“Avoid stocks whose names begin with Bio or end in -ics or -ix.”
-David Brown, Producer, New York City
Source: Esquire Magazine.
As I’ve mentioned previously, the venture industry is undergoing a contraction period. Unfortunately, the venture fund that I’ve been working at for the past two years has not been immune to the current trend.
It is with great sadness to have to leave the fund. It’s been a wonderful experience working in venture. I’ve met a ton of very smart people and learned a lot about emerging technologies and markets.
Unfortunately, it’s a tough time for the venture industry as a whole, and I believe a very difficult time for life sciences investors in particular. While a ton of innovation still exists, healthcare reform and regulatory headwinds have made early-stage life sciences investing more risky. I believe the pendulum will eventually swing back the other way, but it’s hard to say when it will at the moment.
It should be no surprise that pharmaceutical companies – and even some large biotechnology companies – are in need of drugs to fill their product pipelines and to maintain the earnings growth demanded by investors. Companies have shown that they are willing to pay a significant premium for developmental stage products. According to Burrill and Company, valuations for licensing deals during the first quarter of 2006 have increased over 75% relative to the same quarter in the previous year. Not only has the number of M&A transactions grown, but the premiums paid to acquire companies have also increased. One of the reasons for the growing number of in-licensing and M&A deals is the fact that internal R&D has been unsuccessful at keeping up with the demand for new products. McKinsey & Company estimate that in-licensed drugs have twice the likelihood of making it through clinical trials than internally developed compounds. The growing costs of developmental stage products will unlikely change as competition for them only gets worse.
The recent Merck acquisition of Sirna highlights the incredible valuations that are being demanded by biotechnology companies for their products. Merck paid about $1.1 billion, a premium of around 95%, to acquire Sirna, which develops RNAi technology but has only one product in early clinical development for treating age-related macular degeneration. In the Pipeline puts the acquisition into perspective comparing Sirna to Isis Pharmaceuticals. Isis, which also develops RNAi products, first started developing antisense oligonucleotides more than 10 years ago and has yet to launch a drug onto the market. In contrast to the Merck acquisition of Sirna, Lilly recently sought to acquire Icos for approximately $2.1 billion, at a premium of only about 25%. But Icos already has a product on the market, Cialis, which is used to treat of erectile dysfunction. The run rate for Cialis sales is almost $1 billion for 2006. Lilly was already accounting for half the sales of Cialis prior to the acquisition, so the company essentially paid for the remaining half of Cialis sales.
One thing to keep in mind is that the higher premiums are only part of the picture. It is often overlooked that pharmaceutical companies are also doing more earlier stage deals that are inherently much riskier than later stage ones. The October issue of In Vivo from Windhover, looked at clinical stage licensing deals valued over $20 million in 2002 and 2003. Not surprisingly, the deals involving Phase III products had the best success rate: 12 of the 17 Phase III products were still undergoing development and five had been approved. Of the Phase II products licensed, only 7 of 14 are still in development. Although the rate of Phase I products still in development is 60% (6 out of 10), the sample size is small enough to safely assume that the success rate was the same as that of Phase II products. Ideally, when making an investment of any nature, one would want reduce the risk when more capital is spent. But instead, pharmaceutical companies are now taking on more risk at higher costs. It remains to be seen whether taking greater risks will eventually pay off.
A recent WSJ article highlighted the trend that biotech startups are preferring to be acquired rather than go IPO. According to research from Bain & Company, as many as six-times the number of biotech startups have chosen to be acquired compared to only 67 biotech companies which went IPO since 2003.
The market conditions are definitely making it tougher for biotech startups to go IPO. According to Bain, acquirers are willing to pay a premium, an average of 3.5 times a startup’s invested capital compared to the stock market which valued biotech companies at about twice their pre-IPO levels. Institutional investors are wary of biotech IPOs since new offerings have not performed well – in the past year, shares of most biotech IPOs have depreciated since entering the market. Venture capitalists also prefer acquisitions over IPOs because of the benefits of being preferred shareholders.
But as more biotech startups move away from IPOs, the WSJ article asks whether small biotech companies will be able to mature to become independent companies. Even so, there are biotech companies on the market with the potential to become the next Amgen or Genentech.
