Jul 15, 2020

Murders and Executions: Biotech Won't Stop Slayin'

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I have all the characteristics of a human being: blood, flesh, skin, hair; but not a single, clear, identifiable emotion, except for greed and disgust. Something horrible is happening inside of me and I don't know why. My nightly bloodlust has overflown into my days. I feel lethal, on the verge of frenzy. I think my mask of sanity is about to slip.
~ Patrick Bateman, American Psycho

Wait a minute.

What I meant to say is that in all my years as a cold-blooded M&A banker and accredited investor (read: aggressive gambler) in the biotech space, I have never been more enticed by wonton temptation to whip out my wallet and claim my stake in some of the hottest biotech advances in recent time. M&A activity in the healthcare space shows no signs of slowing down after a blockbuster 2019, and I believe that we will see a paradigm shift in the number and types of deals that are executed in 2020 and beyond. I feel like a wolf in a henhouse. The deals look so juicy. Allow me to convince you. 

Not so long ago, in an industry not so far away

Historically, large pharmaceutical companies have relied on a small selection of gangbuster drugs to drive their bottom lines. These proprietary drugs enjoy a 17-20 year term of exclusivity granted by patent protection, after which the value of those drugs essentially bottoms out due to the flood of generics and biosimilars that hit the market. This “viable lifetime” variable is essential in calculating the value proposition of a new drug and plays a prominent role in deciding the price of an acquisition and the sales price of the new drug. A 2017 report by Evaluate Pharma concluded that drug-makers are expected to lose $17B in worldwide sales due to patent expirations in 2020 and a total of $95B in losses for the 5-year period from 2019-2023 (IQIVIA Institute). Generic manufacturers know this and are gearing up to get ahead by pursuing an abbreviated approval pathway for biosimilars under the Hatch-Waxman Act of 1984. Big Pharma has only one option – pack their R&D pipeline full of new proprietary drugs and protect them with new intellectual property. Unsurprisingly, it is much more efficient to scan the marketplace for early-stage drug assets developed by niche biotech companies and either acquire the asset outright or license the rights to development.

This acquisition strategy allows large pharmaceutical companies to: 

  • Quickly and efficiently diversify their product pipelines without having to conduct all the basic research that goes into discovering and validating a potential drug candidate
  • Fill in gaps in their product pipelines without hiring additional personnel or requiring outside expertise
  • Reduce in-house R&D expenditure and relieve pressure on drug pricing

Specialization and division of labor, the cornerstones of capitalism. Who would have thought?

“We expect large pharma companies to continue pursuing category leadership in order to create the scale necessary to compete long term, but these transactions are likely to come in the form of ‘bolt-on’ type deals of smaller/mid-sized companies,” PwC says. It sees $5B - $10B-sized biotechs being “the sweet spot” and potentially some $20B - $30B-sized larger deals, as well.
~ Pharma News Intelligence (Read here)

Huff and puff all you want. The Big Bad Wolf doesn’t care.

It appears that the consensus amongst the American public is that Big Pharma is an evil cabal bleeding the public dry by dangling treatments for life-threatening diseases in front of our eyes then pricing them out of reach. In a culture that is dominated by shifting blame to anyone other than oneself and crying shamelessly in public decrying the “victim”, it does not surprise me that these essential facts are ignored in favor of feelings. As much as I’d like to go on a diatribe about risk-adjusted NPV modelling of the commercialization of first-in-class therapeutics, let’s just say that most early-stage (i.e., pre-clinical) therapeutics incur tremendous research and regulatory costs that necessitate high sales prices to justify developing the drug at all. If you account for all of the failed attempts to bring experimental drug candidates to market, the average cost to successfully develop a therapy is in excess of $5.9B (according to Pharma Innovation Index maintained by Idea Pharma consultants). If you view each independent drug development project as a separate business unit, these insane costs result in extremely low IRRs which simply makes no business sense to pursue when faced with pricing pressure driven by social backlash (don’t get me wrong… pricing pressure is a good thing, but not when motivated by ignorant, entitled fools). Big Pharma is incentivized to find innovative products that will not compete with generics and biosimilars amidst rising clinical costs, pressure from insurers, and an increasingly overbearing regulatory environment.

