Psychology and Physiology of the Biotech Markets Today

Imagine you were an investor version of Rip Van Winkle. You went to sleep in October 2012 and woke up today. You’d take a quick look at biotech and think we were in a raging bull market. A few thoughts would be running through your head:

  • Unbelievable, the NASDAQ Biotech Index is at 3400! When I went to sleep, the NBI was 1400. That’s some crazy good performance in only three years. 
  • And the new issuance market is booming! Bankers must be having a field day – nine biotech IPOs got priced in the last six weeks! This is nearly as many as we got public in all of 2012. Finally, it seems, the IPO window is wide open, and at great valuations too, almost 50% higher at median than we saw in 2012.
  • I recall one of the young companies that went public in October 2012, right before fell asleep, was Intercept Pharma, which had a program in Phase 3 at the time of offering; It went public with a pre-money of only $175M.
  • Gilead has $25B in cash, wow! They only had $6B in 2012. And revenues?  This beast of a biotech added $20B in annual revenues over three years, tripling since 2012.  Their stock price has tripled too. 
  • Let the good times roll!

Though the numbers don’t lie, this Rip Van Winkle investor would be wrong about the sentiment of the market: it’s amazing what a few years does to expectations and investor psychology.

Over the past month, despite those impressive metrics, the sector has become the most negative it’s been since 2013, with the index off more than 25% since July, amidst pricing scandals and Valeant’s shenanigans, and almost all the recent IPOs have come in depressingly “below the range” proposed.  Industry pundits are lamenting the bloom is off the rose of biotech at every turn.  The big question is does the unhealthy psychology in the markets today match the underlying physiology of the sector?

Some of the sentiment change is warranted – public equity valuations have expanded considerably across the large to small cap spectrum since 2012, and a “correction” in some names was probably overdue.  Further, some of the concern is temporal and unlikely to be material – like the pricing bugaboo and political hot potato around the topic, which is unlikely to hurt innovative drugs in the foreseeable future.  But some of the sentiment is missing any historic context, in my opinion, especially around the IPO window.

Here are two observations on the recent IPO environment:

  • Nine IPOs in a six-week period is an off-the-charts pace historically, beaten only a handful of times in the current window and very few times in the 40-year history of biotech offerings. There are more than twenty biotech IPO’s in the public queue for an offering (their S1’s are public), and probably dozens more with confidential S1’s. While pace may slow down this fall, I expect a good number of these will get public over the next six months.
  • The valuations of these IPOs, while “below the range”, are 33% above the median IPOs of the 2013-2014 period ($302M vs $227M). How much of the under-performance is simply because of overly optimistic expectations. Companies in preclinical or Phase 1 (pre-data) are being valued richly by historic standards, between $250-400M, like Cytomix, Myokardia, and Dimension.  Hopefully their pipeline success will move them up positively from here.

But in a world with such a negative sentiment, how is it that we’ve had such a flurry of IPOs and rich-but-below-range valuations? The reason is because many of these recent offerings have really been “club IPOs”.  Most of the nine offerings had significant mezzanine rounds with bluechip crossover investors. These firms were already in the deal, and often priced the rounds to be modest step-ups over their private rounds even if they came in “below the range”.  The range was set to give a great return over the mezzanine, perhaps too optimistically, and those mezz-to-IPO step-ups have largely vanished in the recent market. Although the roadshows were as full and extensive as ones earlier this cycle, the books of many of these offerings didn’t have anywhere near the coverage (demand) of frothier periods in the past few years.

So the big crossover investors, and sometimes the venture insiders themselves, were essentially pricing their own shares in the offerings – without their involvement these IPOs wouldn’t have happened. I heard a great quote from a banker close to a few of the deals: “no one showed up” when it came time to price the deals. Those are obviously not great dynamics for going public with big first day “pops” and upsized offerings.  But by all historic measures the IPOs of the past six weeks are still very robustly valued companies. Only time will tell if they are cheap or expensive at these prices. In fact, since they and others have raised significant amounts of capital, they have the balance sheet to advance their products deeper in the clinic and weather any potential challenging or down-market that occurs in the interim.

