Risky Business: Late Stage vs Early Stage Biotech

Posted November 18th, 2011 in General Venture Capital, VC-backed Biotech Returns

Last week, late stage biotech Alimera blew up after the FDA sent it a Complete Response Letter (CRL) rejecting its Iluvien product for eye diseases.  The stock is off 80%.  This was supposed to be a derisked, late stage investment around a known corticosteriod delivered in a smart way to the eye.  I guess it wasn’t as derisked as many thought.  Which raises the broader question of risk and biotech investing.

Venture capital is often called risk capital.  We are paid to take risks with the goal of outsized returns.  Value today is a function of that risk and return ratio, and asymmetric views of that ratio create arbitrage opportunities as investors.  If an asset was widely perceived to be low risk, it would be easy to raise capital at higher prices, and returns (appreciation) would be smaller.  If an asset is high risk, we can buy it cheaply.  And if we believe there’s a capital efficient path to derisking it, we’ll be able to create and capture the value of that risk reduction.  Without metrics like P/E and revenue multiples, this simplicity around value is especially true in biotech investing, where perceptions of risk become the driving factor (especially since profitability of successful drugs are typically very high).

One common misperception of risk is that early stage biotech plays are more risky than later stage clinical deals.  Its wrong, and Alimera is Exhibit A.  Narrow views of risk as only scientific/clinical/technical are the Achilles Heel of many biotech companies and their investors today, and in my opinion this is one of the biggest misperception in the field. Risk comes in a ton of flavors.  Scientific and technical risk is certainly important – but there are a bunch of other critical risks:

  • Regulatory risk.  The FDA could raise the bar, move the goalposts, change the playing field or whatever other sports analogy you want.  Its a huge factor, and delivers body blows to small companies.  Lots of other Exhibits here beyond Alimera.  Orexigen’s off 80% from its CRL earlier in 2011.  Biodel’s lost 85% since its CRL a year ago.   ARCA’s off more than 85% since its CRL in May 2009.  Alexa’s off 60% since its 2010 CRL.  These events destroy any hope of big returns to existing shareholders.
  • Financing risk.  If you need to spend a ton of money to get to the value inflection, you’ve got plenty of financing risk.  And without an excited public market, financing risk looms large as the cost of capital doesn’t go down with capital intensity.
  • Liquidity risk.  Where’s the exit door for existing shareholders?  With IPOs remaining challenged, M&A is the typical way out.  But what if every buyer is distracted with restructuring or EPS when you’ve got your data?  We’ve all had companies with good data in hand but no buyer. Similarly, if the public markets are in crisis (which never happens), will you be able to get public at all?
  • Execution risk.  We all face this.  Bumps, delays, mistakes – they all add to the burn considerably.  Fortunately, if you’re small and early stage, the fixed cost of delays are modest; for a Phase 3 stage company a 6-month delay in recruitment necessitates another financing.
  • Reimbursement risk.  Look at what happened to Dendreon.  Its not simple to navigate this one.
  • Idiosyncratic safety risk.  One patient has a “possibly related to drug” event?  Tough place to be trying to explain away a weird event.  And weird things are probabilistic – more patients, more likely of a weird event.
  • Many others.  Like global economic meltdown perhaps?

So my thesis is this: early stage biotech investing around discovery or preclinical stage assets, where the aim is to move them through to human PoC and then exit, has an as good or better aggregate risk profile than betting on later stage clinical assets.   In these early stage deals, capital can be titrated into the early stage programs as scientific risk is mitigated, without a great deal of capital exposure, well before major regulatory risks and other later stage issues arise. Value is captured most often through M&A with downstream partners, or in the case of some of the newer structures through sale of subsidiaries (the plan at Nimbus) or pre-negotiated buyouts (AVDC-like deals). Science risk can be managed (not eliminated) through disciplined tranching, focus on killer experiments, and creative early partnerships. Two of the highest multiple biotech exits of the year – Amira and Plexxikon – were both 10x+ and were founded as early stage drug discovery deals.

