Money Moves

A potential solution for biotech's future funding needs

A 'co-existence' model for Indian pharmaceutical and biotechnology companies will help both camps them survive the current market conditions, advocates Navroz Mahudawala, Associate Director, Transaction Advisory Services, Healthsciences practice, Ernst & Young

The last few months have witnessed a gradual "destruction" in the ability of any global life sciences company to raise capital through the public market route. There was negligible Initial Public Offering (IPO) activity throughout 2008 and it's not picked up till date in 2009. The biggest casualty of this trend has been the biotechnology industry; capital herein is a crucial peg for survival. The reason for this is simple to fathom - majority of biotech investments are venture capital (VC) in nature and in times of turmoil; appetite for any investor to play the "early stage" game is limited.

In fact, interestingly across sectors, in the year 2008 there were just six VC IPO exits, the fewest annual venture-backed offerings since 1977, when there were also six IPO exits. Thus, most significant impact of the US financial crisis on the venture capital industry has taken place in the exit markets. It's a full cycle in the funding industry - the inability of even the strongest companies to go public in 2008 and the drastic reduction in acquisitions activity has had a major ripple effect and which now reaches every stage of the venture investment lifecycle.

VC mood barometer

Interestingly, in December 2008 the National Venture Capital Association, USA polled 400 venture capitalists about what they expected from the 2009 investment environment. If 2008 was a rough year for venture capital, VCs felt 2009 could be even worse. Almost all venture capitalists (96 percent) said it will be harder for new companies to get funded in 2009. The poll found that many VCs anticipate a slowdown in early stage investment, due to the closed exit market and a lack of money at VC firms to invest in new projects. Seventy-two percent of those polled did not expect the IPO market to improve in 2009--at best, 18 percent think the situation might ease up in the fourth quarter of 2009. Outside the US, respondents expect to see investment decline in every major foreign region. Europe is expected to be the hardest hit. The emerging markets of Israel, India and China were also expected to witness a decline in investment. However, majority of those VCs also believed that while 2009 will continue to be tough, the IPO market will open up in 2010.

In these times, it's important that the local biotech industry draws parallel and learns from its global counterpart. It's almost been a decade since biotech and pharma (especially in US) have been forming a co-operation model; with pharma acting as the "mother". As global pharma has been running out of pipeline and with major patents expiring in the next few years, biotech has been acting as a near term answer. Big pharma reinvests an estimated 20-25 percent of its revenues in R&D, which is even substantially higher than high tech industries like aerospace or IT. In biotech, the pharma industry seems to have found a way out.

Many pharma companies have acquired biotech companies, in the process solving the funding challenges of biotech. Acquiring a biotech company implies that the pharma company can add new products, product platforms and technologies which would be more economical than to start from scratch. Biotech products are also more difficult to be reproduced by the competing generic companies because of the biologics involved. The big problem remains that Big Pharma is cash-rich but innovation-poor, so it has resorted to buying into bright and innovative ideas while it tries to overhaul its business model. The number of biotech acquisitions by pharma companies has risen remarkably in US (14 in 2005, 17 in 2006 and 20 in 2007; Source: Windhover)

Complementary strengths

This 'co-existence' model which earlier was viewed by many as a 'conflict' has helped both groups grow and prosper with each other's strengths. Biotech has a far better track record in early stage scientific research; however it has had limited expertise in funding clinical trials and managing regulatory bodies and taking drugs to the market. Pharma infrastructure can take care of this competency gap. In the Roche-Genetech deal, Genentech benefited substantially from Roche's infrastructure and ability to take products to the market.

Fortunately for India, both these sectors have co-existed and have common players and some alliances already in place. Many large Indian companies have mid-sized biotech investments. Similarly, some of the biotech players like Biocon, Panacea, Serum have a pharma presence.

Success factors

There are various reasons to believe that the pharma-biotech partnership in India will succeed and lead the Indian biotech sector to the next level of growth:

• Though India will attract billions of dollars in 'growth capital', early stage capital in India will continue to have its share of challenges. Indian corporate has historically grown with 'friends and family' capital as 'VC' capital; followed by bank financing. While this has succeeded in lower paybacks oriented manufacturing and agrarian sectors, it cannot work in high risk, intellectual capital oriented sectors like biotech. The early stage capital will necessary have to come from corporate India and no other industry knows biotech as well as pharma.
• Indian pharma continues to enjoy good cash flows (especially domestic formulations) and can bear the brunt of negative cash flows of biotech. Most domestic pharma entrepreneurs are now tuned in to the fact that they would need to re-invest capital in R&D to have a sustainable growth model.
• With few Indian companies now attempting to build New Chemical Entities (NCEs), managements of these companies are far better equipped to handle out licensing of IPR and negotiate good terms.
• There are quite a few Indian pharma companies which are already targeting the high potential biogenerics market. This would provide the next big upside to Indian pharma.

So, what kind of co-operation models is possible? From a funding angle the following could be potential solutions:

• Large Indian pharma companies look at incubating two-three early stage biotech ventures every year. The stake herein could be significant minority
• Pharma companies taking controlling stakes in biotech ventures which are four-five years old and need large capital for growth ; herein the entrepreneur can continue with a 49 percent or a 26 percent minority stake with option to claw back to majority on achievements of targets (akin to a typical private equity structure)
• Consolidation between some of the larger pharma and biotech companies. While this was a remote probability a few years back; it is a distinct reality now.

Pain Points

There will be potential challenges and some would be similar to what has already transpired globally:

• Many biotech entrepreneurs (especially technocrats) globally detest pharma companies and are convinced that selling out to these 'bureaucratic marketing machines' will destroy the heart and soul of their smaller, more agile firms.
• The startup culture of innovation could be lost once these ventures are part of larger corporates.
• India has some 'regional cultural challenges'. While some of the best early stage biotech work has occurred in southern India, the potential partners may be from western or northern India.

The above challenges can be overcome if we learn from some of the global experiences. Most global pharma companies have preferred to keep their biotech investments separate (with just board level participation) and allowed complete autonomy for these ventures to run. This ensures that the quick decision making, innovation based culture continues to reside in these companies.

To conclude, while Indian biotech has shown astounding growth, funding for the high risk models would continue to be a challenge. Also, while few Indian pharma companies are investing several million dollars every year in R&D, successes have been negligible. For Indian pharma and biotech to effectively play the global biogenerics game, few companies would need to work with each other to leverage on strengths. Maybe in these times of global turmoil, it may be worthwhile for both the sectors to pause and introspect on the road ahead.

(Views expressed herein are the personal views of the author and do not necessarily represent the views of Ernst & Young Global or any of its member firms.)