Even though we know at the closing bell on December 31 how the public equity indices performed in any given year, for institutional investors whose portfolio includes a significant allocation to private partnerships—private equity, venture capital and hedge funds—it is not until reporting season in the early Spring when investors get their first real sense of their overall investment performance for the preceding calendar year. Annual reporting season has never been more important and probative than it is this year, 2009, when limited partners (LPs) learn how the disastrous performance of the public markets in 2008 (e.g. NASDAQ down 41% for the year, and nearly 25% in Q4 alone) and the global economy generally, impacted the value of their investments in private partnerships.

Investors’ expectations for private partnership performance in 2008 have been bleak and unfortunately, as the year-end results trickle in, these expectations are being realized. These losses are even bigger than downturns past due in part due to the introduction of FAS 157 which requires investors to mark non-public investments to market—in this case, a market in free fall. What this means is that even heavy-hitters in private equity are feeling the pain—highly regarded funds Blackstone and Permira reported losses of 35% and 36% respectively in 2008 (1).

These losses, coupled with the losses in the public portion of investors’ portfolios has had a profound impact on many investor’s capital base. . Calpers, has reported a loss of more than $69.7B in 2008, or 25% of its $253B under management (2). Similarly Harvard’s endowment is expected to see a 30% loss on its capital base of $36.9B (3). As a result, investors have been spending much of Q1 2009, and likely the better part of the first half of this year re-evaluating their asset allocation and overall investment strategy to determine whether they should maintain some semblance of their historical allocation or make significant changes to their capital allocation. Investors are most notably scrutinizing their private equity and venture capital allocations, part of their alternative asset bucket, to determine whether the returns of these asset classes justify the complexity, long-term commitment, and illiquidity associated with maintaining a diversified private partnership portfolio within the context of a comprehensive investment strategy for both the short and long-term.

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Box 1: Key Considerations for LPs in Determining Asset Allocation

1) Returns, returns, returns. Private partnership returns are often described as a combination of internal rates of returns (IRRs), and multiple. IRR’s capture the performance of an investment as a function of time, and multiple, the dollars returned on money invested. Contrary to venture investor legend that LPs only care about multiple, both multiple AND IRR matter to LPs. I will take an IRR of 41% any day over an IRR of 7%. While both will double my money eventually, at 41% it will double in two years versus the ten years it will take at 7%. That being said, multiple is of equal importance–LPs shy away from high IRR without a corresponding multiple, as this suggests high capital turnover which is both tax inefficient as well as requiring LPs to indentify new investment opportunities to allocate the capital more frequently. With billions of assets under management (AUM), LPs want to limit portfolio turnover and lock-in a projected return as part of their diversified portfolio.

2) Complexity. Managing a private partnership portfolio and the inflows and outflows associated with the asset class gives rise to multiple areas of complexity, the one most prominently highlighted on today’s front page being the “Denominator Effect”. In brief, LPs allocate to each asset class on a percentage basis of AUM. If their AUM drops while an asset class (e.g. venture) retains its value, its percentage, as a percentage of AUM, increases. Since many investors’ investment activity is tied contractually, by statute or by its governing body, to operate within certain parameters (e.g. no more than 1% of your portfolio can be in venture capital), the large losses incurred in 2008 in certain asset classes may force LPs to sell a portion of its assets to bring their holdings back in line with the percentage approved in their charter, or halt additional investments in new funds until the AUM increases to pre 2008. This means LPs could be forced to sit out of certain asset classes in the 2009/2010 timeframe, exactly when they should be buying; or selling aggressively written-down interests in a period when secondary funds can virtually dictate the price.

3) Long-term commitment. Market perception, sentiment and overall market psychology play a significant role in determining LP allocations–see the recent bubbles in private equity and the complex sub-prime funds that in hindsight few understood but many invested. If LPs believe a certain asset class or sector is positioned to outperform in the coming years they will flock to invest. Look at the recent surge of LP investments in secondary equity & debt funds. Unlike other asset classes, however, it is not easy to move in and out of private partnerships. Given how the hottest areas of 2007/2008 became toxic seemingly overnight, LPs are questioning the value of being locked into a strategy for a decade or more.

4) Illiquidity Premium – to justify the 10 year plus capital commitments by LPs to venture funds in addition to the risk associated with those commitments including the inability for investors to “withdraw” their funds without significant penalties, LPs need to realize a return in excess of short term investments, namely the illiquidity premium. If they cannot get comfortable on this they are less likely to invest in the fund.

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In this analysis, how does biotech venture measure up?

So what will LPs see when they scrutinize the alternative asset allocations of which biotech venture is one – how do biotech venture and private equity returns compare to their peers?

If LPs were to base decisions on Wall Street Journal front-page headlines or the performance of the BTK (the biotech index), the future of biotech as an investment class is guaranteed. While the global market has been bemoaning the loss in value of all major banks, the performance of AIG, Citigroup, UBS, Goldman Sachs, GE, …..the list goes on…biotech and pharmaceuticals have been a hot commodity with Roche announcing a bid of $46.8B for its unowned share of Genetech, Gilead announcing the acquisition of CV Therapeutics for $1.4B, and Cephalon announcing the option to acquire Ception Therapeutics for $350M. Pharma companies too have been busy with Pfizer buying Wyeth for $68B and Merck acquiring Schering-Plough for $41.1B, a premium of 14.7% & 34% over their trading prices respectively (4). The BTK has also performed well, relative to other indices, realizing a drop of -18.35% in 2008 and a growth of 1.7% in Q1 2009 compared to the granddaddy of the tech market, NASDAQ which realized a -34.3% drop in 2008, and -0.63% drop in Q1 2009.