Later stage clinical deals may have less science risk for sure. Alimera had an older, well-known drug with new delivery system. Orexigen’s lead drug is a combo of two known generics. Alexza was a new delivery of a known antipsychotic. But despite having less science risk, the regulatory risks were far higher than expected. In fact, it may very well be that because the innovative science risks were low, the clinical differentiation was less, and the FDA risks higher. Incyte’s new JAK2 Jakafi just got approved in faster-than-PDUFA time in part because it is so innovative. But beyond just exchanging science risk for considerable and largely uncontrollable regulatory risk, these late stage deals suffer from high capital intensity (i.e., a Phase 3 study is hard to do well on a shoe-string) and large bite-sizes (hard to tranche within a study). Delays and clinical blow-ups with this cost structure make late stage clinical asset investing an unforgiving place if you get caught on the wrong side of an outcome. Part of the venture world’s interest in these late stage clinical deals is one can take them public: almost all the IPOs of the past two years has this profile. But being publicly traded doesn’t assure one of making a healthy return; just ask the Alimera investors this week.  And once the drug is approved, actually launching it successfully and building revenues isn’t easy – its incredibly expensive and missing quarterly estimates can be brutal. Zogenix got its sumatriptan migraine product approved and went public in Nov 2010; despite having a marketed product, the stock is off by 55% since its IPO price.

Scale Venture’s decision to shut down their healthcare investing supports this late-isn’t-all-great thesis. Their portfolio filed seven NDAs over the last few years, and got five approved (including Zogenix). I’m not sure I know of another venture firm with that many approvals in their portfolio over the past few years, kudos to Lou and Mark. But the challenge has been that the FDA didn’t approve them without creating enormous headaches. Of the five approvals, all were delayed considerably, and therefore had to raise more at a very high cost of capital, and returns suffer. I know, as we were in Prestwick together. Despite finally selling for $150M, it was a mere 1.4x because it consumed a ton more capital to get around multiple FDA CRLs and an Ad Com. Now some of Scale’s companies will hopefully deliver on the marketing of these products, and grow into billion-dollar biotechs – that was the original investment logic I’m sure, and in that scenario they will have created a good return for their venture investors. But it will take a much longer time, and the compounded risks/delays will have diluted their returns enormously (especially IRRs).

The natural players in the late stage game aren’t VCs but are Pharma and Big Biotech. They are  very good at late stage clinical development, regulatory, reimbursement, and commercial, and they’ve got deep pockets and cash flows to deal with FDA-induced delays, late stage clinical hiccups, as well as big internal groups to deal with all these issues. While CRLs can destroy a small company’s valuation, Merck recently buried two of them in its 10Q because they weren’t material events. That’s resiliency.  In general, my view is that as a sector we should play to our strengths. Let the big companies leverage their skills and balance sheets to handle the later stage risks, and let smaller venture-backed companies focus on delivering high value early stage drugs into their hands.

That said, there are some venture firms who’ve managed this late stage clinical arena reasonably well. You need a big fund and the ability to persist through pain. Jazz is a great example of where persistence would have paid off.  IPO’d at $17, dropped to $0.80, and then rose from the ashes to $37 today, a 2x on the IPO price. That’s a painful ride to hold through, but it would have been profitable. The need for a big fund with this late stage investment style is behind Prospect’s decision not to go forward with its $150M fund. Soffinnova’s recent $440M over-subscribed fund is a testimony to their successful implementation of a late state asset strategy: a number of good late stage deals including a Amarin (>>6x since PIPE) and Trius (up 50% since IPO).  They’ve also been good about when to step out of deals with big regulatory risk; my understanding is they exited Orexigen after the positive Ad Com panel at 2x or so, before the CRL took 80% off the stock.  Lucky or smart, they made the right call with OREX.

I’m not making the case that returns can’t be made in late stage biotech, just that the conventional wisdom that “early stage is riskier” just doesn’t hold up when the full complement of risks are considered.  In short, we shouldn’t mistake lack of science risk with lower aggregate risk.  The risk-return calculus for smart investing in biotech can be made at either end of the spectrum and requires different investment approaches.

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