Six months ago the biotech industry was on the verge of a sizzling season for IPOs, and since then, on average, we’ve seen one new biotech IPO per week. Valuations of many of these offerings have been impressive, and this window has captured the sector’s attention as one of the most interesting IPO cycles in its 40-year history.
But getting public isn’t an exit for the private investors who’ve been supporting the company for the past 5-10 years: an investor actually needs to sell their shares to get liquidity flowing through the system. Right now we’ve got some lofty “paper” valuations, but they are only that – paper. Converting these mark-to-market reporting values into liquid, realized returns is where the rub is likely to be for many in the IPO Class of 2013.
As most readers know, during the 180 days following an IPO, insider investors have to hold onto their shares; but with the expiry of that period, they can begin to sell their stock, or distribute it directly to LPs. Since the flurry of IPOs really started in the second quarter of 2013, we are about to see lockup expiries across a number of the recent offerings. Here’s a calendar from @AndyBiotech on Twitter (here).
This wave of lockup expiries pose the next big challenge: how to accomplish the orderly transition of a shareholder base, lock in returns for private investors and build a long-term public equity investor base, all without disrupting company valuations.
So how big of a challenge is it? Lets look at the numbers:
- Aggregate market capitalization of ~$16 Billion. Because of the impressive valuations, supported by both the IPO pricings themselves and stellar post-IPO performance, the aggregate market capitalization of this year’s biotech IPOs is ~$16 Billion as of today. By comparison, this is 3-4x bigger than all the venture fund flows into 500 private biotechs per year.
- Mostly owned by VCs. I’d guess that 60% of the shares in these companies are still owned by private venture investors broadly defined (i.e., 80% of the pre-IPO capitalization was likely VCs which then took 25% dilution at IPO). That equates to $10 Billion of unrealized stock that VCs are sitting on in these companies.
- And much of it is unrealized profit. Based on the paid-in capital into these companies, which is ~$4.5 Billion by our estimates, VCs are sitting on $5.5 Billion in unrealized profits. That’s a ~2x return for the average investor in this window, with a number of high flier stories sitting far higher than that. This is a large bolus of capital for a biotech venture industry that’s been raising much less than that from LPs in recent years.
The need to “put some points on the board” by sending realized returns back to LP’s is creating real pressure on many of these insider investors. How will they get their positions’ liquid in an orderly fashion? It’s a challenge.
To put that problem in perspective, here’s another set of numbers related to trading liquidity:
- Only a few million dollars of stock is sold per day. The median daily trading volume of these 2013 IPOs is ~$3 Million worth of shares per day. The median market cap is $340 Million. VCs, assuming 60% as above, own ~$200 Million in stock. That’s a big delta.
- Simply trading out of the stock over time isn’t a realistic option. If a single holder doesn’t want to be more than 25% of the daily volume of stock (which is a good rule of thumb for not putting significant selling pressure on a stock), that implies ~260 consecutive days of active trading to exit a position. That’s an unbelievably long time to be continuously selling stock into the market. Waiting for ‘big news’ days and selling into enormous spikes in volume is the only realistic way the “trade out” strategy works in reasonable time periods.
Magnifying the above numbers is the fact that many VCs have still not exited most of their positions from IPOs of 2011-2012 (e.g., Intercept, Tesaro, Clovis, etc…). Those companies represent another ~$11 Billion of market capitalization, of which I estimate there is at least $5 Billion of remaining VC-held positions at reasonable unrealized return levels.
So combining the last few years of IPOs, there’s an unprecedented need for inbound capital flows to create the liquidity required to transition the shareholder bases of 50-60 biotech companies. I suspect some will manage it successfully, and some won’t.
The big fear is that there’s a mad rush to the exit door. This bad scenario goes like this: after the lockups, a bunch of VCs distribute a chunk of shares to LPs who instantly hit the sell button; multiple biotech stocks move into the red in a big way given selling pressure, causing an allergic reaction from generalists to flee the sector; valuations collapse across the board and the IPO window tightens up considerably. Realized returns, with these diminished prices, end up being far less attractive than the valuations suggest today. All can agree this isn’t optimal, and it’s a shared sentiment across most stakeholders – investors, management, employees, boards, etc (except for maybe Big Pharma looking to buy biotechs on the cheap).
