I attended the 11th Annual BIO Investor Forum in San Francisco last month. I don't normally comment on the health care sector but I've been invited to enough pharmaceutical company roadshows to make attendance here worthwhile. Much of what I relate below is from very detailed notes but I've inserted my own observations where appropriate in italics.
The first panel on trends in early stage finance (featuring Campbell Alliance, Thiel Froundation's Breakout Labs, and Third Rock Ventures) started things off right. They explored gaps in early stage funding for life science companies due to funders' risk aversion. Big Pharma seems to be focused on funding later stage and clinical stage companies only. They think it got hard to launch innovative products after the global economic crisis contracted ROIs. Disease foundations are still investing in early stage treatments and university hospitals are also investing directly. I had no idea that companies could bring in an "executive-in-residence" to build out an internally developed technology before they shopped it around to partners, but I guess when you think about it executives can be temporary hires too. The panel identified "venture philanthropists" like the Leukemia and Lymphoma Society that invest in small deals with no strings (like tech rights or special payouts).
The panelists said investors need incentives like project options, but Big Pharma suitors want to see a mature IP portfolio they can extract in a buyout. C-corps aren't as tax efficient as LLCs (color me surprised) so alternatives like "structures acquisitions" that allow distributions are worth considering. Funders who standardize terms will see reduced legal fees and simplified due diligence, and can pre-screen out applicants who want special terms. Standard terms should not saddle startups with rules that will turn off later stage investors. Government funding is available from DOD's DTRA and DHS (I wonder what terms they demand!). Hey, what a great panel. I learned a ton of stuff already.
The second panel was about the hype around cancer stem cell therapy. A lot of this was scientific stuff that went over my head as a finance guy but there's some stuff here I could understand. They said the sector awaits clinical data that will indicate more effective treatments (but you know something, they always say that in health care, don't they?). Stem cell therapy has shown a more durable response with fewer lapses than conventional therapies. Cancer stem cells are meant to be hardy and have many protective and repair mechanisms as fundamental properties, so this is why use of a "therapeutic index" is the key to targeting only malignant stem cells. IMHO, chemo treatments alone can make cancer cells worse, so multi-path treatments that include stem cells seem to be the way to go. Some experts refer to stem cells as "initiating cells" because not all of the cancerous biomarkers have been identified yet. Finally, this year's Nobel Prize in Medicine was for stem cell work using oncogenes.
Next up was a panel on the new pharma-VC model for biotech investing. They started by noting that biotech indexes were outperforming the broad market this year and that new legislation has accelerated FDA drug approval. Venture investing in bio is declining and IPO exits are more difficult. In-house pharma R&D has declined, so Big Pharma is increasingly partnering with VCs because it can't innovate alone anymore. The public capital market can no longer fund clinical the clinical trial phase for early stage drug companies as it did in the 1990s (IMHO this matches what I've seen anecdotally at investment roadshows, where early companies that went public too early end up scrambling for private placements to fund their clinical stage). Wall Street's scrutiny of quarterly financials inhibits big Pharma from making big, risky, long-term R&D commitments (IMHO, if this is so obvious then early stage drug startups should not look for premature IPOs!). I learned something very important: Portfolio companies can shield confidential information from a Big Pharma joint investor so they can pursue R&D for a product that appeals to the entire drug market, not just one big investor.
Big Pharma thinks an ideal target is in pre-clinical to early clinical stage. Delays and doubts make early stage drug discovery a nonlinear process. This process creates discrete assets worth screening and pursuing; my interpretation of a "discrete asset" is some fragmented IP left on the shelf that may be of value to a Big Pharma partner building a larger IP portfolio. Two partners in drug development increase the chances of arms-length transactions later on in an exit strategy. This panel also mentioned a ton of public policy risks, like the FDA's disinterest in communicating drug risk to the public and the favoring of obscure treatments. Finally, the valuation curve "right shifts" from Phase 1 to Phase 3 once early uncertainties are past; in plain English, later stage companies are less risky and more valuable because their product offerings carry more certainty.
