Risk appetite swells

Initial public offerings (IPOs) and secondary offerings are the lifeblood of the biotech industry. Listing stocks gives early-stage companies access to the vast amount of cash necessary to advance drugs through clinical development and provides investors an opportunity to earn a return by investing in new biotech companies.

At the start of 2010, biotech companies that went public possessed more advanced technology and had reached later stages of their drug development cycle than the biotech companies raising public capital today. Following the Global Financial Crisis, biotech companies fell precipitously from their high participation in the IPO market of 2009 to fewer than 10% of IPOs subsequently. Biotech companies that were at an unproven preclinical stage or in Phase 1 or 2 of the development of their drug rose from a small fraction of the IPOs in 2010-2012 to more than the majority of newly public companies, reaching 90% of IPOs in 2021 and 100% in 2022. Companies developing pre-Phase 3 drugs are still highly speculative because they lack much or any human clinical data to demonstrate the probability of their success, but many investors are keen to bet that biotech companies will prevail. As Figure 1 illustrates, investors have undertaken an increasing amount of risk since 2009.

Biotech companies lose favor

Biotechs and their investors have been reaping handsome rewards over the last 10 years, as more young drugmakers than ever went public at much higher valuations than what was typical in the 2000s. In 2021, despite industry disruption caused by the Covid-19 pandemic, more than 100 biotech companies priced an IPO, raising nearly $15 billion in aggregate funds. At the beginning of 2021, the Biotechnology subsector comprised 11.4% of the Russell 2000 small cap stock index, while the Healthcare weight was 20.5% of the benchmark. Now, in 2022, the Healthcare sector is 14% of the index and Biotechnology has fallen to a weighting of 6%. Indeed, the fall of the index’s Biotechnology composition appears to be the sole cause of the decline in the Healthcare sector weighting. Figure 2 demonstrates the overall decline in performance of newly public equities over the last few years.

What happened?

One answer may be the increasing prevalence of crossover funds. They provide a link between private markets and public markets when they invest in the last round of private companies before doing an about-face and selling those shares to the public markets through an IPO. These investors thrived during the IPO boom of the early 2010s, specifically starting in 2013, giving biotech startups access to larger pools of capital. Through this process, crossover investors are “guaranteed” a return on their pre-IPO fundraising round. However, biotech companies that crossover funds favor are still considered experimental and are far from a  commercial stage. The crossover fund movement caused artifice in the market as many investors found themselves stuck owning public biotech companies that came public too early in their life cycle. Such companies fell prey to a vicious and endless requirement of attempting to raise capital in an illiquid market every few quarters merely to keep afloat.

The challenge at the heart of the biotech firm’s trajectory is it sometimes receives excess capital but ultimately needs to raise more – and regularly – to keep pace with its burn rate. Cumulatively, public development-stage companies need to raise ~$15B by yearend 2022 to fund one year of burn. If companies are unable to raise capital, they must cut their burn rate, which forces them to reduce their R&D efforts and impair their likelihood of successful drug discovery. These early-stage companies are constantly looking for the next investor to fund their burn rate. Figure 3 depicts this dynamic in the higher capital needs and greater burn rate of smaller biotech companies, which comprise the majority of businesses in this space.

How does the Schroders US Small Cap team approach biotech?

We concentrate on biotech companies that possess validated clinical data. As long-term investors we favor an average holding period of three to five years and are not bullish on funding “experiments.” Instead, we believe the focus should be on companies that have reached Phase 3 or greater. We focus on companies that offer drug products backed by unequivocal science supported by well-designed clinical trials that can meet the high standards of the US FDA. Their drug products address unmet clinical needs that are reimbursed by the government and insurance companies in order to drive commercial success. Additionally, these companies generate revenue and possess a path to profitability without the need for any additional dilutive capital raises. This philosophy limits exposure to the problems of early-stage biotech companies that ultimately burn cash and survive at the mercy of willing investors seeking to fund their next science project.