The focus in biotechnology investing today has shifted to those companies that can generate products. There are two potential products that can be generated in the drug discovery space drugs themselves, or products and tools used in the drug discovery process (e.g. DNA or protein chips, mass spectrometers, assay reagents, databases and information, platforms). This article looks at the former.
A Recent Theme
Over the past few years in biotechnology investing, genomics has captured the imagination of both public and private sector investors as companies rushed to capitalize on the technologies available to capture or exploit genomic information. In the post-genomic era, investor preference has shifted to those companies that can apply their technologies directly to drug discovery for their own benefit. Many of the companies initially formed to capture genomic information are shifting their business model to include drug discovery. In many cases, the residual information or tools part of their business model allowed initial funds to be raised and continues to support operations, but their market capitalization is driven more by their prospects as a drug discovery company or partner than as a “tools” company.
In Millennia’s view, three major conclusions can be drawn from the genomics era: 1) the risk in drug discovery and development is unlikely to decline as a consequence of exploiting genomic information; 2) the substantial capital raised by biotechnology companies has allowed them to reposition themselves as drug discovery companies; and 3) the capital markets have clearly voted that long term value will accrue to those companies that can exploit their technology platform to discover drugs for their own account. Investors should consider each of these changes in deciding how to invest in early stage drug discovery companies.
In the pre-genomics era, there were approximately 500 drug targets. By and large, these were well-validated targets whose role in human disease was well understood. The sequencing of the human genome has resulted in the identification of new, less understood, targets. As a result, the number of potential drug targets has risen by an order of magnitude to approximately 5,000. This creates significant opportunity. Indeed, improved understanding of molecular biology has resulted in novel drugs like Gleevec, Herceptin and Enbrel. Over the next two decades this trend will continue and we will see a significant number of important drugs directed against targets derived from genomics.
Genomic discoveries, however, are likely to increase risk in the near term. This arises because the genomic discoveries to date have been largely structural. Precisely which of the 35 to 50,000 genes in the human genome are the appropriate 5,000 targets on which to work are unclear. While significant risk reduction can occur from various preclinical target validation approaches, none are perfect predictors of success in clinical trials.
As the pharmaceutical/biotechnology industry works on novel targets, there is an increased likelihood that drugs will fail because an inappropriate target has been selected compared to historical norms. Consequently, at least in the near term, R&D spending per approved drug is likely to increase. Companies working on novel targets seeking to “bet the farm” on a single product/target are at increased risk of losing the farm, and that increased drug candidate/target diversification will be required.
The Cost Of Development
Bringing a new drug to market is expensive, on the order of $500 million to $800 million. Until recently, access to capital restricted the ability of smaller biotechnology companies to discover and develop drugs. Many companies bet their future on a single drug, with disastrous consequences. Alternatively, emerging biotechnology companies had to give away potential blockbusters relatively early on (thereby retaining a smaller percentage of their value) in order to diversify their risk across multiple products. The financing boom of 1999 and 2000 changed the rules of the games dramatically. For the first time, a host of companies without significant product revenues had the capital to bring multiple products through clinical development.
The prices being paid for promising drug candidates have been steadily increasing. Three factors have driven this rise: 1) although R&D spending by large pharmaceutical companies has increased at 18% annually, the number of new drugs being brought to market has remained steady. Consequently, their internal pipelines are not adequate to support the growth rates anticipated by the capital markets; 2) a significant number of large biotechnology players have emerged (e.g. Chiron, Amgen, Genentech) that have aggressively sought late stage products; and 3) some unprofitable biotechnology companies were able to raise significant amounts of cash and are now looking to fill in their product pipelines. Thus, early stage biotechnology companies have a ready market for promising products, and are less in need of established players solely for capital than they were a few years ago. On the flipside, major pharmaceutical companies are now awash in promising targets and leads. Therefore, emerging biotechnology companies will be able to capture significant value only from compounds that are close to the clinic, or that have entered phase 1 or 2 human trials.
From Millennia’s perspective, this challenge creates opportunity for startup companies having the right profile. Most profitable biotechnology companies today, such as Amgen, Genentech, Chiron and MedImmune were founded on biology. Their success was in large part realized because for them biology yielded the product therapeutic proteins, antibodies, and diagnostic tests or reagents. Today, it is much more difficult to do drug discovery based on a core expertise focused solely on biology. All of the genes encoding potential therapeutic products are known (if not fully understood) and may have considerable intellectual property surrounding them. Further, a myriad of large, well-financed companies are searching for their function and potential therapeutic role. This admits some opportunity for companies focused on cellular therapies and/or engineered proteins. However, for cellular therapies, an investor needs to consider ethical, legal and regulatory challenges in addition to the scientific ones. Companies focused on “engineered proteins” face a significant amount of technical/scientific risk. In both these cases, investing requires thorough due diligence on the underlying science.
An alternative business model (with different risks) involves development of more conventional small molecules in concert with “druggable” targets. Several companies have repositioned themselves from biology-based companies to small molecule drug development companies. A key for all of these companies is a broadly applicable discovery technology. Companies in this sector used revenues from their biology to support the development of a chemistry infrastructure. As their discovery platform can be applied across a variety of targets, they companies may be able to keep portions of their biology proprietary and thereby retaining some degree of competitive advantage. Here again, successful investing requires scientific understanding of the proprietary biology along with understanding the likelihood that a given company will succeed in developing drug leads with a therapeutic and chemical profile that will result in clinical efficacy and viability in formulation and production.
A third type of opportunity arises from companies that build expertise in chemistry. Major pharmaceutical companies are already very good at chemistry, so a novel way of going about the chemistry that can confer a proprietary advantage is required. Structure-based drug design and combinatorial chemistry are examples of such methodologies. New technologies that can increase the diversity of chemical libraries or bias those libraries towards compounds with drug like properties will continue to be in high demand. Here successful investing involves both scientific due diligence as well as understanding of which larger companies could be competitors or viable partners. Because of the strong competitive position enjoyed by pharmaceutical companies in this area, investors should also pay attention to the management team and the ongoing mitigation of the company’s execution risk.
Yet another business model is one in which companies focus on gene families. Such target families include G-protein coupled receptors, ion channels, and enzyme subclasses such as kinases or proteases. Genomic advances have yielded many new targets falling into these families. Working on multiple members of a family can bring significant synergies. Target validation approaches, screening assay development, and selection of appropriate chemical libraries are often highly similar across multiple targets from a single family. Just as with some of the early genomics/biology based companies one can generate revenues by partnering some targets while keeping other targets for internal development. An approach focused on target families has become increasingly common in drug discovery.
In Millennia’s view it is necessary to consider factors more related to ultimate source of liquidity when evaluating early stage discovery companies:
- 1) How close is the company’s technology to discovery of the actual therapeutic product?
2) What advantage relative to major pharmaceutical companies does the company have?
3) Can the technology be applied across a range of potential targets of commercial interest?
4) Can the technology be partnered to generate revenues to build the infrastructure for their own internal drug discovery?
5) What does the company lack in structure, technology or strategy in terms of liquidity opportunities and how might such gaps be filled?
The greatest value creation in drug discovery technologies comes when those technologies are translated into drugs. Making successful drugs requires an in-depth understanding of biology. For small molecule drugs, it also requires marrying that understanding to solid medicinal chemistry. Emerging biotechnology companies usually have strong expertise in one or the other but are increasingly likely to require both. Successful companies can be built with either as a starting point, but the marriage of the two is now likely to occur earlier in an emerging company’s evolution. We feel that investing in such companies can be a significant source of wealth generation.