Mergers and acquisitions activity in Canada: Is it a solution to the funding crisis?

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By Michael Herman

At the recent BioContact Symposium in Québec City, I overheard a conversation between the CEOs of two Canadian biotechnology companies. The CEOs had just attended a seminar on innovative funding strategies in the new economy. One of the CEOs said to the other that while the seminar was interesting, he did not hear the speakers say anything that was going to help him solve his company’s acute immediate funding crisis. I was struck by the frustration and resignation in this CEO’s voice. I do not think he was criticizing the speakers. Rather, he was acknowledging an unfortunate reality in today’s environment that no one seems to have any good answers to the question of where he can find funding to keep his company alive.

Funding Crisis

By now, everyone concerned with the life sciences industry in Canada is aware of the funding challenges facing biotechnology and other life sciences companies. According to BIOTECanada, more emerging technology firms than ever are operating with less than six months of cash and a majority of small, emerging companies have less than one year of cash. In the United States, where the environment is better than in Canada, an estimated one third of public biotechnology companies have less than one year of cash.

Even in so-called normal times, access to funding is the number one issue identified by life sciences companies. However, since the financial crisis began in 2008, there have been almost no financing sources available to provide even short term access to the cash needed to keep many companies afloat. Venture capital in Canada, which was struggling before the financial downturn, has dropped to lows not seen in 15 years. Until very recently, the public markets were completely closed to companies trying to raise funds. While many provincial governments have introduced programs in an attempt to stimulate investment, the life sciences industry was all but ignored in the massive economic stimulus package announced by the federal government earlier this year. While a few companies, such as Enobia Pharma and Allostera Pharma, do attract financing, far too many companies are unable to find the funds they require.

There are tentative signs that perhaps the funding environment has hit bottom. U.S. venture capital investment in biotechnology has shown a marked improvement over the past few months compared to earlier this year. There have also been signs that the public markets are opening up. Secondary offerings by U.S. publicly traded biotechnology companies have significantly increased over the past few months. Seattle-based Omeros Corporation and North Carolina’s Talecris Biotheraputics are the first biotechnology companies to go public since February 2008. In fact, the Talecris offering of U.S. $950 million is the second largest U.S. IPO in 2009. At this point, Canadian life sciences companies can only hope that the venture capital and public market trends in the U.S. will migrate to Canada sooner rather than later and that the recently launched provincial government programs will be effective in generating new investment.

In the meantime, well meaning service providers like me advise life sciences companies to focus, devote their limited resources to reduce their “burn rate”, monetize non-core assets if they can and explore project-based financing and non-traditional funding sources such as private foundations. In my view, it is remarkable that so many Canadian life sciences companies have survived as long as they have in this severely constrained funding environment. Unfortunately, as the CEO at BioContact so succinctly noted, what we cannot do is actually find money that does not exist.

If traditional funding sources have more or less dried up, what about strategic alliances or an outright sale of the company as a means to raise funds? What about the M&A option?

Mergers and Acquisitions

Why is M&A Attractive?
At the end of 2007, I suggested that while the life sciences industry had been a late comer to the mergers and acquisitions frenzy of the mid-2000’s, it was likely life sciences M&A activity would continue its upward trajectory even as the global boom in general declined (although I admit I had no idea just how much of a decline we were about to experience). Unlike the general M&A market, activity in the life sciences sector was not led by private equity funds and other financial buyers.

Private equity funds traditionally shied away from the riskier, longer term horizons of the biotech sector. The principal buyers of biotech companies have been strategic investors, in particular the big pharmaceutical companies which have shifted strategic direction and have been looking to fill their product pipelines through the acquisition of biotech assets. These companies face the reality that many of their blockbuster drugs will be coming off patent over the next few years, and many do not have sufficient replacements in development.

Biotech companies with young, entrepreneurial developers and promising technologies offer access to a broader range of potential new products at a reasonable cost. Diminishing pipelines and increasing pricing pressure from purchasers also fuels consolidation among pharmaceutical companies trying to create the required critical mass to compete effectively on a global basis. Biotech companies have become more willing to sell, principally because of their funding difficulties. The large pharmaceutical companies with very strong balance sheets have not suffered from the extraordinary contraction in the credit markets which slowed the global M&A boom in general.

They have continued to search out attractive acquisition targets to help them address their strategic and competitive challenges.

In 2008 and 2009, M&A activity in the pharmaceutical and biotechnology sectors outside Canada has been extraordinarily robust. In 2008, M&A transactions involving U.S. biotech companies exceeded U.S. $28.5 billion, a record if mega deals are excluded. In addition, the potential value of strategic alliances involving U.S. biotech firms reached an all time high of almost U.S. $30 billion, although much of that value is unlikely to be realized. In 2009, there have been pharmaceutical mega deals, such as the Pfizer acquisition of Wyeth and the Merck acquisition of Schering-Plough, and pharmaceutical/biotechnology mega deals, including Roche’s acquisition of the Genentech equity it did not already own and the recently announced Abbott purchase of Solvay Pharmaceuticals. And the record pace of smaller biotech firms being acquired by pharmaceutical companies or larger biotech companies has continued with new deals being announced it seems on almost a daily basis.

