July 29, 2013

by RAPS

Investment Decisions Based on Portfolios of Pharmaceutical Products: Part 3

In Part 2 of this three-part series on investment decisions, the author discussed the 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 in order to have a portfolio effect. Part 2 also covered the feasibility of capital syndication to garner financing for portfolios and ended with a discussion of the key differences in portfolio strategy between big pharma and biotechnology companies.

Part 3 begins with a discussion of key event drivers for biotechnology companies and provides overviews of portfolio management, innovative partnering solution strategies and commercial perspectives.

The series concludes with two case studies from the author's experience while serving in the due diligence group of Quintiles over the last 12 years.

Key Event Drivers

Earnings-driven biotechnology companies are interested in partnerships that allow them to retain control and gain future upside while deferring research and development (R&D) expenses in the near term. The key needs (or drivers for financing) for biotechnology companies fall into three main categories:

financial reporting needs
cash needs
operational needs (include credible partnering with a company that can deliver services, such as large contract research organizations (CROs)

Financial reporting needs are best interpreted in light of acceptable accounting standards (e.g., Generally Accepted Accounting Standards or GAAP in the US, or International Financial Reporting Standards or IFRS in the EU) by qualified parties. In general, earnings-driven companies are interested in mitigating the financial impact of R&D expenses until a compound is marketed. Because accounting factors are subject to expert interpretation, they are beyond the scope of this article.

Cash needs are usually acute. Discovery and bridging companies are often focused on dilutive aspects of financing more than near-term earnings. In general, they also seek to retain control of their assets (e.g., compounds).

Operational needs can only be addressed by credible partners that can provide clinical trial infrastructure or intellectual drug development expertise; therefore, these are limited to major players such as large pharma or global CROs.

Other key event drivers include large milestone payments triggered from relationships with large pharma and initial public offerings, but these events are beyond the scope of this article.

Partnering Solutions

Driving demand for alternative partnering solutions is the biotechnology company's desire to retain strategic and financial control over its assets. Two goals for such transactions are optimizing the drug development process by addressing resource constraints and de-risking innovation by sharing risk in clinical and commercial programs.

Portfolios (Phase 1 or Phase 2 funds)

To mitigate the investment risk associated with a single product or earlier stage assets, as mentioned earlier, an investor group may consider accumulating a portfolio of Phase 1 and/or Phase 2 products. 

This approach can be attractive for companies with platform technologies where many targets can be produced, and, due to cash concerns, only a few can progress to the clinic. Key problems with Phase 1 portfolios include defining success (e.g., submission of an Investigational New Drug application), how to advance the product to Phase 2, and how to have enough targets to make the law of averages palatable from a risk/return perspective (e.g., using Tufts University's Center for the Study of Drug Development's published probabilities of success).

Problems with partnering in a Phase 2 portfolio approach include: 1. dilution of value by large pharma deals already in place with the biotechnology company; 2. justifying an investment sufficient to move the product to an acceptable exit strategy based on the risk profile; and 3. portfolio risk if not confined to one therapeutic class. The third problem involves increased due diligence costs associated with obtaining extra resources, including additional medical expertise, in order to understand different therapeutic classes in a portfolio of diverse therapeutic products.

For fully mature biotechnology companies, a structured finance deal may provide the greatest flexibility and widen the number of options. Structured finance, as used in this article, is defined as "a risk-based commercialization and/or development arrangement whereby funding and/or services is provided in exchange for fees and/or product royalty rights."

Alliance Management

Pharmaceutical and biotech companies are entering into alliances and joint ventures at an ever-increasing pace in order to obtain financial and other resources to begin clinical development programs while managing costs and optimizing earnings. Strategic partnering-when done right-can offer significant advantages versus "going it alone" in solving these major challenges. Identifying the risks and benefits associated with implementing and managing successful alliances begins with the due diligence assessment by the potential alliance partner. After the deal is executed, it is critical that the biotechnology partnering arrangement be optimally managed. Each company must assign a dedicated executive responsible for managing the day-to-day operations of the product partnering arrangement. This executive typically has the title of alliance manager (AM), and it is the AM's role to champion the success of the alliance and to ensure each partner obtains expected financial returns. This role can also assist greatly in bridging any operational issues with partners that provide services as part of the deal. 

