The following post was published on the Knowledge@Wharton website on January 22, 2014.
The data is in, and there is no question that 2013 was the most active year for biotechnology initial public offerings since 2000. During the 12 months ended in December, 38 biotech companies debuted on Wall Street, all but two of which were listed on the Nasdaq exchange, according to FactSet, a Norwalk, Conn.-based provider of financial analytics. The performance of the biotech class of 2013 was rather impressive: As a group, the shares of the newly public companies rose 43% through the end of the year.
Is it a biotech bubble? Or will investors continue to pour money into this exciting but still quite young industry? And what can managers of biotech companies learn about raising capital from the experiences of those who ventured onto the public markets last year? All important questions, to be sure — but challenging to answer in this industry, where disappointments are more common than successes, and the time between an idea for a new medicine and an actual product can be as long as 20 years.
“There’s a huge amount of real uncertainty about the likely performance of some of these companies — scientific uncertainty about whether drugs will pan out in [late-stage] trials and market uncertainty as to how the products will be accepted,” says Patricia Danzon, Wharton professor of health care management. “There have been past booms that have ended up being bubbles, but with these early-stage companies, we may not know until the drugs succeed or fail on the market.”
Danzon notes that one of the most surprising aspects of this biotech boom was that it came at a time when mergers and acquisitions in the life sciences industry — the other popular exit strategy for private investors in small companies — have been rather stagnant. Indeed, the volume of M&A deals in the third quarter of 2013 increased 10% over the previous quarter, but was down by the same amount as compared to the same quarter a year ago, according to a report released in November by PricewaterhouseCoopers.
“It seemed as if, on the one hand, big pharma was looking at these companies and choosing not to acquire, while public investors were willing to acquire them,” Danzon says. “That might suggest that public investors were being overly optimistic.”
Danzon adds that she wouldn’t be surprised if more biotech companies jump through the open IPO window in the coming months, because a public offering can be a much more attractive proposition than an acquisition, particularly in life sciences. “Given the high risks and the significant number of failures that have occurred, pharma tends to acquire now with a lot of payment contingencies,” such as valuations that are tied to the acquired company hitting certain research milestones, she says. “One can see this from the standpoint of the smaller companies. If the IPO window is open, they may choose to go that route rather than accept acquisition offers that have contingencies. The IPO is money you get now. For the investors, it’s probably a better exit.”
The Influence of M&A
Some biotech industry watchers are betting that the resurgence of biotech IPOs will actually re-awaken the appetite for M&A, says Stephen Sammut, a senior fellow in the health care management department at Wharton and a lecturer in the Wharton entrepreneurship program. That’s because publicly held companies are often more attractive bait for potential acquirers than are private biotech firms.
“Most of the biotech acquisitions occur after the companies have gone public,” says Sammut, who is also a partner at Burrill & Co., a San Francisco-based life sciences venture capital firm. “There are two principal reasons for that. The first is that, in most instances, companies don’t become targets for acquisition until their products are much further along in clinical development. The proceeds of the public offering may well allow a company to bring its products to [later stages] of clinical development and therefore be much more attractive to a multinational company for acquisition. The other factor is that it does give acquirers some comfort to know that they’re buying a company that has undergone the scrubbing process of an initial public offering and [Securities and Exchange Commission] filings for some period of time. That translates to risk mitigation on clinical development. They’re more than happy to pay a premium for such companies.”
What’s more, pharma companies are facing increasing pressure to produce growth, which has been hard to come by in recent years due to the loss of patent protection on such blockbuster drugs as Pfizer’s cholesterol pill Lipitor. That’s why many large companies are looking to smaller, more innovative biotech firms to fill their pipelines. Even large companies that are not yet facing patent expirations are showing a willingness to shell out huge sums for smaller innovators. For example, last summer, Amgen upped its offer to buy cancer drug maker Onyx Pharmaceuticals from $9.3 billion to $9.7 billion. Such deals — along with generally healthy balance sheets and access to capital among life sciences companies — prompted PricewaterhouseCoopers to predict that M&A will increase in the coming quarters.
Sammut expects that the appetite for biotech IPOs will also persist, even though there was a slight slowdown toward the end of the year: Only seven biotech firms went public in the fourth quarter, as compared to 15 in the second quarter. The factors driving this boom are quite different than they were in 2000, he says, and current conditions portend a continued enthusiasm for biotech.
