Thursday, May 03, 2007

IPO Cabal? Not Really.

"Everybody knows," one prominent VC told us, "that biotech IPOs are controlled by six people.”

He may be stretching a point (not everybody knows it; there might be slightly fewer, or a couple more, fund managers in control; and control is a highly relative concept)—but, in broad strokes, no one in the financial world really disagrees. To get public, most biotechs need to convince at least some of these investors to buy in—and because they need to do so, these investors can keep the price low—in a very narrow band of market value.

So who are these investors? Among 'em are Kris Jenner of T. Rowe Price, Bill Slattery of Deerfield, les frères Baker from Baker Biotech, and Adam Koppel of Bain. But the point is--the list ain't long. (More on this in the May issue of Start-Up).

So if there are billions of dollars washing around in the market, why are there so few biotech IPO investors that matter?

One reason--somewhat counterintuitive--is that biotech IPOs look less like public venture capital than they used to. In the old days, and particularly in the gravity-defying genomics-enamored market of 2000, companies could go public with very early-stage assets. Trying to figure out whether they'd succeed was an almost complete crap shoot, and so due diligence was comparatively less important. Good for uncovering fraud; or managerial incompetence, perhaps. But not much help with figuring out whether a drug would work, or whether doctors would prescribe it if it did. In 2000, the average fund manager--indeed, the average individual investor--wasn't at a huge informational disadvantage to the knowledgeable investor (there were other disadvantages, of course--like whether he could get a piece of a hot IPO, which would be generally reserved for favored fund managers).

No more. Biotechs virtually can't go public without late stage assets--and those are ripe for due diligence. The usual IPO roadshow -- 20 minutes with the management per investor -- doesn't allow for any real understanding, which leaves just a few experienced investors that anyone who wants to go public must spend time with, and who have probably seen plenty of similar companies come down the pike. In this world, experience counts. And can be used to keep IPO prices down.

Some companies are trying to get around this problem by packing so-called crossover investors -- who can invest in both private and public companies -- into their mezzanine rounds, giving them time to get to know them and thereby seeding the IPO with long-oriented investors who can make their money both on the private-to-public step-up as well as on further public appreciation. But there aren't a lot of those opportunities.

In the first place, some venture investors don't want to bring in crossovers into their mezzanine rounds when their object is to sell the company, not take it public.

And high-quality companies that could go public have sometimes put themselves into positions where they can't. Take Perlegen, which just yanked its IPO filing (and shook up its management team): it had plenty of crossovers among its investor group. But it couldn't pull of the offering, most importantly because its lead drug/diagnostic didn't work. And yet it wasn't getting much traction anyway. The company had raised $256 million privately and, in a world where pre-money IPO valuations are averaging $150-200 million, no one wanted to take that kind of haircut on price.
In short, there may be an IPO cabal. But the peculiarities of biotech keep it in business.

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