to comply with the manufacturers’ return policies
• An increase in upward price adjustments to drugs to compensate for the cost of faulty returns
• Moving reverse distribution in-house, or even acquiring reverse distributors

These types of changing market dynamics inside a specific healthcare sector are not just downside risk.  They are opportunities.  We have seen this play out again and again in other areas, from increased third party payor scrutiny of procedure coding in the provider space to concerns over false advertising and marketing.  In each case, the early losses suffered by companies with loose compliance enabled more sophisticated entrants to rapidly take market share in reaction. 

We believe we are seeing a similar opportunity emerge in reverse distribution.  What’s exciting here, though, is that investors with logistics and distribution experience can bring significant value to the table when paired with the right team of healthcare advisors and operators.