Friday, September 07, 2007

Why Financiers Like Virtual Companies

Capital hates a vacuum.

In this case, the vacuum is Big Pharma’s late-stage pipeline. As deal prices rise for post-proof-of-concept products, investors and clever packagers of financing are stepping into the financing void which, at least relatively speaking, opens up pre-POC. For more on this, see our analysis here and here.

Take Drug Royalty. It’s made a good business monetizing royalty streams from approved products but now is moving upstream, looking to package still unapproved products on which they’d take a percentage of future revenues.

Or Morgan Stanley. Its PhaRMAs (Pharmaceutical Royalty Monetization Assets) likewise package a set of development-stage products into a debt security. The earlier-stage the assets, or the smaller the portfolio, the higher the interest rate. But for the issuer—the biotech with the products--the return is capped: once it’s paid off the investors, the biotech gets all the upside.

It isn’t just biotechs, like NPS and Alkermes, which are exploiting Morgan’s PharMAs. Morgan also used its security idea to place $150 million in mezzanine debt for private-equity firm Celtic Pharma – essentially an investment management team, funded by a set of limited partners, which has acquired a set of eight projects from various biotechs.

Despite its financial structure, Celtic looks a lot like a virtual biotech, exploiting a network of consultants and CROs to get its products developed. And like other virtual biotechs, it has no intention of creating any sort of sales force. The point is to serve the needs of investors, the supreme anti-infrastructuralists.

Most of these investors, usually hedge funds and insurance companies, want “alpha” from these kinds of investments – in this case, a return uncorrelated with major public markets like equity, debt or real estate. Since Big Pharma buys rights to these products regardless of what the markets are doing, they theoretically should provide plenty of uncorrelated return. But once a product is wrapped in infrastructure—into a real company, with an HR department, office politics and an investor-relations group—then its returns begin to correlate with the equity markets.

And the reality is, says Celtic’s founder Stephen Evans-Freke, products are worth more “without the companies wrapped around them.” Big Pharma, he says, needs “more fixed costs like a hold in the head.” And once there’s infrastructure, companies have social and economic incentives to keep working on programs which should be killed. For investors, the faster a developer kills a drug that’s already fated to die, the better – money, being fungible, can be applied elsewhere. Less easy to do with employees.

“The only reason to wrap all that corporate infrastructure around these projects it to take them public,” says Evans-Freke – who, in his days at PaineWebber or in founding companies like Sugen, found plenty to like about IPOs.

And there are indeed other virtues to owning infrastructure. Discovery doesn’t get done without it, for one thing. Happy accidents—like discovering an alternative use for a drug, for example—would be less frequent. It’s hard to think Genentech could have happened without enough R&D infrastructure to figure out which biologies made a difference.

But the virtual is also now real—and investors like it. The development is another unintended consequence of Big Pharma’s earning-driven appetite for variabilizing its costs, creating a vast and technically expert world of CROs and consultants available for anyone to hire. Whether that’s a good thing or not for Big Pharma (and we think in general it’s a good thing—another way to get products), it certainly has opened up a new way for disenchanted pharmaceutical investors to stick with the industry.

No comments: