May 1, 2009 (Vol. 29, No. 9)
Downsizing of the Industry Is Inevitable as Financing Window Is Virtually Closed
This time the biotech industry consolidation is for real. The gloomsayers who predicted an industry downsizing in the past were wrong, but this time they are right. The trillion dollar black hole of derivative speculation has curbed the appetite for risk and slowed venture funding in biotech. Potential funding for the life sciences is trapped in “upside-down” housing where the owner owes more than the house is worth, and toxic collateralized debt obligations (CDOs) in banks worldwide.
Moreover, the risk factors for biotechnology are as real as ever: political uncertainty, the impact of “binary events” like clinical trial results and FDA decisions on stock prices, generic/biosimilar competition, and the emergence of a national healthcare plan implying lower drug costs. The industry has navigated through troubled times and big issues before, but never in times of a financial meltdown.
The markets need to be cleared of securitized debt before risk capital can return to biotechnology. The past few years has seen the greatest misallocation of capital in the history of the modern U.S. economy so it will take time to get back to funding of real technology, products, and services.
The hardest hit companies in the current environment are public microcaps with weak balance sheets, development-stage biopharmaceuticals with longer-term clinical risk, and drug discovery start-ups. Many of these stocks are down 25% or more in Q1 2009.
M&A—Big Is Better
M&A activity is accelerating at the top end of the market such as the $68 billion Pfizer/Wyeth deal and the $48 billion Merck & Co. acquisition of Schering-Plough. Pfizer issued $13.5 billion of debt, three percentage points above treasuries to fund the acquisition. Barbara Ryan, senior pharmaceutical analyst with Deutsche Bank, believes these mega-mergers are positive for the companies in the face of generic competition as they strengthen balance sheets, cut costs, and presumably, improve the yield of basic research.
Eli Lilly CEO John Lechleiter told the Wall Street Journal on March 31 that he was “hungry” for buyouts up to the $15 billion range, emboldened by the acquisition of Imclone. According to data from BioCentury and Piper Jaffray, big pharma deals were up 15% in 2008.
On the other hand, mergers between smaller players, even those with technological synergies, may not fare as well due to long-term funding issues. A case in point is the reverse merger of the public company EPIX Pharmaceuticals with the private biopharmaceutical company Predix Pharmaceuticals. EPIX was the target as it had cash and a cardiovascular imaging agent stalled in the FDA. Predix had a drug discovery platform and a broad portfolio of CNS and cardiovascular candidates in the clinic that needed funding but the $40 million annual burn proved to be overwhelming in a bear market with no milestone catalysts. The stock now trades under a dollar and has a “going concern label” with negative shareholder equity.
Venture Capital Investing
Venture investors in biotech are in lockdown mode as they reserve precious capital for their existing companies. Arthur Klausner, an experienced venture capitalist recently of Pappas Ventures, believes that venture capital is currently facing a painful double squeeze—diminished fund sources on the front-end due to the tight money situation at pension funds and endowments, and limited exit opportunities at the back-end caused by the complete lack of IPOs.
Nevertheless, according to Klausner, “this situation should result in some excellent venture capital investments being made in 2009/10. It’s very much a buyer’s market out there for VCs that have fresh capital to invest, with private financings tending to be limited to top-tier companies—and often at bargain-basement valuations.”
Jonathan Fleming, managing partner at Oxford Bioscience Partners, has shifted some resources away from biopharm to medtech and diagnostics. “Drugs are a more risky investment in these times, not only because the FDA has raised the bar for clinical trials and approvals, but the buyout exit is less likely as the large pharmaceutical companies are investing outside the U.S. for new markets and products,” he reports. “Diagnostics and devices represent a much more dynamic environment with less product risk and faster returns on venture investments.” Supporting this scenario, he cites the acquisition of Sirtris by GlaxoSmithKline for $720 million as one of the few venture-backed companies acquired by big pharma in 2008.