This data only tells part of the story, however, as LPs that drive venture investments are less focused on the public market returns and more focused on the returns, both multiple and IRRs, from their venture investments. Looking at this data also presents a compelling case for biotech venture. As an asset class, biotech venture has performed surprisingly well, outperforming many of its venture peers consistently since the beginning of 2000. Two reports recently published (5 and 6) by Cambridge Associates, a leading independent consulting firm (whom LPs rely on for consulting and advisory services pertaining to fund and asset class diligence and returns) outline the returns over the period of 1995 to 2007 with a terminal IRR data of Sept 30 2008, the data from venture and PE investing, on a per sector basis and total, is shown in Table 1. The numbers correspond to the realized and unrealized US venture capital and Biotech/Biopharm/R&D Private Equity, dollar weighted, IRR on vintage year companies. It is the pooled gross mean of companies receiving initial investment in the year indicated. So the Biotechnology/Biopharm/R&D 8.81 in 2001, equates to an IRR of 8.81% which is the mean, dollar weighted, IRR for Biotechnology/Biopharm/R&D companies where the first investment was made in 2001.

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BOX 2: Limitations of the data:
1) This data is both realized and unrealized returns, i.e. for companies that have not been exited or liquidated it is the projected exit price for funds based on last round, current fundamentals of the company and comparative analysis;
2) The numbers are the mean numbers and not median, however it is dollar-weighted thereby weighing more towards large investments than small seed investments. This is relevant to biotech investments given the binary nature of R&D where successful companies attract significant premiums (Domantis’ sale to GSK for approx $350M, Adnexsus’ sale to BMS for $430M, Alantos Pharmaceuticals sale to Amgen for $300M compared to SGX’s sale to Eli Lilly for $64M and Memory Pharmaceuticals sale to Roche for $50M (4)). Given the nature of venture investing where you “swing for the fences” in nearly every deal the mean return numbers are more relevant to the larger funds where multiple investments are made;
3) Returns are gross returns, which does not subtract the management fees and carry paid to the fund managers. However given fees in venture charged by managers and the fund life are relatively consistent, (2% management fee, 20% profit share and 10 year term) this will have limited impact on each sectors net returns when comparing across private partnerships;
4) Data is until end of Sept 2008, this does not incorporate the greatest decline in the markets (NASDAQ lost 24.61% from Oct 1st 2008 to year end). While the BTK outperformed the market to year end, biotech microcaps and biotech exits were significantly impacted;
5) 2007 numbers are unrepresentative of final returns as it is too early to tell given the overall investment life for a biotech company. As such 2007 data has been largely ignored in this article.

On a positive note the data takes time to exit into consideration (a key driver of IRR), given the long investment cycle for biotech versus other sectors this is especially relevant and has been an argument used on many occasions for not investing in biotech venture.

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An analysis of the data suggests –
1) Overall biotech venture investing, on a per company basis, has performed well consistently outperforming the majority of its peers since 2000 including Information Technology, Software/Services, Media/Communications, Electronics and Chemical/Manufacturing venture investing. Energy and Consumer/Retail are the only two sectors that consistently outperformed biotech venture investing;
2) Over the period 1995 to 1999 biotech has performed solidly however the biotech venture industry has not seen the mean IRR returns that other sectors have generated during that period suggesting that the biotech industry may not as yet have come of age (discussed below). Information Technology realized IRRs in excess of 200% for companies invested in 1997 and 1998, while Software/Services realized IRRs of circa 100% for investments made 1995 to 1998, both returns likely capturing the tech bubble of 2000.
3) The greatest returns for biotech venture investing came from companies where the initial investments were made in 1999, pre-tech bubble when the stem cells had just been isolated, Herceptin had been approved by the FDA in the prior year and the human genome project announced the completion of the first full length human chromosome sequence (CHR 12);
4) It is interesting to note that the number of biotech companies invested in per year exceeded 10% of the total number of companies that received venture investing in any year from 2001 to present. This large number of companies are likely to have smoothened out the returns on a year to year basis given the largely binary nature of biotech venture returns. The number of initial investments remained steady even post 2001 at around 200 new investments per year;
5) Interestingly venture biotech investing has performed well against private equity PE investing (as defined by Cambridge Associates) in the biotech space. It is too early to tell the long term interplay between both approaches.

What does this mean?

In the microcosm of venture investments (taking into consideration the caveats outlined in box 2) biotech venture investing has rewarded Limited Partners (at least on paper) above many of their other venture investments and should justify a continued allocation within alternative assets. Assuming LPs continue to believe these returns warrant the illiquidity and risk, this is promising for serial entrepreneurs who rely on venture funding to build their biotech companies in addition to the general partners that may need to raise new biotech venture funds in the coming 24 months. However on the macro level, LPs will compare these returns against other asset classes including high yield, buyout, REITs and emerging markets, weighing returns versus beta and illiquidity ie their ability to rotate capital in and out of specific investments in line with the ebb and flow of the market.

