Biotech’s Relevancy Challenge In An Expanding Universe

Posted June 1st, 2021 in Biotech financing, Capital markets | Leave a comment

The universe of public biotech companies has been growing for a decade, and increasingly so in the past few years as the IPO market has flourished. Hundreds of young aspiring biotechs have tapped into the public equity markets, swelling the ranks of small- and mid-cap players.

While this expansion has been great for financing R&D pipelines, the rapid increase in the number of biotech companies hasn’t been matched with a similar increase in the number of “core” positions in most public investors’ portfolios – leading to a heightened battle for their mindshare and attention.

First, let’s review some data.

As anticipated with a robust IPO market, the public biotech ecosystem has been rapidly growing in the past decade, as reflected on previously here. After contracting in the wake of the 2008 financial crisis, the number of public biopharma companies has nearly tripled since 2012. As of March 2021, there were over 620 biopharma companies listed on the NASDAQ and NYSE, according to BMO Capital Markets. 

However, the number of biotech-savvy buyside investors hasn’t kept pace with the number of newly public biotech stocks. While anecdotally there’ve been a reasonable number of new funds formed, these haven’t launched at the same pace as new IPOs or the growth of the biotech markets as a whole in recent years. In fact, as explained below, data suggest that many of the bigger and more established public biotech funds have actually grown faster than the overall market.

Though metrics of public equity fund formation and activity in biotech are hard to track, there are a few proxy data points that shed some light. Investor positions for any fund with at least $100M in AUM can be tracked by what the SEC calls 13F filings.

As background, the number of 13F filings scales with the valuation of companies in a linear way; a newly minted IPO may have 60-120 investors that are required to file 13Fs, which typically grows into 500-800 filers if the company is fortunate enough to get into the $10B market cap range, and Big Pharma’s often have more than 2000 filers.

If the pace of fund formation for new investment managers was growing faster than the number of investment opportunities, you’d expect to see the growth rate of the AUM of a stable pool of existing blue chip biotech specialists to trail the growth of the overall biotech market (implying their “market share” was going down as new managers appeared). This hasn’t been the case.

Examining the 13F filings of a sample of ten of the most active crossover/biotech specialists (including Baker Brothers, OrbiMed, Perceptive, Red Mile, RA, RTW, Deerfield, Rock Springs, BVF, and EcoR1) across the 7 quarters, from 1Q 2019 and 4Q 2020, reveals an aggregate value increase from $40B to $83B, or a 108% increase. Some of this is by accretive performance of their portfolio positions, some by net inflows into their funds.

By comparison, total biotech financing activity (in dollar terms) for IPOs and public follow-on’s grew 86% over that period (1Q19 vs 4Q20), and the $XBI biotech stock market index increased 76% over that period (3/31/19 to 12/31/20).

This delta (108% vs 70-86%) implies that despite the arrival of new managers, many of the bigger and more established managers are increasing, not decreasing, in their aggregate share of the biotech investing/funding market.

 

One of the many limitations of this analysis is it doesn’t capture differences in “where” investors play in the continuum of biotech companies, i.e., buying an IPO is different than buying Alnylam today, and some investors do more of the latter than the former. If anyone has better data on fund formation and activity, please share.

That said, I think the analysis is directionally correct around the principle takeaway: the pace of new names to invest in (supply of opportunities) has increased faster than the number of potential “big” holders of those names (demand for core positions).

Fund managers are frequently constrained by the number of true “core” positions they have, due to both mindshare of their team and the need for meaningfully-sized portfolio allocations.

Setting aside the huge long-only mutual funds (like Fidelity) that own large swaths of the biotech market, many of the best buyside investors in the biotech investing world only have 20-30 “core” positions, along with a tail of smaller “toe-hold” positions, irrespective of their fund’s assets under management (AUM).

Given the illiquidity of many biotech names, these big core positions only typically accrue by participating in marketed or structured biotech financings (e.g., crossover private rounds, IPOs, and Follow-On offerings). Buying these big “core” positions only in the open market would put significant upward pressure on the stock prices for most SMid-cap companies.

For an aspiring young biotech to build a successful and supportive investor base for the long-term almost requires becoming a core position with at least a few of the “blue chip” buyside investors. These funds often step-up in every financing with significant anchor orders, and they support the stock on the inevitable volatility dips. As an example, Baker Brothers did this with Synageva and Seagen over the past decade, buying into their equity financings as supportive insiders with strong conviction.

