Canadian Biotech: Investing for the Long Run

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By David Sable

"Canadian biotechs face the valley of death"
Fierce Biotech, April 1, 2009

While I did see some long faces back in April at Toronto’s BioFinance 2009, as speakers and panelists repeated predictions of doom for Canada’s biotechnology industry, I did not see any bodies in ditches or vultures circling.
Nor do I expect to in the near future. This biotechnology value investor believes in the Canadian life science sector and expects to be here for a long time.

I have been investing in Canada since launching the Special Situations Life Sciences Fund in 2005. During that time, I have met with the senior management teams of almost every public biotech company in Canada, participated in and led strategic deals for Canadian companies, spoke on panels at industry conferences and took a board seat with a Toronto-based diagnostics company. Seen close-up, on a size-adjusted basis, the Canadian biotechnology industry is the equal of any life science sector in the world.

Unfortunately, public companies do not easily size adjust, particularly when the availability of risk capital is tight. So despite the strengths of the building blocks of Canadian biotech, the excellent scientists, sophisticated infrastructure for the protection of intellectual property and the efficient collaborations between industry and academia, many individual firms face drastic revision of their business plans. Even the smallest companies need five million dollars per year for administrative, executive, legal and compliance expenses, a figure that, when multiplied by 72 (the number of Canadian public biotech companies, according to Ernst & Young), far exceeds the amount of funding raised industry-wide in all of 2008. 57% of Canadian biotech companies started 2009 with less than half the amount of cash in the bank than they had burned through in 2008.

Business development has always been difficult in biotech, with its long product development cycles, constant need for re-infusions of capital and frequent disconnects between the timing of individual companies’ value inflection points and the availability of risk capital. Biotech executives spend sleepless nights pondering the choice between raising money at a low stock price when a funding window is open or waiting for the clinical trial result, partnership agreement, grant or other value inflection while hoping that the funding window does not shut in the meantime.

Since most biotech companies exist through a pattern of serial equity raises, there is a continued shuffling of assets, through partnerships and acquisition, between the cash-rich and the cash-poor. These companies continue to function based on the willingness of a well-informed investment community to fund them, an investment community that for the past year has been withholding funding while it sorts out the most efficient allocation of its dollars in a volatile environment. As clarity emerges in terms of economic stability, and we are better able to judge the effects of the combined public and private sector responses to the financial sector crisis, investment capital will flow back into the most promising of the technologies under development.

Will some companies fail to survive the next twelve months? Of course, just as some have failed to survive the prior twelve months and each twelve-month period before this one. While the Canadian biotechnology industry is filled with brilliant people passionately pushing forward applied science, it also has many companies with thin pipelines (often one drug), redundant management teams, regulatory obligations disproportionate to their cash balances and chief executives who spend much of their time on the road raising money.

How did this structural volatility come about? The market was actually over capitalized in the early 2000’s, as speculative investment rotated away from computer and information technology and into life sciences. Mirroring the experience with internet start-ups, too many companies built upon expertise in genome sequencing and molecular design appeared, flush with cash but with no clear path to revenues or profitability. Some of these companies ultimately evolved their business plans, and developed products or services to generate revenue. Others saw their assets absorbed by acquisition or out-licensing, and a number ceased to exist due to clinical failures or inadequate funding. Seen in this context, the current market conditions represent a severe downward swing in a repetitive cycle.

Thankfully, market conditions have improved since early spring. Biotechnology started to recapture investor interest in April, after Dendreon reported unexpectedly good results for their prostate vaccine. Biotech strength continued into ASCO, and gained momentum with the unexpectedly approval by the FDA of Vanda’s anti-psychotic drug Fanapt, after it had been left for dead as a result of a non-approvable letter from the FDA. A steady stream of secondary and registered direct stock offerings followed and continued into June. Biotech stock prices rose above cash levels in the United States. While interest in Canadian biotech companies has only just started to reemerge, the second half of 2009 should see a reopening of the financing window for small Canadian biotechnology companies.

These deals will be particularly attractive to investors because most Canadian life sciences companies have responded to the difficult market conditions by undergoing strict and disciplined cost-cutting measures, and stand mid-2009 is much more viable enterprises than they were a year earlier. Pipelines have been streamlined, preclinical development has been curtailed, and unprofitable or unpromising programs eliminated.

This combination of improved efficiency, low valuation, and low expectation, make the Canadian biotech and life sciences sector extremely attractive place to invest. The industry has responded to tough times in a way that makes it inevitable that risk capital will flow into it in the industry will bounce back.
How can companies best positioned themselves to benefit from this reopening of the financing window? From the point of view of a fundamental, institutional value investor who focuses on small cap stocks, several factors, including deal structure, deal size, and the resulting length of the financial runway, differentiate attractive deals.

Deal structure is critical. We prefer straight common stock, with or without warrant coverage. When valuing companies, we prefer to look at the fully diluted share count, taking into account all outstanding options, warrants, and stock needed to fully convert outstanding convertible debt. Rarely will we invest in the company that has a significant convertible debt. We have found that the convertible often places a ceiling on the stock price, close to the conversion price of the debt. Convertible arbitrage by others effectively makes the common stock a derivative security, and the company’s market cap movements become dissociated from fundamental changes in underlying value. Similarly, holders of in-the-money warrants have the ability to short sell the stock without risk. Large outstanding warrant pools can blunt any rise in market valuation that would be expected from normal fundamental events.

How much money should acompany raise? Much depends on how a deal is structured. TSX and the TSX Venture exchanges limit the number of shares that can be issued if shares are sold at a price below the market price. As investors, we are less concerned with the number of shares issued than we are with the length of the financial runway that the new money will give to the company. Ideally, the company should raise two years worth of their cash burn. Further, the money raised should be more than sufficient to fund operations through more than one value inflection point.

Canadian biotech will indeed create much value in the years to come. The industry will weather the current volatility, maintain its competitiveness and remain an important destination for investors and global partners.