With this in mind, biotech venture investors should not become complacent. While pooled mean company returns are positive they are not stellar, not rewarding LPs for the risk and illiquidity in the near term. We are already beginning to see the fallout with a number of high profile funds being unable to raise capital or raising materially smaller funds than previous. For those funds that have raised in the past year, concern remains on capital calls as to whether LPs will meet their ongoing obligations.

The near term remains challenging with IRRs continuing to be impacted by:
1) Time to exit – current R&D tools have significant limitations driving time to clinic and attrition rates. Compounding the issue are the current venture fund structures, which tend to be 10 year (with 2 year extension) terms whereby funds must return capital to investors at the end of the term. Given the time it takes to diligence and invest (6 – 9 months), hire a management team (6 – 12 months), and establish the infrastructure for drug screening (up to 12 months), it can take more than 12-24 months from an investor seeing the concept to the initial library screen against a target from which the 10-15 year drug development timeline begins. There is significant tension between biotech company evolution and the venture fund clock. Compounding the issue is the stage at which the public market provide liquidity in addition to additional capital resources. In 2000 62% of all US biotech IPOs were preclinical stage companies, this decreased to 8% in 2004 while no biotech companies that IPO’d in 2007 were at preclinical stage (7) requiring investors to hold companies for longer periods of time and providing significant capital reserves to point of exit. The structure of pharma acquisitions are also changing with pharma leveraging option and earnout structures making it more difficult for investors to realize the full extent of their returns and complicating LP distributions;
2) Capital requirements – drug discovery and development is an expensive business costing an estimated $1.2 – 1.4B per approved drug (8), while no venture investor ever comes close to investing this amount of money in a single drug the cost to proof of concept from business plan is substantive. As such investors are forced to support companies with significant capital infusions over an extended period of time.
3) Attrition rate – of every 200 drugs that enter preclinical development, 5 go on to clinical development of which only one goes to approval (9). This high attrition rate results in the cost of drug discovery ballooning from $400-500M per drug to over $1B, in addition to the added cost of rescreening and developing backups as lead candidates fail. A key driver of this attrition rate is the lack of predictability of potential drug success in pre-clinical pharmaco-tox and clinical trials. In the absence of high throughput toxicology, in silico tox modeling, human disease relevant animal models, patient population targeting and early human trial indicators of success, this unsustainable attrition rate is unlikely to fall;
4) Exits – venture investors have limited exit options with two primary strategies driving the vast majority of returns, acquisition by pharma or large biotech and public listing with the subsequent sale of venture equity into the public market. While these have provided consistent exits for investors they are dependent on the whims of the pharma industry (an industry that is contracting as a result of the recent M&A activities) which appear to change on a regular basis, through to the health of the public markets which today are being challenged. Without these exits investors either cease operations of the portfolio company (becoming a more regular event in today’s market) or invest additional capital in the hopes of generating additional data to attract acquisition or providing runway to wait out the capital markets. No matter the decision the funds IRR is being impacted;
5) Regulatory oversight – the regulatory environment remains a maze stuck in time, failing to evolve at the pace of modern technology for today’s drug discovery and development techniques. The 10-15 year drug development time is driven in large part by the demands of the regulatory bodies. FDA has been slow in providing direction to the biotech community especially around antibiotics, new therapeutic approaches, follow-on biologics, diabetes/obesity compounds and biomarkers. In addition PDUFA dates have become irrelevant with the FDA routinely extending review times. However the fault does not solely lie at the FDAs door but lies both at biotechs door as it relates to their work and support with the FDA in addition to limited funding for the scope of work they are asked to complete;

In addition revenues from drugs already approved are set to be squeezed by threatened new legislation from the US government possibly reflecting the oversight for drug reimbursement exemplified by NICE in the UK.

Collectively these issues are the central drivers investors point to for stifling innovation through private investment. To continue to exploit the observations and discoveries made in academia and among our entrepreneurs we need to explore alternate strategies for biotech investing. Strategies to consider on the venture side include:

1) Changing venture fund structures – extending the life of venture funds from 10 years to 15 years, while making them larger to support the capital requirements. Extending the term of funds will reduce the time pressure on investors and with additional capital enable them to support the companies for the extended periods of time. This concept is already captured in evergreen funds where the capital is recycled with no term limits on investments. However extended times further compromise IRRs and increase the illiquidity risk to LPs;
2) Syndicate structures – the current concept of the syndicate is antiquated, venture investors should consider building syndicates from day one that collectively carry the company through clinical proof of concept without the need for trawling the market for new investors 2+ years after company has been formed. Positive implications of this include keeping the company focused on internal development versus spending 6-12 months every 2+ years in new financings, managing valuation as investors will only need to value the company at point of exit, removes the predatory late stage investor who recaps the company due to limited follow-on capital being available among the original investor syndicate, and aligns the investors objectives on the returns (removes the need for liquidation preferences);

