Coc in Biotech Study June 09 Final

7/31/2019 Coc in Biotech Study June 09 Final

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TheCostofCapitalforEarly

StageBiotechnologyVentures

IainCockburnandJoshLerner

BostonUniversityandHarvardUniversity


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ExecutiveSummary

EvidenceshowsthattheCostofCapitalfor

venturebackedearlystagecompaniesinlifesciencesishigh:

Manyestimatessuggest20%orhigher

Thisreflectsinvestors expectationofareturnsufficienttocompensatethemfortakingonextraordinaryrisk

Permanentlyloweringrealizedreturnswillleadtolowerinvestmentinacriticalcomponentofthelifesciencesindustry

2


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PurposeofStudy

Understandingcostofcapitaliscriticalin

economicmodelingoftheimpactofregulatoryandpolicychangesoninvestment

andindustryeconomics:

Forallpubliclytradedcompanies,allsectors,

averageisaboutaround10%

Projectseekstounderstandwhetherthisisappropriateforprivatebiopharma companies

3


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4

TheCostofCapital CostofCapitalisacriticalbenchmarkforassessing

commercialviabilityofaproject Measuresopportunitycostofresourcesemployed

Oftenusedasahurdlerateofreturn todecidewhethertoinvestinacompany

Alsousedasadiscountrate toevaluatefuturecashflows

Outsideinvestorswillputmoneyintoventurefunds

onlyiftheyexpectreturns(IRR)>CostofCapital Veryimportanttogetthisrightinevaluatingthe

economicsoflongterm,riskyprojects


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TheCostofCapital(2)

Combines(1)timevalueofmoney,(2)riskof

notgettingyourmoneyback Forlarge,diversifiedcompanieswithpredictable

cashflows,typicalCostofCapitalisabout10%

Forsmallercompaniesfacingsignificant(andnondiversifiable)businessandtechnologyrisk,CostofCapitalismuchhigher:hereinvestorsdemandadditionalcompensationfortakingonhigherrisk(e.g.,biotechstartups)


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Simpleeconomicsofbiotechventures

Biotechhasseveralchallengingfeaturesforventure

investors (1)Verylongtimetomarket(typically10yearsormore) (2)Veryhighlevelsofrisk(fewerthan1%ofdrug

candidateswillmakeittomarket)

(3)Largeamountsofcapitalcontinuallyneededtomovemosttechnologiesforward

(4) Thefewsuccessfulcompaniesusuallyhaveabigdevelopmentpartnerand/oranacquirer

Comparedtomanyotherassets,ventureinvestorsneedtotakeonmorerisk,holdilliquidinvestments,andwaitlongerforareturn andthereforerequireahigherrateofreturn

=ahighCostofCapital


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Thebiopharmaceuticalecosystem

Drugdevelopmenttakesplacewithinacomplexweb

ofinterdependentorganizations universities/NIH,R&Dboutiques, established

biopharmaceuticalcompanies,healthcareproviders

Venturebackedcompaniesplayacriticalroleinfillingthefrontendofthedrugdevelopmentpipeline(andincreatingtoolsandplatformstomake

drugdevelopmentfaster/better/cheaper) Morethan50%ofmoleculesthatgointohumansoriginate

andareacquiredfromentrepreneurialcompanies

Seee.g.CockburnHealthAffairs (2004)


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Thebiopharmaceuticalecosystem

New Drugs

New biotech

companies

Established

pharma and

bio firms

Physicians

and providers

Universities, NIH,

foundations etc.

Acquisitions, partnering,

and licensing from

biotech accounts for

67% of new drugsNature Rev. Drug Discovery,2008


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Successfulproductsneedtogeneratereturns

toencourageinvestmentininnovation

Mostbiotechstartupsrelyonpartnershipswithlargercompaniesforlateclinicaldevelopment,regulatoryaffairs,

manufacturingandmarketing Ifthesepartnersexpectpotentialnewproductstohavelower

salesorshorterexclusivityperiods,theywillplacelowervaluesontheproductstheylicenseoracquire

Inturn,thismeanslowerexpectedreturnstoinvestorsinthesmallcompanies,leadingtohigherinvestmenthurdle

Impactofthiswillripplethroughtheecosystem fewerprojectsbeingfundedmeansaweakerindustrypipeline,and

fewernewdrugs Venturebackedfirmsareakeystonespecies intheecosystem

Thissectorisalreadyunderseverestress currentperceptionsaremakingithardtoraisemoney


