The biotech ecosystem looks healthy moving into 2013. With the space above $1 billion more than replenished in 2012, mid-cap names have money to create their own tier-jumping stories this year, while investors see natural selection plucking winners from the small and micro-cap spaces.

Fund managers suggest the run-up in large caps could lead to a rotation of investment into lower market cap tiers, fueling the cycle of replenishment necessitated by take-outs like Amylin Pharmaceuticals Inc. and Human Genome Sciences Inc.

Of the 85 companies that began last year in the $200-$499 million market cap tier, more than half had at least three years of cash at the end of 3Q12. By the start of 2013, 25 had jumped one or more tiers.

This year, 80 companies are starting out in this small cap space; 44 have development programs in key areas of buysider interest, while only 14 are operating in no-fly zones shunned by public investors (see BioCentury, Jan. 7).

Buysiders also expect to see larger sums of money targeted at a few small and micro-cap names. This would continue a pattern that emerged in 2012, when specialists provided funds needed to get well beyond important inflection points to a select list of companies while subjecting others to Darwinian forces.

As for the IPO market, the reemergence of crossover investors, a strong performance in the after-market by last year's class of new public entrants, and implementation of the JOBS Act could help improve prospects for private biotechs looking for a public exit in 2013.

Biotech's big run

Biotech had an impressive run in 2012. Despite a sector-wide slowdown in 4Q12, on the year the NASDAQ Biotechnology Index gained 32% and the BioCentury 100 gained 26%, handily outperforming both the NASDAQ Composite (up 16%) and S&P 500 (up 13%).

Much of this performance was driven by companies valued above $5 billion, which as a group have been the best-performing market cap tier for two quarters running. In fact, the big caps were the only biotech tier to finish last quarter in the black (see "Raised by Market Cap").

Ladenburg Thalmann's Edwin Gordon suggested last quarter's selloff was motivated by uncertainty about how capital gains would be taxed as politicians dealt with the fiscal cliff.

"There was a decided preference for selling winners rather than getting out of losers last quarter, indicating fear about capital gains was driving much of the selloff," he said. "That means there is a lot of cash on the sidelines, setting us up for lots of activity in the first quarter."

The standout performers last year were bellwether Gilead Sciences Inc. and rising star Regeneron Pharmaceuticals Inc.

Last year, Gilead tacked on $23.5 billion in valuation, a 76% increase, thanks to continued clinical success with its HCV portfolio. The company ended 2012 with a market cap of $55.8 billion.

Regeneron, which crossed into the $5 billion-plus tier in 1H11, rode the commercial success of Eylea aflibercept for wet age-related macular degeneration (AMD) to a valuation of $16.5 billion at YE12. That was up 213% from $5.1 billion at the end of 2011.

Little laggards

Buysiders offered several reasons, both fundamental and psychological, for why they think biotech's lower tiers are in position to play catch-up in the near term.

Rajiv Kaul, who manages the Fidelity Select Biotechnology Fund, said large caps have gotten expensive.

"The valuations of the big caps are certainly less compelling now than they were a year ago," he said.

Indeed, biotech's healthy P/E ratio of 18.4 is down 24% from 3Q12. But it is still up 11% from the end of 2011 and matches up favorably against 11.7 for big pharma (see BioCentury, Jan. 7).

Kaul said he may look more aggressively at smaller cap names in 2013, though the size and liquidity requirements of his fund means companies valued at $200 million are the smallest he can consider.

The top three holdings in Kaul's fund are Gilead, Amgen Inc. and Biogen Idec Inc. The only one of his top 10 holdings valued under $5 billion is cancer company Medivation Inc., which closed 2012 with a market cap of $3.8 billion, up 125% from $1.6 billion at the end of 2011.

Gordon also noted the Chicago Board Options Exchange Volatility Index (VIX) suggests volatility will be low. VIX is a measure of implied volatility of S&P 500 index options for the following 30 days.

"Financing in life sciences falls off anytime the VIX rises above 25, but right now we're at around 14 or 15, so we should be in pretty good shape" as far as investor willingness to rotate out of the safe haven of big caps and into the riskier mid- and small cap arenas in search of stronger returns, he said.

Harald Schwarz, managing director at healthcare investment consultancy Medical Strategy GmbH, also expects investor appetite for beta will increase, which he said should be good news for the smaller caps.

"We anticipate investors will take on additional risk with small cap investments, especially as the overall stock market rally continues and as fixed-income yields remain anemic," he said.

There is recent precedent for expecting some rotation out of the larger caps and into smaller names. The large caps outperformed the other segments in consecutive quarters beginning in 1Q11 and running through 4Q11.

Then, in 1Q12, the $200-$499 million group took the leadership role with a 16.4% gain, followed by the large caps at 14.6%. The micro-cap group of companies valued under $200 million was close behind at 14.3%.