M&A in Canada
A year ago, I predicted M&A activity in Canada would also be strong in 2009 and advised life sciences companies as follows:
It is likely to become even more difficult for life sciences companies to raise new or follow-on on funds in the months to come. Companies need to carefully assess whether they can delay or reduce the costs of their development programs to conserve as much cash as they can. Companies that do attract venture capital interest will discover that the terms offered to them will be much more onerous than they would like. Many companies will not be able to reduce their cash burn rates sufficiently or raise new funding. For these companies it is important that they evaluate their situations soberly and realistically. The one silver lining in all of this mayhem is that the M&A trend in life sciences, especially for biotechnology companies, will continue its upward trajectory. Big pharmaceutical companies are still looking to fill their product pipelines by acquiring or otherwise locking-up biotechnology assets.

Licensing arrangements, strategic alliances or partnerships and outright sales to pharmaceutical and other strategic investors may be the most effective way for many life sciences to keep their products alive. If these companies wait too long to consider and pursue such opportunities, they may run out of both cash and time. The best advice for such companies may be that, until the funding environment improves, careful evaluation and assessment of possible M&A transactions should become an integral part of their ongoing strategic planning.

And yet, for some reason, the M&A activity occurring in the U.S. and globally has not been mirrored in Canada at nearly the levels I would have expected. It is difficult to determine exactly why we have not witnessed M&A activity in Canada comparable to what is happening elsewhere. There have been a few deals, notably Vertex’s acquisition of Laval, Quebec’s Virochem, and collaborations and strategic alliances have increased relative to the very low levels of 2008, as companies such as Cardiome and AEterna Zentaris completed agreements allowing them to proceed with their development programs. Nonetheless, the activity has been proportionately less than in other jurisdictions.

In the PricewaterhouseCoopers Canadian Life Sciences Industry Forecast 2009, Canadian life sciences executives cited valuation issues, conflicting management personalities and lack of interest from large firms as the main barriers to M&A. Based on the survey responses, PricewaterhouseCoopers predicted, more accurately than I did, that 2009 would be another year of relative quiet on the Canadian M&A front. Interestingly, nearly two thirds of the executives still think being acquired or participating in a merger is the most likely scenario for a successful Canadian life sciences business.

Presumably, valuation issues and management personalities are challenges faced by buyers and sellers everywhere and are not limited to Canadian companies. To address the valuation gap, acquisitions with earn-outs have become fairly common even for public companies. Another creative solution to the valuation problem has been the option-based acquisition. For example, in early 2009, Ception Therapeutics, backed by Canadian venture capital fund, Lumira Capital was paid U.S. $100 million by Cephalon in exchange for which Cephalon has the option to acquire Ception for an additional $250 million based if Ception achieves certain milestones. Other transactions have included similar staged buyout structures where an up-front payment is made in exchange for an option to buy the entire company upon achievement of specific thresholds.

As for management personalities, in the past few years, big pharmaceutical companies have committed to maintain the management teams and cultures of biotech firms they acquire. They recognize that the smaller, nimble teams are better at developing new products than the large bureaucratic organizations which exist within their large multi-national organizations. Further, conflicting management styles are a challenge in almost any merger transaction.

Lack of interest by potential buyers may reflect a combination of factors. While there have been some significant transactions in Canada in recent years, including Roche’s acquisition of Arius Research in 2008, it is quite possible that big pharma has not actively devoted time, effort and people to assessing opportunities in Canada. Further, the pharmaceutical companies are interested principally in more mature companies, which have at least one product in Phase II clinical trials or have products or services generating revenue and profits.

It is possible many Canadian companies are still at too early a stage in their development to attract interest. A third possibility is that Canadian life sciences companies have not been sufficiently aggressive in seeking out potential buyers. The major pharmaceutical firms continue to announce publicly that they remain active in seeking out good acquisition opportunities. In the current environment, one would expect they are being inundated with business plans of companies looking to make a deal. To get their attention, a company must not only have a breakthrough product or technology; it must be persistent in pursuing potential buyers. Waiting to be approached will not work. I cannot say for certain Canadian life sciences companies have been less aggressive in looking for buyers than in seeking venture capital or other forms of funding; if they have, they need to recognize that they must become much more proactive in seeking out possible deals.

Conclusion

BBIOTECanada’s annual opinion poll reveals 9 of 10 Canadians believe the biotechnology industry is an important part of Canada’s future economic prosperity. Some argue that Canadian life sciences companies being sold to U.S. or other foreign buyers is a negative outcome, a “hollowing out” of our science and technology sectors. It is suggested a more realistic assessment would recognize that, according to the Tufts Centre for Drug Development, the average capitalized cost to bring one new product to market is U.S. $1.3 billion, an amount which many industry experts suggest is very conservative. It is most unlikely many Canadian life sciences companies will ever be able to complete this process without having to sell their businesses or enter into strategic alliances, either of which will result in much of the underlying products or technologies being owned or controlled by foreign entities. This does not mean Canada cannot have a vibrant and sustainable industry, contributing significant research and development and other value-added components to the global life sciences industry. In these times of financial and economic uncertainty, would we prefer to have important and meaningful activity occurring in Canada or see companies close their doors due to lack of funds and have the crucial scientific and managerial talent leave Canada completely?

Michael Herman is a partner in the corporate finance department in
Gowlings’ Toronto office, practising in corporate finance and business law. He is also the vice chair of the firm’s Life Sciences Industry Group.