Suspending disbelief for a moment, and assuming that little Johnny has set his heart on being an investor in the life sciences, there are still plenty of options for where he might invest his money to make a fortune. Many seasoned investors restrict themselves to one (or a small number of areas), such as
diagnostics, medtech, therapeutics or healthcare services. But there are investors specializing in all these areas, so how would you chose one over another?
A common presumption, which may have more than just a substratum of truth, is that investors specialize in the particular area they understand the best. Experience is, after all, the best training you can have as an investor. Whether in life sciences or any other area, successful investing comes down to a mix of knowing a little bit more than the next man and a fair portion of luck.
The kind of knowledge that might yield a competitive advantage may be technical (assessing with some accuracy the likelihood that a concept can be converted into a product) or perhaps more likely commercial: an understanding of the valuation that can reasonably be ascribed to a particular asset based on some product of its market-readiness and the eventual market size.
But imagine you had no such asymmetry of information. Are biotech assets in some areas intrinsically better bets as investments than others? To an extent, it depends on factors such as your appetite for risk and the amount of capital you have to put to work. Yet there must be some useful general yardsticks, even though data is often hard to get hold of.
Recently, Total Medical Ventures (a boutique life-science seed investment house headquartered in Cambridge UK) published an assessment of its assets, which was very revealing. Admittedly, the dataset is a relatively small sample: around a dozen companies created over the last five years, all of them based in the UK. But despite this, a clear pattern emerged.
The companies fell into a wide range of subsectors across life sciences: several in diagnostics, a couple of toolkit companies and healthcare services companies, one in consumer healthcare, and the rest in therapeutics (one late stage and several preclinical stage). For each, Total Medical Ventures calculated the net present value of the asset at the time the company was created, benchmarking the sale of each company at the optimum point in its development. Importantly, as a seed investor, they calculated how much additional capital was likely to be required, and at what cost to the company.
Of course, with any such forecasts the errors are likely to be substantial, but the findings were so clear that the conclusions nevertheless seem robust: preclinical therapeutic assets had an NPV that was about a tenth as large as the average for the companies in all the other disciplines. And, since all the NPVs were calculated from the viewpoint of the initial investor, this was not simply the result of the longer time to exit for such assets. Interestingly, the NPVs for all the other disciplines were remarkably similar suggesting that the market adjusts asset valuations relatively efficiently.
For sure, all of the forecasts assumed that the underlying technology would eventually be proven, since in every case if the technology could not be successfully developed the company would be worthless. One possible explanation for the lower NPV for preclinical therapeutics is the failure rate – the asset value is heavily discounted because so many fail to reach a successful exit (let alone eventually reaching the market). But is that the only contributory factor? All the other companies were based on unproven technologies in their disciplines too. Are preclinical therapeutics really 10 times more likely to fail than novel diagnostic content?
Probably not. The lower values for preclinical assets may also reflect the highly capital intensive nature of drug discovery. One or two rounds of capital raising is enough to achieve proof-of-concept for technologies elsewhere in the life sciences (including later stage therapeutic plays, although, of course, the size of the rounds would be larger). For preclinical therapeutics, however, its not just the amount of capital required, but the number of rounds over which it must be raised (to reflect the many stop:go decision points that need to be passed to achieve regulatory approval of a new product).
Even the largest venture capital backers of drug discovery often cannot bear the full burden of taking a preclinical asset to clinical proof-of-concept (at least not if they want to maintain a sufficient diversity of product candidates to achieve an acceptable risk profile). So new investors are sought at each round to share the risk.
Financial regulations also play a part: to achieve a validated valuation at each round (particularly important for the protection of minority shareholders), external investors need to join the syndicate.
The overall impact is that with each new round of capital raising that is required, the incoming investors have the upper hand, and the capital already invested (and spent) is substantially undervalued. The more such rounds that have to be completed, the more the early investors are over-diluted. This phenomenon, more than anything else, accounts for the severely depressed asset values for preclinical therapeutics compared to unproven technologies in other areas of life sciences.
The consequences of these observations are severe: the number of investors who will consider backing an early preclinical therapeutic asset, however promising it looks, is shrinking year on year. New models for financing early stage drug development are badly needed before the supply of assets achieving clinical proof-of-concept dries up altogether.
What is clear, is that small investors (and ‘small’ in this context might include some very substantial investors indeed) should avoid putting their money into early stage therapeutics plays – no matter how outstanding the scientific rationale seems to be. Diagnostics, healthcare services and medtech – for so long the poor cousins of biotechnology – offer substantially better returns to their inventors and seed investors, with a lower technology risk to boot.
So assuming little Johnny’s mum didn’t do the sensible thing and recommend a career as a premiership footballer or patent attorney, the next best option would be to restrict his life sciences investing to the quick-to-market opportunities, and to shun therapeutics altogether. The vast market sizes of blockbuster drugs are nothing more than a mirage on the (very) distant horizon.
This article was written by David Grainger. David is a scientist directing an internationally recognized research laboratory in the Department of Medicine at Cambridge University, focused on inflammation. David is a biotech entrepreneur and investor, having founded several biotech companies, and he runs a successful consultancy business, TCP Innovations. He is also a Senior Partner at Total Medical Ventures, a life sciences boutique investment group, and a Principal at ATPBio.