Proactively managing the liquidity process will be key. Many Boards and their management teams are acutely aware of this challenge and are working to get out in front of it. Bankers are facilitating dialogues with most, if not all, of the recent IPOs about marketing follow-on offerings. The good news is that many IPOs were significantly over-subscribed and key buyside accounts got less of an initial allocation than they originally wanted – meaning there should be pent up demand to help buy up the shares from private venture investors and get them into the hands of long-term public investors.
First follow-on offerings provide two mechanisms for facilitating an orderly transition of shareholders after an IPO:
- Improving the liquidity in a stock by increasing the float: First follow-ons after a biotech IPO offer big increases in trading liquidity: biotechs that have done them since 2011 have increased their average daily trading volume by ~100%; without a follow-on, average daily trading volumes increase by only ~10% over the first year. Driving up daily trading volume in the stock is an important enabler of liquidity for private investors to ‘trade’ out of stock over time
- Providing the orderly transfer of shares from old to new investors via secondary sales: Unlike first follow-on offerings from Tech companies, where 100% is often secondary sales, biotech companies rarely have material secondary components to their offerings. Since 2011, out of 13 offerings done within the first year of an IPO, only Endocyte and Aegerion had a secondary piece (14 and 23%, respectively, of those offerings). But in today’s market, there appears to be more demand for secondaries: Morgan Stanley and Cowen, among other bankers, have helped with recent offerings from Chimerix (100% secondary) and Portola (29% secondary) in October. Merrill Lynch supported Intercept’s 100% secondary offering in October as well. Unfortunately all three are off 15-30% in October (vs -1% for the Nasdaq Biotech Index) so the market wasn’t entirely thrilled with the offerings; remains to be seen whether this lackluster stock response has scared off other recent IPOs from going this path or not.
It’s worth noting though that the expiry of a lockup doesn’t have to mean a weakening of the stock price: Enanta and Tetraphase both saw their lockups expire in September and both are up since then (4% and 38%, respectively). Assuming insiders don’t rush to the exit door stocks don’t have to suffer.
The last reflection on this topic regards the choices venture firms have to make. There are at least two big issues VCs face as they ponder their exit strategies:
- “Should I stay or should I go”. In the 2000s, when an IPO was a financing and not a recognition of value creation, most VCs stayed on their boards, sometimes for years after the IPO to help play a role in governance over time. This allowed them wait until the “investment thesis” played out (read = the stock price became attractive enough to sell) before locking in their realized returns. But staying on the Board clashes with the ability of a fund to easily trade out of a position. If a firm likes the valuations today, which I suspect many do, we’ll begin to see lots of VCs leaving boards to create more flexibility for driving liquidity.
- Distributing stock or waiting to send cash back. Many firms have different policies regarding the distribution of stock vs the need to sell shares and return cash. Sending shares to LPs raises the question of what is the right ‘price’ that gets locked in for calculating a VC’s return (e.g., 1-day, 10-day, or 30-day moving average stock price). This is always defined in the partnership agreements, but still can create tension, especially if most LPs instantly sell the shares they get in a distribution and that selling pressure drops the price. In essence, they risk locking in a VC’s returns at one price, only to have those shares well under that price a few weeks later. But making the VC sell the position and send cash home also poses challenges: the VC has to architect how to sell over time in an innocuous way to the stock, often taking longer to achieve realizations. It differs dramatically by venture firm, but its fair to say that most LP’s dislike getting illiquid share in small cap companies in a distribution (but still like the realizations). There doesn’t appear to be an industry ‘standard’ on how firms approach this question.
At the end of the day, this ‘exit strategy’ challenge is obviously a high-class problem for the biotech sector to have, and I certainly wouldn’t have expected this to be the tone or subject of discussion just one year ago.
But it is an interesting problem, and I’m hopeful the markets will be cooperative in supporting an orderly transition. This IPO cycle should be a major contributor to returns for the biotech venture sector and bring IPOs on par with M&A as a source of liquidity. By my estimation, VCs collectively own ~$15 Billion in unrealized stock of 2011-2013 IPO’s. The aggregate value of all of the private M&A of 2010-2012, a robust period for biotech exits, created a similar amount of liquidity (~$16 Billion according to this recent SVB report). Having both IPOs and M&A contributing meaningfully to overall venture returns in biotech is a good thing for all of us.