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NewVentureFundraisingHasDeclinedSource:ThomsonReutersVentureXpert database

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

New

CapitalRaised

byVentureFu

nds

$B 19.2 28.7 31.9 35.6 28.3 17.2

2004 2005 2006 2007 2008 Q109x4


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VentureInvestmentisDown;

BiotechInvestmentMuchMoreSoSource:ThomsonReuters/NVCAMoneyTree Report.DataSource:ThomsonReuters

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

VentureCa

pitalInvestmentinCompanie

s($B)

AllVC 22.2 23.0 26.5 30.7 28.2 12.0Biotech 4.2 3.9 4.6 5.3 4.5 1.1

2004 2005 2006 2007 2008 Q109x4


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WhatistheCostofCapitalfor

biotechnologyventures?

EvidenceonCostofCapitalcomesfromtwo

principalsources Actualreturnsrealizedonventureinvestmentsin

biotech

Weassumethatcompetitivesupplyofinvestmentwill

driverealizedaveragereturnsclosetotheCostof

Capital

Unlessinvestorsgetgoodreturns,theywontputmoremoneyinventurefunds!

Expected returnssuggestedbyfinancetheory


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Whatistherateofreturnto

investmentsinventurecapital?

Verydifficulttomeasure

Highlyvariableovertime Manyfailures+afewbigwins

Privatelyheldcompanies,proprietarydata

Fundsversusindividualinvestments

PooledaverageIRR,allventurecapital: January1989December2008:17.0%.

Largecapreturnsoversameintervalwere8.4%.

Source:ThomsonReutersVentureXpert;IbbotsonAssociates

Exceptionalreturnsreflectexceptionalrisk! Longrunaverageconcealsplentyofbadyears


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10yearrollingreturnsto

investorsinVCfundsintheU.S.

0%

5%

10%

15%

20%

25%

30%

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

Source: Authors' analysis of Thomson VentureXpert dataNetIRR


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Cumulativeventurereturns

overvarioustimeperiods

20%

15%

10%

5%

0%

5%

10%

15%

20%

20Years 10

Years 5

Years 3

Years 1

Year

15Source:ThomsonVentureXpert.AllreturnsfortheperiodendingDecember31,2008.

NetreturntoinvestorsinVCfunds.

Verylowreturnsin

recentyears likelyto

discourageinvestorsif

continuetobelow


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Decliningreturnsinrecentperiods Dramaticdropinreturnssinceburstingofbubble in2000:

IPOexitshavedriedup Manyobservershaveexpressedconcernsthat

ventureecosystemisunderstress:

Institutionsandindividualsunlikelytoinvestatsamerateunlesscanbeassuredofsatisfactoryreturns

Fallenpublicmarketvaluationsmeanlowervaluationsofprivatecompanies

Investorconcernsaboutfutureoutcomes

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Whataboutbiotech? CambridgeAssociatesInc.isanindustrystandarddatasource,

andmaintainsunusuallycomprehensivedata,tracking80%+ofindividualventureinvestmentssincethelate1970s

Canidentifybiopharma ventureswithsomespecificityinthesedata,notjusthealthcare ingeneral

Rateofreturn(IRR)on1606biopharma companiesnowacquired,gonepublic,orfailedwas25.7%grossfrom1986

2008;correspondsto20.7% netreturntoinvestors Aboveaveragereturnscomparedtoallventurecapitalreflectabove

averageriskofbiotech Assumes500basispointgrosstonetdifferential

Usefulguidetohistoricalrealizedreturns,butdoesntaccountforoverhang ofunrealizedinvestments: OverallIRR,includinganother1223unrealizedinvestmentscurrently

heldinportfolios,is~15.7%nettoinvestors


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Cashmultiplesrealizedfrombiotechinvestments

Source:CambridgeAssociates.Includesallexitedbiotechdealsasof12/31/08.1606totaldeals.

44%ofdealswereafullorpartialloss


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HistoricalreturndataCambridgeAssociates

1606biotechcompanies19862008:

20.7%averagegrossIRR onrealized biopharmainvestments,afterfeesandothercosts(5%)

Buthugerisks:

44%ofinvestmentswereafullorpartialloss 2/3ofprofitableinvestmentstook5yearsormoretoberealized

Another1223investmentsinthisdatasethaveyettopayout:evenripe investmentsareverydifficulttorealizeincurrentmarketconditions

SoVCsevaluatinganinvestmentwouldneedtoanticipate40%todeliver20%IRRoverall


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Howdoesthisrelateto

CostofCapital?