So what’s the big driver of the negative sentiment today?  A lot of public equity investors in healthcare are in pain and have huge holes in their portfolio performance. As noted above, the NASDAQ Biotech Index is off more than 25% and that takes its toll. The big drivers of performance (or lack thereof) in the sector as a whole aren’t the small cap recent IPOs (that I like to focus on) – it’s the big biopharma companies. Think about the two big cap names with monster stock losses of late: since July, Valeant lost $60B in market valuation, and Biogen lost $22B.

To put those astronomical sums in perspective: the losses in market cap in those two companies alone are equivalent to 1.6x of all the combined market cap’s of the 2013-2015 IPO window! Imagine an event destroying more than the market value of all 135+ recently public biotech companies in less than two months. That event would shell-shock even the most resilient investor. For a portfolio, any real exposure to $VRX or $BIIB would put a huge hole in performance, especially on a relative basis. There were large numbers of generalists and hedge funds in those names and they’ve been rocked. I’ve heard from several hedge fund managers that they “gave back the year” in September – meaning they lost all their gains and aren’t unlikely to see the incentive compensation they were hoping for.

These portfolio setbacks and massive valuation losses have pushed generalist investors out of biotech, at least for the time being, as they lick their wounds.  Fortunately for biotech, other sectors don’t look very interesting (consumer, technology, energy all don’t offer a better alternative to biotech), and many are just sitting on the cash. It will take a few months if not quarters for them to rotate back into the sector. Smaller healthcare specialists are also not jumping to get into new biotech offerings. Until they have a reason to get back into the game, these generalists and the shell-shocked specialists will likely sit out of the IPO markets. From what I’ve heard, only the big name bluechip biotech investors (like Fidelity, Adage, Baker Brothers, Great Point, etc) have stayed involved in the recent crop of offerings, largely because they know the stories well from the mezz rounds.

What are the positive catalysts that could change this sentiment?

Improved post-IPO performance would certainly help: the 2015 cohort of IPOs (about 40) have, at the median, traded down 10% since their offerings. Nothing kills interest in the IPO markets faster than newly issued stocks that trade down and stay down after their offerings. We need to see some outperformance from a few breakthrough names in the group, and from the broader sector as a whole.  Big positive surprising trial news at AALSD or ASH would be a nice bolus of confidence for the markets.

Large M&A deals that recycle cash and infuse optimism into the small/mid-cap markets.  Recall the July acquisition of Receptos by Celgene for $7.3B; that spit off more cash to investors for recycling than has been raised in the last 18 months of IPO proceeds.  If we see a a few big M&A deals over the next six months where cash can get recycled, we’ll likely see more demand into emerging names and more fuel for new issuances.

A big positive would also just be the removal of the negative: getting the Valeant crisis behind us; leaving Hillary and her tweets about pricing; keeping Shkreli out of the news. And, it would be great not to be talking about tax inversions; unfortunately, I guess Pfizer might put the kibosh on the latter hope.  But, on the whole, less negativity in the news will be a big positive over the coming months.

Unfortunately, there are some potentially negative catalysts though that could prevent the resurgence of biotech.  Obviously, more scandals in our space wouldn’t help.  But lots of investors also have their eyes set on the Duchenne’s panels coming up – if they go poorly, they could cause an “FDA-is-biotech’s-bugbear” sentiment to ripple through the sector. Also, if there are surprisingly bad clinical news from AALSD or ASH, that could greatly dampen spirits, especially if it pours cold water on some of the “hot” areas like gene therapy or CAR-T immunotherapy.

All this combines to make for a very sensitive and fickle market today. Don’t say “Boo!” too loudly or you could damage the NBI. Volatility is always big in biotech (2x more so than the S&P, for instance), but it is ever heightened these days.

Fortunately, though, the fundamentals of biotech are still very much intact even amidst the market’s vicissitudes, and a few months of animal spirits in the markets don’t change this dynamic: we are witnessing a great scientific renaissance in biomedicine that is advancing new therapeutics with huge promise for patients, and huge upside for the innovators developing them. In short, biotech’s long term potential remains very positive, and future Rip Van Winkles will undoubtedly be impressed.