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Assessing the Canadian Biotech
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assessing The canaDian BioTech financing gap:
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WHat sourCes leFt, WHy & HoW to rePlaCe tHeM
Biotech discoveries have a fi nite period within which they need to be commercialized, unlike gold and oil which can sit in the ground for decades and probably increase in value. Many biotech discoveries are now stagnating because Canadian biotech has suffered from a large fi nancing gap for over four years. The annual gap might be approaching $1 billion when considering reduced levels of fi nancing for private and public companies, plus the missed opportunities for growth and establishment of new companies.
This problem and potential solutions can be assessed using the capital market concept of risk and reward. There is a wide spectrum of risk, ranging from government bonds and GICs at the low end to high risk discovery companies in resources, technology and biotech. There is also a wide spectrum of rewards, from the current two per cent GIC rates to potentially several hundred per cent, or more, returns for a successful discovery company.
Capital pools are allocated across this riskreward spectrum. Some of this capital is allocated to specialized healthcare and biotech funds and generalists may also allocate a portion of their funds to these sectors. However, there is no dedicated global or Canadian biotech capital pool.
There are times when risk and reward become unbalanced. The tech boom of 2000 resulted from capital recklessly chasing the huge potential of e-commerce businesses while ignoring the risks in a new sector with miniscule revenues and ridiculous business plans. The tag-along biotech boom was similarly caused by capital chasing the huge potential of genomics and proteomics while ignoring the risks of these novel technologies with miniscule revenues and ridiculous business plans. Some e-commerce concepts have now matured into very large and highly profitable companies while proteomics and genomics are just starting to realize their commercial potential.
Biotech is a high-risk proposition and funding Canadian biotech has never been easy. The critical question now for Canadian biotech is how to bridge this financing gap. However, two other questions need to be answered first – what capital sources left the sector and why did they leave?
WHat FunDIng sourCes leFt tHe seCtor?
Private companies lost two major sources of funding. First, the limited partners (LPs) who previously funded many venture capital (VC) groups have not committed capital for new Canadian biotech funds. With few potential Canadian co-investors, it is harder to induce U.S. VCs to look at Canadian companies. Second, retail investors who funded the various labour-sponsored investment funds or LSIFs have been withdrawing funds and not reinvesting for several years.
Public Canadian biotech companies have depended on three sources of funding, all of which have declined in the last few years. In the case of Canadian retail investors and small cap funds, biotech has not fared well competing with $1,500 per ounce gold and $100 per barrel oil. Competition is intense at foreign healthcare funds, which can now choose from over 1,000 public companies.
WHy DID tHese FunDIng sourCes leave tHe seCtor?
One reason is a dramatic shift by capital to the safe end of the risk spectrum after the financial crisis of 2008.
• Big generalist funds reduced their risk profile, with many abandoning small cap biotech. • Pension funds facing growing unfunded liabilities looked to mature companies for yield (dividends, distributions) and smaller potential capital gains. • Many specialty healthcare funds narrowed their focus to Phase 3, commercial and large cap investments. • Most Canadian small cap funds opted for the momentum of the mining and oil industries and reduced their biotech holdings. • Many retail investors adopted a similar approach or abandoned all high risk investments looking for dividends from stable large caps and distributions from REITs.
Several Canadian companies have been involved in the successful development of novel therapeutic products but these successes have not always resulted in longer term shareholder returns. BioChem Pharma, AnorMED and CryoCath were acquired but those gains have been long forgotten by the capital markets. The $120 peak share price of QLT happened over 10 years ago, followed by a more recent $2 low. The success of Angiotech was followed by CCAA filing and debt restructuring which wiped out shareholder equity. Theratechnologies’ share price was over $12 during the Phase 3 trials of tesamorelin but is now about 80 per cent lower even with its U.S. approval.
As a co-author of Equicom’s Canadian healthcare sector reviews 1, I track share price performance of Canadian healthcare companies. For a group of 97 companies tracked for share price performance in 2011, decliners outnumbered gainers by almost 2 to 1 (64 to 33) and 43 of 97 companies in this group had share price changes of 40 per cent or more. This volatility and poor share price performance does not help attract new capital.
HoW Can tHe seCtor rePlaCe tHe MIssIng FunDIng?
There are two approaches to increasing the Canadian biotech capital pool – increase the overall high risk capital pool, from both returning and new sources, and induce some high risk capital to shift to the biotech sector.
The global high risk capital pool will increase as capital markets stabilize and capital increases its risk tolerance. The largest exit from the Canadian high risk capital pool was by the large Canadian pension plans. I expect any return will be gradual, which has left the Canadian biotech VCs looking to new LPs for funding. Pharmaceutical companies have been expanding their VC funds but the $50 million for the GSK Canada Life Sciences Innovation Fund is the first one dedicated to Canadian biotech.