In addition to assigning an AM, a governance committee may be formed. The governance committee may sit on top of other committees, such as a joint operating committee (JOC), and is comprised of upper management executives (with merited voting and non-voting privileges) who meet on a regular basis (e.g., quarterly or semi-annually) to assess progress and make course corrections as necessary. This team is charged with strategy for the alliance/partnership and overall relationship dynamics. Members should have decision authority and ultimate responsibility for the success of the alliance, as well as serve as the executive sponsor for the alliance in their respective organizations. The JOC should meet more frequently than the governance committee as members are charged with oversight and delivery of day-to-day operations, operating plans and milestones. Members of this committee should have the technical knowledge to lead the operations and decision-making authority at an operational level to minimize elevation of disputes to the governance team.

If the deal environment changes substantially, such that mutual interests become misaligned or issues in development change the scope of the original deal, both parties may need to consider renegotiation of terms.

Biotech Summary

Large pharma and biotechnology companies have profited from mutual partnering relationships in the past, and large pharma is spending a significant amount of cash to access early-stage biotechnology assets. Alternative business models are now being employed to create partnering solutions whereby a biotechnology company can share risk while retaining control of its assets. In summary:

Biotechs have different needs for partnerships, depending on their level of maturity.
Direct equity investments can be a solution for some biotech companies seeking to gain infrastructure and intellectual capital and retain intellectual property.
Single product risk, associated with biotechnology companies, can be mitigated by forming a portfolio.
Biotechnology companies gain intellectual property (IP) and clinical drug development experience by choosing the right partner.

Innovative Partnering Strategies

A partnering solution for large pharma companies that is often discussed but, in the author's opinion, is difficult to execute is the creation of a Special Purpose Entity (SPE) to house a portfolio of products.

The key benefits of creating an SPE are:

Accounting treatment may be transferred from the partner's parent company to the SPE.
Larger sums of capital can be obtained from disparate capital sources.
Each capital provider agrees to the upfront requirements (e.g., returns are generally scaled to the magnitude of each capital provider's investment in the SPE).
Larger numbers of products (or perhaps a mix of products) can be developed and moved forward (to the next value inflection point, such as Proof of Concept (PoC)).

The downsides to an SPE are:

It is difficult for potential partners to agree on the number and type of assets in the portfolio (e.g., variables such as stage of development, therapeutic area, commercialization potential).
Larger capital providers may wish to renegotiate the terms of the initial partnership started by a third-party provider with insufficient capital to fund the entire transaction.
There may be lack of agreement on the amount of upside, what to do with failed assets, how to replace failed assets, how to define (or redefine) success, etc.
In some countries, IP may need to be transferred to the entity so the sponsor can obtain desired accounting treatment (e.g., IFRS). Although this may allow for the desired accounting treatment, the sponsor, in essence, loses control of its asset(s).

Commercial Perspectives

When forming a portfolio, whether by choice or by merger and acquisition, there are a number of critical decisions that are influenced by commercial considerations. These can include, but are not limited to:

size of the market
number of patients with the disease
number of treatments currently-and predicted to be-available over the time span of the partnering arrangement, along with patent status of current products
level or degree of satisfaction with the currently available treatments
differentiation between the product candidate and another commercially available product with the same MoA
efficacy and risk profile
whether the approval is conditional upon a FDA-mandated Risk Evaluation and Mitigation Strategy (REMS) program
ease of use (oral vs. subcutaneous)
the internal capacity of the potential partner to market a product
geographic reach
formulary status and reimbursement expectations for the US, EU, Japan and rest of world, along with distribution of payer mix (i.e., if disease is predominantly seen in the elderly population, the Centers for Medicare and Medicaid Services becomes more important in the US than other third-party payers)
distribution channel (retail pharmacy, hospital, specialty distribution, physician office)

"By choice" means that a third-party capital provider is given the opportunity to partner with a number of unencumbered products. For companies that offer a large number of product candidates for portfolio selection, the initial portfolio can be pared down to a smaller number of candidates with the right risk that makes deal palatable to the investor and the owner of the compounds.

"Merger and acquisition" means that the potential partner (e.g., owner of the assets) may have inherited a number of compounds, and these candidates are not necessarily selected on a strategic, high-value basis. For example, in the oncology setting, it is often advantageous to go after the largest markets (e.g., breast cancer and prostate cancer) first, but this approach may not align with the MoA of the candidate, the commercial resources of the potential partner (e.g., sales force), or the best exit strategy for the business (sale after Phase 2 to large pharma). Therefore, although breast cancer and prostate cancer, for example, may be potentially more lucrative markets, one of the portfolio candidates may actually compete with an existing product in the portfolio or may end up being a "me-too" product in a highly competitive market and thus, actually be less attractive from an investor standpoint (or a net present value, NPV, perspective).