But the number of core positions “available” in the industry only scales with the number of skilled and size-able investors, since most funds generally don’t have big positions beyond their core 20-30 names. Despite increasing in size (as shown in the data above), most of the top funds haven’t scaled by adding a proportional number of new “core” names. In short, their core portfolios have increased in valuation, rather than in the number of underlying stocks.

This is part of what has driven the feed-forward flywheel of crossover and IPO sizes and valuations: larger raises mean larger allocations that are more meaningful for funds, driving up demand for participation in those raises, which increases the valuation and enables ever-larger raises – and so the positive cycle feeds itself.

There are two ways for a fund to make room for new “core” positions. They can sell out of a position, believing their capital is better deployed elsewhere (due to either valuation levels or a loss of conviction on the biotech’s prospects). This trading obviously happens, and many observers track the 13F filing changes of the top funds (like this one, tracking EcoR1).

Or, a fund’s core position could be cashed out because of M&A.  An acquisition recycles cash back into the fund for redeployment into new names. Over the past year, though, M&A has been rather quiet relative to past bull periods in this 10+ year super-cycle, reducing the relative role of recycling in fund-level portfolio reallocations of late.

So all these trends highlight the “relevancy challenge” in the biotech equity capital markets today: in an ever-expanding world of names, where the “supply” of possible core positions is outstripping “demand” for additional core positions, how does a biotech become or maintain relevance to the best long-term investors?

The obvious answer is to have an unusually compelling story to tell with great data revealing huge potential for transformative impact on patients. Much easier to say then to truly demonstrate, and “compelling” for an early stage story is often in the eye of the beholder.

But beyond the obvious, there are a number of things that can be important.

For achieving relevance, one way is to become a core position for a set of public investors before an IPO. This is the crossover phenom we’ve talked about in the sector for years, and it’s only increased in its importance over time. By building a diverse and deep investor base as a private company via appropriately-syndicated crossover rounds, you establish yourself as a core holding for a half-a-dozen or more key funds. But it’s a tricky Goldilocks formula: too many participants and the position will be immaterial so you won’t become a core name; too few participants and you won’t have broad-based support in the IPO and after-market. The same Goldilocks situation exists in how an IPO book is allocated.

These crossover and IPO allocations should reinforce the “core” positions of the best, “thought-leader” accounts who will be there for the long-term, as those are the funds that other investors will follow (e.g., if Orbimed or Perceptive are big buyers in the deal, others will want to be in the deal). Scarcity creates demand, but only as long as you’ve already ensured your biotech is a core position for some of the key investors.

As a young public company trying to achieve relevancy in the SMid-cap markets, there’s a multi-faceted approach that requires Board-level strategic prioritization. This includes detailed investor outreach plans built around the company’s key milestone/data releases, as well as medical and scientific meetings, publication strategies, and investor conferences.

The old adage is true in this relevancy-challenged world: always be selling. Not in an over-promotional way (a common mistake in biotech IMO), but in a credible, data-driven, and sophisticated way. You build support for the next financing by earning the respect and support of investors over the long run. In addition to good IR skillsets inside of companies, it’s often very valuable to work closely with IR firms and banks to help drive investor connectivity. Cultivate good relationships with a broad range of sell-side analysts, who can often help communicate a story within the context of a new space (e.g., where Company X sits in the neuroscience landscape). A management team with deeply credible reputation is often sought-after for advice about other topics by investors, further strengthening the respect and connectivity they have from the investment community. To this end, building your personal brand as a “thought leader” beyond your specific corporate role can be helpful. Remember, people buy from people they trust and respect – and investors are no different.

The bottom line is that achieving and maintaining relevance with the top buyside funds in an ever-expanding universe of investable opportunities only comes through hard work and planning, plus a healthy dose of good fortune in R&D. This buyside relevancy is critical to getting the attention required to access funding at a reasonable cost of capital – which is an existential requirement for success in loss-making R&D-stage biotech over the long term.

 

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Five Macro Risks To Biotech Coming Out of Washington

Posted April 22nd, 2021 in Biotech financing, Capital markets, Pharma industry, Pricing and Policy | Leave a comment

Despite saving the world from COVID, pharma and biotech are still in the crosshairs of many politicians. With many anti-Pharma politicians and regulators emboldened in the current environment, and with more aggressive tax and spending policy in the works, there a number of risks to biotech over the next 1-2 years out of Washington.

Here are five themes that could cause sleepless nights: drug pricing, deal-making constraints, drug approval uncertainty, inflationary pressures, and adverse tax policy changes.

