Biopharma companies are still undervaluing external innovation

The case for being bolder and taking risks on early clinical deals

The trend in recent years toward earlier-stage licensing and asset acquisitions is healthy, but it’s not nearly large enough. Companies still all too often prioritize seemingly safe, quickly accretive deals for assets close to the market at the expense of “riskier” early clinical deals that are more affordable and could have more upside.

In an analysis of returns from more than 50 M&A historical deals, Cowen’s Biotechnology Team found that Phase III and registrational assets tended to be pricey, often falling short of the rosy sales projections supporting their hefty premiums. Assets in Phase I or II testing that had yet to reach proof of concept were less likely to strain balance sheets, yet still posted attractive returns, albeit over longer time horizons.

Interviews with dozens of dealmakers, board members and biotech executives emphasized the importance of embracing external innovation at all stages when it is backed by sound science.

We argue that external innovation at all stages of development from preclinical to registrational is critical to sustaining long-term pipeline growth, and advocate for a more balanced approach that, for many companies, means a greater appetite to go earlier.

To realize this vision, companies need to do the work necessary to foster a deal-friendly culture that involves both a comprehensive, proactive external innovation strategy and doesn’t fall prey to a common bias — overweighting the merits of internal programs.

The analysis behind these conclusions can be found in our latest Ahead Of the Curve report and podcast on dealmaking in biotech.

Risk is central to value creation

In our conversations with dealmakers, we heard conflicting sentiments about the merits and shortfalls of acquiring programs late in development, after initial clinical validation. Assets in Phase III development with clear-cut clinical validation in prior studies, those in registration or on the market, have already achieved an inflection point in valuation and are discounting a high level of probability of success.

While dealmakers acknowledged that Phase III programs may be more likely to make it to market than clinical assets that haven’t yet reached proof of concept, they emphasized that these deals could create a false sense of safety. Mature assets are not immune from late-stage trial or regulatory upsets, and often miss the lofty sales projections used to justify their high price tags.

Public companies are sometimes swayed toward late-stage deals because they fear blowback from the Street for pursuing “riskier” early-stage deals. But we see different ideologies among investors with respect to their willingness to absorb deal risk. While generalists and value investors may be more protective of cash flow streams and wary of deal risk, specialists often benefit from an active deal environment. Companies sometimes have limited visibility into these dynamics, however, and can become overly cautious as a result.

A rebalanced approach that includes late-stage deals but puts greater emphasis on earlier stage assets can pay dividends over time and reduce the need to overpay for late-stage programs. Such an approach can allow companies to take on more risk while protecting cash flows, dividends and share buybacks, which should satisfy both types of investors.

The myth of the perfect deal

We often hear from investors that deals should be synergistic, inexpensive, and rapidly accretive — and we completely agree.

But such transactions are a rarity. They are great when you can get them, but you could be on the sidelines forever trying to find the “perfect” asset at a low price point. Realistically speaking, lucrative deals are unlikely to be reasonably priced in a seller’s market.

Unsurprisingly, the analysis showed a higher peak sales multiple for late-stage deals than those before the inflection point of clinical proof of concept (2.5x vs. 1.6x, respectively). But comparing the actual peak revenue from the lead asset in each deal with peak sales forecasts used to support the deal valuation showed that almost all late-stage deals missed forecasts, while nearly half of the early clinical deals that made it to market beat projections.

Though fewer early clinical assets reach the market, when they do, they tend to offer better financial returns than late-stage assets.

An analysis of 10 years’ worth of post-deal sales data from the lead asset in each transaction showed that most deals were not successful, as many products failed in development. When we analyzed the subset that had successfully developed products, we found that early-stage deals were less expensive and offered superior returns than pricier late-stage assets, which frequently missed their unrealistic sales projections. We surmise that those lofty sales projections sprouted the high valuations for those late-stage assets and required buyers to be bolder in their internal projections to justify such deals.

The median return on invested capital (ROIC) at year five post-deal for late-stage deals was 26%, compared with 10% for early-stage deals — an expected outcome given that early-stage deals are disadvantaged by this analysis because their time to revenue generation is longer than that of their late-stage counterparts, many of which were already generating revenue. However, the number of clinical-stage deals that posted strong returns despite this caveat underscores the value of incorporating such deals in the strategy.

By year 10, at which point most clinical-stage deals had begun generating revenue, the relationship flipped (Figure 1).

The median ROIC at year 10 post-deal for late-stage deals was 58%, whereas it had reached 83% for early-stage deals (average year 10 ROIC: 71% vs. 274%, respectively). Among clinical stage deals, 75% had more than 60% ROIC by year 10 while only 36% of marketed and registration stage deals had reached the same benchmark.