Realizedratesofreturnindicatehowmuchventurebackedcompaniesneedtopay foroutsidecapital

TheoryofcorporatefinancetellsushowtomeasureCostofCapitalmorerigorouslyin

termsoftherateofreturninvestorsexpectedatthetimeoftheinvestment,usingtheCAPM model


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Costofcapitalandthecapitalasset

pricingmodel(CAPM) ProvideswaytocomputeCostofCapital, basedon

ratesofreturnondebtandequity)

IntheCAPM,returnonequityisgivenby:

RateofReturn=riskfreerate+ xriskpremium

Riskfreerate=Tnotes(e.g.4%)

Riskpremium=paymenttoequityinvestorstotakeongeneralundiversifiable risk(5% 7%)

isacompanyspecificmeasureofrisk Fortheaveragematurecompany, =1 Forriskiercompanies, >1

Forveryriskycompanies, >2


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IllustrativeCostsofCapitalRiskfree

rate

Equityrisk

premium

WACC/

Costof

Capital

Riskfree(e.g.,Treasury

bonds)

4% + 0.0 = 4%

Mature,diversifiedfirm 4% + 1.0 x 7% = 11%

Midcapbiotechcompany 4% + 1.5 x 7% = 14.5%

Smallcap,earlystage

biotechcompany

4% + 2.0 x 7% = 18%

Ventureinvestmentinbiotech

4% + 2.5 x 7% = 21.5%

Note:Assumesnodebt

Publishedstudiesshow forpubliclytradedsmallcapbiotechs isaround1.52.0(Barra Betas,

IbbotsonBetaBook,Golec &Vernon.2007,DiMasi &Grabowski,2007). Forallventure isaround2(DriessenLinPhalippou,2007;Woodward,2005),likelyhigherforbiotechinvestments

Notemuchhigherthan

recentreturns!


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CostofCapitalRiseswithRisk

0.0

5.0

10.0

15.0

20.0

25.0

Cost

ofCapital(%)

CoC 4.0 11.0 14.5 18.0 21.5

RiskFree Mature

Firm

(Fortune500)Mid

cap

biotech Small

cap

biotechPrivate

biotech

startup

Note:Illustrativedata.Assumesnodebt.

Publishedstudiesandstandardreferencesourcesshow forpubliclytradedsmallcapbiotechs isaround1.52.0(Barra

Betas,IbbotsonBetaBook,Golec &Vernon, 2007,DiMasi &Grabowski,2007). Forallventure isaround2(DriessenLinPhalippou,2007;Woodward,2005),likelyhigherforbiotechinvestments


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Evidenceonriskandreturns

forbiotechnology WACCforpubliclytradedbiotechstocks

Golec &Vernon(2007): 16.25%

DiMasi &Grabowski(2007):1317%

Estimatesof forsmallcapbiotechstocks Forasampleof90lifesciencescompanieswithmarketcapbelow

$250MM, srangeashighas3.0 [Bloomberg]

AICPAguidanceforvaluingearlystagecompanies:19.2%CostofCapital

GolecVernonmodelsuggests2/3rdsofhigherCostofCapitalforbiotech(versuspharmaceuticalfirms)isduetosmallsizefactor: Impliesthatcostsofcapitalwillbeevenhigherforsmallestbiotechfirms


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Whyis andthereforeCostofCapital

sohighforbiotechcompanies? Immaturityandresultingfragility

Size Microcap riskpremiumis9%

Limitedliquidity

OTCtraded,smallvolumes Considerableexposuretoeconomicfluctuations,

whichcanleadto:

Inabilitytoaccesscapitalmarkets

Cutbackoncorporatealliancespending

Reducedwillingnesstoholdyoung,riskystocks


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OtherevidenceonCostofCapital Almostnoabilityofthesecompaniestoborrow

mediumorlongtermevenatcreditcard interestrates riskissohighthatlendersrequiresubstantialupsidethroughwarrantsetc.tocompensatethemforhighprobabilityofdefault

VeryhighhurdleratesusedbyventureinvestorstobeabletomeettheirCostofCapital:

Oftenashighas50%oreven75%forearlystagecompanies.

