Investment Decisions Based on Portfolios of Pharmaceutical Products: Part 2

Introduction

In Part 1 of this three-part series, the author provided an overview of the definitions and boundaries for key investment aspects associated with product-based portfolios, including the number of assets available for partnership and investment appetite.

Part 2 begins with a discussion of boundaries set up by the capital limit of a fund or artificially created boundary (e.g., special purpose entity or SPE), and whether the portfolio is a group of assets or the goal is to partner on multiple single assets to have a portfolio effect. Part 2 also discusses the feasibility of capital syndication to garner financing for portfolios and the key differences in portfolio strategy between big pharma and biotechnology companies.

Part 3 concludes the discussion regarding the key differences in portfolio strategy between big pharma and biotechnology companies and covers portfolio management, innovative partnering solution strategies and commercial perspectives.

Portfolio Effect

Some companies have a business plan that entails partnering on a number of single product assets, usually at a later stage, such as Phase 3, with the goal of obtaining a greater number of assets to dilute risk and obtain an "artificial" portfolio effect. This can be an effective strategy if it can be accomplished quickly, as the risk is not optimal until the full portfolio effect is achieved.

In the author's experience, many third-party capital providers are reluctant to be first in an investment vehicle with single-product assets with the goal of a portfolio effect-especially with portfolios of higher risk, e.g., a basket of Phase 2 products.

Phase 1 vs. Phase 2 vs. Phase 3

It has long been known in industry that, by combining a group of products, especially in one therapeutic area, the risk of total capital loss for the group is reduced. In essence, risk is diluted. But there is an art to evaluating the risk vs. cost of groups of products in different stages of clinical development. For example, when looking at a group of Phase 1 studies, there is usually insufficient evidence to draw a definitive conclusion on either efficacy or safety. At the other end of the spectrum, for a basket of Phase 3 products, the cost to run the trials makes such an experiment prohibitive for any one company and it is unlikely, with current competition models, that large pharma companies would be willing to place their key Phase 3 assets into a separate entity. What about Phase 2? Perhaps this might be the place where a balance could be found between cost (lower with Phase 2 development) and the likelihood of being able to draw a definitive conclusion at the end of each trial.

Syndication

Theoretically, syndication (e.g., for larger portfolios) should be an easy, straightforward way to gain access to additional sources of capital. Syndication, for purposes of this article, refers to having more than one capital provider investing a portion of the total amount of capital required for an executed portfolio deal.

In reality, however, syndication is very difficult and often impossible. The reasons can include:

• Timing-the point at which a potential partner is brought to the table for a term sheet (the earliest stage of negotiations between a buyer and a seller whereby the return dynamics and risk assessment evolves as due diligence is undertaken) or contracting (when due diligence concludes, the deal terms are finalized and lawyers draw up a final contract which is signed by both the buyer and the seller upon deal execution) discussions
• the desire to have disproportionate influence on the deal (e.g., a $20 million capital provider in a $100 million deal wanting undue influence on contractual protections)
• differences in desired investment returns (one party willing to take less vs. one partner seeking greater returns)
• the novelty of the transaction
• the financial market climate
• the ability of the potential partner to raise more funds
• perceived differences in the risks identified by different due diligence teams

Because of the large number of expert resources required to perform due diligence (functional area experts in preclinical, clinical pharmacology, medical, chemistry, manufacturing and controls (CMC)/supply chain, commercial, sales analytics, patent law), plus deal term negotiators, some companies will "piggyback" their investment on top of a credible, additional third-party capital provider with the primary goal of reducing cost to invest. This can be helpful, but then that third-party capital provider is at the mercy (e.g., lacking control) of the conclusions reached by the other provider's due diligence team.

Key Differences between Big Pharma and Biotechnology Companies

Based on the author's experience in partnering with biotechnology companies, this section outlines several successful approaches that provide alternatives to partnering with large pharma and venture capital entities. These solutions remain beneficial and financially profitable to both parties over the long-term (i.e., five or more years).

The Productivity Dilemma

Today, the research and development (R&D) pipelines once enjoyed by large pharmaceutical companies are no longer producing a sufficient number of drug candidates. As pipelines shrink, the pharmaceutical industry has tried to develop novel solutions, such as creating "incubators" or "accelerators" where efficiencies in smaller development companies can be leveraged to expand pipelines. Often these smaller biotech and pharma companies are the innovation engines filling major pharmaceutical companies' R&D pipelines, as these firms continue to invest in exchange for downstream milestone payments and royalties, or even purchase options on one or several compounds.

Additionally, collaboration between pharmaceutical companies and academic institutions provides a mutually beneficial arrangement, as academic centers are not positioned to commercialize a product. 

Investments by large pharma can provide the smaller biotechnology company with the capital to build out its infrastructure and further develop its earlier stage pipeline. This type of partnering relationship establishes credibility for the smaller company and creates value for the larger pharmaceutical company without the need to fund and direct its own internal development program. In addition, the ability of smaller companies to nimbly adapt to changes in technology and overcome development hurdles are key advantages that large pharma lacks. Generally, these smaller firms take their compounds to the proof of concept (PoC) stage of drug development and exit to pharma companies that are better positioned for costly late-stage development and commercialization of the product. A key benchmark of this approach is the opportunity to change the accounting dynamics regarding research infrastructure with smaller firms and outsource the burden of fixed cost inherent in development. With this outsourced approach, the smaller company turns the fixed cost into a variable cost to obtain more desirable accounting treatment.

It should be noted that this risk-shifting approach often carries a high price for the smaller company, as it frequently relinquishes control over the asset(s) and awards a significant share of any potential upside to the large pharmaceutical partner.

Therefore, partnering alternatives are necessary because of companies' desires to retain strategic and financial control over their assets. Two main goals of such partnerships are to optimize the drug development process by addressing resource constraints and to minimize the risk of innovation by sharing it.

Types of Biotechnology Companies

For purposes of this article, three main categories of biotechnology companies are defined based on their corporate maturity. The first is discovery, the second is bridging, and the third is stand-alone. Each company type has different capital needs related to the number of compounds in the clinic. No biotech firm, regardless of category, is anxious to part with its intellectual property to partner with another entity-especially if the upside is perceived to be significant.

The discovery biotechnology company frequently has a novel approach to identification of drug candidate leads, usually based on a new target or novel delivery system, combination of existing products or novel technology platform, but does not have sufficient infrastructure or cash to advance them all in the clinic. These small entrepreneurial biotechnology entities often live hand-to-mouth existences, working to obtain just enough capital to get to their next R&D milestone. These less mature enterprises face a shrinking runway and may seek to mitigate risk by partnering with large pharma. Unfortunately, such deals tend to come at a high price. The biotechnology company is often forced into mortgaging a good portion of its future value in exchange for a chance to continue development.

The bridging biotechnology company has advanced compounds into the clinic and has more credibility within the pharmaceutical industry than the discovery company because of existing partnerships or early demonstration of clinical PoC. These companies frequently have partnerships in place with large pharma and seek an alternative and more innovative financing strategy that will allow them to retain more asset value than in previous partnerships with large pharma.

Stand-alone biotechnology companies are characterized by sufficient resources from existing revenue streams to advance their own candidates to commercial success. They act like large pharma in the way they deal with other, smaller, biotechnology companies. They tend to either use less innovative partnering solutions or more complicated ones, such as those highly correlated with internal accounting standards.

Private vs. Public

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Another interesting distinction between biotechnology companies is the different ways in which public versus private companies finance their research and development programs. In general, both private and public companies, especially those not generating earnings, consider their valuations depressed. A brief overview of selected funding option considerations for private and public companies is provided in Table 1.