The Venture Funding Boom In Biotech: A Few Things It’s Not

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Venture-backed biotechs continue their blistering pace of funding. According to the latest MoneyTree Report from PricewaterhouseCoopers (PwC) and the National Venture Capital Association (NVCA), with data from Thomson Reuters, over $2.1B was invested in biotech companies in 2Q 2015, bringing the year to date total to almost $4B(covered here, here). Four of the last five quarters are amongst the largest record-setting quarters in ten years.

It’s clearly one of the best periods for biotech funding in the history of the industry, offering an opportunity for emerging companies to scale and develop their pipelines more significantly than ever before.

But the averages and top-line data convey only so much – huge fund flows, big year-on-year gains, and meaningless averages. There’s much more than meets the eye, and I thought it worth reviewing a more nuanced, data-rich look at what this hot funding climate is not as a way to frame up a few broader observations.  Here are four things the current market is not:

1. It’s not “venture” in the traditional sense. The big recent uptick above the normal $1-1.5B that’s invested quarterly into biotech isn’t coming from the coffers of venture capitalists, it’s coming from hedge funds and public market “crossover” investors. Take as an example the top 10 biotech deals of the second quarter – Denali, Adaptive, RegenX, CytomiX, Melinta, Unum, Dimension, Voyager, Jounce, and Edge. My rough deal-by-deal calculation, based on participating investor mix, is that 67% of the $920M raised by this group came from non-venture sources. These include biotech crossover fund specialists like Deerfield, Brookside, RA Capital, and Wellington, but also significant contributions from alternative investment groups like the Alaska Permanent Fund and Malin Plc.  Although lots of new venture funds are being raised, they get deployed over 5-7 years, not a few quarters – so while it is fair to say venture is booming, the real driver of the financing spike in the quarterly data has been from the eager participation of non-traditional biotech investors.

2. It’s not distributed broadly. The concentration of these “venture” dollars in the biggest deals is significant. The top 10 deals (like the list above), which in any given period represent roughly the largest 7-8% of the financings, accrued 45% of all the biotech funding.  The top deals have captured a similar proportion for the past twenty quarters, as per the chart below. This concentration of funding reflects a very high Gini Coefficient, to steal a term from income inequality literature; there are relatively few “haves” and lots of “have-nots” when it comes to the flow of funding. More broadly across the distribution of deals, this funding bias creates an enormous skew in the “funding per company” metrics over time, making the “average” an utterly meaningful snapshot (since its not a normal distribution at all). The bottom quartile and median metrics are almost identical, with the top quartile significantly higher (see second graph below). It’s also worth noting that the big financings we commonly hear about (like the top 10 ones!) are in the rarefied few, above the top decile of financings; in fact, the top quartile metric for funding per company has only been above a “paltry” $20M in three quarterly periods across the past ten years.  And the median biotech financing, regardless of stage, is still not that much higher than $4-8M – way below the average figures.

Top 10 Deals Percentage

Funding per company

3. It’s not increasing the number of biotechs that get financed. Unlike software venture capital, which is backing 2x more companies today than five years ago, the biotech venture community isn’t funding an expanding ecosystem of private companies. It’s been a relatively constant funding pace for the past decade of around 100-150 per quarter. So the uptick in funding of late is just leading to more money for the same number of companies; and, in light of #2 above, its really just more money for the top few companies. Hopefully it’s being deployed wisely in a manner that can efficiently convert invested capital into value creation (the essence of “capital efficiency”).

Biotech Financings Over Time

4. It’s also not leading to increased startup formation. The number of biotech startups receiving their first financings continues to be flat despite the unprecedented later stage demand, reflecting the massively constrained startup ecosystem discussed previously (here, here, here). While the numbers of startups are flat (25-30 per quarter), there’s an even bigger spike in funding amount per first financing in recent quarters. The median funding per first financing in a biotech startup company hit $10M this quarter, which is 300-400% higher than the last decade’s running average. In fact, the top quartile of these first financings are now very similar to the top quartile of all stages of financings – around $20M – which is a real surprise. It’s fair to say that significantly more capital is backing a constant number of new startups – reflecting the “launching” of larger, more highly powered-up startups by a handful of venture groups.