ReflectsbothhighCostofCapitalandcorrectionforfactthatentrepreneurs projectionsareoftenoptimistic.

Plummer(1987);Lerner,Leamon,andHardymon (2007).


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Finalthoughts Canidentifyreturnstoinvestinginearlystageinvestments

(andthusCostofCapital)from:

Actualreturns Expectedreturns

BothmethodologiessuggestCostofCapitalisquitehigh

Recentreturns(IRR)haventkeptup

Reflectsharsheconomicsofbiopharma investorsrequiresufficientreturnstoovercomeilliquidity,longtimehorizons,andtechnologyrisk

Regulatory/policychangesthatreducereturnsinbiopharma

willdriveventureinvestmentintoothersectorsorassetclasses

Lessventureinvestmentwillmeanfewernewdrugcandidatesatatimewhentheindustryisstrugglingtomaintainproductivity


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TechnicalAppendix

MeasuringtheCostofCapital


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1.Measuringventurereturns

Venturereturnsarehighlyvariable:

Insomeperiods,hugelypositive:e.g.,19962000.

Insome,verylow:e.g.,198389,200103.

Toget averagereturnsthatinvestorsanticipate,mustlookoveralongtime

periodandaverageoutgoodandbadperiods.

Keyquestionisadditionalrateofreturn(spread)overotherassets

classes Noteasytocalculatethisforventurecapital:needtoidentify specific

investments,thenfollowthemoverlongperiodsuntil(if)apayoffis

realized

Truncationbias ifpotentiallargepayoffsarestillinplay Needtotrack2nd,3rd,4th subsequentroundsofinvestmentinthesame

company,adjustfordilutionofshareholdingsetc.

Datahighlyproprietary:usuallyonlyreportedinaggregate


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Totalventurecapitalreturns

ThomsonVentureXpert compilesreturnsovermanyfundsoverlongtime

periods:

Looksatactualreturnsrealizedaswellasinterimvaluations.

PooledaverageIRR,allventurecapital:

1970s December2008:15.3%.

January1989December2008:17.0%.

January1999December2008:15.4%.

ProblemisthatsourceslikeVentureXpert compilereturnsonafundbyfundbasis.

Mostfundsinvestinamixtureofinformationtechnologyandlifesciences.

Thus,whilewecanmeasurereturnstoventureinvestorsinaggregate,wecannotsaybasedonthesedatawhatreturnsareforbiotechspecifically


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CambridgeAssociatesdata

C.A.maintainsunusuallycomprehensivedata,trackingindividualinvestmentssincethelate1970s

Canidentifybio/pharma ventureswithsomespecificity,notjusthealthcare ingeneral

Forinvestmentsin1606biotechcompanies19862008:

25.7%averagegrossIRRforfullyrealizedinvestments,upto500basispointslesstotheinvestors

Forall2829companies,including1223unrealizedinvestments,IRRtodatehasbeen20.7%gross/15.7%net

Notehugerisks: 44%ofinvestmentswereafullorpartialloss

2/3ofprofitableinvestmentstook5yearsormoretoberealized


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2.Lookingatexpectedreturns

Theright approachtoestimatingtheCostofCapitalistolookatwhattheexpectationsofinvestorswereatthetimeoftheinvestment.

Financetheorygivesusindicationsofwhatthisexpectationwouldbe. Evaluationofpublicmarketshasadvancedconsiderablyrecently, based

ontherecognitionthatinvestorsmusttakeportfolioviewofinvestments.

InsightoftheCAPMmodel.

Riskisameasureofthecorrelationofoneassetsreturnwiththeoverallmarket.

Newinnovationsinmultifactormodels.

Correlationwiththemarketisnottheonlysourceofrisk.

Multifactormodelsincreasinglyusedtomeasurereturnsofanassetclassandreturnsofindividualinvestors.


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Riskadjustingreturns:CAPMmodel

Allmodelsofreturnsshowthatrisk isdeterminedbythecorrelationofonereturnwiththereturnonasetoffactors

CapitalAssetPricingModel(CAPM) Riskismeasuredbythedegreeofcorrelationwiththemarket.

Investorswealthisdependentuponwherethemarketis.

Woulddemandlowerreturnsonaninvestmentthattendstobeahedgeonmarket.

Greatercomovementwiththemarketimplieshigherrequiredreturns.

Regressionanalysisusedtoestimateparameters Betaiscommonlyusedmeasureofrisk.

Betaofthemarketis1.