“The high total cost of drug development can become an existential question on the health of pharmaceutical companies as we cross over into the next decade. The declining return on in-house R&D will continue to create pressure on the pharmaceutical companies to a point where they are forced to broadly expand their M&A effort with renewed urgency.”
– Seeking Alpha, Tarun Chandra, CFA, Feb 2019

Scientists, after all, love doing science

I love consulting with the founders of pre-revenue and smallcap biotech startups. Typically, these guys and gals are PhD/MDs with a penchant for scientific sensationalism and possess a charming awkwardness. These individuals are the life-blood of their companies (and they know it). Unfortunately (well, fortunately for me), they do not usually have a shred of business acumen. The ivory halls of academia (where a good deal of drug therapies are first discovered and then licensed into an impromptu R&D company) are outside the reality that you and I experience – in academia your ideas are currency, you are judged only on your scientific aptitude, and the commercial merits of your research are never really considered. This breeds overly idealistic founders in need of seasoned C-level management to keep the research projects focused on commercialization of the technology and dissuade from exploratory science (scientists, after all, love doing science). The most common founder pipedream is that the company has the potential to become a full-fledged Pfizer after their first drug is approved. When investors ask, “what is the exit strategy of the company”, this is definitively not the answer that they want to hear. The smart money goes towards early-stage drug assets that have the potential to disrupt a large market segment and will be attractive acquisition targets to Big Pharma once a certain amount of risk is dispelled (more on risk management later). Most pre-revenue R&D companies understand this now, but I still run across the bright eyed and bushy tailed scientific wizard who must be convinced. And my argument is simple… making a deal with Big Pharma offers:

  • R&D support and intellectual capital
  • Access to new markets
  • Managerial skill and operational synergies
  • Exit strategies (licensing, acquisition, IPO) for early investors

Small Pharma is just as incentivized as Big Pharma to wade into the M&A waters and realize the synergies afforded by passing the widget down the assembly line. 

“Mid-sized biotech companies will continue to drive the activity as the next wave of progress in developing life-saving drugs is advancing at [an] accelerated rate,”
(PWC) [2]
“From supporting front-end operations for new entrants to R&D and co-promotion arrangements, we see this area continuing to grow,” PwC says. “Now, more than ever, the need to invest early or partner with innovative businesses (for delivery, data, etc.) is a critical success fact.”
(PWC) [2]

A little too cold, a little too warm… ahh that’s just right

A wise man once said, “something is only worth as much as someone else is willing to pay for it.” If you believe in the efficient market hypothesis then you are comfortable with the idea that the market assigns reasonable fair value to assets provided that no significant information asymmetries exist. The trouble with assigning a valuation to an early-stage drug asset/company is that a fundamental lack of knowledge underpins the negotiating process. Obviously, later-stage companies will have higher purchase prices because they are significantly de-risked, but early research-stage companies actually have higher acquisition premiums (see “Median takeout premiums” chart below). As it turns out, the sweet spots for buyout are in pre-clinical and Phase 2 trials (see bar chart below)3. I find this very interesting because it implies that there are 2 “goldilocks” levels of optimum risk-reward for potential acquirers. I believe that these levels exist because the highest rates of failure are experienced at those stages. A survey of clinical trials conducted between 2006-2015 revealed the success rates of Phase 2 trials to be 30.7%, as compared to 63.2% and 58.1% for Phase 1 and Phase 3, respectively (BIO industry Analysis). Pre-clinical experiments are by far the riskiest of all because the proposed drug candidate has only been shown to have some sort of efficacy in vitro or in small animal models of disease (i.e., in a petri-dish in a lab or maybe in a rodent). Acquirers swoop in during the riskiest phases of development to scoop drug assets at attractive discounts to their potential value.

Private early-stage R&D companies should be thinking about maximizing their eventual purchase premiums from Day 1. This is rarely a topic that is brought up in the early days of company formation when all attention is turned towards developing the drug candidate(s) for clinical trials. Recently, I have noticed that more attention is being given to the construction of patent portfolios that are robust enough to ward off potential insurgents but also detailed enough to hold up in court. This indicates to me that management is aware of the importance of intellectual property and is keeping their eye on the exit. What companies fail to do is think about all the other activities that will yield a higher return on shareholder dollars in the distant future when a deal is on the table (perhaps in Phase 2…). These value-add activities have one thing in common – they must help overcome the inherent information asymmetries in the market and signal the company’s value to potential acquirers.  