Startup Financing Over Time
Funding per first-time company

 

So what does this all mean, besides being a good reminder that averages and top-level data always leave a lot of nuanced insight behind? Here are three questions worth reflecting on:

What will happen when the public and non-traditional investors decide they don’t want to allocate their capital to private biotech companies?  They have significantly inflated the pool of capital available today, but they could quickly depart if they start losing money in the space or if the overall market sentiment turns against the biotech sector (big clinical failures?), healthcare (pricing issues?), or equities as a whole. Its unclear how long-term and sustainable many of these non-venture players are in the biotech funding environment.  It would be great to have them around for the long term, helping us launch and build great companies.  But I think its likely more a matter of when, not if, this cadre of investors cools towards biotech (at least temporarily), and so young companies should be executing strategies today that account for these future funding contingencies (e.g., identifying and cultivating potential partners, creating flexible operating models with variable burn rates, etc…).

Are we over-funding and losing discipline? Anytime buoyant markets channel more capital than the historic norms into a space, questions around bubbles and over-funding get raised. It’s a frequent refrain in biotech today – is their a funding and valuation bubble? As a long-term investor and company-builder, the critical question to focus on is whether the current wave of funding is leading to governance complacency and a lack of discipline in how companies use the proceeds of these financings. Is the capital efficiently being deployed? Common mistakes one would expect in an overly permissive environment would be building excessive amounts of non-critical fixed infrastructure, hiring big teams too rapidly, locking into long-term expensive leases for too much space, funding immature science projects before they prove themselves, etc… I’m sure there are examples of these happening right now, but its not endemic: I still sense that most biotech teams and their boards are being thoughtfully disciplined around most of these areas of growth and spending.

Is there sufficient venture creation of new startups to refresh the ecosystem? Asked another way, what’s the right number of private biotech companies at steady state in a healthy ecosystem? I’m not sure, but it’s clear we aren’t creating an expanding pool of venture-backed biotechs, and the IPO and M&A exit markets are removing them from the venture ecosystem at a rapid clip. The number of compelling private biotechs today is far less than it was just two years ago, and many BD teams in Pharma know this as they struggle to identify compelling early stage partners – especially in areas like cardiovascular disease and neuroscience. We simply aren’t creating enough new corporate substrate as a sector. As a supplier of new companies, Atlas and other early stage firms are in a good position to feed future demand for innovation, which bodes well for venture returns – but a healthier ecosystem would be one that expands the number of participants, albeit at a modest and measured pace.

With this funding backdrop, it’s an exciting time to be a young biotech company – especially if you can broaden your sources of long-term investment capital, scale your company with less dilutive financing rounds, and deploy the funds with discipline and diligence. Only time will tell how all these variables play out, but every company (and its investors) will get judged by hindsight soon enough.

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Volatile Mixture: Young Biotechs’ Stock Market Rollercoaster

Posted in Biotech financing, Exits IPOs M&As | Leave a comment

The stock market has been a wild ride of late – big moves up and down, NYSE getting halted, Grexit, China – lots of reasons for added skittishness. The VIX index, which measures the volatility of the S&P500, has gone up more than 50% in the last twelve trading days, into the range seen only a handful of times since mid-2012.

But the VIX measures the bigger end of the stock market. Biotech is a high beta equity sector, meaning it has a tendency to swing more than other stocks in respond to market changes. Within the biotech sector, younger small cap stories are notoriously more volatile, but historically there’s been little aggregate data given how few biotech companies made it public. But that’s changed in the past two years, so it may be more useful to examine the ups and downs of these newly minted IPO stocks.

