Friday, June 29, 2007

Private Equity: Muscling in on Big Pharma at Biotech's High Rollers' Table

Talk about co-dependency. Pharma needs biotech’s products; biotech needs pharma’s cash. Oh, they say they need other things, but when it comes down to it – that’s about the equation.

So if biotech had a different source of cash (or Pharma had a different source of products), well – this marriage would turn open.

That’s why private equity has become such an interesting game changer. PE firms, stuffed with too much cash as it is and incentivized with management fees to stuff themselves still further, are all chasing the same buyout opportunities, throwing ever greater sums at owners and managers in order to get into the deals.

Biotech, which certainly needs cash, doesn’t return money on anything like a PE firm’s preferred timeline. But biotechs are also relatively unmined territory. Therefore cheap. That’s why you’re beginning to see major private equity players doing things private equity rules say they shouldn’t do.

Consider this progression. In 2004, KKR put something like $200 million into Jazz Pharmaceuticals—a theoretically stable, spec pharma-ish kind of investment. The financing underwrote Jazz’s takeover of the commercial-stage Orphan Medical, so KKR at least got some cash flow, which PE investors like to see. And there was no discovery risk—but certainly development risk. (Not that it's worked out brilliantly, so far. See our recent post.)

Two years later, New Mountain enables the Ikaria/Ino deal – creating a theoretically self-financing company (like Jazz, it has a commercial organization providing the requisite cash flow) but it nonetheless depends for its success on the crapshoot of discovery.

And now The Invus Group is putting $205 million into Lexicon, with the potential to add another $345 million down the road. They’ll get a minimum of 40% of the company and could end up owning far more. But now the whole thing is based on discovery – and not just me-too discovery, but Lexicon’s novel-target, novel-compound approach (see our upcoming article in the July/August IN VIVO).

In short, private equity is moving into pharma territory, funding companies the way only pharmas once could. The whole point is to build organizations of such size that a biotech can do its deals on relatively equal terms with pharma – which means that if it doesn’t get its deal price, it can walk away and do its own development and commercialization, continuing to increase its assets’ value.

The theory underlying this game is that biotechs are still leaving way too much value on the negotiating table. That’s the value the PE investor needs to retain in order to counterbalance his basic disadvantage as a purely financial, not strategic, buyer. That strategic buyer—Big Pharma--can pay more for particular assets because they can do more with them (like shoring up a fading portfolio or keeping profitable and busy a sales they don’t want to lose). Can PE use its money to extract that strategic premium biotechs on their own can’t? It’s an interesting gamble: both biotech and Big Pharma need to get to know the new dice-throwers at the high-rollers’ table.

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