David H. Crean, Managing General Partner for Equitos Venture Partners and Cardiff Advisory, highlights the latest trends and recommendations for business and corporate development transactions and capital financing of life sciences companies in 2022.
We are currently experiencing economic headwinds, making it a challenging time for growth companies such as in the biopharmaceuticals and medtech sector. Public equity markets have been heavily impacted in H1 2022 over inflation (currently at 8.6%), the war in Ukraine, supply chain issues and the Fed’s monetary tightening and move to raise interest rates, making the cost of capital more expensive, with more raises expected over the course of the year. The biotech-heavy Nasdaq is having its third largest drawdown in 20 years, with many high-growth stocks losing two years of price appreciation. As of mid-May, biotech was down by about 60% from its high in February 2021 (SPDR S&P Biotech ETF (XBI)).
Last month, one of Silicon Valley’s most successful venture capital (VC) firms, Sequoia Capital, sent a message to all its portfolio companies warning them to tighten their belts as a result of the macroeconomic conditions faced by growth companies. Sequoia laid out numerous risks making it harder for founders to raise money and operate, calling it a “Crucible Moment.”
Sequoia’s letter comes at a time when many VC and private equity firms (PE) are sending out messages to investee startups, advising them to cut excess costs, hire conservatively, and focus on profitability. PE/VC firms are also suggesting startups that need funds to survive to raise immediately without negotiating much (i.e., investor friendly terms), or be open to flat rounds, to sustain.
Capital Markets and Valuations
The VC sector had two record years in a row in 2020 and 2021 with regards to fundraising, investment and exits. However, like the rest of the investing world, the market has cooled in 2022. Initial public offerings (IPOs) and special purpose acquisition companies (SPACs) and their deSPAC transactions have stalled. Many experts expect a significant portion of SPACs in the market to not find a deal and end up returning capital to IPO buyers. Valuations in the private capital markets are now being closely evaluated by investors as they watch the declination of valuations in public equities with many public companies trading at or below cash levels creating negative enterprise values.
Data from Hany Awadalla of LifeSci Capital highlights the challenging market faced by publicly traded US listed biotechnology companies in 2022 (as of mid-May) versus prior two years.
The pricing dynamics playing out in public markets are also happening in private markets to varying degrees across asset classes and industries, although it may take several quarters for this to show up in the data. Assets that gain most of their value from expected revenue and earnings growth are more sensitive to increases in discount rates and changes in implied growth rates, given that cash flows will be realized well into the future. The onset of significant inflation and subsequent increase in interest rates have thus challenged the feasibility of future revenues and cash flows in the private market, increasing discount rates, and causing the repricing that we are seeing in public markets. Therefore, a sharp, rise in interest rates is not favorable for companies that rely on cash flows far into the future to justify their current market capitalization.
As of the end of Q1 2022, we are in a wait-and-see pattern for Q2 data. The US VC Valuation Report by Pitchbook for Q1 has yet to show any significant declines because of the illiquidity private ownership affords these companies as well as the slight lag in data collection. For example, median pre-money valuations in Q1 2022 for biotechnology and pharmaceuticals are broadly unaffected relative to 2021 for most segments, except for late-stage VC, which has already started to display some signs of valuation decreases at the median. Time will tell if a valuation reset will eventually trickle through to VC-backed businesses at the angel, seed, and early stages.
Life sciences VCs appear to be putting more emphasis on building early-stage syndicates that can finance a company through multiple rounds. In times where there is an abundance of capital, such as in 2020, private biopharma companies are not only able to raise large series A rounds from dedicated early-stage VCs, but they often add new investors at series B. In recent years that has meant that while early-stage VCs have often continued to invest in portfolio companies through later rounds, those syndicates and accompanying valuations were larger to accommodate the interest of crossover or institutional investors. But the steep sell-off in the public markets, which initially had some crossovers redeploying funds to earlier-stage investments, has since restricted the ability of some of these crossover investors to continue to participate.
Strategic acquisitions and partnerships are likely the most stable group of options. Over the last few years, pharmaceutical M&A and strategic partnerships hit record highs as larger companies turned to young biotechnology companies for innovation. Often, these deals focused on cancer, rare diseases, and immune system disorders — areas of drug research that were seeing major victories in clinical trials and huge profits for treatments that made it to market. DealForma’s Chris Dokomajilar stated that one clear trend is a steady, brisk pace of licensing deals.
In terms of M&A, we are doing better than the same period in 2021. But buyers seem content to wait it out for de-risking data releases rather than rush in to buy up targets in a miserably weak market. Balance sheets of active acquirors are strong and they can be patient to a certain extent.
Recommendations for the Road Ahead
While we have shed some light on where markets and economies are today, the more significant question is always what happens going forward and recommendations for adjustment. Overall, there is still plenty of dry powder available to support existing portfolios, though that will vary from fund to fund.
At the time of this writing, the Chicago Board Options Exchange (Cboe) Volatility Index (VIX) has a high reading of 28. As a rule of thumb, a VIX reading below 20 suggests a stable and low-risk environment. Until inflation eases, volatility is expected to persist in liquid assets. Second, opportunistic investors and buyers will look to take advantage of quickly falling valuations.
Inflation and rising interest rates can be destructive to investment returns, but Limited Partners (LPs) are tactically eyeing cash and less risky asset classes, and private debt for potential areas of relief. Expect net cash flows to stay negative, putting a damper on LP fund commitments. Institutional investors will typically pause to assess the situation, hold steady in their long-term thinking, and think about tactical ideas only around the margins. General Partners (GPs) should be patient with LPs, settling in for a longer fundraising cycle and taking good care of their existing portfolios.
As a result of the difficulties in raising capital financing, expect to see more openness by companies to do early-stage collaborations, partnerships or M&A with large or mid-sized pharmaceutical companies in order to realize or bring in more value,. When capital financing markets are challenged, companies are encouraged to run parallel processes of seeking partnerships and/ or M&A to ensure their growth or exit goals are accomplished.
Peter Kolchinsky, founder and Managing Partner at RA Capital Management, recently published an article with colleagues and provided guidance to executives and boards at biotechnology companies. The authors noted that we should recognize the true measure of the world’s appreciation of the life sciences ecosystem is not the valuations of development-stage companies but the demand from patients and physicians for the products those efforts ultimately deliver. Big and mid-sized biopharmaceutical companies are generating more in revenues than ever before and they must remain acquisitive of new drug candidates to replenish their pipelines ahead of patent expiries. So, what we are experiencing now in the biotech sector is not a fundamental failure to create or realize value but a working capital problem we can get through prudently.