Is the stock market going to give up on biotechnology companies, and are biotech companies going to give up on it?
In the past few days, one of the UK sector's oldest drug development companies, Xenova, announced it is to be taken over by a venture capitalist after running out of cash. A vaccines company which failed to float last year has been taken over by a private US company. Several companies to have raised money this year have share prices languishing below their fund-raising price. And behind it all, there is the gnawing fear that the biotech business model is broken in Europe.
It is easy to see why the public markets are attractive to biotech companies. It might typically cost £350m to turn a drug from a bright idea in the laboratory into a drug available in doctors' surgeries and hospitals, once you have added in the cost of the inevitable failures along the way.
It is less easy to see why a stock market fund manager should be attracted to biotech.
Xenova is, in many respects, the sector in microcosm. Founded in 1987, it has been through several acquisitions and several refinancings without making a profit or getting a single drug on to the market. In the end, it has been sold - to a new private equity fund jointly founded by the former Marconi finance director John Mayo - for just £26.1m, much less than the amount of money it has spent over the years. Xenova's most advanced drug, a brain cancer treatment, could still be two years away from the market, and promising vaccines against smoking and cocaine addictions are even further away.
Microscience, the vaccines company which was turned down by public market investors last year, was finally sold to the US for less than the money it has invested in its experimental vaccine drinks. These examples of value destruction ring as loudly in generalist managers' ears as do the biotech industry's claims that it is only a matter of time until the UK produces its own superstars to rival Amgen and Genzyme in the, admittedly more mature, US biotech industry.
The number of specialist biotech funds is declining, and even some of the big-name managers are now running smaller sums of money. Even then they usually prefer to hunt in the US.
Anthony Milford, the veteran biotech fund manager at Framlington, has 80 per cent of his fund invested in the US and less than 5 per cent in the UK. He says: "If you're a UK investor, a generalist, you don't need to bother with biotech. In the US, they have big, established companies that are an important part of the market, and it is too big to ignore. That's just not the case in the UK. Unless you can attract the generalist money into the UK sector it is going to be very difficult, and unless you have successful, profitable companies you are not going to attract in the generalists. That's the enigma."
So far, UK biotech has created only one blockbuster drug, an arthritis treatment (Cambridge Antibody Technology's Humira) but development costs were borne by a US company so the cash royalties coming back to the UK are relatively small. Most argue that successful biotech investment is about "shots on goal". Only one in 20 drugs that makes it out of the lab into human trials will eventually make it to market. Even going into the final, third phase of human tests, the odds are barely more than even.
Stephen Evans-Freke, the former banker who set up Celtic Pharma, the private equity fund that is taking over Xenova, says he aims to assemble the size of portfolio of products that UK public companies have conspicuously failed to achieve.
He says: "Xenova is a story of wasted opportunities, and yet the company we have bought has a good product portfolio. If you have only got one Phase III product, that is not very attractive, but if you have 12 or 15 of them then that is a metric you can play to. That is the Celtic Pharma proposition."
John Mayo of Celtic argues that the public markets are under-researching biotech companies. "If you are also looking at steel companies and car companies, it is very difficult to make a rational decision about the likes of Xenova. Biotech requires an enormous amount of due diligence, which when you are investing for just 1 per cent of the company might be uneconomic. But if you don't do the due diligence, you might just as well go into a casino."
Chris Collins, the chief executive of the specialist life sciences broker Code Securities, says that biotechs have actually been more successful in tapping the public markets this year and last than in previous years, when the fund-raising window was shut after the excesses of the post-Millennium bubble. But he agrees that investors are demanding companies that have reduced the enormous risks associated with costly drug development work.
"If you want to be able to raise money in most circumstances, rather than being beholden to stock market conditions and having to wait for these windows to open, then you need to have a broader spread of projects, be nearer to profitability and have endorsements of your technology via collaborations with Big Pharma," he said.
This is also one of the reasons why it is proving difficult to consolidate the quoted sector to create the sort of portfolio companies that Celtic is hoping to create in private.
Mr Collins said: "If reduction of risk is a company's top priority and it is moving closer to profitability, then investors may not want it to suddenly turn round and buy something that will delay that by requiring more investment."
Because biotech companies are stuck in the product development phase for so long, they resemble what in other industries would be more likely to be a venture capital investment. Yet the vast sums involved have not traditionally been available through private equity. While Celtic has so far raised about £75m, it remains to be seen whether it will reach its ambition of raising more than £500m in the next few years.
Stuart Rollason, of Bluehone Investors, says we should expect more of a partnership between private equity and stock market investors. "What you will get are venture capitalists staying with the structure a little bit longer. They now recognise that they need to float companies with a later-stage product portfolio, and they are also often pledging money into IPOs. There is a sharing out of the risk rather than a handing on of the baton for these type of entities. Public market fund managers for their part will have to accept a venture capital overhang is going to be there for longer."
Code's Chris Collins is sceptical that the funding of late-stage biotech drug development work can be taken over wholesale by the likes of Celtic.
"There is scope for a private equity fund that can take a longer view and can plug a temporary gap, but it would only be a temporary gap. If fund managers see other people spotting value then the stock market would eventually realise the potential and companies would stop being undervalued. The stock market is a great correcting mechanism."Reuse content