While good in theory it is unlikely that these suggestions are viable in the real world. Instead we need to explore strategies beyond the venture funds which could include:
1) Working with government and state bodies to provide funding for early stage drug discovery and development under the supervision or control of venture investors;
2) Work with federal government to explore ways to incentivize LPs to invest in venture funds. In this reactionary market psychology can outstrip reality. With SBIC funding at an end we need to motivate LPs to continue to support the high risk venture industry and propose incentives either through reduced management fees, carry, or work with legislators to provide tax incentives for LPs to invest in venture;
3) Actively support the FDA to realize its goal of the Critical Path Initiative which should help reduce attrition rates in drug discovery, potentially reducing clinical costs and time to approval. This will reduce investor capital and risk in the drug development process. In addition proactively lobby the FDA to provide detailed guidelines for therapeutic area and drug class specific clinical development and approval path;
4) Work with state bodies and universities collectively to identify and support the most promising concepts, discoveries and technologies. Leveraging the broad range of skill sets across our academic institutes from target identification in one university to high throughput screening in another to clinical trials in a third. Lack of communication and a network to support this inter-institute interaction is hindering the long term success of these programs with institutes acting in silos reinventing the wheel each time.
5) Public:Private partnerships explore strategies for public private partnerships similar to the Californian stem cell initiative (Proposition 71). The money raise through the bond issue will be used to fund early research and help support the formation of new companies. Active participation by venture investors will help make these partnerships a success.

In the near term traditional venture investors can explore alternate investment approaches including secondaries, convertible debt structures, recaps and venture investments in public entities to help maximize IRRs in the current market conditions. In addition to showing LPs that venture investors are versatile being able to respond to market dynamics thereby maximizing the LPs returns.

Biotech Venture—A break out strategy for the future.

Looking back, biotech investors have much to be proud of, we have provided a consistent return to investors, employed countless numbers of highly educated and skilled workers and have helped bring many new drugs to the market while uncovering the mechanisms of disease and therapeutically relevant points of intervention. Nonetheless, the best of biotech is yet to come.

Investors reviewing their portfolio allocation and investment strategy should continue to allocate to biotech in their high risk/high return opportunity bucket. Biotech is a strategy that “swings for the fences.” It’s wins are homeruns; its losses, extreme. The industry is still evolving and has yet to realize its true value potential. In a world where obesity and heart disease is epidemic, cancer continues to be unbeaten and infections remain prevalent new drugs will be always welcomed by physicians. Developments in stem cells, MDx, new drug modalities, new chemistries and the pending uprising against the cost of drug discovery and development in the shadow of unacceptable attrition rates, will force the industry and regulatory bodies, if galvanized to action, to address these issues. The current recession, through natural selection, will lead to the selection of the most effective companies and investors. As the new investment world emerges, the IRRs of 100% plus that information technology, communications and biotech’s other asset class peers have secured, but have evaded biotech to date are certainly a possibility. As they say “you’ve got to be in it, to win it” this should be our mantra to LPs as we look to the bright future of biotech venture following its emergence, alongside the rest of the market, from this Darwinian selection.

Table 1: US Venture Capital and Biotech/Biopharm/R&D Private Equity, Dollar-Weighted Internal Rate of Return (IRR) on Vintage Year Companies
Pooled Gross Mean of Companies Receiving Initial Investment in:

click to view larger table

As of Sept 30th 2008
Data reproduced with the kind permission of Cambridge Associates

References
1) Company data
2) Calpers press release
3) Company statement as reported by Wall Street Journal & New York Times
4) SEC filings & company press releases
5) Cambridge Associates LLC U.S. Venture Capital Index And Benchmark Statistics. September 30 2008.
6) Cambridge Associates LLC U.S. Private Equity Index And Benchmark Statistics. September 30 2008.
7) Johnston Blakely Research, Biotechnology 2009 The Current State of the Industry and its Implications
Tufts Institute Center for the Study of Drug Development
9) Biotechnology Industry Organization

Acknowledgement
I would like to thank Cambridge Associates for allowing me to use the data in this report. I would also like to thank the help of Nina Ross.

Note the full Cambridge Associate reports can be found at
www.cambridgeassociates.com/foundations_endowments/working_together/specialized_expertise/alternative_assets/indicies_benchmarking.html

(Please see accompanying powerpoint)

Following my last post,” Where do we go from here?” where I wrote about potential investment opportunities one of which was the micro cap universe, a number of you asked – “What of the micro caps? Is this a real potential opportunity?”

Rather than engaging in an intellectual debate I dove headlong into the specific data supporting my thesis that micro cap stocks (defined it as companies with market caps of less than $200M) warranted evaluation by investors as a potential investment opportunity.

First I am delighted that I have piqued your interest on this topic. The micro cap universe is an area I have been intrigued by for the past 8 years. Companies such as Isis Pharmaceuticals, RPI (later to become SiRNA) and more recently Lev Pharmaceuticals, have all done their time in the sub-$200M universe or in the case of Lev still were when they were acquired. As those of you who were (or still are) investors in Onyx, this is a company that traded at less than $4, with a market cap of less than $100M, when they were developing 015, an oncolytic virus for cancer, today the company is trading at nearly $30 a share with a $1.6B market cap after successfully developing Nexavar for the treatment of kidney and liver cancer. Isis has also seen lows, regularly trading below $5 with a recent high of $20, valuing the company over $1.6B. My thesis has always been that if you identify a fundamentally sound micro cap company and are willing to hold, you can realize venture returns. However, the benefit of investing in micro caps, unlike venture investments, is that companies having already completed IPOs, have access to a larger investor base and in many cases provide you with liquidity or theoretical liquidity. In addition, there is rarely a liquidation preference or senior preferred shares in place, making follow on financing more palatable for entrenched investors. Finally they are first out of the block on returns when the market reopens, not limited to the lock-ups or other trading limitations that venture investors are used to with venture backed IPOs.

