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Biotechnology Investors Forum

Biotechnology Investors Forum






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    Biotechnology Investors Forum Biotechnology Investors Forum Document Transcript

    • TB, HMS Page 1 8/20/2003 Where do biotechnology venture capitalists go from here? Thomas Boehm and Helmut Schuehsler, Techno Venture Management The venture capital industry plays an important role in the overall economic landscape in developed countries (see The Economic Impact of the venture capital industry on the U.S. economy, NVCA 2001). This is true for biotechnology and information technology (IT). Most biotechnology companies would not exist without the VC financing option. Because developing a successful drug can take a decade or more, the forces governing the biotechnology industry are quite different from the short time frames that rule the IT sectors. Historically, biotechnology companies have been able to attract significant funding in the private and public equity markets without substantial revenue streams and with potential revenue lag times of more than 5 years. Over the last decade the bankruptcy rate of biotechnology companies was lower compared to the IT sector. Using a “Class of” status analysis, a method to follow companies through the different development stages, over the last 10 years, the average “out of business” rate in biotechnology is 5.7% versus 11.3% in software and communications (data from Ernst & Young/Venture One). The mostly binary outcome, to have a drug or not to have a drug, allows biotechnology companies to prosper despite a negative net present value of its development programs. The potential upside of a blockbuster drug is just too enormous. How long can the biotechnology industry sustain this dynamic? Is the industry at an inflection point causing much suffering among many but allowing the few winners to thrive in the years to come? Many biotechnology companies and the venture capital firms are suffering from a severe post-bubble headache. It might get worse without the administration of stronger medicine assuming we know what to prescribe. The Economist (The unfinished recession: A survey of the world economy, September th 28 , 2002) published a figure describing the US price/earnings ratio, the S&P 500 Index divided by the ten-year moving average of profits, from 1881 to 2002. Amid many ups and downs two peaks clearly stand out. The first one is the Great Depression showing a peak ratio of 33. The historical average hovers around 15. The dot-com bubble peaked at 45. During the last five years, we witnessed by far the largest equity bubble in the history of the US. Japan performed a similar experiment a decade ago and is still suffering from the longest recession of its history. Normal business cycles or the more pronounced but fortunately less frequent “boom and bust” 1
    • TB, HMS Page 2 8/20/2003 periods are not caused by one factor. The latest mega-bubble was created by over-investments and “mal-investments” according to the Austrian business cycle theory (see The Economist for a detailed description of the different theories used to describe the business cycle). Excessive investments create abundant supply. Investments will not rebound until excess capacity has been cleared and profits have improved. The NASDAQ has lost several trillion dollars in market capitalization since its zenith in March 2000. After peaking in September 2000, the biotechnology index has lost about 50% of its value despite a current bullish phase. One of the economists involved in developing this business cycle paradigm, Joseph Schumpeter, remarked that only by allowing the “winds of creative destruction” to blow freely could capital be released from dying firms to new sectors of the economy, thereby boosting future growth. What does this mean for the biotechnology sector? Are the same concepts applied to this relatively small market segment? Historically, bankruptcies played a minor role in the biotechnology market and significant lay-offs did not take place. The pharmaceutical companies attempted to fill their pipelines and fulfill the growth estimates of Wall Street by substantial mergers and acquisitions activity during the last decade. With some exceptions like the purchase of Immunex by Amgen, biotechnology companies use this strategy sparingly. Will the historical behavior patterns continue or should we prepare for a different scenario? Should we expect a more significant role of bankruptcies in biotechnology in the years to come? The following table gives a flavor of the investments made during the last six years in the biotechnology market segment. Table 1: The Bubble Factor 1st Round Investments Total Biotech Investments Years Number Dollars (M) Number Dollars (M) Time Horizon 1996-2001 516 3162 1355 14953 6 1979-1995 555 1043 1567 4602 17 Ratio 0.9 3.0 0.9 3.2 0.35 Bubble Factors 7.99 7.96 Bubble Factor 8.0 2