Re-cycle of life

The number of companies that jumped tiers last year suggests the healthy cycle of replenishment continues, and many companies in the $200-$499 million group appear particularly well positioned to graduate in 2013.

Five biotechs disappeared from the $1 billion-plus tier last year, including four via M&A and one - Dendreon Corp. - due to a loss of market cap.

Among the biggest biotech takeouts of 2012, Bristol-Myers Squibb Co. paid $2.5 billion for HCV play Inhibitex Inc. in February and plunked down even more in August - $7 billion - to take out diabetes company Amylin.

Autoimmune, cancer and infectious disease play Human Genome Sciences was taken out by GlaxoSmithKline plc for $2.9 billion.

The fourth company to exit by way of M&A was Gen-Probe Inc., which was acquired by fellow molecular diagnostics company Hologic Inc. for $3.8 billion in August.

Dendreon closed 2012 off 30% to $5.29, valuing it at $791.3 million, as punishment for disappointing sales of prostate cancer immunotherapy product Provenge sipuleucel-T.

Twelve companies moved up to take their place (see "Biotech Restocks").

Among companies crossing the $1 billion threshold were three that jumped two tiers, starting 2012 in the $200-$499 million group: Arena Pharmaceuticals Inc.; Infinity Pharmaceuticals Inc. and Synageva BioPharma Corp.

Arena's obesity drug Belviq lorcaserin received FDA approval in June (see BioCentury, July 9).

Infinity has two compounds in Phase II testing: IPI-145, an oral inhibitor of phosphoinositide-3-kinase (PI3K) delta and gamma for asthma; and retaspimycin (IPI-504), a small molecule heat shock protein 90 (Hsp90) chaperone inhibitor for non-small cell lung cancer (NSCLC).

Orphan disease company Synageva's lead compound is sebelipase alfa (formerly SBC-102), a recombinant human lysosomal acid lipase (LAL) enzyme replacement therapy. The product is in Phase II/III testing in infants with early onset LAL deficiency, also called Wolman disease.\

An analysis of the 39 biotechs that began 2012 with a market cap of $500-$999 million suggests the group had ample access to capital, as virtually every unprofitable company with less than three years of cash was able to raise money over the past 12 months.

In fact, 2012 turned out to be one of the strongest years for follow-ons on record. A total of $6.3 billion was raised in 111 follow-ons last year. In the mid-cap group, 30 companies took in $2.3 billion (see "Follow-on performance," A4).

One exception was Aveo Pharmaceuticals Inc., which stumbled in August after FDA expressed concerns about the overall survival trend in a Phase III trial of Tivopath tivozanib to treat renal cell carcinoma (RCC). The company, saying it had addressed the agency's concern, submitted an NDA for the inhibitor of VEGF receptors 1, 2 and 3 in September.

Tivopath, which has a July 28 PDUFA date, is partnered with Astellas Pharma Inc.

Aveo subsequently reduced headcount by 45 (17%) to 235 and scaled back investment on research programs in October. At the time, it said the $189.7 million in cash at Sept. 30 would provide it with runway through 2013.

The company lost 62% of its valuation over the course of 2012, opening the year with a market cap of $741.8 million and closing at $281.9 million.

Next in line

Among companies valued below $500 million, the sentiment among buysiders is nearly unanimous: selectivity is the new normal. As a result, many of these companies are going to struggle to raise the capital needed to reach the next inflection point. But the ones that do raise money will get more.

Indeed, in total, small and micro-cap groups each raised more money in 2012 than in 2011 (see "Raised by Market Cap," A2).

Roth Capital's John Chambers noted investors channeled the money into almost the same number of companies. He believes this trend will continue as investors pick out a smaller set of companies to fund beyond important inflection points.

"More selective investors are going to invest more dollars into fewer companies," he said. "Companies achieving institutional support will garner ample funds to bring them through and beyond milestones, thus removing the financial overhang, while those that do not are at risk of a Darwinian process in which it may no longer be viable to remain a stand-alone entity."

RA Capital's Peter Kolchinsky said capital always will be available for small companies based on sound science with competent management to guide it.

"The sector is a pyramid with maybe a few dozen notable large companies," noted Kolchinsky. "But there are many more companies in the $100-$300 million range, many of which have the capital to generate Phase II data that might cause them to rocket into the next segment."

The good news is there is a strong concordance between what investors want and what the small cap universe is working on.

In BioCentury's 21st Annual Buyside View, money managers said cancer, antibiotics and Orphan diseases are areas of high interest heading into 2013 (see BioCentury, Jan. 7).

Among the 80 companies that began 2013 in the $200-$499 million space, 28 are in cancer, 11 each in infectious and Orphan diseases, and six in diagnostics.

In the latter space, Ladenburg's Gordon, Baird's Selena Chaisson and Eli Casdin of Casdin Capital argued there will be an expanding role for diagnostics in the context of personalized medicine, which makes them an interesting investment option.