To this end, I carried out an analysis of the sub-$200M market cap healthcare sector across the US and Europe from an overall financial standpoint (part I) and product development stage (part II), in the hopes of identifying some unifying characteristics and potential areas for investment opportunities. In this first piece I analyze the underlying financial state of these companies segregating them based on geography (US vs EU) and market cap, segregating companies into market cap categories of 5-19.9M, 20-49.9M, 50-99.9M, and 100-200M USD based on data as of market close on Dec 10 2008.

The US & EU micro cap universe encompasses 466 companies, the majority, 301 (or 65%), of which are listed in the US with the remaining 165 (or 35%) in Europe, where 55 companies (32%) are listed in the UK (see accompanying slide 13). As a European I cannot hide my dismay when I see the disproportionate number of US companies versus European. There is no reason why we cannot support and fund companies in Europe given the quality of the research, in addition to the quality of the people there. It starkly highlights the question of how we can support the European healthcare sector thereby guaranteeing its longevity and continued growth, however that is a piece for another day.

Back to the task at hand – In keeping with the global market dynamic the valuations of these companies have fallen significantly over the past four months. Surprisingly, in Europe, there has been a slight uptick in the average PPS versus the prior 4-month low, however this is probably short lived with my expectation of further near term declines. In the US, micro caps continue to trade at an “all time” 4-month low, interestingly not a yearly low. Capital starvation is evident across the sector with the majority of companies (>65%) having less than one year of cash on hand. Given the current market conditions we should expect to see significant fallout across the micro cap sector over the coming 12 months as few companies are expected to find financing. In addition these companies are highly leveraged, as a class, with the US universe accounting for over $4B in debt with Europe trailing at $3B. However, on a per company basis Europe is, on average, at a significantly higher leverage ratio compared to their US counterparts.

It is to be expected that these companies are not generating investor attention at the moment, one only needs to look at the Aug 2008 $31.1M financing of Achillion (NASDAQ: ACHN), a company with multiple compounds at various stages of development. The PPS at which the deal was done was $2.9049 per unit (1 common share + 0.25 of an option). Since close, the PPS has dropped to $1.05. That being said the company is well financed as a result of the raise and has enough capital to ride through this down turn. Deals such as this do raise the question of where is the floor? Given we cannot predict where the floor is we should focus on the long term growth potential of these companies and not the short term PPS fluctuations.

Lets take a look at the numbers broken out by geography…..

Snapshot of the Financial Status of the US Healthcare Micro Cap Companies

US Data Analysis

The US healthcare micro cap universe is comprised of 301 companies, of which the majority, 176 (58%), are NASDAQ listed, with 79 (26%) listed on the OTC:BB (see accompanying slide 5). The average age of these companies is over 15 years old; putting this in perspective – it takes nearly 13 years to take an NCE from identification to market (http://dev.innovation.org/archives/DiscMed04-Drug%20Cost-Dickson-Gagnon.pdf) costing up to $1.2B to develop (a number open to debate) (http://csdd.tufts.edu/NewsEvents/NewsArticle.asp?newsid=69), suggesting that some of these companies maybe at a true value inflection point.

In this capital-restricted market over 75% of these companies have less than one year of cash on hand and are already debt-ridden, with the average company carrying between $13M – 50M in debt, category dependent. Interestingly the median debt is low, at between $0.15M and 3.46M per company, indicating that there are a number of highly (over?) leveraged companies out there. One commonality however, is that without a capital infusion and debt restructuring, many of these companies are facing an uncertain future.

Given the range of valuations, is there a category that an investor should focus on first with the potential for a greater risk reward? In essence yes – but not the group I would have initially expected.

An analysis of the current average PPS to the average Hi/Lo PPS of the same companies during the preceding 4 month, 1 year, 2 year, 5 year and “all time” periods, indicates that the most attractive categories based on today’s PPS versus historical, are those within the $5 – 100M range accounting for 83% of the US companies (see accompanying slides 6 – 9). However don’t be fooled by single data snapshots – an analysis of the overall performance of these categories over the preceding 5 years in a market weighted index (see accompanying slide 10) indicates that the $50 – 200M categories are the most market responsive displaying significant value appreciations in H1 2004, H1 2005 and H1 2006. The least attractive category is the $5 – 19.9M, hardly surprising given that over 50% of this category is OTC:BB listed, an exchange that tends towards low liquidity, and short term volatility, effectively trading by appointment.

I believe valuations today will rebound to the historical 4 month, 1 year, and 2 year highs, an investment across this universe would generate returns of 1.7x to 6x, depending on category and valuation (see chart below). These returns could be enhanced by carefully selecting the companies and negotiating discounts to current market price (a 20% discount would provide some cushion should the markets devalue further), in addition to cashless warrants exercisable over an extended period of time, further removing any sting from continued near term devaluation.