Ooh goody, here comes one of my favorite panels on late stage private company decisions. They revealed that investment banks are now requiring existing investors to "double down" on a pre-IPO company with more investment. I kept thinking: "Value creation" can happen any time in the entrepreneurial process even if a final drug patent isn't marketable; it may still have legacy value as baseline R&D that can be sold as part of an IP portfolio. I heard a acronym for the first time: "FIPCO" means a fully integrated pharma company that contains an entire value chain - initial development, clinical trials, approvals, and marketing a mature product. There's a very limited buyer base for pharma IPOs despite claims of typical 20% initial returns (but I wonder about the length of the holding period for measuring that first IPO pop). Those market returns have driven institutional investors to become hyper-short-term focused. Private funds and family offices can make investment decisions much faster than larger institutions that outsource their due diligence to gatekeeper consultants. This panel was fun because their consideration of the JOBS Act tempted me to ask a question during Q and A. I asked about the effect of crowdfunding on exits. They said there's more angel investing than VC investing in biotech, and this requires real technical expertise to understand details, so a crowdfunding approach for biotech may not find a wide enough audience to fully fund a startup's needs. Bio startups (especially pharma) need hundreds of millions of dollars to be successful and crowdfunding may not be able to deliver that much. It can be a helpful factor but it won't be big enough to drive a bio startup's success. Okay, I'll buy that line of thinking for pharma, but a medical device company that only needs a few million is easy to crowdfund. I chuckled when one panelist kept calling it "cloudfunding." LOL! That brings new meaning to the term rainmaker if it catches on.
The next panel on diagnostics was kind of boring. Diagnostic makers will impact the debate on cost-effective care, and private payers will need to watch bottom lines thanks to Obamacare forcing more people into the system. Panelists think a best-in-class business model for a diagnostics maker includes barriers to entry like trade secrets and regulatory arbitrage. They see downstream opportunities in informatics where IP know-how in sorting and analyzing data can add value. IMHO more bio sector folks need to attend the trade shows I've seen in Santa Clara on enterprise computing and cloud architectures. Calling out IP infringers and pursuing them with litigation is not as viable a business strategy as pre-emptive IP defense. How Clausewitzian! That reminds me of the old truism in warfare that a defensive strategy has a three-to-one strength advantage over an offensive one.
The lunchtime panel was all about dissecting the corporate VC model. Lunch was awesome BTW, with the Palace Hotel giving us plenty of high-quality grub at this shindig. Anyway, MedImmune Ventures, Novartis Option Fund, and Baxter Ventures showed up for this one. The panelists mentioned how some corporate funds keep their business development officers away from a funded portfolio company until whatever project they have is mature, but others allow some BD officers to cross the confidentiality wall. This means that not all corporate VC arms have a strong confidentiality wall. IMHO it would take a courageous startup to take money from a corporate partner with no confidentiality barrier. Lack of a barrier will limit a startup's options with future partners. I like how they addressed the problem of a major competitor acquiring a stake in "their" startup while they still owned a minority stake. They said they were willing to let that minority interest liquidate after IPO if they no longer had a strategic interest, but IMHO this leaves open the question of what they would do in the absence of a public market exit. Startups that get tied up too early to one corporate sponsor may be less willing to share information later.
What's a more important investment criteria, ROI or a match with corporate strategy? Some corporations want their VC fund returns to stay in the top quartile of all corporate VCs, so ROI for them is paramount over strategy with the CFO as the ultimate authority in defining metrics. There doesn't seem to be room for a balanced scorecard approach here; senior corporate officers are not willing to throw away capital on a strategic option if there's no ROI. Corporate funds can syndicate investments with other VCs but ultimately still adhere to ROI over strategy. Corporate VCs like entrepreneurs who present single term sheets to both corporate and traditional VCs, so they can attract more capital to the same deal. Corporate VCs can even pick other syndicate members if a single term sheet will attract enough total capital to get the startup to the next stage of its value creation strategy. Corporations do invest in pure VC funds; I'd like to know what their ROI metrics are for something they pursue outside their own shop. Corporations that demand options want them to fund additional work or new corporate infrastructure that will enable the funded startup to fit its work into that particular parent. Some corporate funders are even willing to introduce a startup to other VCs if it's not the right fit for their investment philosophy. I guess some bio executives go out of their way for the good of the industry once in a while.
Here comes another technically-oriented panel on treating rare diseases. This was a little bit over my head but worth it. The expense of treating rare diseases gives certain drugs pricing power. Bigger primary markets give regulatory pushback, making drug development tougher. These facts mean a high-priced drug even with low volume means blockbuster sales in the rare disease segment. The FDA has opened accelerated approval to rare disease drugs, with the "breakthrough therapy" designation for drugs demonstrating substantial improvement in conditions. Cross-sectional studies of patient progress are a cost-effective way to identify biomarkers, making R&D easier for startups.
