May 1, 2012 (Vol. 32, No. 9)
Benjamin J. Conway
Investors Turn Focus to Products and Profits Rather than Hype and Hope
From multiple perspectives, the biopharmaceutical industry is a study in contrasts. As measured by the major stock indices, it would appear that the sector is performing well. The Amex Biotechnology Index (BTK) has more than doubled since the September 2008 financial crisis. The Nasdaq Biotechnology Index (NBI) is at an all-time high and has outperformed the technology-heavy Nasdaq by more than three times and the broader S&P 500 by an astounding seven times since the beginning of 2011.
At the same time, much of the sector appears to be in a state of upheaval. An analysis of companies with market capitalizations under $300 million indicates these smaller companies have lost an appreciable portion of their value over the same period. News headlines underscore the significant challenges faced by many, with companies struggling to make a successful public market debut, often pricing well below the expected range and then only with significant insider support.
Many others are simply abandoning the effort. Venerable venture firms whose names have become synonymous with the industry are turning away from the sector or shutting down. A host of sector influences best explain this divergence in market performance.
The long-recognized predicament of faltering new product development facing the pharmaceutical industry explains much of biotech’s strength.
Over $75 billion in U.S. drug sales are at risk to generic competition over the next five years, representing 30% of all domestic revenues generated by the industry and a staggering sum. At the same time, rather than ushering in a new paradigm in drug development, the mapping of the human genome and subsequent scientific and technological advances have only come to underscore its complexity.
Indicative of the complexity is the cost to bring a new drug to market. As illustrated in Figure 1, in little more than a decade, the R&D investment required to bring a new drug to market has tripled, from $770 million per new molecular entity in 1999 to $2.3 billion in 2010. Nothing has emerged to suggest a shift in the trajectory of these expenditures.
Moreover, the continued disaggregation of the pharmaceutical value chain has increased the industry’s reliance on the biopharmaceutical sector as the source for product innovation. Simultaneous to big pharma increasing the percentage of its R&D budget targeting downstream clinical trial expenditures has been its reduction in preclinical discovery and development spending.
The numbers illustrate just how precipitous this drop has been. As late as 1989, the allocation for preclinical R&D was over 50% of total R&D expenditures. By the late 1990s, that figure had dropped to just over 40%. That percentage continued to drop through the first decade of the new millennium and is estimated to today stand at less than 25%.
Not surprisingly there has been a change in the origins of new therapeutics. In the mid 1990s, 60% of new drugs came from big pharma. Today, 60% of new drugs originate with biopharma.
This would be even more skewed toward biopharma absent the recent wave of acquisitions including Millennium’s acquisition by Takeda, Sanofi’s hostile bid for Genzyme, and Roche’s purchase of Genentech among others, which have distorted the comparison as industry boundaries continue to blur. Acquisitions, and big pharma’s insatiable appetite for new products underlying that activity, have been and appear likely to remain a dominant industry influence for some time.
Inflated Rumors of VC’s Demise
In contrast to popular perception, equity financings displayed surprising strength in 2011. Proceeds from venture financings, initial public offerings, and secondary equity placements totaled $10.5 billion, rebounding after witnessing a sharp decline in 2010. Significantly, the total raised in the capital markets last year represented the largest amount raised in the past 10 years.
Equally as significant is the distribution of that funding. In 2011, $4.7 billion was invested by the venture community in biopharma companies. While down from the peak funding levels seen in 2007, venture commitments to the sector in 2011 still exceeded the $4.6 billion average annual amount of venture funding since 2000, even when measured in constant dollar terms (Figure 2). The 15% to 20% of venture dollars committed to Series A investments has also held relatively constant over that time period, with 2011 being no different.
That said, the number of completed Series A financings continues a decade-long decline, from 35% in 2000 to 30% in 2005 to 22% in 2011, having accelerated since the 2008 financial crisis. While it remains unclear whether this trend reverses as economic conditions improve, data over the past decade suggests that the trend may have some degree of permanence.