Some of these are priced into the markets already, some are not. Depending on how they unfold, these risks could even resolve to the upside, in ways more favorable than current expectations. But all of these risks have the ability to shape market sentiment for biopharma, as well as accelerate sector rotations and asset class reallocations.

Of course, each risk is not created equal. Some pose more significant threats to innovation than others. Yet all could be impactful, so figuring out how to mitigate the downside risks and position the sector most favorably for the long run is important.

Here’s my rather long-winded take on these five macro risks and some possible implications to the sector.

  1. Drug pricing overhaul could hurt innovation.

We’re likely to see drug legislation of some sort this year as certain politicians from both sides of the isle embrace a populist anti-Pharma view of the world; it seems the drumbeat for “doing something” has become too loud to ignore. Rather than address the real issues around insurance and out-of-pocket costs, Pharma is an easy albeit lazy target for politicians. Around the time of the 2020 election, there was almost a pollyannaish view that Biden’s moderate position and the COVID vaccine/therapy halo would push off any material pricing reforms for a few years. That sentiment is no longer, and we’re bracing for the rumored upcoming announcements on the topic. 

Recycled bad ideas like slashing the prices via international reference pricing, outright caps on prices or increases, importing drugs from elsewhere, or adopting more draconian “NICE-like” reviews are being discussed. Framing drug price cuts as a source of funding to support other ideas of the administration makes them seem more palatable to the public, even if the end result is the same. Many of these ideas will hurt the innovative biotech sector if they come to pass.

For the record, it’s not that drug pricing and healthcare spending reforms aren’t needed – they are, as out of pocket costs to consumers are just way too high. But it’s the fear that innovation-crushing reforms will discourage the necessary drug R&D investments required to bring medicines from bench to bedside.

I shared my views in Dec 2019 when H.R.3 was being considered in the House, in a blog post titled “Venturing a Perspective on the Drug Pricing Debate.” This blog still captures my views, which support concepts like true value-based pricing, greater transparency around the gross-to-net pricing dichotomy, and clearer biologic genericization pathways (maybe including “contractual genericization”).

If reforms were done well and addressed these issues, without damaging the rewards for innovating, it would likely strengthen the biotech sector. Further, it could shift Big Pharma’s focus from squeezing the juice out of older products with steep annual price increases towards launching greater numbers of new and innovative products – a large proportion of which will need to come via external innovation (partnerships, M&A). This is the potential silver lining for biotech M&A, which I reflected on during the 2016 pre-election drug pricing discussion, that a well-crafted drug pricing reform legislation would deliver.

But the prevailing winds in Washington don’t give me great confidence that a rational, informed perspective on the subject will win the day. Rumor has it the Biden administration may share some policy ideas on drug pricing later this month. Let’s hope these ideas support the first principle of early stage biotech investing: if we can positively impact the lives of patients by discovering and developing an innovative new medicine, the system will reward that risk-taking with superlative investment returns.

  1. FTC could block future M&A deals.

For years, there’s been a chorus of ill-informed voices claiming that biopharma M&A was anti-competitive, and that this consolidation kept drug prices too high. This has been an anti-Pharma talking point by politicians for multiple election cycles.  Sadly, even though it is wrong, it has gotten renewed energy in the current environment.

In March, the FTC announced a new multilateral working group, involving sister trade commissions from other countries, aimed at addressing the “issue” of M&A in Pharma, flailing the tired “mergers are bad, because prices are up” rhetoric (here). This new working group comes after a period of increasing chatter in Washington.

For example, Rep Katie Porter’s “bombshell” report (here) was released in January, claiming that M&A kills innovation in smaller biotech firms, citing some anecdotal complaints of former Immunex folks 20 years after the fact. There was so much, so wrong with the report, and it showed a striking lack of insight into how biopharma ecosystem works.

Big Pharma M&A certainly creates a temporary dislocation, and popular sentiment is often negative towards them. But there’s actually significant counterpoint scholarship that big M&A can create value when done well. An analysis of mega-mergers over the past few decades showed that “large pharma mergers are associated with higher R&D productivity” in delivering medicines to patients. But I’m not here to debate their merits with politicians, when the markets are the real and rightful allocators of demerits or merits for corporate takeovers.

I do, however, take the fundamental view that M&A is a good thing in the long run for the biopharma sector. It’s not just about the myopic company-centric view of M&A, where of course there are good and bad deals that get done. But at an industry level, M&A helps to efficiently allocate talent, science, and capital across the ecosystem. M&A frees up talent to populate new startups and cross-fertilize new perspectives; it free up assets to find “better champions” (out-licensing); and, it frees up capital to shareholders (cash) so it can be redeployed elsewhere. The diaspora from many of the big M&A events now populate the leadership ranks of countless startups, as well as other large companies.