According to Gordon, that's particularly true in light of valuations that have recently contracted "due to the questions around reimbursement and thus their value proposition."

He predicted "CMS will come around to paying for diagnostics that can be tied to efficacy or lack thereof in specific patient populations. This would result in an upward revaluation of this group from 2x revenue."

Gordon said it may take two or three years for this to play out.

As to the unpopular spaces, 10 of the 2013 group of small caps are working in neurology, where buysiders said they are less willing to deploy significant funds due to the unpredictable nature of clinical trials and a dearth of knowledge about the physiopathology of many diseases.

Three of the small caps are working on gastrointestinal disorders, which several buysiders noted often require large and expensive clinical trials and sales forces.

Exit strategies

Following a modest uptick in IPOs last year, buysiders are looking to three positive trends that could grease the wheels going forward.

Last year, 24 companies went public compared to 19 in 2011, although most took haircuts in the double-digit percent range to get the deal done.

"The IPO market remained challenging in 2012," said Cowen's George Milstein. "The mean file-to-offer discount was in the low 20s, so pricing has been difficult."

The amount of insider participation also has increased as investors seek to help companies out the door. "We seem to have reached a new normal on insider participation, with insiders picking up around 30% of an initial public offering," Milstein noted.

One thing buysiders think will improve the IPO market this year is the Jumpstart Our Business Startups (JOBS) Act, which was enacted in April 2012 to help small companies access public capital.

"Companies are now allowed to file silently with the SEC," said Marina Bozilenko of William Blair. "This allows more flexibility for picking your time and is important because IPO windows don't say open for long."

Perhaps more importantly, according to Bozilenko, is the change to SEC policy that now allows companies to speak with investors "to help familiarize them with the complexities of their story rather than having one 45-minute discussion and expecting the investor to make a decision."

Gordon said more communication should help manage expectations, "since companies will now have a better feel for where their shares should price."

The banker did note one downside. "The ability of companies to file silently means there is less clarity about who and how many candidates are in the queue," said Gordon.

A second factor that could fuel the IPO market is the larger role crossover public investors have played in late-stage private financings, providing an additional source of capital to help shepherd companies to reach a stage where other public investors will take notice.

Two examples from 2012 were a $60 million series D round by gene therapy company bluebird bio Inc. in July and a $210 million equity and debt raise by diabetes play Intarcia Therapeutics Inc. in November.

"These two deals included a virtual who's who of crossover investors," said Milstein. "If you look at these types of transactions, it's a new financing paradigm where companies are reaching directly into public financing institutions for later- and last-stage rounds" that should help see a company out the door.

A third positive indicator was the strong after-market performance of last year's IPOs.

The class of 2012 finished the year up 22% compared to the BioCentury 100's 26% gain. What's more, the 4Q IPOs ended the quarter up 24%, while the BioCentury 100 was off 4% (see "IPO Performance," A8).

In contrast, the IPO class of 2011 lost a median of 13% of their value six months after going public.

"What you are clearly seeing is an appetite for new issuance," said Milstein. "There were certain times during the year that were more fluid than others, but it is clear that for the right story" the public markets are accessible.

Chambers noted the lack of access to the public markets over the past few years has resulted in a build-up of mature candidates waiting for the right opportunity (see "IPO Queue," A5).

"Many private companies are further along in the clinic, and the more mature and advanced they become, the more attractive they will appear versus their public comparables," he said.

Milstein agreed: "I expect that more companies will look to go public next year and, if the market dynamics mirror 2012, then we should have a bigger class this year."


Amgen Inc. (NASDAQ:AMGN), Thousand Oaks, Calif.

Arena Pharmaceuticals Inc. (NASDAQ:ARNA), San Diego, Calif.

Astellas Pharma Inc. (Tokyo:4503), Tokyo, Japan

Aveo Pharmaceuticals Inc. (NASDAQ:AVEO), Cambridge, Mass.

Biogen Idec Inc. (NASDAQ:BIIB), Cambridge, Mass.

bluebird bio Inc., Cambridge, Mass.

Bristol-Myers Squibb Co. (NYSE:BMY), New York, N.Y.

Dendreon Corp. (NASDAQ:DNDN), Seattle, Wash.

Gilead Sciences Inc. (NASDAQ:GILD), Foster City, Calif.

GlaxoSmithKline plc (LSE:GSK; NYSE:GSK), London, U.K.

Hologic Inc. (NASDAQ:HOLX), Bedford, Mass.

Infinity Pharmaceuticals Inc. (NASDAQ:INFI), Cambridge, Mass.

Intarcia Therapeutics Inc., Hayward, Calif.

Medivation Inc. (NASDAQ:MDVN), San Francisco, Calif.

Regeneron Pharmaceuticals Inc. (NASDAQ:REGN), Tarrytown, N.Y.

Synageva BioPharma Corp. (NASDAQ:GEVA), Lexington, Mass.