Higherbetameanshigherrisk.

Interceptintheregression(alpha)measuresriskadjustedreturns. Whatsleftoverafteradjustingforcomovement withthemarket.


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Riskadjustingreturns:AlternativetotheCAPM

Alternative3factormodel(FamaFrench).

Marketrisk.

Sizerisk. Smallcompaniesareriskierthanbigcompanies.

Booktomarketfactor.

Highbooktomarketcompanies(valuestocks)areriskierthangrowthcompanies(distress).

Bothmodelsusedtopricevariousstockandbondportfoliosquitesuccessfully.

WillfocushereonCAPM,thoughbothapproachesgivesimilarresults.


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Returnsandriskpremia forsmallfirms

Riskpremiumismuchlargerforsmallcapstocks:pointstomuch higherriskformicro ventures

Ibbotsonanalysisofallstocksgivessizepremium forsmallestcategory(mktcap5%(JohnCampbell,Estimatingtheequitypremium, Harvardworkingpaper,2008.)

Impliesexpectedreturnof2021%.


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Difficultieswithapplyingframeworkto

analyzingventurecapitalreturns

Allexpectedreturnmodelsaredrivenoffofreturncorrelations.

Privateequityreturncorrelationwithotherassetclasseshavelittle

meaning. Privateequityportfoliosoftenkeptatbook.

Hesitancytowritedownandup:

Certainlyhistorically,andeveninpostFAS157world.

Leadstolargedownwardbiasinestimatedcorrelations.

Cannotusemostcommonmodelstoriskadjustreturns.


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Acriticalproblem:staleprices

Whateffectdoestheaccountingconventionofkeepinginvestmentsatbookvaluedotopotentialcalculations?

Significantdownwardbiasincalculatedcorrelationswithotherassetreturns:Investmentsseemlessriskythantheyactuallyare.

Needperiodicportfoliovaluesthataretrue values.

Thesolution:markingtomarket:

Differentpapersusesdifferentapproaches.

Revalueattimesofwritedownsorwriteups.

Lookatchangesinoperatingperformance.

Lookatchangingpriceearningsratioinpublicmarket. Usetheinformationonmovementinsimilarprivateequityprices toadjust.

Getperiodicseriesofreturns,whichthencomparetopublicmarketdata.

Illustration:

Correlation

with the S&P

500

Correlation

with the S&P

500

Correlation

with the S&P

500

GE 0.743 IBM 0.582 S&P 500 1.000

GE with One Stale

Month 0.372

IBM with One

Stale Month 0.307

S&P 500 with One

Stale Month 0.490

GE with Two Stale

Months 0.334

IBM with Two

Stale Months 0.249

S&P 500 with Two

Stale Months 0.407


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Noteonexpectedreturnsforventurecapital

Thetrueexpectedreturnsinventurecapitalarelikelytobehigherthan

thecalculatedonesdueto:

Theneedtocompensateinvestorsforilliquidity(these

calculations assumenoliquiditypremium).

Thegreaterriskofbiotechinvestments(asseenabove,actualreturns

arehigherforbiotech).


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ReferencesCockburn,I.(2004)TheChangingStructureofthePharmaceuticalIndustry Health

Affairs, 23(1),pp.1022.DiMasi,J.andGrabowski,H.(2007)TheCostofBiopharmaceuticalR&D:IsBiotech

Different? ManagerialandDecisionEconomics, 28,pp.469479.Driessen,J.,Phalippou,L.andLin,T.(2007)ANewMethodtoEstimateRiskand

ReturnofNonTradedAssetsfromCashFlows:TheCaseofPrivateEquityFunds,Unpublishedworkingpaper,availableatSSRN:http://ssrn.com/abstract=965917.

Golec,J.andVernon,J.(2007)FinancialRiskInTheBiotechnologyIndustry NBERWorkingPaperNo.13604.Lerner,J.,Leamon,A.andHardymon F.(2007)VentureCapitalandPrivateEquity:ACasebook.NewYork,JohnWiley&Sons.

Plummer,J.(1987),QEDReportonVentureCapitalFinancialAnalysis,PaloAlto,CA,QEDResearch.

Woodward,S.(2005),MeasuringRiskandPerformanceforPrivateEquity,Unpublishedworkingpaper,availableathttp://www.sandhillecon.com/pdf/MeasuringRiskPerformance.pdf.

Coc in Biotech Study June 09 Final

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