Guest column: The 3 big waves reshaping investment strategies in early-stage biotech
We are at a time in life sciences when significant strides are being made to solve some of the most complex medical challenges. Rapid advancements in science and technology coupled with abundant capital are leading to new investment strategies that may permanently change how companies at the cutting edge of drug development are funded.
Let’s take a step back. For years, early-stage investors and drug development companies faced impossibly high fundraising hurdles, hampered by the high cost of capital, low clinical success rates and a long regulatory process that might stretch years.
Now, this is all changing. Biopharma investing overall is on pace to reach new heights in 2018. In particular, biopharma Series A investments are exploding; by mid-year 2018, these have already exceeded full-year 2017 totals. Some early-stage companies are now attracting investments at levels once seen only in later-stage deals.
Source: SVB “Trends in Healthcare Investments and Exits 2018,” PitchBook, SVB Proprietary Data
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Move to portfolio-style investing
What is driving this shift in investor confidence and fueling new biopharma company creation? Forward-thinking investors and entrepreneurs are looking at early-stage drug development opportunities from a mutual fund perspective. Their goal is to increase the odds of a large return from a single successful drug investment, while reducing the typically high risk of a single early-stage investment. They achieve this by building and investing in a portfolio of drug development assets that, when pooled, carry a lower correlation of risk and a high-enough probability that at least one will reach clinical and regulatory success. The odds are improved by that fact that lifesaving advances are being made to unlock mechanisms underlying many specific diseases, leading to more effective treatments.
While this new model remains capital-intensive, it works to spread the risk and, by extension, provides a more predictable pattern for returns. As a result, private equity and deep-pocketed investors now have more confidence in early-stage biopharma — in a few cases enough that some portfolio assets are being spun out as independent companies.
This shift in early-stage biopharma investing, in fact, has evolved in three waves.
First wave: Spin off a single asset
In the first wave, exemplified by Adimab and Nimbus Therapeutics, smaller companies directly took on the risks of drug discovery. For example, Adimab launched as an LLC with no clear intention of ever exiting as a whole company, an event that traditionally would have led to a big lump-sum payday for investors. Instead, Adimab’s business model centered on de-risking the earliest stages of drug discovery for larger biopharma and profiting from the overall decreased uncertainty. This provided investors with a somewhat predictable dividend stream from regular asset-licensing deals, and the large biopharma asset purchaser with a source of less risky assets. Still, the larger biopharma company had to move early to acquire the asset, and as a result assumed a relatively high risk of failure. Without transferring all the risk, the investors were left with some constraints that limited their returns.
Second wave: Build to buy
The next wave took the concept a step further. Instead of developing a single drug candidate, “build-to-buy” companies were established around each asset and spun out as new companies. Versant Ventures’ Inception Sciences, a drug discovery incubator that spawned young companies, and orphan drug company Dauntless Pharmaceuticals are prime examples. Very early on, they partnered with a big biopharma company that gained the exclusive acquisition rights at preset terms. However, early-stage investors had to take a smaller return on their investments to compensate for the lower risk associated with a predefined exit. On the flipside, strategic partners were willing to pay slightly more than normal because they were acquiring more-mature assets, often with scientific teams in place to help bring the drug candidates to the finish line, instead of having to dedicate their own R&D staff.
Third wave: Portfolio-theory approach
Now, investors are experimenting with a full portfolio-theory approach, which is partially based on an investor theory called “research-backed obligations,” developed by economics professors Andrew W. Lo and Roger Stein of the Massachusetts Institute of Technology. Most investors are familiar with the concept, known as portfolio investing. It works like this: The goal is to own a controlling interest in a large number of high-risk, potentially high-return early-stage companies built around single assets. The idea is to spread the risk across a large enough number of companies that the binary risk of failure is reduced, in the hopes that one company will significantly outperform.
To do this today in biopharma, an investing entity needs massive sums of capital, which in the past was targeted only to late-stage companies. As a result, the pioneers in portfolio investing with early-stage companies have very deep-pockets. For example, BridgeBio is backed by private equity firms KKR, Viking Global Investors and Perceptive Advisors. BridgeBio has funded subsidiary companies working on a variety of drugs to treat everything from skin conditions to inherited heart disorders, most of which are early-stage. In these cases, the investors may be prepared to take a loss of tens of millions of dollars in the short term with the expectation that clinical breakthroughs will lead to at least some of these bets paying big returns in the end.
The future of biopharma investing
Other companies are applying a portfolio-theory approach to biopharma R&D with a broader strategy beyond pre-clinical R&D. Velocity Pharmaceutical Development (VPD), for example, is based on investing in underfunded or shelved drugs. VPD established a “project-focused company” around the asset. Similarly, Roivant Sciences, which incubates and launches new subsidiaries known as “Vants,” is pooling assets and has attracted some massive investments. As its first biopharma investment in August 2017, SoftBank Vision Fund made a $1.1 billion investment in Roivant Sciences, not its subsidiaries. Mereo BioPharma Group is another portfolio play that keeps development of clinical-phase assets under a single entity.
Looking ahead, as the portfolio-theory approach evolves we envision large pools of low-correlation risk assets combined with a more predictable financial return model, attracting huge new sources of capital from investors, even retail investors. This has the promise of fueling new drug development at earlier stages and solving medical challenges faster. These models also lend themselves to very sophisticated capital enhancements, such as leverage and securitization. We could be at the very beginning of a new investing strategy that may lead to major disruptions in traditional scientific investing as we know it.
Jennifer Friel Goldstein, BSE, MB, MBA, is the head of Silicon Valley Bank’s West Coast life science and healthcare practice. Andrew Olson, PhD, is a senior manager leading market research in support of Silicon Valley Bank’s life science practice.