A Life Science Leader Expert Roundtable
Few companies go far in this business without a financial firm on their side. But companies most often experience finance houses first as gatekeepers, not supporters. Seasoned, knowledgeable funders do not take on just anyone who comes in the door; they make informed judgments on the feasibility of early development candidates, seeking to wash as much risk as possible out of their intrinsically risky portfolios. Investment banks, which furnish much of the money for funding companies either directly or indirectly through backing funds, rely largely on the judgment of analysts in the financial firms, creating a true gatekeeper system.
But the financiers vary widely in their preferences for companies and candidates at specific stages of development, from early start-ups with high burn rates to mature players with commercial products. They have created a variety of funding options that allow companies to borrow money against various kinds of assets, some based on market projections.
Our financial roundtable panel, assembled by chief editor Rob Wright at the 2015 BIO International Convention, represents a cross section of financial firms and investment banks, including a Big Pharma-related VC, plus a small company on the funding trail. (See “At the Roundtable.”) Many of the firms offer or specialize in the relatively new financing option of “royalty financing,” in some ways a simpler, cheaper form of loanbased funding, giving the lending firm a share of future royalties as collateral. The panel discusses how and when the various funding options make sense, as well as changing internal and external conditions for the biotech funding environment.
Aside from standard funding sources, such as angels, grants, and VC rounds, under some conditions it makes sense for a start-up or small company to borrow some of the capital it needs. So moderator Dennis Purcell, founder of Aisling Capital, first asks the panel to look at biotech investment from the lending perspective:
When and why should a company take on debt?
Todd Schwarzinger of Hercules Technology Growth Capital (HTGC) explains that the loan option is in a “complementary asset class” of funding. For a mature or an early-stage biotech company, loan-based funding can help a company expand in its own way between equity fundraising events, such as taking on an additional set of candidates or to funding internal growth initiatives. Because a loan is a nondilutive form of funding, the company gives up no equity to the lender.
Greg Brown says his firm, Healthcare Royalty Partners (HRP), specializes in royalty financing, as its name implies, with a preference for companies with approved or late-stage products needing capital for further product development. “If you are receiving a royalty stream or about to receive a royalty stream, lending can give you a higher NPV [net present value] use of that capital.” Although the stock market tends to undervalue royalties, “because stockholders have difficulty calculating them, and because they don’t believe management will do anything except spend the money,” royalty-based lending adds value in Brown’s experience, sometimes boosting the stock price after the loan. Thus, royalty financing can both leverage a company’s assets and actually raise the market cap over its preloan value.
John O’Meara, part of the fixed income trading division at Morgan Stanley, represents the other end of the size spectrum from HTGC and HRP, but he shares similar views and preferences with the boutique firms, along with caveats: “It’s less about companies for us and more about the product itself. For products that are already approved, there is a wide variety of options that we’ve developed over time to monetize royalty assets. For pre-approval, we’ve seen a lot of growth in that area. The interest is growing, but it’s very much product-specific. It needs to be something that’s significantly de-risked or has a uniquely compelling upside profile.”
Robert Urban says his Big Pharmafounded investment group, J&J Innovation, prefers the very space the first three panelists approached more warily — and its investment model is not equity-driven. “We do everything in the early-stage space, on behalf of Johnson & Johnson. In 2012, when we launched, we allocated a range of technical expertise to our Menlo Park, Boston, London, and Shanghai sites, because we believed there was a significant gap in the market where we weren’t confident of seeing enough progress in all three of our sectors — consumer, medtech, and pharmaceuticals.
“We’ve done more than 200 investments in the last two years, but only about 45 of them involved equity. When we say investment, it means our putting capital to work, putting people to work, putting the kind of relationships in place that help advance projects toward a licensing or acquisition relationship. We invest only in prospects that we and the innovators believe will benefit from having Johnson & Johnson as a commercialization partner.”
BIG BANK OR BOUTIQUE
Purcell directs a question to Brian Silver of Perella Weinberg Partners regarding investor size:
With investment banking, how should companies weigh the prospects of talking to a large firm, compared to talking to a boutique?
