Financing in a Down Market

Printer Friendly

by Vivek Jain, managing director and co-head of Healthcare,
John J. Mitchell and Philip Ross, JPMorgan
from Biotechnology Investors' Forum – Worldwide – Issue 2 2002
www.biotechnology-investor.com

Vivek Jain

Accounting controversies. Insider scandals. Decimated stock prices. The biotechnology industry is no stranger to any of the major issues facing today's markets. One could argue that biotechnology has dealt with as many, if not more, of these issues as any other sector. From Alkermes to Sepracor, the biotechnology industry has certainly taken its lumps.

Of course, one could make the same point about many industries. Biotech has trended in the same direction as the overall market: down. The Amex Biotechnology index is down 38 percent on the year, compared with a 31-percent decline in the Nasdaq Composite and 19-percent drop in the S&P 500. The last thing anyone needs, however, is a restatement (pardon the pun) of the obvious. Understandably, the questions on investors' minds are 'When will biotech come back?', and, 'what type of biotech companies will succeed?' and 'where do biotechs go for cash?'

A BRIEF HISTORY OF TIME, AND BIOTECH MARKETS
The answers to those questions will be driven by any number of factors. However, like any history teacher worth his or her salt would stress, we feel that a look back will provide important guidance for the future. The majority of publicly traded biotechnology companies have lacked both liquidity and profitability; thus, the industry's historical means of financing has come through equity issuance.

The graph plots the number of life sciences IPOs and follow-ons over the past 12 years. As we have illustrated, there were three significant equity financing windows in this period.

Life Science IPOs and Follow-ons, 1990-Present

WINDOW 2: AUGUST 1995 TO NOVEMBER 1996
Prior to discussing this 1995-1996 biotech financing window, we should take a moment to consider reasons why such a robust period for biotech equity issuance occurred in the first place. We have long argued that outstanding big biotech performance, coupled with demographics, created the promise necessary to drive investor interest toward earlier-stage biotech stories. Consider, for example, the period of big biotech growth that preceded this window. Amgen, capitalizing on the success of Epogen and Neupogen, grew its top-line between 1991 and 1995 at a 30-percent CAGR, while net income increased at a 53-percent CAGR. Genentech, driven by Actimmune for the treatment of chronic granulomatous disease as well as its cardiovascular drug, Activase, grew its top and bottom lines at CAGRs of 16 percent and 35 percent, respectively. Moreover, beyond those big biotech companies with products on the market, investors in the early and mid 90s witnessed a number of products advance through clinical trials (or in some cases, receive FDA approval). IDEC and Genentech joined forces in 1995 to complete the development of IDEC's anti- CD20 monoclonal antibody, Rituxan, for non-Hodgkin's lymphoma. Genzyme received marketing approval in 1994 for its Gaucher disease treatment, Cerezyme. In 1995, MedImmune's Synagis for respiratory syncytial virus began Phase II trials and Financing in a down market Life sciences IPOs and Follow-ons,1990-Present RespiGam for respiratory tract infection received FDA approval. There is no doubt that the performance of these bellwether biotechs contributed greatly to the sector's ability to raise equity capital in late 1995 and 1996.

Between August 1995 and November 1996, there were 161 life sciences IPOs and follow-ons completed. Proceeds amounting to US$1.9bn in IPO were raised, with an average deal size of US$26m. For follow-ons, the average deal size was US$61m, and biotech follow- ons as a whole raised US$5.3bn. This surge in equity offerings coincided with a 38-percent gain in the Amex Biotechnology index, as well as 30- and 35-percent increases in the Nasdaq Composite and S&P 500, respectively. Of the 161 companies who accessed equity capital, 83 were product companies (those focused upon clinical development), while 78 were technology platform companies (those whose technologies help increase the efficiency of the expensive and timeconsuming drug discovery process, but who lack a focus on the clinical development of drug candidates). Some examples are combinatorial chemistry, diagnostics and screening technology.

1997-1998
Following this window, however, equity markets were closed to most biotech issuers for the majority of 1997 and 1998. While the collapse of Long-Term Capital Management and the Russian ruble crisis certainly affected all potential equity issuers during this time, there were a number of industry-specific problems in biotechnology that contributed to the sector's inability to tap equity funding. Consider again window 2 biotech IPOs and follow- ons. An index of the product companies that completed offerings in the aforementioned window advanced 46 percent in 1997 and 1998, while technology platform companies rose just 0.2 percent. Technology companies that focused on just one aspect of drug discovery – outsourced chemistry, for example – failed to sign up partners as quickly and/or profitably as hoped.

