Bottom of the food chain?

1 June 2006

Big pharmas are spending huge sums on R&D to tackle conditions like Alzheimer's and depression - yet many neuroscience start-ups struggle to get funding. Is the investment model flawed?

Mike Underhill, managing director of investment management firm Pacific Corporate Group, has good news for the high-tech and biotech sectors. He told angel investors last month that the investment climate is going to be very favourable for the next seven to ten years, particularly for private companies, and that one of the challenges facing the sector will be in managing all the new opportunities. He also pointed out that the Mergers and Acquisitions (M&A) market is heating up, with a 25 per cent increase in volume during the first nine months of 2005 in the US and Europe. That's good news for investors looking for an exit.

Not all investors share that confidence, however, particularly in the biotech space. Thanks to a previous spate of mergers, there's only a relatively small pool of companies in the market for acquiring start-ups - which means there's less competition for deals and as a result, prices could stay low. In addition, the prospects for going public aren't good. 'The IPO (Initial Public Offering) market for early-stage biotechs is poor,' says Carl Goldfischer, managing director of Bay City Capital. 'We're at the bottom of the capital food chain - we're the riskiest of risk capital.'

This divergence of views reflects the different nuances of the biotech investment scene, a sector where investment sentiment is cyclical, and what looks like a good bet this year may be out of fashion in a couple of years' time. The long research cycles, combined with the risks inherent in trials and the onus of regulatory approval, have always made it challenging for investors. While some sectors are attracting a lot of attention from investors - such as early stage medical device companies - there are other parts of the market where investment can be hard to come by.

One of the most challenging - yet also most promising - of these sectors is neurotechnology, a discipline that focuses on the treatment of brain and nervous system illnesses such as Alzheimer's disease, schizophrenia, multiple sclerosis, and depression. Neurological disease and psychiatric illness are estimated to afflict 1.5 billion people worldwide, making it a huge potential market for biotechs - which helps explain why Pfizer devotes 20 per cent of its Research & Development budget to the sector. None of this has been lost on London - market specialist NeuroInsights ranks London/Cambridge fourth on the list of leading neurotech clusters in the world after the San Francisco Bay Area, Boston and San Diego.

At the same time, however, the investment risks in neurotech are perceived to be high. Speaking at a recent conference organised by NeuroInsights in San Francisco, Roger Quy, managing partner at Technology Partners, pointed out that trials are tough, and it's sometimes difficult to prove a drug is effective even when it's known to be safe. Experts warn that results in preclinical animal trials don't always translate to humans because of differences in brain 'plasticity', and there have been some high-profile failures in areas such as stroke, which is notoriously hard to treat. And it's a long haul - Daniel O'Connell, director of NeuroVentures Capital, anticipates the majority of his firm's portfolio companies will take between five to seven years to get to the point where they have enough value to be sold or taken public.

Investors tend to balance these risks in early-stage investments by fleshing out their portfolio with later stage companies, but these carry their own burden. Matthew Perry, portfolio manager of Biotechnology Value Fund, estimated that a later stage company takes ten times as much money to build (because of the sales and marketing requirements). The scientific risks may be lower - but the cash risk is far higher.

At the same time, the prospects for exits tend to be cyclical. Quy pointed out that there are big opportunities for medical device companies today - yet between 1996 and 2003, there was not a single device company IPO.

All of which has caused some experts to question the fundamental investment model. 'I think the IPO in biotech is broken,' said Perry. He argued that the IPO was designed for 'widget' companies that had products and built sales, but the biotech sector has a very different profile and lifecycle. For one thing, it requires much more fundamental due diligence - that's not easy to do during the short timeframes of investor roadshows that take place in the run-up to a public offering.

Yet despite these concerns, all is not doom and gloom in the neurotech sector - far from it, in fact. Perry points out that while many people are afraid to invest in the sector and perceive it to be high risk, sometimes that's where the most attractive valuations are. As Zack Lynch, managing director of NeuroInsights, says: 'Given that these companies are addressing the largest unmet markets, the successful ones are very lucrative for their investors. Equivalent or marginally better treatments are generally approved to give patients more options.'

He adds that while biotech is going through a difficult period now in the IPO market, neurotech companies are faring better than most. In 2005, venture capital investment in neurotechnology rose slightly to a little over $1.5 billion. And from 1999 to 2005, venture funds invested over $7.5 billion in neurotech companies, a 230% increase over the period - by contrast, total life science investment was up 38% over the same period.*

In addition, start-ups always have other options, particularly in terms of corporate partnering and licensing. At a separate panel discussion at the conference, senior representatives from pharma giants Pfizer, Novartis, Bristol-Myers Squibb (BMS) and Wyeth spelled out what drives their partnering plans, each of them stressing the opportunities open to start-ups in different parts of the neurotech space.

Inevitably, this model has one or two drawbacks of its own. While companies like BMS consider M&A targets at all stages of the investment cycle, the deals they strike depend in part on what's in their pipeline at any one time. If BMS already has a full complement of discovery projects, for example, the hurdle for similar ventures will be that much higher. Just as it is in an M&A, that means the timing of any deal will largely be outside the start-up's control.

By Keith Rodgers, Webster Buchanan Research

* 'The Neurotechnology Industry 2006 Report: Market Analysis and Strategic Investment Guide of the Global Neurological Disease and Psychiatric Illness Markets' Published by NeuroInsights www.neuroinsights.com