“What happened in 2000 was there was an overflow phenomenon from the tech boom on the one hand and the tech burst on the other. There was an overabundance of capital looking for opportunities,” Sammut says. “As 2000 wore on and the tech stocks were in free-fall, there was still capital searching for good opportunities, and it buoyed the IPO market.”
The 2000 biotech boom also coincided with the mapping of the human genome — a milestone that investors mistakenly assumed would lead to an immediate revolution in drug development. “That has not materialized,” Sammut notes.
Now, however, he points out, there are strong signs that the genomic revolution may be starting. In 2012, the FDA approved 39 novel drugs — the highest approval rate in 16 years. The agency green-lit another 27 in 2013. “A large proportion of those drugs were products of the biotechnology industry. That, I think, sounded a wake-up call,” according to Sammut. “Are we at last seeing the fruits of nearly 40 years of investing in biotechnology? We’re at least seeing the front end of that.”
The performance of the Nasdaq Biotechnology Index reflected some of the industry’s recent accomplishments, and likely encouraged managers of privately held companies to jump into the IPO market. The index had a 66% return in 2013 — its best performance in at least 10 years, says David Krein, managing director and head of index research at Nasdaq, adding that in 2012, the biotech index rose 32%. “The big run of IPOs was backloaded in the second half, but it really came after a two-plus year run on biotech stocks generally,” he notes.
Biotech also outperformed the health care industry as a whole. “The health care sector itself was up 42%. So even within health care, biotech was a leader,” Krein says. The Nasdaq US Benchmark Index — which reflects the broader market — was up about 33%, he adds.
Some of the new biotech offerings performed so well last year that they were added to the Nasdaq Biotech Index, including Epizyme, Agios Pharmaceuticals and Chimerix. Because the index serves as the basis for the iShares Nasdaq Biotechnology Index Fund, which is an exchange traded fund (ETF), any company added to it automatically gains access to a whole new group of individual investors. “The ETF market has become in aggregate quite significant in investor portfolios, so these index changes actually result in meaningful capital flows,” Krein says.
Weighing the Pros and Cons of the IPO
The ability to exploit favorable market conditions and gain access to new investors is one of the major advantages of going public, states Wharton finance professor Luke Taylor. But that alone should not drive the decision to go public, he adds. There are, in fact, at least as many cons to the IPO as there are pros, Taylor notes.
“The cons are increased disclosure. You may not want your competitors seeing all your performance information,” he says. “If you’re public, you’re under a lot of pressure to produce short-term results, possibly at the expense of long-term results. There’s a lock-up period of roughly six months when the founders and VCs cannot sell their shares. And you do lose some control.”
Taylor has done research looking at all the factors that surround the decision about whether to go public. The bottom line: Entrepreneurs should ride the news cycle. “As soon as a company gets enough good news, it should go public,” Taylor says. Once a company has enough good news, he adds, the so-called diversification benefit of going public — the ability for the founder and other investors to take their money out of one company and spread it around — outweighs the benefits of staying private. The capital raised also gives the company the ability to accelerate clinical trials of lead drugs, and to take other projects off the back burner, he notes.
Biotech companies that went public in 2013 witnessed the effects of both good and bad news. Acceleron Pharma, for example, rose 164% from its September IPO through the end of the year, according to FactSet. Much of the gain came in December, when the company announced that it had advanced its anemia drug into mid-stage trials, prompting a $7 million milestone payment from its biotech partner, Celgene. On the other end of the stock-performance spectrum was Prosensa Holdings, which dropped 64% from its June debut. It didn’t help that shortly after the IPO, Prosensa announced that its experimental drug to treat Duchenne muscular dystrophy failed in a late-stage clinical trial.
One of the most important lessons the biotech industry will take away from the boom of 2013 will come from observing how the CEOs of the newly public companies manage their capital over the long run, Danzon says. “One of the facts about biotech is that oftentimes, the companies that do succeed have a strategy that is quite different from [what they intended initially],” she notes. “It’s as much betting on management as it is on the actual drugs. If the original strategy fails, there’s always the question of how managers will pull themselves out of that hole. That’s something we’ll only see over the next five-plus years.”
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