Overall, the ROIC of late-stage deals is more predictable and more evenly distributed across many deals included in our analysis. But by and large, the upside is more muted as early-stage deals include more standouts driving the group’s strong performance, such as the 2009 acquisition of Cougar Biotechnology Inc. by Johnson & Johnson (NYSE:JNJ); the takeout of Medarex Inc. by Bristol Myers Squibb Co. (NYSE:BMY) the same year; and the 2012 acquisition of Pharmasset Inc. by Gilead Sciences Inc. (NASDAQ:GILD;)

Elite basketball players know that a 30-40% shooting rate can be a path to success, as long as they take a lot of shots. Likewise, companies that take frequent, measured risks on early clinical-stage assets are making an earnest effort at long-term value creation. We argue that companies shouldn’t shy away from taking risks on early Phase I and II clinical assets that have yet to establish clinical validation as long as they are backed by sound science, clear strategic rationale, and complement their existing pipeline or capabilities.

Fostering a deal-friendly culture

For dealmaking to be successful, it needs to become part of a company’s DNA. Companies that seek to be active dealmakers should aim to become partners of choice by fostering a “deal-friendly” culture that places external innovation on the same pedestal as internal capabilities.

Companies sometimes neglect business development activities until after a high-profile pipeline failure or after revenue and EPS growth moderates, at which point it is already too late — the stakes are higher, sentiment is working against them, and they are more likely to face the “desperation premium” that materializes when companies are backed into a corner.

Instead, companies should be taking a clear-eyed view of their internal R&D efforts and how they stack up within the clinical development landscape. Balancing internal and external innovation is key to establishing a robust pipeline built for sustainable growth.

Companies that achieve a deal-friendly culture have comprehensive, proactive outreach efforts to build external relationships at top levels, so they can be quick to react when opportunity arises. Many dealmakers interviewed by Cowen noted that business development teams have long memories — even if a deal for one asset never materializes, an initial positive impression can open the door for additional opportunities down the road. Moreover, in competitive deals, it is the relationships that will tilt the scales, not just the economics.

Proactively seeking deals is not enough, however. Companies must be willing to take risks and align incentives internally to obtain support for these external assets.

This is easier said than done.

Many dealmakers noted that it is difficult to strike a balance between internal and external innovation as there are opposing spheres of influence and interest within the acquiring or in-licensing entity. Companies can sometimes fall into the trap of advancing an internal program because it is the path of least resistance and avoids generating friction with R&D stakeholders, and not necessarily because it is the worthiest asset.

Naturally, there are many voices advocating for a company’s internal pipeline, but few championing external programs. The unfortunate consequence of this imbalance is that homegrown programs may be carried forward by influential internal champions despite being more capital-intensive or less scientifically robust than alternative external assets. As a result, the probability of technical success for internal programs tends to be lower than that for external programs. External programs are thoroughly vetted by multiple parties and presumably passed muster, while the scrutiny imposed on internal programs depends on the rigor of the research organization.

Active dealmakers interviewed by Cowen had managed to overcome bureaucracy and risk aversion, and to be objective in their assessment of internal innovation. To get comfortable taking on new science, these companies advise other potential acquirers to have in-house scientific expertise that allows them to adequately vet transactions.

Successful dealmakers not only adopt a culture of openness to partnerships and collaborations that could enhance the company’s portfolio, but they also budget accordingly to leave room to fund these external programs.

Know thyself and your partner

Dealmakers that we spoke with also proffered advice to smaller companies seeking a partner, since many of them had been on both sides of the negotiating table. Younger biotechs should ensure that the deal structure aligns with their objectives, have an unbiased view of their risks and opportunities, and know what skills and capabilities they are bringing to the table versus what they are seeking from a partner. Experts cautioned that it requires substantial effort to keep a partnership on track, and so management should be prepared for what can often be a considerable drain on time and resources.

Dealmakers advised that an ideal partner should play to your strengths and complement your weaknesses. Communication, transparency, and collaboration are key to setting the foundation for a healthy and productive partnership. Several dealmakers also stressed the importance of building relationships at all levels to ensure continuity when turnover occurs and have the strong connectivity that is required to withstand the challenges and disagreements that must be overcome. Above all, both parties should strive for win-win dealmaking.

Yaron Werber is a managing director and senior biotech analyst at Cowen and Co. Eve Reilly is an associate in equity research at the firm.

Signed commentaries do not necessarily reflect the views of BioCentury.