There’s also a reality in biotech: it’s hard to escape the gravity of the balance sheets of larger firms. These big firms need external innovation to feed their pipelines and salesforces. This cycle of life often makes sense: the biotech takes the early stage R&D risk to bring new product candidates forward, and bigger firms take the later stage and commercial risks to get those to patients around the globe. And this “M&A put” underpins the price behavior of a lot of biotech valuations, as there’s an expectation great emerging companies will get acquired (e.g., Loxo, Juno, Kite, etc).

If the FTC creates real roadblocks to M&A in our sector, this “put” goes away and stock prices will certainly decline – raising the cost of capital for R&D-stage biotech companies. If they tried to “ban” only Big Pharma mega-M&A (which I think would be bad for the ecosystem), at least smaller biotech will potentially be spared. But how do you draw the line?  Right now, a biotech like Moderna has a larger market cap than a conventional Big Pharma like Takeda. Seems very hard for the FTC to be the adjudicator of a Big Pharma vs Small Biotech difference.

Fortunately, despite the noise around the FTC in the recent past, deals are getting approved.  AZ’s purchase of Alexion was cleared by the FTC on April 16th, which is a good sign for continued M&A activity. While 18-months ago, it’s worth noting that after a lengthy review, the FTC voted 5-0 (including Democrats and Republicans) to approve the Roche-Spark acquisition in Dec 2019. These might suggest that, despite the bluster of the headlines, sanity and thoughtfulness will prevail behind the scenes when it matters. Let’s hope so.

  1. FDA could make approvals harder.

Twenty years ago, the FDA was commonly cited as being counterproductive to innovation, more an adversary than an ally. Since that time, due to great leadership and a number of very productive initiatives, the FDA changed that perception dramatically and has been widely viewed in a favorable light in recent years. Sure, the FDA is still tough on some drug applications – but they have been actively encouraging new medicines for underserved diseases, facilitating the study of new modalities, and partnering with industry, big and small, in ways that foster innovation.

Recently, there’s been noise that the FDA’s pendulum will swing from this industry-friendly view to becoming more aggressive and less accommodating towards innovation.  Some recent surprise rejections via Complete Response Letters (CRLs), as well as a series of high profile delays, suggest this might be the case, amid calls that they are “moving the goalposts” on new drug applications. In addition, the FDA is certainly making it harder for new modalities, especially around the CMC aspects of gene and cell therapies.

Further, the FDA is holding prior “accelerated approvals” to task for needing to prove themselves in some of their “conditional” indications. Several drugs have failed to confirm, and have been pulled in those indications (like Imfinzi in bladder cancer, Keytruda in metastatic small cell lung cancer). I actually applaud these moves as holding a high standard.

The aducanumab FDA decision is coming and is seen by some as a bellwether for the FDA. But it’s honestly not a clear or slam dunk case, and I don’t think we should read too much into the FDA’s action on a single drug as an indication for an overall posture towards drug approvals. For those supporters of the drug and Biogen, an FDA rejection will be viewed as an aggressive action by an overzealous regulator, raising broader concerns for them. For those that think the mixed data require further confirmation, like those that agreed with the FDA’s Advisory Committee of experts, an approval will be viewed as a weak regulator, sloppy science, and a bad precedent, raising broader concerns for them. Either way, this one is likely to have a complicated set of bipolar responses from the investment community.

My view of the FDA overall remains more positive than most, and perhaps more positive than the market’s expectations. The FDA has had a ton on its plate and is processing a bigger industry portfolio of programs than ever before – and it’s a more complex portfolio with many new and exciting modalities. All this while prosecuting a COVID response with new vaccines, drugs, and diagnostics in record time. In many ways, I’d argue they are doing a great job.

Importantly though, a rigorous FDA with a high bar for safety and efficacy is important to the health of the sector.

One critical regulatory risk factor right now is who will be leading the FDA and what is their overall posture is to working with the industry to advance new medicines. This remains the open question for the biopharma community.

  1. Monetary and fiscal policy could drive interest rates unfavorably higher.

We’ve been in an unprecedented time from a fiscal and monetary perspective: the Federal Reserve has been locked into a “zero rate” policy for over a year, and the stimulus packages out of Washington have flooded the country with trillions of dollars.

Typically, prolonged near zero rate environments are good for “risk-on” sectors like biotech. Low borrowing costs, abundant liquidity, and low returns on interest-bearing securities push investors towards betting on higher risk sectors to seek better returns. We saw this in 2020 in particular, with tech and biopharma booming with positive fund flows.

