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Pharma Gets Unwelcome Competition

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I love it when a plan comes together

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Big pharma (and big biotech) are seeing their best plans go awry by the rapid influx of venture capitalists into public market companies. This new source of cash is driving up deal values and shows no signs of letting up any time soon.

Background

Big pharma and biopharma (big biotech) had things set up perfectly. About the time a clause in the American Jobs Creation Act afforded them nearly tax-free cash flow from overseas, the valuations of publicly-traded biotech companies were plummeting. For big pharma, this was perfect timing as they badly need to replenish their pipelines due to patent expirations and failed drug classes (COX-2 inhibitors, for example). For biopharma, they now had a less-expensive opportunity to close the revenue gap with their big pharma competitors.

While valuations of publicly-traded companies were plummeting, big pharma and biopharma went into the private sector to make their first acquisitions. While these deals always registered on the radar screens of investors, dollars flowing into private companies did nothing to raise valuations in the public markets. The reason for this is very, very few people knew the valuations of these deals. It was not apparent to Wall Street that private companies were being acquired at enterprise values at some multiple above a goodly percentage of publicly-traded biotech firms.

This disconnect became especially apparent in Q1 of this year, making the decline in biotech valuations all the more frustrating to those of us who had some insight into the broader biotech universe. We knew something had to break, but the timing of it was very uncertain.

Recent history

We knew big pharma and biopharma had to start purchasing late-stage products via acquisition or partnership. We also knew there was enough repatriated cash available to just the top pharma firms to buy almost all of the 160-odd stocks in the NASDAQ Biotech Index. Something had to give.

Yet 1H-2005 biotech valuations continued to plummet as none of the usual players in the public biotech space wanted to be long biotech stocks. Fidelity, in particular, was selling everything biotech. This emboldened short sellers who, for about a year, looked invincible. I related in these pages and on the Buzz how I was getting calls from long-time long investors saying they were opening short-side biotech funds.

Things were bad.

Then Pfizer (PFE) acquired Vicuron in a bidding war among pharma companies. The amount paid finally sunk into the skulls of Wall Street, waking them up to the huge pool of cash targeted to the biotech space. Biotech valuations really haven't looked back since, despite short sellers continuing to pile on their negative bets.

Going forward

We have been puzzled as to why we are not seeing more deals. Biotech execs, partially via our own efforts, understand the dynamics behind pharma and biopharma's push into their sector. They already knew something was up given the huge increase in phone calls from biz dev people interested in their products. Where a small biotech might have one or two interested suitors, they now had a dozen or more.

Pharma and biopharma are experts at stressing small biotechs during negotiations. They know small biotechs are in a race between their checkbook and the clock and are more than happy to wait that out until small biotech becomes desperate. The longer they wait, the big companies believe, the better the deal will get.

That whole strategy has been upset by the rapid and forceful entrance of private VC money into the public market space. Tired of paying significantly higher valuations in the private space, VCs are now offering money direct to public companies. The investment is ideal for them - fabulous liquidity, lower valuations, and (generally) later-stage products. Some biotech CEOs we speak with are getting multiple calls per day from VCs offering cash at par or even at slight premiums.

Now small biotech CEOs have leverage against big pharma and biopharma. They can tap the VC funds - which are the ideal shareholders given their notoriously patient attitudes - for precious cash and turn the waiting game tables on their negotiation partners. Deal values are soaring even as small biotech increases their demands for pieces of the partnership pie.

One side effect of this is we expect to see the mix between partnerships and acquisitions skew more towards acquisitions. When partnership valuations get above $500M, cash flush biopharma and big pharma would rather just pay the $2B or more to buy the company out. With favorable purchase accounting rules, the impact on the acquiring company's bottom line is actually less for an acquisition than a partnership allowing the acquirer to, as the publication In Vivo put it "have their cake and eat it too."

My mantra of "I want to be invested in the acquisition targets, not the acquirers" resonates even more now with this new development. As more and more VCs flood the public markets with offers of cash, biotech deal values will soar. The key for investors is, as always in the biotech sector, timing. Will these deals be a 2H-2005 event? A 2006 event?

I wish I could tell you one way or the other. My guess is the next twelve months - particularly Q4-2005 and Q1-2006 - will be exciting. If you run fast money, that's a tough prospect because the timing is so uncertain. If your investing style is more patient - and has the ability to withstand the downs and ups involved with investing in biotech - the ripples from the move of VCs into the biotech space could be a very nice opportunity to outperform the markets.
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No positions in stocks mentioned.

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