    • TB, HMS Page 3 8/20/2003 We calculated the “bubble factors” by multiplying the ratio of the number of 1st round or total investments with the dollar amount ratio followed by dividing the product with the time horizon factor. In other words, approximately three times more money was spent on the same number of companies but in only 40% of the time. If one compares the venture capital for biotechnology and the corresponding IT investment amounts, the curves are almost identical on a relative scale. Over 20 years venture capitalists spent about 8.7% with a standard deviation of 3.3% of the available venture capital money for biotechnology opportunities. We believe that the biotechnology bubble was as big as the “all industries” venture capital bubble. The addition of $3.6 Billion venture capital investments into biotechnology companies in 2002 would increase the bubble factor even further. From 1996 to 2002 biotechnology venture capitalists poured $18.6 billion into private companies only in the US. What exit scenarios can we expect? Where do or can we go from here? In addition, tools companies receive less and less attention from venture capital investors. In normal economical terms, overcapacity means that the warehouses are filled and supply is excessive over demand. In the venture capital universe we could translate this into an overabundance of new and promising technologies waiting for commercialization. Grossly oversimplified, in biotechnology the customers are the patients. We do not want to entirely ignore tools companies but at most they obtained 50% of the investments in the last years. We normally have no difficulties calculating the demand for new drugs. The difficulty lies in the attrition rate of drug development, in the enormous endogenous complexity of scientific research and in the intricacies to translate the research into a marketed drug. Is it possible that in the last six years an abundance of groundbreaking scientific breakthroughs justified this investment frenzy? If the answer is YES, private biotechnology companies and their financiers are in good shape. If the answer is NO, how can we pick the winners and what happens to the losers, the ones who do not have an adequate technology or a full drug pipeline, which potentially can support self-sustainable existence? The genomics and proteomics momentum certainly did not do the trick but it might be too early to reach this conclusion. The extraordinary attention stem cell research and nanotechnology obtained recently is fading slowly but surely. The recent rush to convert many tools into drug discovery companies might also not save the day for these entities. The complexity of drug discovery and development is substantial 3
    • TB, HMS Page 4 8/20/2003 and given that almost all pharmaceutical companies have difficulties filling their pipelines, “micro-pharmaceutical” companies will certainly also have a hard time considering the limited resources available, certainly relative to the “big-players” in the industry. Table 2 below summarizes the different attrition rates from target identification to new drug approval. It is only relevant for the development of new drugs based on “old-fashioned” chemistry and is not applicable for “classical” biotechnology drugs like recombinant proteins or antibodies. Appropriate data are not available yet. Table 2: How many validated targets do we need to get 1 drug approved? Attrition Rates in Pre-Clinical Development Mean Targets Proportions of Targets Abandoned 31% 51.8 Attrition from Hit to Pre-Clinical Candidate 57% 22.3 Attrition from Pre-Clinical Candidate to IND 27% 16.2 Attrition Rates in Clinical Development IND 10% 14.6 Phase I 75% 3.7 Phase II 63% 1.4 Phase III 23% 1.0 NDA 5% 1.0 Number of Validated Targets 75 Data Source: Drug Discovery World Summer 2002, pp67 and PhRMA One needs at least 75 validated targets to get one drug approved. It is not an easy task at all for a biotechnology company to have and even less to develop a product from five novel and unique validated targets. Not many biotechnology companies have such valuable targets. In a recent presentation Steven Holtzman from Infinity Pharmaceuticals showed that 37 validated targets are necessary. The truth probably lies somewhere in the middle. The quality and depth of the validation steps will ultimately define the likelihood of development success. These numbers assume outstanding medicinal chemistry expertise not available to many companies. But if the odds are so low to bring a new drug to market, where should the revenues come from to support the growth or the mere survival of 500 new companies created during the last semi-decade? And how should the venture capitalist satisfy his or her limited partners? Should they simply return 4
