Biotech Revival: US Market Provides Further Evidence

Early in January this year, we wrote about a decisive shift in sentiment towards the biotech sector in the US. As February dawns, it is becoming increasingly clear that this more positive backdrop is continuing. Although the XBI (an equal-weighted index that draws its constituents from the biotechnology segment of the S&P total market index) has consolidated around the levels it reached earlier in January, elsewhere in quoted biotech, there have been some further robust gains, such that the total biotech sector value is up over 42% from the market nadir in late October last year. Last week, for example, three of the ten biggest contributors to the value of the biotech sector were not in the XBI.

Not only are biotech share prices recovering, but so is corporate activity. After a nearly two-year period of very limited IPO and secondary activity, deals are progressing. As we highlighted earlier in January, big pharma has its chequebook out and is once again shopping for innovation with a flurry of deals, especially in neuroscience, and at very significant premiums. Clearly, there is a long way to go before this more positive market backdrop becomes embedded, but the omens are increasingly promising.

The chart above shows the volume of biotech deals in 2023 compared to the last nine years. The chart below, lists the top ten deals in the sector in 2023 and the more dramatic increase in deal value compared with 2022.

Most importantly, the macro backdrop is also more positive. With inflation having peaked some months ago and forward indicators anticipating a return to the FED’s target, policy bias has shifted decisively to an easing stance. In an election year, investors’ attention will inevitably be drawn to the presidential rival’s healthcare policies. Still, our view is that the biotech sector—both public and private—will be influenced much more by the improving macro-economic and market fundamentals than by politics.

Of course, the other overriding consideration for investors looking at this sector is valuation. A two-year biotech bear market has left public and private biotech valuations at incredibly depressed levels, with the challenging funding backdrop being the single most depressing factor in our judgment. For example, as a proxy, for much of 2023, over 200 US-listed biotech businesses had market values that were below the value of the cash on their balance sheets, and it is these depressed valuations that are driving the excessively high premiums we see in most of the recent pharma deals (the average premium of the last eight big pharma takeovers of biotech companies is in excess of 80%).

Anecdotal evidence also supports this more positive investor tone. The “mood” at the annual JPM conference was generally described as “positive” which made a refreshing change after the last two more downbeat gatherings. The massive success of recent drug launches in the obesity space has clearly helped, but the shift in sentiment is much broader than this. Investors now anticipate more M&A activity, are beginning to look at IPOs and crossover deals, and seem prepared, even keen, to put more money to work in the biotech space.

We believe that with a lag, this more positive market environment will inevitably filter across to the private market where, if anything, sentiment and investor activity have been even more depressed. In parallel with public markets, valuations are extremely depressed, especially for earlier-stage businesses and those yet to reach the clinic. For example, in the public arena, the average value for a biotech with good Phase III data last week was US$3.5bn. This compares with US$2.6bn last June and US$1.9bn at the start of 2022. Conversely, the average value of a US biotech with good, not necessarily great, Phase II data was US$107mn last week, some 3% only, of the average of companies with good Phase III data. This compares with US$211mn in June last year and US$597mn at the start of 2022.

This anomaly, although obviously extreme and a clear manifestation of what the sector has been through over the last two years, is what we would expect to see. As investors return to the sector, they will inevitably focus initially on the less risky end of the spectrum, especially in later-stage businesses, which are more likely to be the targets for large pharma companies. Later, and we believe this will happen quite quickly, this positive sentiment will filter down to the best quality earlier-stage clinical, pre-clinical, and private businesses.

We believe we are in the early stages of a return to a more normal biotech and healthcare investment environment. The hiatus of the last two years has been painful for the industry and investors, but we see much to be positive about looking forward. The excitement in the sector that followed the COVID pandemic clearly took valuations to dangerously high and unsustainable levels, but those excesses have now been cleansed and more.

Meanwhile, the industry has not been sitting on its hands. Even in a constrained financial environment, the many talented scientists in this sector have been progressing projects through pre- and post-clinical studies. So, not only is the sector cheaper in valuation terms, but in many cases, the products these businesses are developing are more advanced than they were two years ago. This means the development teams and their investors know more about the technologies they are growing and the risks they confront.

Summary

Recent developments in the biotech sector indicate that the long and punishing bear market that started two years ago is finally coming to an end. Improving sentiment in the US towards publicly traded biotech stocks will inevitably spread to other geographies and, we believe, to private markets where valuations are still on the floor.

Developments in differentiated science and clinical advances are not linear processes. Our guess is that the significant advances we have observed in the companies we know well in the biotech sector over the last two years, in precision medicine in oncology, neuroscience, and immunology, have, in many cases, gone unnoticed by the investor community. Still, we believe this is about to change.

Large pharma companies, which have traditionally looked to the biotech sector to acquire innovation, are once again looking to do deals and, judging by the flurry of activity in recent months, are becoming significantly more active. This is not just opportunistic or driven by depressed valuations. It is as much driven by the requirement to repopulate late-stage pipelines as the patent cliff around the end of the decade approaches for many of the largest companies in the sector.

For many reasons, we believe this revival in fortunes for the biotech sector has legs. We expect dealmaking to continue to focus on precision medicine in areas such as neuroscience, oncology, and immunology, and, reflecting something of a renaissance in 2023, weight loss and cardiovascular.

Some analysts have calculated that large pharma companies have over US$200bn to deploy in this sector and given the scale of their ambition, we expect the deals to come thick and fast in 2024 and not just in public markets.