Returns based on investment at today’s price exiting at historical highs

Snapshot of the Financial Status of the EU Healthcare Micro Cap Companies

EU Data Analysis

In keeping with tradition, the European healthcare micro cap universe has a bleaker outlook than its US counterparts not even taking into consideration the significant reduction in the EU investor base. While this universe is limited to 165 companies investments are made challenging due to listings across 9 exchanges and 22 countries, each with its own regulation and language (see accompanying slides 12 – 13). To compound the issue, the European micro cap sector as a whole is more expensive than its US counterparts. This surprised me, with both mean and median enterprise values exceeding those of the US across the $5 – 99.9M categories. I wonder if this is a function of liquidity or local hero effect which we have seen on multiple markets. Similar to the US, these companies are capital starved with the majority, over 65%, having less than one year of cash on hand. To date EU companies have not faced the discounts to historical highs that their US peers have been exposed to; however given the US to EU lag, this may just be a function of time. Worryingly, unlike the US, EU companies, on average, are more highly leveraged with an average debt of between $13-$53M, category dependent. This again was unexpected as I had believed that the European conservative nature would act against this, however it maybe a reflection of the reduced access to equity for these companies.

An analysis of the current average PPS to the average Hi/Lo PPS of the same companies during the preceding 4 month, 1 year, 2 year, 5 year and “all time”, periods, indicates that the most attractive categories based on today’s PPS versus historical, are those within the $20 – 99.9M range accounting for 48% of the EU companies with the $100-200M category close behind (see accompanying slides 14 – 17). However an analysis of the overall performance of these categories over the preceding 5 years in a market weighted index indicates that $50 – 200M categories are the most market responsive, displaying significant value appreciations in June 2006 to April 2007 (see accompanying slide 18). Similar to the US, the least attractive category is the $5 – 19.9M, hardly surprising given that over 35% of this category is AIM listed. Over the five year indexed period this category did not respond to the market remaining flat or down, (see accompanying slide 18), similar to the $20 – 50M category. My experience with the AIM market has been mixed and I am not surprised that we find ourselves in this situation. Going forward I would expect a large number of AIM listed entities to file for bankruptcy, however some of these companies warrant attention as the underlying assets may have some real value.

Despite these differences, like the US I believe valuations today will rebound to the historical 4 month, 1 year, and 2 year highs but over a longer time frame than the US. In looking at an investment across this universe investors would generate returns of 1.7x to 5.9x depending on category and valuation (see chart below). As with the US, but more challenging, these returns could be enhanced by carefully selecting the companies and negotiating deal terms.

Returns based on investment at todays price exiting at historical highs

Overall Conclusion

No of us should be surprised by the overall data – the micro caps need cash thereby creating the perfect opportunity for investors – companies facing limited options for accessing capital with significantly depressed valuations. Today the most attractive, based on prior performance and current price, are US listed companies with market caps in the $50-100M range, with the least attractive being the European listed companies with market caps in the $5-50M range. Whether this will hold up on a product pipeline basis is yet to be seen and will be analyzed in detail in part II. However one thing is clear, the US capital markets are more welcoming to companies, with greater research, a larger more risk tolerant investor base providing the much needed capital to reach real value inflection points, in addition to investors that are willing to reward successful companies.

I have no doubt that we are all sick of hearing “Buy low, sell high”, if not now, when should we consider buying?

If you would like to be notified of Blog updates please send me an email on nessanb@bioequityrisk.com

Comments and questions always welcome,
Ness

Acknowledgements
I would like to thank CapitalIQ for access to their database. For more information on CapitalIQ visit http://www.capitaliq.com/. I would also like to thank GoodwinProcter (http://www.goodwinprocter.com/).

Disclaimer
Nothing contained in this Blog should be construed as legal or financial advice or an offer for sale or purchase of any securities.

© 2008 Nessan Bermingham. All rights reserved.

The global market is in free fall with the DJIA dropping more than 35% YTD and NASDAQ Composite falling more than 45%, wiping out any gains since the 2002 bear market. Global unemployment is rapidly rising with consumer spending at a low. From Lehman Brothers to AIG to Fortress the global financial map is being redrawn and the long term implications impossible to predict.

With the global economy facing an uncertain future the fallout is rippling through all sectors, not least of which the battered biotech industry, exacerbated by biotechs inability to leverage the glut of capital in the credit market and PE sectors pre H2 2007. However the capital need in biotech is at an all time high with over 25 companies with filed but stalled S1s, a closed IPO window resulting in the withdrawal of more than 35 S1’s since ’06, median cash on hand for biopharma microcap companies below 1 year and a dearth of venture funding for followon investments. In addition Angel investing in biotech has dropped to only 8% of total US Angel Investments for the first half of 2008. Traditional seed investors are exploring options to move upstream, the pool of high net worth individuals has been decimated and venture reserves for follow-on financing are already depleted due to the prolonged need to support portfolio companies in the absence of liquidity, an issue we have faced since 2001. To compound the issue the once stalwart pharma industry, from whom biotech has long time relied on for a bailout, is faltering as they are struggling to adapt to a shifting regulatory and market environment as has been exemplified most recently by Pfizer whom we have seen halt the sale of Exubra at a significant cost, failure of potential blockbusters torcetrapib and apixaban in phase III, the imminent Lipitor patent expiration and yet another internal reorganization.

The future of traditional funding sources looks bleak, in the near term, necessitating a paradigm shift for providing access to capital for biotechs in addition to liquidity for current investors and our response to these needs will determine whether the biotech industry will emerge intact or whether it will be relegated to the investment shadows.

So Where Are We Today?

