If you were to make a simple scan of news headlines, you might get the impression there is a corrosive connection between the biotech sector and Big Pharma. Indeed, some US policymakers are currently attempting to block mergers and acquisitions (M&A) in the biotech space – saying innovation is being stifled as a result of takeover activity. However, this could not be further from the truth.
Roughly two decades ago, large biopharmaceutical companies – which were responsible for R&D through to drug manufacturing and distribution – came to the realisation that smaller, more nimble companies and universities had the upper hand in innovation. Deciding to stick to what it did best – distribution – Big Pharma reduced R&D budgets, opting to acquire or merge with the scientific innovators.
As a result, we saw a clear bifurcation of the sector between ‘innovators’ and ‘distributors’. According to a 2019 report by IQVIA, drug companies with annual revenues of less than $500m – the innovators – accounted for 70% of drugs in Phase III clinical trials, while those with revenues of more than $1bn – the distributors – accounted for only 20%.
The new biotech business landscape is based on a symbiotic relationship between the small and large groups. While research departments within large biopharma companies have shrunk, development teams, which are responsible for identifying promising new drugs and taking these through to manufacturing, have become increasingly sophisticated – sometimes collaborating with innovator firms on the development of new drugs before a potential acquisition.
Pandemic and political pressures
However, deal flow in the sector has recently fallen off, namely due to the pandemic. The value of biotech M&A deals, as recorded on the Biopharmadive database, almost halved in 2020 versus 2019, while it halved again over the first nine months of 2021 – as it became harder for firms to carry out the due diligence and face-to-face interactions needed to complete deals.
In addition, political pressure has intensified. US Congress representative Katie Porter earlier this year released a damaging report claiming biopharma M&A destroys innovation. The study analysed the 2002 takeover of small biotech firm Immunex by Amgen, the largest biotech company in the world at the time. Drawing from first-hand accounts of scientists working for Immunex, the report claimed post-acquisition consolidations curbed scientific innovation – at the expense of patients.
Porter is now calling for legislation to empower the Federal Trade Commission to block deal activity in the sector. But this move would be a mistake. Far from stifling innovation, M&A has accelerated development in the biopharma industry over the last decade – as smaller companies do not have the expertise or scale to market a drug globally.
The report also ignores a crucial feature of the biotech landscape – the expiration of patent protections. Once drug patents expire, other biopharma companies can manufacture the same treatment at production cost. This not only ensures lower drug costs for patients, it also minimises the threat of monopoly and anticompetitive behaviour in the space proffered by Porter. As a result, the report is receiving significant pushback.
Compelling valuations on offer
Despite the pandemic and political headwinds, we believe a rebound in M&A is on the horizon. As patents expire, large biopharma companies must acquire new technologies to replenish product pipelines. Market conditions have also become more favourable. While the success of the Covid-19 vaccines and a general risk-on investment mentality led biotech share prices to overheat at the start of this year, small and mid-cap biotech companies are now trading at much more attractive valuations. The graph below, showing the equal weighted XBI vs the market cap weighted NBI, exemplifies this as the NBI performance is dominated by the large caps, whereas the XBI gives the small caps more prominence in the direction of the index.
However, we may see a shift in the type of deals taking place over the coming months. A spreadsheet deal is the most straightforward type of deal, occurring when it makes financial sense for a larger company to acquire a smaller firm and use cost efficiencies and scale to make the combined entity more profitable. These have been the most common during the pandemic, for example we saw GW Pharma being acquired by Jazz Pharmaceuticals to market Epidiolex, a cannabidiol epilepsy treatment.
Meanwhile, innovation-led deals, are driven by the desire to acquire a new technology – such as cell or gene therapy products. These deals usually command much higher premiums and require a greater level of due diligence. As such, they were less common during the pandemic – but we expect to see a pick-up in technology-led deals as M&A levels bounce back. For instance, targeted oncology, gene-editing and cell therapies are still in a relative early stage and carry a lot of potential, so we expect to see M&A deals in this area.
Regardless of whether it is a new technology or not, small biotech companies addressing a high unmet medical need are particularly attractive to larger entities. We like to invest in this type of group, as they operate in a market with high barriers to entry and have a solid patent estate. As such, these deals can command a substantial premium – averaging at 69% since 2018 – which can provide an additional source of return for investors.
For example, we held Immunomedics which Gilead bought in September 2020 for $88 per share, a premium of 108% to the previous day’s closing price of $42.25 per share. This move gave Gilead access to Trodelvy, a ground breaking new drug for metastatic triple-negative breast cancer.