Biotech funding in a risk-off climate – does upstream trouble loom for pharma services providers?

25/05/2022
Insights
Maxim Lipanov

Biotech funding is the key driver of innovation in the pharmaceutical industry and is essential in supporting the healthcare ecosystem. More than 80% of drugs marketed by large pharmaceutical companies were discovered and initially developed by biotechs1. Biotech companies also discovered more than 60% of FDA-approved “priority” drugs, which treat life-threatening conditions and offer significant improvements over existing treatments2. In light of recent volatility in capital markets, we ask – are these vital funding flows at risk of being stemmed? 

The answer to this question will not only shape the future for biotechs and smaller pharma companies themselves – it will be critical also to the ecosystem of service providers to pharma who depend, one way or another, on the size of budgets for researching new drugs and then developing them to the point of launch. Even further downstream, the commercialisation sphere is dependent on new drugs being launched and marketed. In this way, a biotech funding crunch would represent a major risk to the growth plans of groups across several sectors who have been enjoying consistently benign market conditions for years.  

Biotechs usually secure capital using two methods: private capital raises and IPOs. VC funding has flowed into the sector at record levels in recent years, with $28 billion raised in 2021, which is 26% higher than in 2020 and more than 2x the level raised in 2019. The IPO route has also become popular as increased risk appetite and favourable macroeconomic conditions allowed earlier stage companies to achieve a listing.

Source: Evaluate Pharma

As expectations of rising interest rates and other negative macroeconomic factors started affecting valuations in the second half of 2021, investors reassessed their risk tolerance. As a result, the biotech industry, considered a high-risk sector, experienced a significant capital outflow in the past several months. Many investors who snapped up shares of biotechs during the pandemic have now abandoned the sector, preferring value over growth investments. According to data from Refinitiv, biotech companies listed in 2021 are trading on average 37% below their IPO price3, making further capital raises harder and less attractive.

There are also several industry-specific factors that have contributed to the risk-off sentiment in capital markets:

  • Weak data flow from preclinical/clinical trials has significantly affected investors’ attitude towards investing in early-stage companies. In the past few years, capital poured into the sector but in some cases there was a disconnect between investments and actual progress arising from those investments. Capital came too early and sometimes was unnecessary, trials did not run adequately and management overpromised, leading to poor or weaker than expected clinical data. These factors have affected sentiment to the degree that several public biotech companies are now trading below their cash balances.
  • Talent has become a growing constraint for biotech start-ups. Most sectors in today’s economy are experiencing labour pressures of some kind, but in the biotech world, a lack of experienced personnel can severely limit growth and innovation potential. With a harder path through clinical milestones and lower prospects for M&A, top talent has been harder to attract to early-stage businesses.
  • Regulatory uncertainty in the US, especially the antitrust focus of the Federal Trade Commission and proposed pricing reform, has also featured on the list of investor concerns. While regulatory change could negatively affect ROI in the sector, several biotech VCs Results have spoken to remain positive and believe that the US government will find the right balance in terms of regulation, given the importance of sustaining innovation in biotechnology.

VC funding has held steadier than the public market route, with $7.9 billion raised in the first quarter of 2022 – down 28% year-on-year but still the second highest Q1 on record. Investment horizons for VCs are 8 to 10 years, therefore many private investors are not immediately concerned about the situation in public markets. However, investment strategies have shown signs of change in comparison to last year, with more emphasis on portfolio diversification at earlier clinical stages, and on selective investments in later stage businesses with meaningful interim data. Overall, we expect VCs to continue investing large amounts of capital into biotechs, with the objective to either transact or IPO when conditions improve. Currently, the most plausible exit would be through an acquisition from a large pharma; however, one VC investor Results have spoken to anticipates IPO and capital markets to pick up by the end of the year or early next year, driven by positive data, such as Nkarta’s encouraging Phase 1 results released recently4: “We need more good news in the sector on key data to lure investors back”.

Looking forward, we could expect more transactions across the sector with innovative companies leading the way. Record low valuations could be an opportunity for larger players to acquire emerging businesses. Big US and European pharmaceutical groups have an estimated c.$500bn to spend on M&A5 as they optimise their portfolios and replace revenues lost to patent expirations. Moreover, the need for continued investment remains strong as there is high unmet patient demand in areas such as cancer, HIV and blood diseases.

Despite tough public market conditions, the outlook for private investment remains positive. Unlike in previous downturns, VC firms currently have substantial dry powder to invest; and their long-term investment horizons should offer a cushion against public market turmoil. For the time being, at least, pharma services groups should keep upstream turbulence in perspective.