Silver delivers a veritable primer on the issue. “If you need access to a capital market to do an IPO, you need to go to a big firm. The big firms are and will continue to be the gatekeepers to the capital markets. That’s a very important part of their function, intermediating between investors and issuers.” Still, he says, companies commonly have more than one firm advising them on any given deal, because no firm knows all the potential investors or buyers, and different firms bring different relationships to the table.
Smaller firms can pay closer attention to individual client companies as their needs change over time, Silver asserts. “At different points in the company’s life you can access different parts of the capital structure, and you need to put together the team of advisors that makes sense for the company at the moment. Regulatory pressure on the large investment banks is heavier than it used to be, so there is a big place in the market, especially in the biotech and pharmaceutical sector and healthcare more generally, for the kind of advice a boutique firm can give.”
"Regulatory pressure on the large investment banks is heavier than it used to be."
To bring in the perspective of the small company looking for investment, Purcell calls on Jeffrey Marrazzo of Spark Therapeutics, a gene-therapy development company with a novel funding model. Spark was initially financed by the Children’s Hospital of Philadelphia (CHOP). After a previous decade of “hibernation,” Marrazzo says gene therapy needed a champion, and CHOP, like all children’s hospitals, was “disproportionately impacted” by genetic diseases in the patients it sees and decided to step into the role. “The concept was, if we could create a runway to work out some of the challenges that had plagued the field, and that an industry partner or investment firm may not have the patience for, we could make it over to the other side of this special challenge with potentially viable products.”
First, in 2004, CHOP established its Center for Cellular and Molecular Therapeutics, mainly as part of its effort to expand its leading role as a “clearinghouse” in gene-transfer research for hemophilia and other conditions. In finding new revenue resources for the hospital and its research centers, Marrazzo and CHOP’s CFO, Thomas Todorow, decided to make a bold move into the commercial side with what would become Spark, launched in 2013.
CHOP normally invests some percentage of its endowment in “alternative” or higher-risk investments, largely through fund managers, so it proposed the hospital invest directly in the enterprise. Rather than a typical research-funding or technology-transfer deal, giving CHOP a single-digit percentage of royalty or some other return, the deal would be a preferred-stock structure. Once CHOP committed $50 million and put up $10 million for the first round, other investors wanted to join in, so a syndicate led by Sofinnova Ventures funded a second round, with CHOP as the largest contributor.
Turning from funding-model options, Purcell directs the discussion to two larger issues, actually related: Where will new therapies, diagnostics, and devices arise, and under what conditions will someone pay for them?
Oncology’s been hot, but three years from now what will be the one or two hot areas that we are not talking about right now?
Silver tellingly takes a cautious course: “If I knew the answer to that, I would be sitting in one of these investor seats and not in a banker seat. Where the disease burden is heaviest and where progress has not been as strong, such as neurodegenerative conditions like Alzheimer’s and Parkinson’s, incremental advances can unlock tremendous amounts of value, and we’re seeing a lot of earlystage companies there. Orphan diseases have attracted a lot of investment. Will there be a second or third generation of orphan disease companies using small molecules to affect targets now addressable only by replacing proteins or enzymes or similar methods? Of course, another generation of technological advances for gene therapy will replace some of the first generation approaches, which are by now 25 years old in some cases.”
The other panelists generally agree with Silver’s hot list, so Purcell brings up innovation’s innovation’s
gnarly twin — reimbursement. “What will this new outcomes-based payment model in the United States look like? Will it be capitation or pay for success?
“Because the U.S. healthcare system is so complex, all of the possible variations in the new model will probably play out,” says Marrazzo. “Reimbursement decisions may drive industry’s selection of disease targets to favor those where it is truly possible to transform a patient’s life in a measurable way. Ultimately, this is a positive trend for companies that are the most innovative and perhaps provides a disincentive for developing products that only provide incremental benefit to patients.”