“How can the target firm make it apparent that the deal has potential to add value to the acquirer (through additional resources – tech assets, capabilities, strategies) and reduce the uncertainty inherently involved with the M&A integration process?”
– another wise man

Let the mating game begin

Several variables influence acquisition appeal, and not all relate to the actual market value created by the drug asset(s) in the target’s pipeline. “Market orientation” and relationships with VC or institutions largely dictate the probability of a buy-out and purchase premium paid. Market orientation refers to the signals given by the target firm to attract attention from potential buyers. These signals must be (1) observable and (2) costly. Examples include press releases, tradeshow and conference presentation, and publication in industry reports and peer-reviewed literature. Research has shown that there exists a relationship between development stage and effectiveness of market orientation, with less benefit conferred at a later stage, as the actual clinical success becomes more important than marketing tactics. Additionally, the impact of market orientation is positively affected by the number of patents securing the technology. Combined, a visible company that has an impressive patent portfolio that actively publishes and brands itself as an industry leader has a high probability of being acquired. Market orientation activities should place firm in communication with downstream players (manufacturers and distributors of drugs) through trade shows, industry and market data analysis/collection, and identify and signal to potential corporate partners and VC the value of the firm’s assets (product-market fit).

“Technology ventures should, from the very start, collect research-based evidence on their current or potential customers, end markets, and competitors, integrate customers’ needs into product development, understand their competition, and develop internal communication channels within the firm.”
– Renko, et a., Journal of Business Investing, 20205

“I’ll never sell-out!” Say that again when there is a $100M check on the table.

Whenever I bring up Venture Capital to Founders I get one of two responses: either a resounding, “yes, please help me raise money!”, or a skeptical “this is my baby and there’s no way I’m giving up visitation rights for a quick buck.” And I get it, VC money is aggressive and expensive (discounted value ranging from 10-14% of pre-money value of company) … but the investment risk is huge with pre-clinical and Phase 2 drug assets. But the early involvement of VCs serves as a powerful signaling mechanism that secures solid market orientation. As it turns out, there are several VC-related factors heavily influence acquisition premiums: brand equity of the VCs invested, number of VCs participating in the round (provided enough heterogeneity in resources, capabilities, and information), timing of entries, duration of investment (long durations suggest that the venture is failing), and total disbursements into the venture. A reasonable hypothesis is that the early involvement of multiple, prominent VC firms, combined with short duration and frequent disbursement of investments, lead to a greater probability of exit via IPO or acquisition and higher purchase premiums

Key observations

2019 was a record-breaking year in terms of deal value with $254B in transactions, compared to $155B in 2018 and $76B in 2017. Two “mega deals” dominated the landscape: Bristol Meyers Squibb’s acquisition of Celgene for $74B (3rd largest pharma acquisition in history) and AbbVie’s acquisition of Allergan for $63B (2019). See charts from HBM Partners below.

  • Not all deals are created equal - premiums paid for public companies were almost 100% (up from 70% in 2018 and 82% in 2017) of the market value pre-acquisition, and clinical-stage companies received higher premiums than those with marketed products 
  • Of the companies with marketed products, activity was concentrated in the small cap-midcap space with target companies pulling in less than $500M in revenue (2019)
  • Almost half of all acquisitions had VC-backed support, and most of the transaction volume from private deals was from VC-backed firms (2019)
  • Transaction volume has been steadily increasing from 33 deals in 2017, 36 in 2018, and 43 in 2019 (note: these figures only consider transactions >= $100M in the US and Europe)
  • Historically, the United States is the main contributor to deal activity (followed by Europe)
  • Contingent payments are in vogue for clinical-stage companies. Acquirers have figured out that they can hedge their risk by distributing the acquisition fee over the clinical trial process.  “Straight deals” (fixed amount paid upfront) are typically reserved for companies with products in the market
  • While the Q1 2020 numbers are lower than forecasted, the rest of 2020 will largely be dictated by the 2nd order effects of COVID (to be discussed in greater depth in another post). Chaos presents opportunity, and in this case the opportunity lies in an industry that is rife for consolidation

MedicalGold's predictions

  • More drugs are expected to be approved in 2019-2023 than any 5-year period since 2004 (54 v. 46; IQVIA Institute)
  • Big Pharma will bolster their balance sheet with capital repatriated by the United States Tax Cuts and Jobs Act (2017), which cuts taxes on repatriated returns from 35 to 15.5% (cheaper for companies to repatriate returns). More cash on the balance sheet equals more deal activity. The US government will continue to protect the interests of their pharmaceutical companies
  • Competition between VC and Big Pharma will rise as they find themselves competing for the same biotech deals
  • The majority of deal activity will continue to be concentrated in oncology (especially immunotherapies) and orphan/genetic disease, but there will be many new market entrants and competition for private exit will be fierce. Pay attention to infectious disease companies and immunotherapies (for obvious reasons) 
  • The COVID chaos will ripple through the biotech capital markets and create attractive buying opportunities as small biotechs look to exit turbulent markets and can be purchased at discounted valuations
  • The upcoming election is certainly going to instigate more discussions about the biopharma industry, as it pertains to drug pricing, foreign products, and the regulatory process. Increased pricing pressure will incentivize Big Pharma to look for early-stage drugs to add to their pipelines. 