    • TB, HMS Page 5 8/20/2003 the un-invested money? In a recent presentation Vinod Khosla estimated the over-committed, un-invested venture capital to about $100 Billion only in the US. Assuming a reasonable 10% allocation to biotechnology, the availability of money is not a primary concern but the best use under the current conditions is of real concern. $10 Billion invested at the current rate of about $3 Billion per year will last for three more years without any additional fundraising. Will investors get their money back? Will they see a profit? The following table tries to illustrate the difficulty the biotechnology venture capital industry will face in the coming years. Table 3: Potential exit scenario calculation Start Year 1996 1997 1998 1999 2000 2001 2002 Total Investment $ 1,472 2,133 1,534 2,193 4,203 3,418 3,636 18,589 Exit Year 2002 2003 2004 2005 2006 2007 2008 IRR 20% 20% 20% 20% 20% 20% 20% 4,395 6,369 4,580 6,548 12,550 10,206 10,857 55,506 $ Value at Exit Year Multiple 2.99 MLNM Market Capitalization 2003 2,494 MLNM Revenues 2002 (Million $) 300 MLNM Equivalents 1.8 2.6 1.8 2.6 5.0 4.1 4.4 22.3 A total of almost $19 Billion has been invested in the last 6 years in biotechnology companies. Assuming we use an average of six years before an exit takes place and an internal rate of return of 20%, new biotechnology companies with $55 Billion total market capitalization need to be created and their shares sold. At the time of preparing this article Millennium Pharmaceuticals was trading at $2.4 Billion. The table above calculates the number of new Millennium Pharmaceuticals that would need to be created to have a chance of earning a 20% return per year over the next six years. Is it realistic to believe that exits with a total value of 22 Millennium Pharmaceuticals equivalents can be achieved in the next six years? Let us consider two lines of thought: 5
    • TB, HMS Page 6 8/20/2003 • The total post-offer IPO valuation of all biotechnology companies that went public from 1979 to 2001 was $37 Billion. 50% of the value was “created” from 1996-2001. Simple linear regression analysis covering the last 20 years shows that approximately 10% of all venture capital financed companies undergoing an IPO are from the biotechnology sector. The coefficient is highly significant (p<0.001) and the R squared is 51%. Excluding 1991, 1999 and 2000, which behaved very much like outliers, increases the R squared to 83%. The p-value is 10-7. In other words, it is not very likely that the market will open a window just for biotechnology companies. A general comeback of the economy is necessary to allow biotechnology companies to go public. On the other side, assuming a market capitalization of $250 Million post-IPO per company, 220 biotechnology companies must go public over the next few years to reach the $55 Billion. From 1991 to 2002, 217 biotechnology companies went public in the US. Are institutional investors hungry enough in the years to come? • Millennium was trading at a price to sales ratio of 7.7. At the same time Amgen was listed at $65 Billion and a price-to-sales ratio of 13. Assuming an average price to sales ratio of 10, $5.5 Billion of drug revenues need to be earned. Although $5.5 Billion does not sound a lot considering biotechnology blockbuster drugs like Aranesp/Epogen, Neupogen/Neulasta or Rituxan, which together had revenues for the first 9 months of 2002 of $3.9 billion, the issue is that approximately 1400 private biotechnology companies received significant funding in the last six years and if they, absurdly though, all have to share the $5.5 Billion revenues, only ~$4 Million would be available for each of them. On the other hand according to the Biotechnology Industry Association 370 biotechnology products are in late stage clinical trials. The potential to close the $5.5 Billion revenue gap is certainly within reach but how many companies can reap the benefit and secure their long-term survival? Considering both thought experiments, interesting times are ahead. We used strictly US market numbers so far. Is Europe different? The first European biotechnology company was Enzymatics started in 1988, Cambridge, UK. This is more than a decade after Genentech. Table 4 shows the investment appetite for biotechnology in the last decade in Europe. Although the gap is becoming smaller, it is still substantial. 6
    • TB, HMS Page 7 8/20/2003 Table 4: Still room to grow in Europe? Is Germany leading the pack? EUROPE GERMANY US VC Biotechnology Biotechnology Biotechnology Years Invest's $ % $ $ % of EU Soft $ % B'tech $ US/EU 1989 4271 3.4% 144 50 35% 0 0% 335 2.33 1990 4126 2.3% 95 7 7% 0 0% 306 3.22 1991 4632 1.9% 87 19 22% 0 0% 272 3.13 1992 4701 1.3% 62 15 24% 0 0% 466 7.52 1993 4115 1.4% 57 12 21% 0 0% 432 7.58 1994 5440 1.3% 73 29 40% 3 10% 510 6.99 1995 5546 2.1% 118 16 14% 7 45% 830 7.03 1996 6788 2.7% 182 59 32% 6 10% 1472 8.09 1997 9655 2.6% 250 61 24% 27 44% 2133 8.53 1998 14461 2.4% 347 148 43% 84 57% 1534 4.42 1999 25116 2.6% 643 247 38% 119 48% 2193 3.41 2000 34986 2.9% 1018 505 50% 193 38% 4203 4.13 2001 24331 3.5% 844 497 59% 93 19% 3418 4.05 Total 3920 1665 531 18104 5.42 Total 96-01 3284 1517 521 14953 % of Total 84% 91% 98% 83% German B'tech as % of Europe 42% Soft $ as % of German B'tech 34% Europe started at least a decade later and slowly tried to catch up. In the mid nineties the investment amounts increased significantly. Germany played a dominant role in this movement investing 42% of the total European funds allocated for biotechnology. The investment boom in Germany was additionally fueled by the availability of “soft-money” matching or supplementing venture capital investments. The “soft-money” numbers were obtained from the Technologie- Beteiligungs-Gesellschaft (TBG), the most significant funding agency in Germany. It was estimated by the TBG that approximately 70% of all the “soft-money” was provided by them. Therefore, to obtain the total contributions we multiplied the TBG numbers by 1.43. About one third of all funding dollars in the last 6 years came from government programs. In 2002 the TBG allocated only 15 Million Euros to biotechnology, a dramatic drop to the 2000 level. 7