According to Urban, J&J Innovation is already looking far ahead in its disease-target selection. But the group has narrowed its focus over time, from about 30 disease areas when he arrived about three years ago to about a dozen now. “We made a very explicit, conscientious choice to get much deeper into the underlying biology of all diseases we seek to treat,” he says. “We intend to use that information to intervene earlier and earlier, as well as find new biomarkers and other ways of helping us achieve the outcomes those products will be expected to achieve.” He elaborates:
“Ancillary technologies have emerged that we might use to capture some of the expected evidence or to become involved in the continuum of care earlier on the device and consumer sides. We have made quite a number of investments in the microbiome space — an out-of-body experience for a big company like Johnson & Johnson. But it’s clear to us the microbiome is having a very important, early contributing role in some of the diseases we’re targeting.”
"It is likely that value-based pricing will be where everybody goes, and the utilization of drugs will be far more driven by price."
Morgan Stanley reflects J&J’s bigplayer, long-term focus on selected disease areas, as O’Meara highlights one example: “Away from oncology, our firm has been involved in orphan drugs as a general matter — we did a large monetization for the Cystic Fibrosis Foundation last year. It has been very successful in the investments it made, and it resulted in a large asset for them, to monetize Kalydeco (ivacaftor, FDA-approved in 2012). We’ve also done a financing recently, for Intarcia, in the diabetes space. Diabetes isn’t necessarily a new topic, but they’re approaching it in a new way, with a different device and a different approach. Those are some of the things that are more innovative, from our perspective.”
Healthcare Royalty Partners, considering its kind of collateral, naturally has a more practical consideration in mind than innovation, at least in the abstract. “Our average investments last around 10 years,” says Brown. “What we probably worry about the most is payment, because that is an area where, with an aging population, with a secular diminution in real economic growth rates, payment is becoming paramount.”
“It is likely that value-based pricing will be where everybody goes, and the utilization of drugs will be far more driven by price. Probably the single biggest thing that will drive medicine, sadly, is not biology, but economics. Pharmaco-genomics — the ability to stratify diseases based on real genomic markers and to guarantee efficacy within a narrowly constrained population — will be realized. That speaks to value-based pricing as well.”
Are there any diseases less subject to reimbursement risk than others?
"We’ve done more than 200 investments in the last two years, but only about 45 of them involved equity."
“On a pragmatic level, orphan diseases,” says Brown. “Let’s say you’re a health plan with millions of subscribers and you have 12 patients with a lysosomal storage disease, babies who will die if you don’t treat them. You don’t care how much that costs. There is complete inelasticity of demand, so it is one area not susceptible to pricing. At the other end of the spectrum, I’d say vaccines. The big public health vaccines have a huge impact on herd immunity, as we’ve seen this past year. There is a lot of inelasticity of demand for vaccines in the developed world. That is generally used to fund vaccine distribution in the developing world. Those are two ends of the spectrum where there is a lot less price sensitivity. Information technology will also play a huge role in enabling the various trends that have come up, whether stratifying patients in some rare diseases or addressing the continuum of care for chronic diseases.”
Assuming a company hits the sweet spot for investors in the ways discussed, it could make one of many common mistakes that would either derail a deal or render it useless. Purcell polls the panel: “Each of you sees a huge number of deals a year. What’s the biggest mistake you see, when companies come to see you?”
“Being prepared for capital is the most critical piece,” says Schwarzinger. “Coming too early, capital can be challenging to some companies. Being prepared, understanding the opportunity and your long-term funding goals, and picking the right partners are all critical as you’re thinking through that process. Just taking the first bit of capital that becomes available to you is not always the best decision.”
Silver cites dysfunction in venture=backed boards as “the biggest mistake” in preparing for capital infusion. “Just signing up where you can get the money the quickest or the best valuation at any given moment sometimes is not wise. You really have to think about that dynamic of the old versus the new investors. Can they get along?”