Common commercial questions include:

Are the candidates in the same therapeutic area? If so, are they synergistic, i.e., Do they treat the patient at different points in the disease spectrum, or are they competitive?
- If a third-party capital investor wishes to create a portfolio of products in multiple therapeutic classes, in the author's experience, this diversity will require additional experts and thus add cost to the due diligence exercise.
Are the candidates in different stages of drug development?
- Return or success criteria may need to be modified for each candidate.
- If so, it may make it more complicated to define a milestone for Phase 1 asset success vs. Phase 2 (PoC) success.
- The range of probability of success (PoS) may make the cost of capital too high for the potential partner.
Does the return structure include a commercial element? If the third-party capital provider is paid on milestones (e.g., the entire amount based on regulatory approval alone), it may not be important-from the investor's standpoint-to conduct commercial due diligence.

Direct Equity Investments

One solution that has proven successful for earlier stage biotechnology partnering deals is a direct equity investment (DEI). These smaller investments usually require a lead investor to validate due diligence and minimize due diligence time and cost for co-investors.

The author has experience in performing due diligence in conjunction with, or on top of, others' due diligence activities (mostly for independent validation purposes) for multiple, small cap, early stage companies, where the capital provider puts a small amount down on a lead product with the hope that it will progress to the next stage (and thus increase the value of the company) or sell it to a large pharma company as a viable exit strategy. For this goodwill (and demonstration of expertise), many companies will partner with the capital provider (such as a CRO), if it can provide drug development services such as the conduct of a trial, particularly if those services are offered at a preferred vendor rate.

This approach has two main drawbacks: 1. the company may not have enough money to progress to the next stage; and 2. the drug may fail. One large upside for a potential partner could be the valuation and exit reward for a biotechnology company purchased by a large pharma company. An upside to partnering with a CRO is the additional benefit of access to technical expertise and global clinical trial contract services.

Some companies have enough DEIs in a portfolio that, in the event several companies fail to progress their compounds, others will advance (and thus, increase in value) or be purchased to make the initial investments palatable and obtain a reasonable return on investment.

Series Summary

Investing in pharmaceutical products is a risky business. One way that single-product risk can be mitigated is by forming a portfolio of products. Individually, these products may have a high potential for technical failure, but grouping them with other compounds can increase the chance for single or multiple successes. Portfolios are generally limited by the number of assets, the stage of drug development of each candidate and the amount of capital required to advance each candidate to the next stage of development or sale (e.g., out-licensing as an exit strategy).

Due diligence, performed on behalf of the capital provider, should investigate the strengths and weaknesses of each candidate in the portfolio to understand the likelihood of loss of capital. If the results are unattractive, the deal should be modified or, if that is not possible, the candidate should be discarded and a substitute identified. In general, the greater the risk taken, the greater the expected return.

The optimal number of candidates can be defined using a variety of methods ranging from the simple law of averages to calculate a return (e.g., the Solvay case study), based on certain milestones (e.g., the Eisai case study) to more complicated methods (e.g., Bayesian statistics).

Single sources of capital are easier to work with than syndications when funding a portfolio. Deal complexity increases with a diversified portfolio in multiple therapeutic areas at different stages of drug development (in part because of the larger variety of due diligence experts needed to understand each technology/candidate) and generally decreases when all products are in the same therapeutic area and stage of drug development. Less risk is usually associated with later stage compounds, and for this reason, these are probably the most attractive and most difficult to find.

If set up correctly, the partnership should not end at execution. It is critical that after the deal is executed, the portfolio partnering arrangement be optimally managed. Each company must assign a dedicated executive to manage the day-to-day operations of the product partnering arrangement, and may also form a governance committee.

Due to the ongoing need for capital and drug development expertise, portfolios will continue to offer an attractive partnership/investment option. Companies that wish to partner on portfolios of products and have access to both capital and scientific and clinical trial (e.g., operational) expertise will be at an advantage over those lacking such resources.

