December 1, 2010 (Vol. 30, No. 21)
Benjamin J. Conway
With Current Funding Paradigm Faltering, the Search Is on for Nontraditional Financing Sources
While the life science sector has experienced the effects of the market’s broad-based autumn rally, the sector’s performance for 2010—like that of much of the market—has been decidedly uneven. The support for the sector seen in the first quarter of the year seemingly dissipated rather precipitously in the second quarter, only to rebound later in the year.
These market fluctuations have done little to restore confidence among investors that a sustained market advance is at hand. Instead, this uncertainty has seemingly brought capital preservation rather than capital appreciation to the forefront of investors’ minds. The capital constraints that have resulted from this shift in market sentiment have profoundly impacted capital-intensive industries, with biotechnology affected perhaps more than most.
Nonetheless, the performance of the sector in 2010 is quite a bit improved over where we stood prior to the fourth-quarter rally last year. Five quarters had passed without a single life science IPO, and the prospects were not encouraging. Life science issues that went public in this first decade of the new millennium had not performed well, down more than 20% in aggregate at the depth of the market downturn. Add to that a severe contraction in venture capital financing with quarterly capital commitments down more than 60% from the 2007 peak.
While a vast improvement over the depths reached in 2009, with the Nasdaq Biotechnology Index up over 50% from its 2009 lows, the financial health of the sector remains guarded. The numbers bear this out. The $3.1 billion that public biotechnology companies raised through September is not significantly ahead of 2008’s financing pace, with the year’s total likely to fall well short of the $8.3 billion raised by the sector in 2009 when companies rushed to raise money during the late-year rally. Moreover, despite the renewed interest among investors in sector IPO activity, with 18 new life science issues coming public since the IPO window cracked open in the later part of 2009, new issues have come to market at a much more subdued pace than they had previously.
Of particular note is the profile of those companies that have managed to come public. At the height of the technology bubble a decade ago, 53 new biotechnology issues debuted. Of this total, less than 40% had even a single compound in clinical development. By 2004, only four years later, over 90% did. Among this current crop of IPO issues, not only do all the companies have programs in clinical development, 80% have programs that are in Phase III clinical trials or are approved products.
Yet even with more mature product pipelines, these issues have, save for a single issue, all priced below the ranges indicated on the S-1 “red herring” filings—often well below. In addition to the significant reduction in per share price, heavy insider buying has often been required to complete these deals.
While higher-caliber buyside participants such as Wellington, Putnam, and Fidelity have been active in these issues, they have been willing to step up and buy into these deals only at levels where they believe the downside risk to be minimal. Even at these “can’t lose” prices, the vast majority of these issues continue to trade lower post-IPO. That there remains a willingness to test the public market waters despite the sharks, with more than a dozen active registration statements on file currently, likely underscores the limited financing alternatives available to many companies.
One gauge used to measure the financial health of the biotechnology industry has been the percentage of companies with more than 12 months operating cash on hand. In late 2007 that figure approached 75%. By the later part of 2008 that figure had dropped to slightly over 50%, though it has since improved and currently stands between 70% and 75%.
Yet this apparent improvement in cash position seems to conflict sharply with the activity in the capital markets. What explains this apparent incongruity? Industry growth versus contraction. In other words, absence access to capital, extended operating runway is only achievable through a reduction in operating costs.
Merger and acquisition activity underscores this contention with many companies concluding that size does, in fact, matter. From January 2008 through January 2010, M&A activity, together with company liquidation events, has led to a 25% reduction in the number of publicly traded biotechnology companies. This trend does not seem to have weakened as the year has progressed. Through the first nine months of the year, life science M&A activity has picked up considerably, increasing over 50% when compared to the same period last year.
All the while, big pharma appears increasingly reliant on the biotechnology sector to supplement its own product pipeline. From 2004 through 2009, R&D spending by PhRMA member companies increased by an anemic 1.7% annually, when calculated in real dollar terms. Moreover, since spending peaked in 2007, R&D expenditures have actually contracted 9%. Over this same five-year period, non-PhRMA companies, primarily smaller biotechnology companies, have on average increased their R&D spending by 10% annually. In fact, R&D spending by non-PhRMA members rose more than 50% and currently approaches $20 billion. This divergent spending pattern largely seems to explain why biopharma and specialty pharma companies have accounted for two-thirds or more of new therapeutics approved in four of the last five years.
Yet the performance of smaller market cap biotechnology companies in the financial markets more recently brings into question whether their innovation is being rewarded. From October 2000 through October 2010, the AMEX Pharmaceutical Index, comprised of big pharma companies, has declined in value by 14%.
During the same period, the AMEX Biotechnology Index saw gains of 72%. Ironically, though, the Nasdaq Biotechnology index, populated by a larger number of smaller companies than the AMEX index, declined 22%. This would suggest that while the financial markets continue to place a premium on innovation, the perception of financing risk in this market environment appears to have increased substantially, especially for smaller development-stage companies. By extension, the negative returns of the NBI may indicate that investor focus on financing risk is beginning to outweigh the premium afforded innovation.
This situation then begs the question, where does the future of innovation lie?
During the period when public-market appetite for biotechnology companies extended well back into the earliest stages of clinical development, venture investors felt comfortable investing even earlier, reasonably assured that they could secure a public market exit within a reasonable time horizon. Yet, with the continued maturation of the industry, with the public markets focused less on hype and hope and more on products and profits, venture investors have had to adjust their investment horizon accordingly.
If the profile of a public company now mandates late-stage product candidates, if not already approved products, the math suggests that venture investors cannot invest much before a company has compounds in the clinic. As a result, a pronounced funding gap seems likely to emerge, particularly in discovery and preclinical development. The origin of the funds required to replace this traditional source of financing remains to be identified.
Benjamin Conway (email@example.com) is founder and managing director of Johnston Blakely & Company.