Consider ArQule, a combinatorial chemistry company, as a prime example. Having completed an IPO in 1996, ArQule reported its first profitable quarter in the third quarter of 1997. It continued to show profit in the fourth quarter of that year, and in the first quarter of 1998, only to disappoint the market with net losses beginning in the second quarter of 1998. ArQule has never returned to profitability since.

When ArQule slipped out of profitability in 1998, management cited three reasons: uncertain timing of signing additional partnerships, a slower pace of initiation of projects and uncertain terms of a partnership renewal agreement. In no way was this situation unique to ArQule. Many technology platform companies faced situations much like ArQule's; these types of scenarios were significant contributors to the entire group's poor performance in 1997 and 1998.

WINDOW 3: OCTOBER 1999 TO NOVEMBER 2000
Once again, it is worth noting what helped open the door for biotechnology during window 3. Surely, the success of tech offerings throughout 1999 played an important role in helping biotech companies raise equity. Moreover, extensive media coverage on the sequencing of the genome brought widespread investor attention to the biotechnology sector. Finally – and most importantly – much like the period leading up to window 2, big biotech played an instrumental role, leading the way with a string of successes in 1999. Genentech completed a highly successful, US$1.8bn carve out IPO in the summer of 1999 and traded up in the aftermarket. Amgen filed BLAs for Aranesp, a long-lasting EPO drug with blockbuster potential, and Kineret, an IL-1ra for rheumatoid arthritis. Biogen announced positive Phase IIb efficacy data for its psoriasis product, Amevive, and experienced strong sales growth from Avonex, its flagship drug for multiple sclerosis.

Beginning in late 1999 and continuing through November 2000, the Nasdaq Composite actually fell five percent and the S&P 500 increased only three percent. Biotech, however, was an equity market darling. The Amex Biotechnology index ran up 126 percent and companies rushed to fill their coffers. Sixty-one product companies and 59 technology platform companies completed offerings. Proceeds of US$3.9bn in IPO were raised, with an average deal size ofUS $73m. For follow- ons, the average deal size was US$136m (excluding Immunex and Genentech's US$2bn+ follow- on offerings), and biotech follow-ons as a whole raised US$16bn.

However, along with the overall market, biotechnology has plummeted 40 percent since December 2000. It is instructive to look once more at the respective performance of the product and technology companies that completed offerings in window 3. Of the 120 biotech companies to complete an IPO or follow-on, an index of the 61 product-driven stories has fallen 39 percent, driven by drug setbacks and/or failures such as Dendreon's Provenge, Inspire Pharmaceutical's INS365 and Cubist's Cidecin. Technology plays are off even more, down 50 percent since the beginning of 2001. The reasons, much like the hangover period following window 2, are straightforward. With few exceptions, technology plays have failed to sign enough collaborations to live up to profitability expectations. Many of these technology investments have become simple big pharma derivative plays. When blockbuster drugs emerge from pipelines and double digit EPS growth is the norm, big pharma companies are more apt to roll the dice on biotechnology collaborations. But with pipelines dry, legislators pushing for price controls and earnings growth slowing, big pharma is ever mindful of entering into expensive collaborations.

Unlike the period following window 2, when product companies continued to provide superior returns, these companies too have experienced painful falls, no doubt due to the spate of recent clinical trial failures and rejections at the FDA. From ImClone to Inspire, Celgene to Cubist, numerous product companies have disappointed.

ONCE BURNED, TWICE SHY; OR IS IT TWICE BURNED, THRICE SHY?
When will the market turn for biotechnology companies? What companies will be able to access the equity capital vital for the longterm success of biotechs? It is notoriously difficult to time markets; we are no more qualified than anyone else to make such a prediction, although we will point out that the time between window 1 and window 2 lasted 38 months, while the time between window 2 and window 3 was 34 months. Incidentally, it has been 22 months since the end of window 3.