Case Studies

Eisai Portfolio

In the final quarter of 2009, Tokyo-based Eisai Co. Ltd. announced it would partner with US-based NovaQuest-then part of Quintiles-on the development of six cancer drug candidates from its R&D pipeline.^{1, 2}

The agreement called for NovaQuest to co-fund 11 PoC studies on the six cancer drugs. Quintiles' CRO business agreed to run 11 Phase 2 studies on the candidates and provide capacity expansion through collaboration (e.g., expertise, infrastructure and funding). In addition to the 11 trials Quintiles is conducting, Eisai is running 18 trials on the six drug compounds. The trials will test the effectiveness of the drugs on a number of different cancers. The deal offers an opportunity to accelerate the development of the cancer drugs in Eisai's pipeline. The development plans were created through a robust governance structure that included high levels of collaboration.

The development of anticancer agents is expensive because of the need to conduct a large number of clinical trials to develop multiple indications for a single compound. R&D resource limitations make this process difficult. A risk-sharing and reward model allows pharmaceutical companies to develop multiple anticancer candidates at the same time by minimizing initial investments. This enables companies to shorten development and maximize sales.

The deal leverages Quintiles' strength in cancer-drug testing. Between 2000 and 2009, when the agreement with Eisai was announced, Quintiles conducted 640 oncology studies involving more than 131,000 patients at nearly 20,000 sites in 68 countries.

According to Mr. Hideki Hayashi, senior vice president and chief product officer for Eisai, "We are maximizing the potential of Eisai's oncology compounds. I am pleased that Quintiles and Eisai share the same goals and our incentives are aligned for speed, quality, and efficiency. We will explore multiple indications in parallel so that we can deliver our compounds as fast, widely and appropriately as possible for cancer patients' benefit."³

This case study was created using only publicly available information as noted.

References

Jiho (electronic newsletter), Quintiles to Offer More Risk-Sharing Models: Dr. Winstanly, Pharma Japan, 4 January 2010; Factiva Inc., 2010.
Drew J. Quintiles teams with Eisai on Cancer Drugs, Triangle Business Journal, 30 October 2009. http://www.bizjournals.com/triangle/stories/2009/10/26/daily62.html  Accessed 3 June 2013.
Quintiles Announces Strategic Alliance to Advance Eisai's Oncology Pipeline, Obesity, Fitness and Wellness Week, 21 November 2009; http://www.newsrx.com/newsletters/Obesity,-Fitness-and-Wellness-Week/2009-11-21/33112120093080OW.html., Accessed 3 June 2013.

Solvay Portfolio

Solvay Pharmaceuticals had a robust pipeline of products in Phases 2 and 3 but lacked both the global infrastructure and financial resources to develop these products in a timely fashion. NovaQuest-then part of Quintiles-and Solvay formed a multi-phase strategic and co-investment alliance.

Step one was a master services agreement giving Solvay access to state-of-the-art clinical trial execution by Quintiles at competitive, volume-dependent prices. The relationship simplified and accelerated study start-up, reducing the CRO's learning curve and the delays often caused by contract negotiations for each new product. This streamlined operational relationship significantly enhanced Solvay's development capabilities.

Step two was a services partnership to help fund Solvay's Phase 2 portfolio. Under the agreement, NovaQuest provided $25 million in professional fees for up to 10 proof-of-principle studies over three years, making it possible for Solvay to process more assets through its Phase 2 pipeline. Solvay, in exchange, made milestone payments to NovaQuest for each compound that reached positive proof of principle in Phase 2 and moved into further development. This helped to match Solvay's out-of-pocket costs with the increased value of its assets. Each partner bears about 50% of the normal costs and risks for outcomes.

With this customized operational and co-investment relationship in place, the partners are firmly aligned to optimize the speed, cost, and quality of clinical development programs across Solvay's portfolio. From 2001, when the deal was inked, until 2007 (the date of the published report upon which this case study is referenced), the alliance achieved the following results:

completion of three Phase 3 trials
the shift of two compounds from Phase 2 to Phase 3 testing one year earlier than expected, which holds the potential for millions of dollars in additional patent-protected sales if either product is approved
quick production of conclusive Phase 2 data (Solvay then stopped the development of the two compounds, freeing resources to work on others.)
receipt of a $298 million contract from the US Department of Health and Human Services to develop cell-based influenza vaccines, with Quintiles to conduct nine clinical trials
completion of the influenza "annual update" studies that secured yearly marketing rights for Solvay's traditional egg-derived vaccines

Solvay Pharmaceuticals and Quintiles used the balance scorecard kit to manage their alliance and together reduced the total cycle time in clinical studies by 40%.