    • TB, HMS Page 8 8/20/2003 Although the gap to the US narrows, US levels were still 4 times higher in 2001, though down from 8 times in the mid 90ies. An international consultancy, BCG, compared the growth rates for the Bay Area and Boston with Cambridge UK and different biotechnology clusters in Germany. Their conclusion was that the growth rate per year is comparable. Obviously, the UK started about a decade later and Germany almost 20 years later compared to the US. It will take some time to close the gap. Assuming that the American biotechnology sector is not over- saturated, Europe has room to grow. In addition, in the US 342 biotechnology companies are public compared to 104 in Europe. This translates into 76% of companies in the US are private versus 94% in Europe. Therefore, venture capitalists in Europe might have better odds to exit their investments with a public offering. The US market is certainly more crowded and many companies are waiting for the next window. Nevertheless, the higher rate of private companies is counterbalanced by the lower liquidity of European stock exchanges. The closing of the “Neuer Markt” is certainly not helpful for biotechnology companies to raise money and their venture capitalists to find an exit in Germany. After the significant stock market losses in Europe in the last 2 years, the generally more risk-averse nature of Europeans might freeze money allocated for high-risk ventures like biotechnology in the near future. It is not entirely clear whether a US or European listing is more advantageous to raise money. Seize the opportunity wherever you can do it and whenever a local or regional window is open! In the last five years Germany pushed very hard to become number one in Europe. The German government and venture capital funded within the last few years more than 350 biotechnology companies. The current market climate will not allow sustaining this investment pace and significant reductions are expected for 2003 and even probably also 2004. Germany and also Europe need a big biotechnology blockbuster drug. This would create a lot of momentum, interest in the sector and could also absorb the employees who might lose their jobs due to this over-investment in the last 5 years. Although we cannot calculate a bubble factor for Europe or Germany because appropriate historical data do not exist, we believe that too much money was invested in biotechnology in too short a time period. Now it is necessary to allow market forces to act again. Schumpeter’s “creative destruction” Sirocco, a dry dusty wind, will sort out the wheat from the chaff. Other EU members criticized Germany for its massive subsidies of the biotechnology sector in the last 5 years. In 2002 only ~15 Million Euros were 8
    • TB, HMS Page 9 8/20/2003 provided by the TBG to biotechnology companies. Consolidation will be painful but necessary and unavoidable. Germany is also impatiently waiting for the biotechnology blockbuster drug to act as a necessary buffer. Without a strong success story continued enthusiasm about biotechnology might be difficult to sustain. The access to “easy” money has expired. Let us hope that the Sirocco does not convert to a White Squall. Biotechnology lived through a period of tremendous excitement and many unrealistic hopes, mostly about the speed of translating scientific breakthroughs into pharmaceutical products. The next two to three years will be as challenging for the industry as for the economy in general. Nevertheless, as long as patients suffer, biotechnology will play an essential role in the health care market. The drugs discovered and developed by Amgen, Genentech, Idex or Biogen make an enormous difference for patients´ lives and have created significant value for public shareholders and venture capitalists. However, the breadth of the “generalist” biotechnology company model a la Millennium, GPC or Curacyte will be difficult to finance in the coming years. We believe that biotechnology companies, which are “specialists” in a certain area or a certain indication, will be favored. Targacept, Idenix or Icagen would be good examples. They might have a better chance to attract pharmaceutical alliances and collaborations, necessary ingredients for survival. Venture capitalists need to choose wisely the few investments in the near future, build strong syndicates and have a network available with deep industry knowledge and expertise covering all areas necessary to find “The New New Drug”, in reference to Michael Lewis’s The New New Thing. In the near future hundreds of exciting new products will be created and many companies will rise and fall. Some of them will deliver their founders, private investors and the public outstanding returns. The times when all the medical problems on this planet will be solved are far away. We have a lot of work to do. Acknowledgement: We would like to thank Jennifer Vandermosten (EVCA), Michael Steinmetzer (TBG), Michelle Lappen (Ernst & Young) and Jeanne Metzger (NVCA) for data and the rest of the TVM Life Science team for helpful discussions. 9