VC Lockdown-Mode Paralyzes Bioindustry

Downsizing of the Industry is Inevitable as Financing Window is Virtually Closed

Rod Raynovich 5/1/2009 GEN

This time the biotech industry consolidation is for real. The gloomsayers who predicted an industry downsizing in the past were wrong but now their time has come. The trillion dollar black hole of derivative speculation has curbed risk appetite and slowed venture funding in biotechnology. Potential funding for the life sciences is trapped in “upside-down” housing and toxic (now called legacy) CDO’s in banks worldwide. Moreover the risk factors for biotechnology are front and center: political uncertainty, so called “binary events” of clinical trial results, generic/biosimilar competition and the emergence of a national healthcare plan implying lower drug costs. The industry has navigated through troubled times and big issues before but never in times of a financial meltdown. The markets need to be cleared of securitized debt before risk capital can return to biotechnology. The past few years has seen the greatest mis-allocation of capital in the history of the modern US economy so it will take time to get back to funding of real technology, products and services.

Hardest hit companies in the current environment are public microcaps with weak balance sheets, development stage biopharmaceuticals with longer term clinical risk and drug discovery start-ups. Many of these stocks are down 25% or more in Q1 2009. Burn rate is the key metric among the small caps as cash must be conserved. Even public companies with ample cash can’t be complacent. Recently the microcap Avigen was in a Proxy Fight with 30% shareholder BVF (BiotechValue Fund) with a proposal to liquidate the Company for $1.20 in cash after the Avigen AV650 drug failed in a clinical trial for MS. However in the March 31, 2009 stockholder vote the Board of Avigen prevailed over BVF and the Company will “Pursue full value of its assets”.

M&A-Big is better

M&A activity is accelerating at the top end of the market such as the $68B Pfizer/Wyeth deal and the $48B Merck acquisition of Schering-Plough. Pfizer issued $13.5B of debt, three percentage points above treasuries to fund the acquisition. Barbara Ryan, Senior Pharmaceutical Analyst with Deutsche Bank believes these mega-mergers are positive for the companies in the face of generic competition as they strengthen balance sheets, cut costs and presumably improve the yield of basic research. Lilly CEO John Lechleiter told the WSJ on March 31 that he was “hungry” for buyouts up to the $15B range emboldened by the acquisition of Imclone. According to data from BioCentury and Piper Jaffray big pharma deals were up 15% in 2008, continuing a trend from 2004.

On the other hand, mergers between smaller players even with technological synergies may not fare well due to long term funding issues. A case in point is the “reverse merger” of the public Company EPIX with the private biopharmaceutical Company Predix. EPIX was the target as it had cash and a cardiovascular imaging agent stalled in the FDA. Predix had a drug discovery platform and a broad portfolio of CNS and cardio candidates in the clinic that needed funding but the $40M annual burn proved to be overwhelming in a bear market with no milestone catalysts. The stock now trades under a dollar and has a “going concern label” with negative shareholder equity.

Venture Capital Investing-first quarter funding OK

Venture investors in biotech are in “lockdown” mode as they reserve precious capital for their existing companies.

Arthur Klausner, an experienced VC and recently of Pappas Ventures, and
others state that venture capital is currently facing a painful double
squeeze: diminished fund sources on the front end due to the tight
money situation at pension funds and endowments, and limited exit
opportunities at the back end caused by the complete lack of IPOs.
Nevertheless, Klausner said, “This situation should result in some
excellent venture capital investments being made in 2009/10. It’s very
much a buyer’s market out there for VCs who have fresh capital to
invest, with private financings tending to be limited to top-tier
companies — and often at bargain-basement valuations.”

Jonathan Fleming of Oxford Bioscience has shifted some resources away from biopharm to MedTech and Diagnostics. Fleming said, “Drugs are a more risky investment in these times not only because the FDA has raised the bar for clinical trials and approvals but the buyout exit is less likely as the large pharmaceutical companies are investing outside the U.S. for new markets and products. He added, “Diagnostics and devices are much more dynamic environment with less product risk and faster returns on venture investments.” Supporting this case he cited the acquisition of Sirtris by GSK for $720M as one of the few venture backed companies acquired by big pharma in 2008. Another example of this “land grab” expansion strategy is the interest in skincare specialist Stiefel Laboratories with revenues of about $1B.

Tom Kiley, a one-time Genentech executive who has served as a director of many life science companies, echoed what many VC’s are saying: “VC’s seem to be triaging their portfolios, denying further infusions to the ‘runts of their litters’. To the extent that NewCos are being funded at all the focus seems to be on diminished regulatory risk-medical devices, drug repurposing, etc.
One question is whether big players on the venture and IPO side such as JPMorgan and GoldmanSachs will continue to focus on biotechnology now that they are commercial banks and have to reduce risk and bolster their capital.
National Venture Capital Association data shows $4.5B of biotechnology investments in 2008 of which $1B was in Q4. In comparison another top category software was $4.6B. 479 deals were concluded in biotechnology. Over the years since 2004 biotechnology VC annual investments have been in the $4B+ range. Recently Essex Woodland Health Ventures (www.ewhv.com) announced today that it raised $900M for its latest healthcare fund and will invest across the spectrum of drug device and service companies globally.
EWHV currently has $2.5B under management. And the Boston Globe recently reported that Google has launched a $100M venture fund based in Cambridge, MA and Mountain View, CA in a broad range of fields including biotechnology start-ups. Google already has an investment in personal genomics with the Company 23andMe.
Another positive trend was Burrill and Co. reported VC financings of $1.486 M in Q1 2009 a substantial increase over the $837M in Q1 2008. However the data may require further trending as the average size of the deal fell from $20M to $7M and the funding increase may be skewed by one large deal. An indicator of lean times in venture capital is that office space rents in prime VC property such as Sand Hill Road in Menlo Park, CA are down from $20 sq.ft. to the $12 sq. ft. range.