Another indication suggesting not weakness but some degree of sector strength may be the trend seen in net venture cash flows. By this measure, venture investing seems to have reached something of an inflection point—and is trending up. In each of the past two years, realizations of investments have outpaced investments made, increasing year over year. As these calculations do not include contingent payouts based on future milestones, the inflection may, in time, be more pronounced.
These positive cash flows reverse the trend of the prior five years, which saw a net negative cumulative cash flow to investors totaling nearly $15 billion—the public markets have not similarly embraced a change in sentiment and shifted direction.
Dampening Public Market Enthusiasm
Plaguing the sector is the appearance of an escalating risk profile, both in terms of regulatory burden and reimbursement uncertainty. Increased regulatory risk is reflected in annual drug approvals pre- and post-Vioxx.
From 1997 through 2004, 33 new molecular entities and biologics were, on average, approved annually by the FDA. In the wake of Vioxx, that number dropped by one-third, with an average of 22 NMEs and biologics approved each year from 2005 through 2010.
Reimbursement, too, has become increasingly uncertain. Gaining in popularity are concepts such as outcomes-based pricing and comparative effectiveness, initiatives that together potentially equate to increased development costs and decreased revenue—this on top of the enormous clinical risk inherent in drug development.
Not surprisingly, the public markets’ tolerance for this aggregate of risk is reflected in the profiles of those companies that have succeeded in going public. More than 80% of the 2011 biopharma IPO class had drug candidates in Phase III development if not approved and on the market versus 2000, when nearly two-thirds of the new issues did not have a single compound in the clinic.
This trend is also reflected in the percentage of new issues coming from biopharma. While certainly IPO volume is down overall, the number of biopharma IPOs has declined even more sharply. The 53 biotech IPOs in 2000 represented 18.1% of all new issues that year. The eight biopharma IPOs last year made up only 6.9% of last year’s total.
The period of time venture investors are required to hold onto (and fund) private companies prior to an IPO event continues to lengthen as well. Among biotech issues to go public in the 1999–2001 IPO window, the average holding period for a venture investor was five years. During the 2005–2007 window, that time period had increased to seven years. Today, the average holding period is nine years (Figure 3).
This extension in time suggests that the public markets are willing only to back much more mature companies where the increase in regulatory- and reimbursement-related risk is offset at least to some degree by a reduction in clinical risk. Yet this extended holding period does not fit within the 10-year lifespan of many venture partnerships, complicating investment dynamics.
Even with greater maturity, public market reception to new biopharma issues remains tepid. Continuing an ongoing trend, six of the eight new issues last year priced below the indicated range—four significantly below. In addition, significant insider support was often required, with insiders in some cases buying as much as 50% of the shares issued.
For a period of time that lasted at least through 2000, the biopharma industry adhered to an established financing model, with venture investors typically funding companies through preclinical development and exiting those investments, often through an IPO, upon reaching an IND. Public market exits were the preferred path, often considered more predictable than the shifting sentiments of corporate acquirers.
Over the past decade the industry has undergone significant maturation. Evolutionary advances have replaced prior years’ revolutionary advances. Likewise, increasingly sophisticated investors are focused more on products and profits and are less influenced by hype and hope. With this change in investor sentiment has emerged a transformation of the established financing model.
While venture investment has not retreated from the biopharma sector, the venture community has been forced to adjust its investment horizon accordingly. With the shift in public market interest toward later-stage deals and with the dominant focus of the pharmaceutical industry on product-oriented acquisitions, the definition of early-stage venture investment has likewise shifted.
Where once the investment thesis was fund at late-stage discovery and IPO at IND, the thesis today is fund at IND, to be acquired in late-stage clinical trials. The implications of this change in the financial dynamics suggest a future industry structure quite distinct from its current form. The emergence of capital-efficient innovations, including virtual companies, project-oriented financing, and academic involvement in development activities, perhaps offer hints.