Boards can also confound early-stage financing by pushing too soon to sell the company, he adds. Often, start-up boards contain noninformed angel or family investors who push for a premature sale. “Early-stage companies are not sold; they are bought. When you pass the data event, all of a sudden, people are lining up to buy it. But there is no way to rush that event. If the event hasn’t happened, there is no buyer. Once there is an event, then you have a lot of buyers. What really drives the price is the stage and the ripeness of the asset.”
Various panel members chime in with a string of responses: Failure to plan for “negative eventualities,” such as a failed trial or patent loss, is another common reason a company cannot handle its capital. Optimism is endemic in the industry, simultaneously feeding persistence and inflated projections — a frequent cause for companies’ surprise when their capital runs out. And when companies are caught off guard, so are their partners and investors.
“Companies need to have some contingency plan and some idea of how they’re going to deal with situations if there’s a $50 million funding gap and the last round has a 3X liquidation preference and somebody whose fund is on its last one-year extension owns 40 percent of the stock,” someone says.
“We are a strategic investor,” says Urban. “The only way that we really make money is by going the distance. Unfortunately, what happens is some company teams underappreciate the complexity of the long haul, especially on a global basis. We’re willing to get into these conversations in the earliest moments.
“The other piece that’s often underappreciated is the competition. The competition, as we see it, is nothing like what the world looks like today. The competition that we have to imagine is what the world’s going to look like 7 to 10 years from now, and it is all about getting your products paid for. You need to have the deepest possible appreciation about what the world might look like. It’s a very important component of setting the expectations around the product, and setting the expectation around the team that you need to develop it.”
From the company CEO perspective, Marrazzo describes lead-investor CHOP’s openness to bringing external experts into Spark’s board as independent members, in some cases to replace original members. Consequently, he says the board has become a resource of expertise and advice he can lean on reliably. “Even if you have that optimism gene, it helps if you can turn to some people who balance you at times and ask tough questions about your assumptions based on realworld experience.”
Purcell sets off a volley of parting predictions with his final question for the panel:
What would be our biggest surprise, sitting here next year, that nobody’s thinking about now?
Silver: “We have been in a climate for a long time, really in the last three or four years, where money was easy to get, where debt, equity, and the markets were very strong. I tell companies they need to protect their assets and think about their downside because the world could change very quickly. This post-crisis liquidity we’ve enjoyed will not last forever.”
Marrazzo: “With people generally getting excited and putting capital into gene therapy, I think we will now see and hear about other potential technologies that can play a role, somehow, together with current ones. There are all sorts of things that could be ancillary or supportive in that context. But there is so much we can do with current gene replacement technology, it will be squarely and continually where our focus is.”
Urban: “I’ve made a long history of never trying to predict the breathtaking moments of science. I don’t know what we might be delighted by next year, but I would be willing to bet that we’ll see more and more evidence, over the course of the next 12 months, of products that didn’t, for whatever reason, turn out to be exciting enough to achieve the hoped-for pricing. We will continue to see more and more evidence that the bar is going up for products to achieve the pricing we hope they will support. That will be the headwind of our world for some time.”
O’Meara: “At least until Brian’s doomsday scenario, we anticipate an increased interest by investors in pre-FDA assets, simply because that’s where the return is and where the yield is, in an environment like this.”
Brown: “My folk hero is a little character in Winnie the Pooh called Eeyore. All of you who’ve read to your children have read about Eeyore, who’s a pessimist. I’m with Brian — we’ve been in a period of incredible liquidity and artificially low interest rates. Nassim Nicholas Taleb has a bunch of black swans sitting in his backyard. Next year we will be talking about one of them. We just don’t know which yet. [Taleb authored The Black Swan: The Impact of the Highly Improbable.]”
Schwarzinger: “I guess I’m Eeyore’s tail — I agree with both these gentlemen. These days of nirvana are not going to last. I don’t know how it will end or when it will end, but sooner or later, it will. Typically, when that does happen, the drawback of capital is rapid and very dramatic. The present time is a very nice window for us to be thoughtful about opportunities to apply capital, while it is available. But I wish I knew what will be the catalyst for closing the window.”
Purcell adjourns the panel … until next year?