Biotech M&A transaction activity will continue to follow the upward trend in number of deals and total volume observed from 2017 through 2019. While first quarter numbers are lower than expected due to the COVID pandemic, this chaos presents the opportunity for investors to buy at suppressed valuations. This is a fantastic time to get in on small and microcap companies that are in the early-stages of clinical development for their lead drug candidate(s). Looking forward from 2021, I predict that the number of transactions will go up significantly, while the size of the individual transactions will be smaller (more companies acquired during the early-stages of development). However, total deal volume will also rise due to the proliferation of new market entrants and competition between VC and Big Pharma for these buying opportunities. Early-stage acquisition and VC investment will result in higher purchase premiums, which mean a higher exit multiple for all investors. My advice: get in while the gettin’ is good.

“EY expects M&A activity to maintain record, or near record levels in 2020 based on data from their Global Capital Confidence Barometer. They report that 52 percent of life sciences executives said their company plans to actively pursue M&A activity in the coming 12 months, and that 68 percent are expecting the M&A market to be even more lively in 2020.”

So you want to be a biotech investor?

First, you need to be completely honest with yourself. Do you have the subject matter expertise to pick winners?  Does the phrase “programmed cell death ligand as a target for immune checkpoint inhibition” give you flashbacks to failing your first biology exam? If so, you’re not alone. In fact, you are in great company. Some of the most successful biotech investors I have met do not even know what “DNA” stands for yet somehow pick winners. Let me let you in on a little secret: when you are investing in a an early-stage biotech you are putting your money on the team, not the drug(s) in their pipeline. Furthermore, you are not really concerned with the probability that the drug will make it to market and out-compete the standard of care. Your focal point of assessment is on the probability that the market (whether it be public or private) will assign a high exit multiple (IPO share price or private purchase price) once the company has taken their drug candidate(s) into clinical trials. Remember what I said at the beginning of this article? Something is only worth what someone else is willing to pay for it. Seasoned investors know the game and think about the characteristics of an investment opportunity that other individuals (if the company IPOs) or institutions (VC, Big Pharma - private sale) look for when making a bid. With the abundance of opportunities to invest in early-stage biotech R&D, the company must meet specific criteria to warrant serious consideration:

  • A strong, deep management team and advisory board filled with key opinion leaders in: basic research, pharma business development, regulatory/clinical trials, and the capital markets 
  • A track record of accomplishing R&D objectives and capital raising milestones
  • A technology that has demonstrated some degree of success either in the lab (pre-clinical) or in clinical trials (bonus points if the mechanism of action of the drug is well-defined)
  • A huge market segment ripe for disruption
  • Protected by an airtight patent portfolio (this is what is purchased or licensed in a private deal, after all)
“The best way to be positioned for rising M&A activity in biotechs will be to have portfolio exposure to the sector. After all, if the M&A pace sustains, then a rising tide will lift all boats. A mix of promising companies across the market cap continuum can have an advantage of even being potential M&A targets.”
– Seeking Alpha, Tarun Chandra, CFA, Feb 20193

In this game the risk is high but the reward is higher. Alright, got to go. I have to return some videotapes...


The work included in this article is based on current events, technical charts, company news releases, and the author’s opinions. It may contain errors, and you shouldn’t make any investment decision based solely on what you read here. This publication contains forward-looking statements, including but not limited to comments regarding predictions and projections. Forward-looking statements address future events and conditions and therefore involve inherent risks and uncertainties. Actual results may differ materially from those currently anticipated in such statements. This publication is provided for informational and entertainment purposes only and is not a recommendation to buy or sell any security. Always thoroughly do your own due diligence and talk to a licensed investment adviser prior to making any investment decisions. Junior resource and biotechnology companies can easily lose 100% of their value so read company profiles on www.SEDARplus.ca for important risk disclosures. It’s your money and your responsibility.