Survival of the fittest Dr Regina Hodits at Apax Partners Beteiligungsberatungs’ healthcare group asks how biotechnology compani

After the golden age of the late 1990s, the second half of 2000 brought the beginning of a tougher climate for companies on the public markets both in the US and Europe. The general market down turn had a particular effect on the high risk technology stocks listed on stock markets such as Nasdaq or the Neuer Markt. IPOs on the Neuer Markt for all stocks have fallen from 83 in the first half of 2000 to 10 in the first half of 2001. In the biotechnology sector alone IPOs have dropped from five to zero in the same time period.

Investors are no longer investing in stocks due to hype’ or ideas’ and once again seem to be basing their investment decisions on old economy markers’ such as earnings and revenues. This fundamental change in investors’ behaviour has made flotations for biotechnology companies at early development stages (which were common in 1998 and 1999) virtually impossible.

During the late 1990s, biotechnology companies were able to float with business models where substantial revenues and the break-even point were projected only four to six years after IPO. The return of more realistic market conditions has meant that companies need to be further advanced in product development, or change their business model to be more focused on near-term service and collaboration income while cannibalising part of their future upside.

This can be done successfully, for example Lion Biosciences has created a revenue-generating software and service business that subsidises new product development, while Atugen, a Berlin spin-off of an American biotech company founded 1999, has projected it will break-even early next year based on its target validation services.

Although public markets are on the whole closed there has been a mixed response within the biotechnology sector. Europe has seen investors strongly favouring biotechnology companies that have either managed to bring products to the market, such as Celltech, or

that have successfully managed their burn rate with service contracts while maintaining upside in their own product development, like CAT or GenMab. Companies focused on drug development, even in later stages, but with no revenues like Antisoma have been severely

punished by the public markets.

Alternative exit routes such as mergers and acquisitions are also proving difficult. Combining

two companies with high cash burn and a long time to break-even has not been high on the investors’ preference list, and pharmaceutical companies have had trouble integrating acquired biotechnology companies.

These market situations have had an obvious knock-on effect to private equity. There is, however, still a lot of money available in the market in Europe. This is especially true

in Germany, where several biotechnology focused funds have recently been raised.

Investors are favouring companies that create tangible products or services to which a price can be attached and for which there is demand amongst potential customers. These customers are pharmaceutical companies, to whom the biotechnology companies offer their services or partly developed products rather than patients, doctors or insurance companies paying for the treatment. Knowing both the requirements and particularities of the pharmaceutical industry and the investment community has become a pre-requisite for companies to be attractive to a potential investor.

Very early stage projects are moved further back in the investment chain, back into academia, where timelines and funding requirements are more suitable for them. Experience counts,

but it has to come paired with entrepreneurship.Not every seasoned pharmaceutical company manager will turn into a star biotechnology CEO. Experience not only in the industry but also in how to create and finance new businesses is essential.

In contrast to the first group of biotechnology companies listed on the Neuer Markt, several private German biotechnology companies have over the last year recruited CEOs of this calibre that combine entrepreneurship with experience. For example, metaGen in Berlin recruited Juerg Ambuehl from BASF Knoll, who has been substantial in building BASF’s pharmaceutical business, and Cosmix in Braunschweig recruited Rikju Rautsola, the former leader of Boehringer Ingelheim’s hospital division, who created BI’s operation in China.

The changed market conditions require biotechnology companies to focus on products and services that lead to near-term revenues and to a reduced burn rate (ideally to break-even). Companies also need to create business and financing plans that allow them to develop into sustainable businesses. During this process they need to balance public markets as cash sources versus strategic alliances with pharmaceutical companies. The management of successful companies will have to be able to handle complex interfaces with pharmaceutical partners, end customers and the financial community alike. On the positive side, the biotechnology industry is uniquely positioned to adapt to the current market climate.

There are several characteristics of the biotechnology industry that make it attractive to private and public investors alike:

* Long development cycles mean it is possible to be more independent of short-term

market trends.

* Discrete steps towards development of new products make progress relatively easy to monitor. An increase in value can be justified on the basis of facts rather than hype’.

* Biotechnology companies are usually based around a portfolio

of intellectual property. This should give the companies a solid asset base in which investors can invest, rather than relying on ideas and speed, as they tended to do during the Internet days.

* The pharmaceutical industry is a strong partner that is not only

a source of development know-how and management, but also the

main customer for both services

and half finished products. The pharmaceutical industry has an unsaturated demand for innovative services and products for target markets with high unmet medical need, such as cancer and metabolic diseases like diabetes.

* Pharmaceutical products in general, including those based on innovations in the biotechnology arena, have a relatively low market risk compared to other industries. The rigorously monitored and costly development process ensures that products which

come to the market are addressing an unmet customer need’, and thus make it more likely to capture high market share within a short timeframe. Patent protection and long development times also ensure that once successfully introduced to the market, demand for products remains high over a considerable period of time.

* Finally, business models in the biotechnology arena tend to be flexible. This is

primarily because biotechnology as a b2b market place is catering towards the pharmaceutical industry rather than towards patients as end customers.

The pharmaceutical industry is now used to collaborating with different types of biotechnology companies.

This can range from using the technology as a pure service, via joint developments of new products, to pure acquisitions of products at different stages of the development chain.

This allows biotechnology companies to balance their cash burn and further upside potential, by entering into a suitable mix of such collaborations.

Taken together, these unique characteristics position the biotechnology industry favourably compared to other high tech sectors even in troubled times.

For sophisticated investors in the biotechnology/healthcare arena the current markets should not significantly alter investment decisions and processes. Biotechnology companies are less dependent on short term market trends than other high tech industries, given their long development and product cycles. Fundamentals in the industry also change slower than in other areas.

The current environment however shows that in gold rush’ times successful investments should be based on fundamentals, and that companies need enough money to develop into sustainable businesses. This gives the companies and their investors a solid basis to successfully develop biotechnology companies towards a suitable exit even in tough market conditions.