Analysts have recently speculated that publicly traded Sepracor may be a target of acquisition for either Pfizer or Schering-Plough. Sepracor sells sleep medication, Lunesta, and asthma drug, Xonepex. Buyout speculation has driven Sepracor’s market cap to just over $6B, which is relatively affordable for most major pharmaceutical companies.
Although Sepracor may provide Pfizer or Schering-Plough with an earnings benefit, there are a number of risks associated with the potential deal. Generic drug makers are challenging Xonepex’s patents, while sleep product Ambien from Sanofi-Aventis loses patent exclusivity towards the end of the year, which may hurt Lunesta growth.
Further fueling acquisition speculation, Pfizer recently terminated its partnership with Neurocrine Biosciences on Indiplon after the sleep drug only received an approvable letter from the FDA. This week, Pfizer sold its over-the-counter business to Johnson & Johnson for almost $17B. In addition to buying back shares, Pfizer has stated that it intends to make a number of acquisitions with this cash in hand.
As I have alluded to in previous posts, major pharmaceutical firms will likely continue to look for acquisitions to fill their product pipelines. For the first half of the year, global M&A volume was the highest it has ever been, and the current trend does not appear to be slowing down. European CEOs have expressed interest in doing even more deals in the remaining half of the year. It will be interesting to see what other smaller specialty pharmaceutical and biotechnology companies will be targets.
A reverse merger, also known as a reverse takeover, occurs when a private company merges with a public company, which no longer has a viable business, to essentially gain access to public financial markets. Reverse mergers generally cost less and take less time than IPOs but the failure rate tends to be higher than traditional IPOs. Even so, as many as half of all companies that go public choose to go the reverse merger route.
Last week, TorreyPines Therapeutics merged with Axonyx, and PharmAthene merged with Siga Technologies. Both TorreyPines Therapeutics and PharmAthene were privately funded, while Axonyx and Siga were already trading on the NASDAQ. TorreyPines Therapeutics, funded by Alta Partners, Sorrento Associates, SR One, and others, focuses on developing small molecule therapeutics to treat CNS disorders. The company has a number of products in development; two are in Phase I development for migraine and Alzheimer’s disease. PharmAthene, funded by MPM Capital, MDS Capital, HealthCare Ventures, and Bear Sterns Health Innoventures, focuses on chemical and biological weapons countermeasures.
Given the high hurdles to IPO, reverse mergers will likely continue in the biotechnology space. It will be interesting to see how reverse mergers compare to IPOs this year.
Continuing the trend of recent biotechnology acquisitions, Novartis yesterday announced its purchase of publicly traded NeuTec Pharma, a British firm founded in 1997 that uses antibody fragments to develop treatments for infectious diseases. Novartis will pay approximately $569M for NeuTec, representing a premium of 109%. Novartis does not appear to have had any partnerships with NeuTec prior to the acquisition. Last year, Pfizer paid $1.9B, about an 84% premium, for Vicuron Pharmaceuticals, another company that focuses on developing anti-infectives.
NeuTec does not have any products on the market but has two in late-stage development. Mycograb, which targets hsp90, is currently awaiting EMEA approval for treating invasive candidiasis. Novartis anticipates a US filing in 2009. Aurograb is in Phase III development for treating methicillin-resistant staphylococcus aureus. Novartis plans to file Aurograb in both Europe and the US in 2010.
No surprise, Sidney Taurel, Eli Lilly’s CEO says that consolidation will continue as pharmaceutical companies struggle to find growth. As mentioned in a previous post, both private and public companies will continue to attract substantial premiums with such a demand for pipeline products.
Last week, the Boston Globe had an interesting article on how hedge funds were starting to invest in private biotechnology companies, investments traditionally made by VC firms. Venture capitalist, Bill Burnham discusses the trend on his blog and how hedge funds may eventually shake up the VC industry. Some venture capitalists are even throwing in the towel and starting hedge funds.
The growing trend is not that surprising considering the enormous amount of capital that hedge funds manage and their need to diversify. Instead of chasing the same public companies, private companies represent market in need of capital that still has a lot of opportunities for expansion. For entrepreneurs, hedge funds provide access to public investors and sometimes at less onerous terms since hedge funds tend to manage more funds. So far, most hedge fund investments in private companies have been limited to late-stage or mezzanine rounds. Being passive investors, it seems unlikely that hedge funds will ever migrate into early-stage investments. It will be interesting to see how the industry will evolve.