The capital base of LPs that have provided funding to venture and private equity has been decimated. The Harvard endowment alone has just reported a loss of 22% for the current fiscal year which is expected to rise to 30% by fiscal year end. Funding restrictions are exacerbated, not only by reduced overall capital within the LP funds but also due to the denominator effect (for more on the denominator effect and the effect of FAS 157 visit http://feg-research.com/focus_topic.php?nID=92&issue=2008_09). As a result LPs are re-evaluating their current commitments with new commitments being moth balled for the near term. GPs are right to be worried that some LPs will not meet their capital commitments, the extent of this is difficult to determine however a number of high profile LPs have already asked GPs to hold off calling capital in the near term. Interestingly a number of LPs are moving away from primary direct venture capital investments to the secondary market, believing that they can acquire LP interests today in portfolios at a deep discount in than if they had invested directly into the original fund. We are seeing this trend across venture and PE.

The hedge fund market which has played a crucial role in facilitating IPOs for biopharma companies in addition to providing the much needed liquidity and churn in the market place on data has dried up. Hedge funds are currently facing the largest redemption rates to date with a number of funds closing, such as Ospraie (http://www.bloomberg.com/apps/news?pid=20601213&refer=home&sid=aIVvdfesmczQ), the splitting of funds into two (http://www.reuters.com/article/fundsFundsNews/idUSN0136917420081201) or the shutting of the redemption gates on investors (http://www.reuters.com/article/hedgeFundsNews/idUSLNE49U02T20081031), the long term implications of which are unknown. In many cases this is placing the illiquid small/micro cap companies in a catch-22 position, on the one hand many of these companies need to raise capital, while on the other investors are reluctant to invest while the overhang from liquidating hedge funds remain. It is clear that the hedge market is in distress, this market is an essential component to the viability of the IPO and public markets and we will not see an IPO window open until the hedge fund market rights itself.
Compounding the distress is the short overhang question. In my view shorting is a critical component of a healthy market, however reinstatement of the uptick rule certainly makes sense. Similar to VCs, the current market dynamic will result in the contraction of the capital base and a more conservative investment strategy is sure to emerge, something that we can all benefit from.

On the venture side traditional venture seed investors are re-evaluating their strategies, with dollar value of first time deals across all sectors dropping by 12% in Q3, the lowest since Q2 2004 (http://www.nvca.org/pdf/08Q3MT_PR_FINAL.pdf). Fortunately a number of early stage investors have replenished their funds and should be out looking for new deals, not least of which is Abingworth, Essex Woodlands, MVM & Atlas Venture. However the days of concept seeding with little or no data appear over for now as seed funders ability to go back to LPs in the mid term is challenging. With limited visibility on time to exit for current portfolio companies, the pool of capital for new deals will be smaller as early stage investors are forced to commit additional capital for follow-on’s to prevent significant dilution.
Later stage investors face the same dilemma, with many late stage portfolio companies failing to IPO over the prior 18 months, S1’s are being pulled and insider rounds or acquisitions being explored. The need to support these companies beyond the traditional lifecycle depletes fund allocations for new deals.
To compound all of this private companies are still not facing the potential recaps that their public peers have already been exposed to making it difficult for new investors to justify a new investment at untenable premoney valuations. While this trend is starting to shift I suspect it will not be until the latter half of H1 2009 that we will see an overall repricing of the biotech private sector.

Exits & Overall Access to Capital remain challenging. The IPO window has firmly shut. It is unclear when it will reopen, with consensus leaning towards late 2009/early 2010. This requires investors to explore alternative exits such as M&A or product out licensing. On M&A the days of the $500M+ (Adnexus, Sirtris, Domantis, & SiRNA) deal for the concept/pre PoC company is probably over. Recent M&As have been more opportunistic with pharma acquiring companies on the cheap (see SGX, Genelabs & Memory Pharmaceuticals), pharma has clearly indicated that they will not be the savior here preferring to transact through option to acquire or license structures (see the Novartis Option Fund (http://www.novartis-venturefunds.com/index.php?id=234)) with an equity investment or a tranched acquisition with limited upfront payment.

In difficult periods in the past companies have turned to non-traditional IPOs or alternative sources of funding. Most notably reverse IPOs, SPACs and direct listing such as Speedels listing on SWX without a concomitant financing. However a quick look at these strategies suggest that they do not present an alternative route in today’s market – the two most recent proposed reverse IPOs, Raven’s reverse into Vaxgen and Archaemix’s reverse into Nitromed, has met with resistance from the public company investors, who look to realize cash today through liquidation and cash distribution, than turn the card on another biotech venture. SPACs have faired no better, proving difficult to execute on with SPAC shareholders outright rejecting the deal as we recently saw with Apex (SPAC) proposed acquisition of Dynogen (VC backed private company). One has to ask if these deals had been successful how would they have faired? I cannot but believe companies are trading one challenging situation for another. In the case of the SPACs a significant warrant overhang and an investor base that may not be biotech savvy, understanding the ebbs and flow of the drug development market while for the reverse approach having an investor base in the public shell that had originally backed a different strategy and may now just want to realize some cash return flipping their position upon close or post lockup.