One inducement for individuals to take more risk is tax-related, as in the LSIF and flow-through share systems. As the economy improves and investors are looking at their tax strategies, the capital investing in flow-through shares will probably increase as long as commodity prices remain high. We do not know whether allowing biotech and other companies to issue flow-through shares would significantly increase the high risk capital pool or just spread the existing pool across several more industries. I doubt that healthcare-based LSIFs could recover based on their poor performance over the last decade.
In summary, a large portion of the financing gap faced by Canadian biotech was created by and is still subject to global market trends. There is no consensus on when, or if, these trends will again increase the Canadian biotech capital pool. Assuming that the Canadian high-risk capital pool will only slowly trend towards prior levels, the onus is on the Canadian biotech industry to increase its share of that capital pool and adjust its strategies to fit the new realities of the capital markets.
In the short term, the onus is on the industry to bring high risk capital back to Canadian biotech by delivering positive events and share price increases to shareholders. There is a long list of products in Phase 3 or under regulatory review which can provide positive events 1, 2. For the earlier stage products, boards and management must create and execute sound clinical and regulatory strategies and quickly kill products that do not justify further development.
Many companies are frustrated when their positive events are ignored by the markets or viewed as a liquidity event. Amongst over 1,000 public healthcare companies worldwide and 3,000 or more Canadian small cap companies, positive events have to compete for investor attention. Companies also have to realize that investor strategies have changed dramatically. `Buy and hold` does not apply to small cap stocks – the strategy is often likely to be `buy, sell on the event and then decide whether to buy for the next event`. Bottom-fishing and momentum-buying are also investment, or more appropriately, trading strategies for small caps. Companies have to adjust their corporate and financing strategies to fit the current realities of the high risk and small cap markets. I believe that investors are more comfortable considering sectors where they understand the risks and rewards. Many biotech investors feel that they are just throwing money into a black box. Therefore, one way to induce more capital to at least look at biotech investment opportunities is to properly educate investors about the sector, company and product specific risks. This approach is unlikely to have much impact in the short term but might create a more friendly capital base in the long term.
WHat roles Can governMent Play In tHe bIoteCH InDustry?
Scientific discoveries at Canadian universities, hospitals and research institutes are equal in quality to discoveries from the best institutions worldwide. These discoveries are the foundations for many Canadian biotech companies. For the longer term sustainability of the biotech industry, governments must sustain their funding for these institutions.
Governments have always picked some industries for special support and that is not likely to change. In some cases, they provide broad industry support. In other cases, they do choose individual companies, hopefully with sufficient external input to make unbiased, informed decisions. The Jenkins report recommended that the federal government look at more direct funding rather than relying on broad tax credit systems like SR&ED.
Most companies starting pivotal studies of novel therapeutics, devices or diagnostics can be financed by the capital markets or industry partners. There is a financing gap between academic research and these advanced clinical studies. What novel fund structures can use direct funding from various levels of government to induce high risk capital to return to the biotech industry and help fund this preclinical and early clinical gap?
Governments are looking for sustainable companies which create jobs and tax revenue. The increased direct funding will probably go to those industries which can make the best case for their delivery of these two items. In the broader healthcare sector, an obvious target is long term care facilities: hospitals want them so they can free up beds for acute care, existing healthcare REITs can build and manage these facilities and there are many investors looking for the stable yields these facilities could generate.
The Canadian biotech industry needs to do an inventory of all the companies which have been started and their fate: successful and sustainable, acquired, failed or still developing. Failed companies have still delivered value if personnel have acquired expertise which they can use at their next company. Some acquired companies are shut down and the technology transferred to the acquiring company. These companies have also generated experienced personnel and hopefully capital gains for investors, some of which gets recycled into other biotech companies. Some acquired companies remain operational, such as the CryoCath development and manufacturing facility in Montreal after its acquisition by Medtronic, and the flu vaccine development and manufacturing facilities in Quebec after GSK’s acquisition of ID Biomedical.
There is no simple list of solutions to the Canadian biotech financing gap. A large portion of the financing gap faced by Canadian biotech is beyond its control. I have tried to ask some basic questions about this gap, which could help create a list of potential industry actions for assessment and, hopefully, some implementation.
There is no simple list of solutions to the Canadian biotech financing gap. A large portion of the financing gap faced by Canadian biotech is beyond its control. I have tried to ask some basic questions about this gap, which could help create a list of potential industry actions for assessment and, hopefully, some implementation.
reFerenCes
1. 2011 Canadian Healthcare Annual Review (W. Schnarr & R. Marshall, TMX Equicom) 2. Canadian Healthcare Roadmap - January 2012 (P. Flint, Bloom Burton & Co. Inc.)
Wayne Schnarr is a mostly-retired healthcare consultant with over 30 years of experience in the biotech and financial industries. The opinions expressed in this article are strictly personal and do not reflect the opinions of any current or past employers or consulting clients.
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