This panel's insights into payers' mentalities was enlightening in the context of Obamacare. Pharma developers have seen very little concern about the cost of rare disease treatment from payers. Payers are more concerned with the cost of treating more common diseases (like diabetes). Read between the lines. Forcing more minimally-insured customers into the health care system means more stringent cost reviews are coming for drugs that treat common diseases, with little attention to cost controls for rare disease drugs. Some segments now have a wildly profitable market opportunity thanks to overcomplicated regulation. In pricing a one-time treatment, the best method is for a drug developer to just set one but charging six figures for every rare drug treatment isn't sustainable. A new regulatory approach in Europe will probably shorten patent life, so rare drugs will fall off a pricing cliff. Performance-based pricing is workable, i.e. paying only if a drug actually works as intended. Consider this together with my observations earlier in this paragraph and get a picture of the profitability window for rare drugs remaining high but gradually shortening, with more potential opening up for generic drugs over the long term. The panel thinks the Affordable Care Act won't drive a pricing solution; instead payers will ultimately balk at paying exorbitant prices and will force price control regimes like performance-based pricing. This further confirms what I've read in public media about how Obamacare won't control costs! Payers who aren't allowed by law to drop coverage will probably have to raise premiums and co-pays before they turn to generics or cost controls.
The final panel for this two-day bio gabfest gave forecasts for 2013, so here comes a bunch of randomly disconnected observations. They said regulators only approve differentiated products, so early stage investors want to see a well-defined treatment population that will justify moving to Phase 3. Non-dilutive A-round terms mean a lot to investors. I learned a new term called "preserve optionality," a funding syndication strategy that enables continued capital raising in case unfavorable market conditions delay a company's success. In the analyst community, generalists don't have an interest in biotech small caps (except me, of course) but every five years or so a large cap breaks a big exciting drug story that captures generalist interest. Small caps need "take outs" like good data and new developments to outperform the broad market. Innovation may explain IPO pricing; small caps can be risky but are attractive because the inflection point of public recognition of value hasn't happened yet. The great cash flow and low growth of Big Pharma implies they should be acquiring. Public sentiment for a sector can drive generalist coverage in biotech as it did for Facebook.
One fund manager known to the panel keeps about 20% of his fund in biotech small caps. It sounded like the manager picks six to eight small caps just to avoid blame if one has a downturn, regardless of whether each is a good investment on its own merits. The number of funds capable of syndicating deals is declining, so there may be chronic underfunding of deals in the future due to a depressed market. There will always be more money than good ideas. Creating value means getting through the "risk gates" of commercialization and competition. Perhaps less money available will lead to only better companies getting funded. That sounds great, because too much money means chasing bad deals just for the deal's sake in any sector. Figuring an early stage company's capital requirement means considering its early wins, which conserve capital. Here's the most important thing I learned at the conference: Only about one of every fifteen drugs goes from pre-development to approval, so the discount rate for early capital raising must be set high. Investors pay VCs to wring out technical risk early on, and breaching the commercialization risk gate comes after Phase 2 trials (probably the second most important thing I learned here). The overlooked risks of manufacturing difficulties and operational problems are areas where investors can make a difference. IMHO, this is where VCs with access to a broad body of knowledge covering drug and device manufacturing operations can add value, because I got the impression that common problems are so widespread that knowledge of their solutions could help startups break through those risk gates. Knowledge management solutions need to be widely available! Low returns drive institutional investors away from VC as an asset class. R&D investments have recently generated low ROIs, so Big Pharmas have used cash flows to support share prices with stock buybacks. One panelist said, "We're investing in a fifteen year business, trying to stick it in a five year box." Investors' expected time horizons are much shorter than the standard drug development process.
This panel finally got around to making its predictions after all of that random analysis. Here they are. Expect some great primary-care launches in twelve to eighteen months. I'll hazard a guess that this means we can expect more cash-only health care providers as an end run around the Affordable Care Act's insurance mandates. Health care reform won't change, regardless of the election. How right they are! Obamacare should really be called Romneycare 2.0. Finally, both the panel and the audience here thought diabetes treatments will be huge within five years. That is really great news for my investment in CVAC Systems.
Well, there you have it. I've dumped a load of knowledge into the public realm. The task for investors like yours truly is to use it to develop screening criteria for health sector startups that are worth supporting.