As we enter 2009 we face a near term uncertainty not just within the global capital markets but also an uncertainty with respect to the global response. The governmental response appears reflex rather than well thought out. I believe few were surprised when the infusion of capital into banks did not reopen access to credit, as they say once burnt twice shy. As the Fed and central banks continue to reduce interest rates, with limited effect one of our key weapons is becoming defunct. The lessons we thought we had learnt through the Japanese experience are not proving to be the case. On a local level with the inauguration of a new US President in January we should expect to see a change in the healthcare system here in the US given this is a potential “easy win” and a central tenant of President Elect Obama’s platform. As yet it is unclear the exact structure of a realistic and enforceable healthcare plan but it is clear that the market will look to quantify its impact on overall healthcare revenues. Worse case, and unlikely scenario, is the introduction of a NICE like system for pricing however we should be prepared for some type of capping on drug pricing in the US.
We also should be preparing for the introduction of new market regulations following the period of de-regulation that resulted in the current debacle. One hopes it will not impact the biopharma companies to the extent SOX 1.0 had, however I suspect this is likely to be the case with an initial overcorrection, followed in time with a more pragmatic and practical solution.

Fortunately a number of strategies are emerging that may help secure the longevity of our industry both for companies in need of capital in addition to investors need to realize returns.

First: Companies Need For Capital:

As companies stuggle to recapitalize we are seeing Chapter 11 protection (Introgen Therapeutics (http://phx.corporate-ir.net/phoenix.zhtml?c=190273&p=irol-newsArticle&ID=1232185&highlight=)), bankruptcies (Ardana and Phoqus (www.ardana.co.uk/30062008.html; www.phoqus.com/RNS08071601.aspx)) and internal restructurings facilitating capital conservation (Titan Pharmaceuticals, Targeted Genetics & WuXi PharmaTech, all announced restructurings recently). However other options for a fundamentally sound company exists:
· Traditional follow-on – a number of venture funds have closed in the past 12 months including Essex Woodlands, Abingworth, Clarus, Atlas and MVM. These funds are looking to put their new capital to work in new investment opportunities. While it is unlikely we will see new funds close in the near term there remains traditional sources of capital;
· Joint ventures – I believe we are at the tip of significant growth in joint ventures/collaborations with pharma exploring option structures around specific assets such Novartis’ option fund (http://www.novartis-venturefunds.com/index.php?id=234), non-pharma based funds are also exploring these options, Symphony Capital (www.symphonycapital.com/) recently closed a deal with Oxigene (www.oxigene.com/press/pressreleases.asp) establishing a collaboration around specific assets within the company. Other structures worth exploring include Puretech’s recent fund and Synecor;
· Royalty funds continue to be a potential source of funding, Cowen Healthcare Royalty Partners Fund (www.cowenroyalty.com/) has recently been closed with multiple other royalty funds currently in the market looking for deals;
· Secondary Market – secondary direct funds such as W-Capital (www.wcapgroup.com/) and Saints (www.saintsvc.com/) are acquiring single positions or portfolios from investors. They have adequate reserves for follow-on financings into their newly acquired positions;
· Buyouts – for the right company a buyout remains an option, PE groups are sitting on significant amounts of capital that need to be invested. However the barrier here is significant;
· M&A – for many companies they should consider options for M&A with peers, enhancing the overall investment opportunity for a new investor. While this, in many cases, will have a significant impact on overall valuation it maybe the only option for survival and one not to be ignored. In addition co-development or cross licensing deals among peers may also help enhance the investment rationale for new investors.

Investor Opportunities
This is a great market for investors.
Given the current market dynamic I believe that there are investment opportunities for the savvy and nimble investor. Key areas worth exploring include:

· Small/micro caps (we are already seeing companies filing a stock shelf in preparation with a number of PIPEs also being closed – see Achillion’s & Micromet’s recent PIPE transaction)
· Distressed debt
· Growth equity opportunities
· LP secondary interests
· Joint ventures – I suspect a number of corporates & LPs will be receptive to new investors committing capital for their current direct commitments eg follow-on investments in co-invests or partnership where there was an equity component. The new investor participates in 100% distributions from their capital investment while participating in a % of distributions from the original underlying equities held by the corporate or LP. This has significant advantages to both the new investor in addition to the old
· Also potential opportunities exist in specific program investments (see Symphony Capital’s strategic collaboration with Oxigene)) and potentially royalty stream acquisitions

I believe private equities will not become attractive for another 1 – 2 quarters however given the number of filed S1’s there are a glut of late stage, mature assets out there requiring funding. In addition there are potential pharma spinout opportunities given the recent triage that has taken place. We will continue to see company liquidations as this the nature order of events.

Looking ahead the rollercoaster ride is far from over, with the consumer market facing one of its worst seasons to date, the global unemployment rate steadily increasing and the weapons the central banks rely on to combat a recession slowly being overwhelmed we are facing challenging markets through 2009 and into 2010. We have yet to realize the full extent of the credit default on main street in addition to the State Governments facing significant deficits in their budgets – one must consider the possibility of State defaults on notes. We also cannot ignore China, a driver in the global economy that is facing unprecedented layoffs and a significant decline in their growth. This will have long term implications on our respective economies.

This downturn does not mark the end of anything but rather is part the natural cycle of investing where valuations get reset before the next bull market. I believe that while the market is challenging, both companies and investors, that are open to working outside the traditional box, stand to be well positioned for near term returns and to capitalize on the rebound that is sure to come.

Questions/comments always welcome. Email address at the top of the page.
Ness