First, the dataset used here tracks 112 biotech’s that went public in the 24 months of 2013-2014, and are still trading today; for these stocks, the daily closing prices were compiled and day-to-day changes were analyzed. Here’s the summary of the findings.

As a group, this cohort of young companies has rollercoaster volatility, as you might expect. On a typical day since start of trading this year (122 days through June 26), 43% of stocks in this group move down by more than 1% and 46% move up over 1% (meaning only 11% trade between 1% and -1%). Beyond that, the outliers are significant: 8% of the stocks in this group move down more than 5% on an average trading day, and 11% move up more than 5%.

Below is a chart that captures the cumulative distribution of daily stock changes. With 112 stocks coming into the markets over this period, this distribution represents over 37,000 daily closing prices.

Daily outcomes

Digging into the individual stocks themselves, an annualized historic statistical volatility can be calculated (as described here). Here’s a table with the ten most and least volatile stock tickers, with a comparison to some large-cap biotechs and the NASDAQ Biotech Index (IBB). It also tracks some of the more high profile IPOs of the past couple years.

Table Historical Volatilities2

As expected, the volatilities of even the least volatile group of stocks are much higher than their large cap comparators, which range from 25-37% across names like Amgen, Gilead, Biogen, Regeneron, and Celgene.

High flying “premium” valuation stocks have also seen significant day-to-day volatility, with annualized rates in the high double digits: for example, Juno Therapeutics has shown annualized statistical volatility of 90% given the dynamic stock moves around news in the CAR-T field. Of the 129 trading days for Juno in this dataset, 16% were moves upward by over 5%, and 12% were moves downward greater than 5%. Another example is bluebird bio, which has an annualized volatility above 80%, reflecting the excitement in its programs and the gene therapy space; 15% of its~500 trading days have delivered stock movements greater than +/- 5%. Further, the most volatile stocks in this IPO cohort reflect crazy levels of stock volatility: Neuroderm, Nephrogenix, and Vascular Biogenics all have annualized statistical volatilities north of 150%.

It’s well understood by most investors that these stocks should be more volatile. They are by and large a thinly traded group, with small floats of outstanding stock and significant insider ownership. The prices of these stocks are therefore easily moved by modest changes in trading volume: in short, small orders can gyrate their pricing. Add this technical trading dynamic to the dynamic newsflow in these areas (e.g., CAR-Ts, gene therapy, orphan cancer drugs) and their specific R&D updates, and it’s a volatile mix.

It would be interesting to compare these “IPO cohort” volatilities with the stocks from past IPO windows (but I haven’t the data nor the time); its not likely that any of the technical fundamentals (like insider ownership, float, etc…) have changed significantly from past vintages, but the level of institutional specialist investing and long/short hedge fund activity in the space has almost certainly increased.

In light of the significant volatility, there are a few takeaways for those of us interested in long-term fundamental investing:

  • Get a seatbelt and focus on the destination. Buckle into the stock as long as the investment thesis remains intact and the valuation has room to grow into that thesis. Expect lots of ups and downs between now and then. Reconsider as the thesis plays out.
  • Don’t try to time the market; pick great stories, high impact medicines, and stick with them. Great companies are built over years and decades, not days and months.
  • If you are an active trader, have fun with the volatility and have your Xanax ready. I have no stomach for that, and hence am in the most-illiquid, long-term part of the biotech sector.
  • Big macro shocks are likely to further exacerbate these biotechs’ volatilities: although gene therapy has little to do with Grexit, traders correlate everything during market meltdowns. Given the macro issues today and on the horizon, expect things to stay exciting.

The capital markets in small-cap biotech are, as usual, awash in volatility. Accessing the public markets is essential for scaling new business and accessing the required capital, but it obviously come with expectation of potentially distracting and volatile stock movements. The key for management teams and their long-term investors is to not let daily or weekly or even monthly moves in your stock consume your attention. Build long-term value and the rest will come.

As many others have said, “the markets are a great servant but a bad (and volatile) master”.

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