“VCs seem to be triaging their portfolios, denying further infusions to the runts of their litters,” explains Tom Kiley, a one-time Genentech executive who has served as a director of many life science companies. To the extent that new companies are being funded at all, the focus seems to be on diminished regulatory risk, i.e., medical devices and drug repurposing.
One question is whether big players on the venture and IPO side such as JPMorgan and GoldmanSachs will continue to focus on biotechnology now that they are commercial banks and have to reduce risk and bolster their capital.
Data from the National Venture Capital Association shows that around $4.5 billion was invested in biotech in 2008, $1 billion of that in Q4. For comparison, $4.6 billion was invested in the software industry in 2008. Since 2004, VC investments in biotech have exceeded $4 billion.
Recently, Essex Woodland Health Ventures (EWHV) raised $900 million for its latest healthcare fund and will invest across the spectrum of drug device and service companies globally. EWHV currently has $2.5 billion under management. Also in recent news, Google launched a $100 million venture fund focused on a broad range of fields including biotechnology start-ups. Google already has an investment in personal genomics with 23andMe.
Another positive trend is a recent report from Burrill and Co., revealing that VCs invested $1.486 billion in biotech in the first quarter of 2009, a substantial increase over the $837 million in Q1 2008. The data, however, may require further analysis as the average size of the deal fell from $20 million to $7 million and the funding increase may be skewed by one large deal.
Investments in public companies such as PIPES (private investment in public equity) were stable for the first quarter with 65 healthcare PIPES deals and a total value of $810 million compared to $894 million in Q4 2008, according to Rodman and Renshaw.
According to Burrill and Co., U.S. biotech industry financings totaled about $20 billion in 2006 and 2007, in addition, $20 to $25 billion was allocated to partnering deals. Twenty IPOs were launched in 2008. For Q1 2009, Burrill reported total capital flow of $9.8 million, compared to $6.647 million in 2008. However, $2.651 million of this was debt and $4.761 million was partnering money.
In a study conducted with PhRMA, Burrill reported drug R&D spending of $65.2 billion for 2008, a healthy investment in the industry for future products. Targeted diseases include cancer, cardiovascular, diabetes, and HIV/AIDS. In April, the WSJ reported R&D spending by big companies such as Johnson & Johnson and Abbott continued at last year’s pace despite revenue weakness.
A downsizing of the industry, with a loss of about 100–200 publicly traded companies due to failures or takeovers, is predicted by Burrill, which reported that on April 1 half of the 344 public biotech companies were trading at cash value.
Public Markets Rally in March
The life science public markets held up well in the first quarter of 2009 despite a severe correction in February exacerbated by fear of Medicare reimbursement cuts and the Obama administration healthcare initiatives.
The financing window for start-ups and small cap biotechs will be virtually closed for the next 12 months, however. Of course, creative deals will be cut and alternative financing routes will be found such as angels, government grants, the Stimulus Package, and corporate partnering. As the industry restructures the stage will be set for a rebound. The data indicates financing should still be available to medtech and healthcare service companies with emerging growth in revenue or positive cash flow.
Near-term events such as clinical conferences and product milestones may provide an impetus for rallies and funding through PIPES, but the bear market is intact until we view the fourth quarter of 2009 landscape. Investors have short memories so any positive developments should spark the markets; supposedly, there is a lot of money on the sidelines (but where?).
Over the years healthcare investing has always found a way to re-create itself and, even as details of a national healthcare plan emerge there will be new opportunities. Corporate and NIH R&D investments combined with total healthcare spending provide the core engine for creation of compelling new products and services. For example, the aging population will require home healthcare services in the near term and related diseases such as cancer and Alzheimer’s disease require new cost-effective drugs in the longer term.
Greater regulation of security markets and banks may actually be a positive development for healthcare investments as we go back to funding real companies and technologies rather than leveraging money to make money through financial engineering and derivatives.
The big issue remaining, once the credit crunch subsides, is whether there will be fundamental shifts in the business model away from biopharmaceuticals to tools, diagnostics, and devices.
Rod Raynovich (email@example.com) is a principal at Raygent Associates.
Web: www.raygent.com. Phone: (310) 796-9990.