More importantly, although investors have been burned by both product and technology companies alike, stellar returns have never been missing. Long-term investors in Amgen, Biogen or Genentech will attest to that. A US$10,000 investment in 1990 in Amgen, for example, would be worth US$417,094 today, a 138 percent annual rate of return. Whether it is Epogen, Avonex or Rituxan, the common bond between those companies is a blockbuster drug. For that single reason, when an equity financing window re-opens for biotechnology, product-driven stories will again lead the way. Companies with drugs that possess blockbuster potential, like a Scios or Neurocrine Biosciences, will remain at the vanguard of investor attention as biotechnology markets rebound.

Platform technology companies have long promised investors that their cutting-edge technologies will forever change the process of discovering life-saving therapies. Investors, however, now know all too well that when it comes to making money in the biotechnology sector, successful drugs are the alpha and omega. Indeed, technology and discovery companies that have had the financial ability have made significant moves to transition themselves into product companies, either through acquisition (e.g. Millennium) or through a combination of acquisition and internal development (e.g. Human Genome Sciences). We are confident that technology companies will make money, and that many will become outstanding market performers. However, due in large part to their predecessors' lackluster performances, technology companies will not be afforded the premium valuations they previously received.

SO HOW WILL BIOTECHS GET FINANCED?
As if anyone can forget, equity markets remain weak, product failures continue and management scandals have affected every industry. Investors are looking for safe havens; unfortunately, the volatility of biotechnology stocks does not represent a low-risk investment. It is no surprise that healthcare mutual fund outflows have increased. Finally, biotech companies have long relied upon the ability of sell-side equity research analysts to effectively communicate their complex businesses. With the credibility of sell-side equity research analysts under scrutiny, one can only wonder how much retreat there has been from the biotech sector due to investors' (in)ability to rely on biotechnology research. With all this negative news, where can biotechs turn for capital? Fortunately for many biotechs, the table above demonstrates that the industry as a whole remains extremely well capitalized. NIH funding continues to grow, and although public market financing hasn't approached 2000 levels, many biotechs still possess large amounts of cash on their balance sheets. Moreover, private equity funds still have a tremendous amount of undeployed capital.

For those public companies who have been unable to tap public equity markets, private investments in public equity (or PIPEs) have become a preferred financing tool. Unfortunately, investor appetite for PIPEs has decreased along with the market for public offerings.

Moreover, it is important to note that these deals often price at a discount. Biotechnology PIPEs in 2002 have averaged a 9-percent discount to their trailing 20-day, volume- weighted average price. Furthermore, the majority of recent PIPEs have consisted of straight equity, and lack the warrant coverage structures seen in years past. Nevertheless, we believe that biotechs strapped for cash will continue to opportunistically complete PIPE offerings as one means of financing, so long as more traditional public equity financing mechanisms remain inaccessible.

SUMMARY
With war looming in Iraq, continued conflict in other parts of the Middle East and daily reports about corporate governance, it is hardly surprising that investor sentiment remains short-term oriented. It is quite clear, however, that biotechnology investing requires a long-term horizon. Although the events of the present day are certainly unique, nevertheless equity financing markets have always proved enigmatic for the biotechnology sector: closed one day, open another.

For the time being, biotech companies will be forced to hunker down and execute on their business models. Financing will be available for those companies that hit their milestones, and advance products through clinical development. Whether it come in the form of a rapid shelf take-down or PIPE, or a more traditional public offering, companies with promising products in development will be able to access equity capital.

Should the biotech sector as a whole wish to see equity financing markets reach historical window levels, big biotech will, once again, have to lead the way. Whether big biotech hits its milestones will largely determine the shape and nature of any rebound in the financing environment. Recent events have not provided much hope: Genentech recently experienced a disappointment with its cancer therapy, Avastin; Biogen has seen delays in the approval of its psoriasis drug, Amevive and Genzyme continues to ratchet down sales estimates for its kidney dialysis treatment, Renagel. Nevertheless, there are a number of important catalysts on track for the next 12 months. Although Amevive has taken longer to come to market than anticipated, the drug is on track for early-2003 approval and launch, and would be the first biologic to market for psoriasis. Amgen has the potential to demonstrate strong growth as its recently launched drugs, Aranesp and Neulasta, begin to make inroads. Genzyme recently submitted a BLA for Aldurazyme, and will go to the FDA with Fabrazyme at the end of September.

Should big biotech deliver positive results on these and other milestones, we believe the equity financing environment will become significantly more receptive to biotech offerings. Unfortunately, with the unpredictability of the biotech sector in general and today's markets in specific, such an outcome is hardly set in stone.

About advertising opportunities