Financing Update Q1 2009-money flow continues

Investments in public companies such as PIPES were stable for the first quarter with 65 healthcare PIPES deals with a total value of $810M compared to $894M in Q4 2008.
(Data courtesy of Rodman and Renshaw.)
According to Burrill and Company, US Biotech industry Financings were about $20B in 2006 and 2007 plus another $20-25 B in Partnering. 20 IPO’s were launched in 2008. For Q1 2009 Burrill reported total capital flow of $9.8M compared to $6.647M in 2008. However $2.651M of this was debt and $4.761 was partnering money.
Burrill reported a study with PhRMA that showed drug R&D spending at $65.2B for 2008 a healthy investment in the industry for future products. Targeted diseases in order of investment are cancer, Cardio, diabetes, and HIV/AIDS. On April 6 the WSJ reported R&D spending by big companies, such as JNJ and Abbott, continued at last year’ pace despite revenue weakness.
Burrill is predicting a downsizing of the industry with a loss of about 100-200 publicly traded companies due to failures or takeovers. On April 1 the Burrill Report stated that of 344 public biotech companies half are trading at cash.
BioWorld Financial Watch data through March 5, 2009 showed total public and private biotech financing excluding corporate partners of $2.027B vs $2.703B for 2008, a drop of 30%. Private biotechs raised $789M for 2 months in 2009 compared to $582M the previous year. This reflects higher private investments in later rounds since the IPO window is not open.

Public Markets rally in March

In the meantime the Life Science public markets held up well in Q1 2009 despite a severe correction in February exacerbated by fear of Medicare reimbursement cuts and the Obama administration healthcare initiatives:

• The Rayno Biopharmaceutical Portfolio was down 2% for Q1 including value of the Roche takeout of Genentech (DNA). A new large cap stock will be added to replace DNA.
  Winners were ABAX, BIIB, DNA, HOLX, ILMN, ISIS, SGEN, and TRGT.

Losers in the portfolio were CBST, REGN, and VPHM and several microcap picks. Portfolio is weighted by price of the stock.

• The Burrill Biotech Select Index was down 4%.
• Among the ETF ‘s the IBB was down 7% and the XBI was down 8.6% although it is not clear how the DNA buyout impacted these ETF’s.
• On the positive side, some of the $47B from the balance of the Genentech buyout should flow into other mid and large cap biotechs.

The S&P was down 11.7% QTD and the NASDAQ was down 3.1% QTD.
Among the Dow blue chip healthcare stocks Merck and JNJ were down 12% and
Pfizer was down 23%. The S&P Healthcare sector performance is trailing the S&P Technology sector.

The lone IPO for Q1 was Mead Johnson Nutrition (MJN) which was spun out of Bristol Myers and listed on the NYSE raising $828M.The MJN stock is currently trading above its offering price of $24/sh.

Positive drivers for the longer term

There is underlying support to the market:
Amount spent on national healthcare ~$2.2T
NIH Budget for 2009 $28B
Total industry R&D expense $65B
Stim Package and Government Grants

• M&A at higher end frees up capital with food chain effect
• New Venture Capital investments continue to flow albeit at lower rate~$3B
• Angel investing will continue such as a new fund Mass Med Angels (MA2) in Boston
• Leveling of playing field with fewer companies-creative destruction reigns
• New technologies and sector shift: stem cells, IT, generics, specialty pharmaceuticals, diagnostics, tools, devices and home healthcare
• Partnering will remain a viable financing alternative

Summary

The financing window for start-ups and small cap biotechs will be virtually closed for the next 12 months. Of course creative deals will be cut and alternative financing routes will be found such as angels, government grants, the Stimulus Package, and corporate partnering. As the industry gets restructured the stage will be set for a rebound. The data indicates financing should still be available to MedTech and healthcare Service companies with emerging growth in revenue or positive cash flow.
Near term events such as clinical conferences and product milestones may provide an impetus for rallies and funding through PIPES but the bear market is intact until we view the Q4 2009 landscape. Investors have short memories so any positive developments should spark the markets; supposedly there is a lot of money on the sidelines (but where?).
Over the years healthcare investing has always found a way to recreate itself and even as details of a national healthcare plan emerge there will be new opportunities. Corporate and NIH R&D investments combined with total healthcare spending provide the core engine for creation of compelling new products and services. For example the aging population will require home healthcare services in the near term and related diseases such as cancer and AD requires new cost effective drugs in the longer term.
More regulation of security markets and banks may actually be a positive development for healthcare investments as we go back to funding real companies and technologies rather that leveraging money to make money through financial engineering and derivatives.
The big issue remaining once the credit crunch subsides is whether there are fundamental shifts in the business model away from biopharmaceuticals to tools, diagnostics and devices.