But expectations are that rates have to go up. The economy, juiced up on all the free money, is booming: US GDP is expected to be above 10% annualized rate in 1H 2021. Inflation measured in various ways jumped in March, pegging above 4% annualized that month on the CPI. The heat in the economy, captured in these inflation measures, mean that rates are going to be increasing. The yield on the 10-year Treasuries has already gone up considerably in past few months.

As rates go up, the relative risk-adjusted returns elsewhere in the economy start to look attractive. In addition, industries whose valuations are more dependent on expectations of future cash flows, like biopharma, tend to be weaker as rates go up. Discounting the future values by higher rates depresses today’s value, or so the logic goes.

Fortunately, all of that is just good textbook theory. Empirically, the data aren’t as black and white. According to a Cowen report from March, historically periods of rising rates have actually correlated with strong biotech returns. But they also correlated with strong overall equity market returns in general, and the delta in performance to other sectors was actually smaller during periods of rising rates vs other areas.

Every market period is different, but there’s certainly merit to the view that a booming economy outside of biotech could cause a sector rotation that pulls capital out of the biopharma – which in general would be a bad thing for biopharma. Fund flows have been a net positive force in the sector for the past few years, and have helped drive biopharma to its highest ever percentage of the Russell 2000 small cap index.

How much this inflation/interest rate risk really impacts biotech depends in large part on how attractive other opportunities are relative to those in the sector.  If any of the aforementioned risks (pricing, M&A, FDA) play out unfavorably, the downside reaction could be amplified by this interest rate risk.

  1. Tax policy could discourage longer-term risk-taking.

Biden’s tax policies could also have negative impacts on biopharma, including both individual capital gains tax rates and corporate tax rates.  I’ll just focus on the former.

Low long term capital gains (LTCG) tax rates encourage risk-taking by investors, by compensating them for locking up their capital for longer periods of time. The LTCG tax rate fundamentally affects investor appetites for extended holding periods. In long cycle time industries, like biotech, these tax incentives play an important role for investors in a world of alternative investment opportunities.

The recent Biden tax proposals to move most LTCG tax rates up to current income removes the incentive to keep capital at work (“buy and hold”) in a specific deal, as patient capital no longer benefits relative to more rapid trading strategies.

We may already be feeling the acute effects of this: the mere expectation of higher future LTCG rates creates pressure to take gains now before tax increases occur.  I’ve heard from some buysiders that they believe the swoon in Feb/Mar of 2021 could have been due to investors with huge paper gains (up 100% over a year) selling as soon as they were into LTCG territory, trying to get in front of the future tax changes. Many expect 4Q 2021 to be particularly active for realizing gains before a new tax law takes effect.

The longer term effect of removing the incentive for LTCG is likely two-fold.

First, it could lead to less investor interest in the sector, all else being equal. In aggregate, investors will demand higher returns to offset their increase in capital gains taxes, which will cause valuations to tighten. Or they will seek less risky, less long-term investments, depressing the fund flows into the sector.  Either way, assuming other factors don’t change, investor interest will soften for a risky sector like biotech with higher LTCG taxes.

Second, with no incentive to hold longer term, more investors may adopt active trading strategies (vs patient “buy and hold” strategies) which will create increased volatility in an already volatile sector. Given the small floats in many stocks, higher trading velocity will have an accelerator effect on stock movements.

In short, the expectation (and reality) of increased LTCG tax rates is generally bad for long term investing.

The second major tax issue is around corporate tax rates. I won’t get into them here, as these tax rates generally don’t affect early stage biotech directly (since they are unprofitable for years).  However, they do affect the ability of bigger firms to deploy their global balance sheet efficiently for doing acquisitions, partnerships, etc…  Further, the global minimum tax concepts described by Treasury Secretary Janet Yellen are widely believed to be a negative for the Pharma (and tech) industries, as described elsewhere (here, here).

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How all these macro risks play out, and how much is already embedded in the prevailing market sentiment, is anyone’s guess at this point. I’ve never been very good at predicting acute market reactions to events.

While these five risks are independent variables in many ways, they have the potential to amplify each other.

If they become compounded negative outcomes unfavorable to the sector, the downdraft in the markets could accelerate significantly, tightening up the financing environment.

But if several unfold in more positive ways than expected for the sector (e.g., more M&A, a friendly FDA, and only “smart” drug pricing reforms), removing the negative overhang could unleash renewed bullish sentiments.

Only time will tell.

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