By: Clay Thorp, General Partner, Hatteras Venture Partners

 

Michael Yee of Jefferies is one of the best analysts in biotech, and he knows his stuff. Yee recently wrote a report predicting a growth in biotech M&A. Yee cited the fact that the amount of cash in big pharma now exceeds the cumulative market cap of small cap biotech suggests that pharma could and maybe should buy the small cap class. In the abstract, big picture, he is absolutely right. The prolonged bear market is putting public biotech companies into a zone in which product-rich, cash-poor biotech companies will be hard to resist for the cash-rich, product-poor pharma and large biotech companies. The recent announcement of the acquisition of Biohaven (BHVN) by Pfizer for $11.6 billion in cash could be a harbinger of the fulfillment of Yee’s vision. How this will impact small cap biotech is the biggest question. Whether an entire stream of these acquisitions will happen, and when, are key unanswered questions.

 

How many sellers are there are there and what are their mentalities?

 

Digging into the details, by our count, there are ~900 public biotechnology companies. Approximately 670 of these are small, with market caps under $500 million. As of May, around 200 of these are companies with market capitalizations less than their cash on hand, compared to ~80 at the beginning of the year. Yee’s argument is straightforward: if the small cap companies have any pipeline at all, then the bigger companies would buy them. This would especially be the case with the companies trading below cash because, even with a reasonable premium, part of the acquisition would be “free” because of the cash on the balance sheet. This is true in the abstract. In the specific, it is much more nuanced.

 

Small cap biotechs (those with less than $500 million market cap) are not all the same. In terms of the day-to-day operations, there is a wide diversity. Some companies are virtual companies with small development operations. Some are less virtual but have manufacturing or even commercial operations. Some are brand new public companies within 6 months of listing. Others have been listed for over a decade. The management teams of these companies are usually experienced in their lane of expertise but less so running the full P&L. The boards of these companies are sometimes highly concentrated with the original backers. This is always the case with newly public companies. Over time, the boards diversify with industry experts. In my observation, small cap biotech boards generally want to do the right things to balance risk and reward for the shareholders. In the current market, small cap biotech companies fall into three main categories:

 

1. “The Strong” - Well-capitalized companies with more than two years of cash. Of the 670 small cap companies, over 200 of these have cash into 2024. Some of these companies have broad pipelines or are pipeline companies. They will continue to prosecute trials in pursuit of a clinical breakthrough that will interest investors. A good example of this from the Hatteras portfolio is Shattuck (STTK). Shattuck trades at below cash but has enough cash to last well into 2024. It has a broad Positive data would likely lead to an uptick in stock price. Some other companies have a smaller number of assets but are later stage, approaching product approval or with recent product approvals. G1 Therapeutics (GTHX) is a good example of a company like this. The company trades at around $300M market cap but has cash into 2024 and is commercializing its novel drug, Cosela. Revenue growth and pipeline development could lead to appreciation.
2. “The Weak” - Under-capitalized companies with between one and two years of cash. Another 250 companies are in the under-capitalized ranks with more than a year’s worth of cash. These run the gamut from early to late stage. There are many companies in this group. They have strong prospects but will need to raise capital sometime in the next year.
3. “The Desperate” - Distressed companies with less than one year of There are another 150- 200 companies with less than a year’s worth of cash. Some of these have products near approval. Others are earlier stage and have varying levels of validation. For better or worse, Hatteras has direct experience with companies in this zone. If the underlying products are promising, the strategic choices are surprisingly numerous, even if the near-term prospects appear bleak.

 

These three categories of companies will all engage differently in the M&A market going forward.

 

How many buyers are there and what are their mentalities like?

 

It is important to look at the buy side of the equation also. For sure, not all buyers are the same. As we see it, there are four types of buyers: 1) big pharma, 2) big biotech with market caps greater than $25 billion, 3) mid-sized biotech with market caps between $5 and 25 billion, and 4) smaller biotech with market caps between $500 million and $5 billion. I’ll analyze each of these:

 

1. Big pharma (~30). The first and most obvious buyer set is the top 30 pharma. Companies from Pfizer on the high end to UCB on the low Market caps from $500 billion to $20 billion. Highly profitable, lots of cash. Also, lots of bureaucracy. These companies operate like small countries with many committees and governing bodies. Power is highly distributed, so buying decisions can easily be vetoed. Risk is generally not rewarded. The R&D organizations in these companies are usually broken down by therapy area. For example, Pfizer metabolic diseases would have a therapy area head who arguably ought to be able to make decisions on pipeline additions or divestments. Generally, however, this person would have to go to core finance, business development, and executive management groups to argue for and get the resources for a deal. Pharma has toyed with making itself more “biotech-like” by vesting authority closer to the pipeline. It has never worked . . . yet.
2. Big biotech (~10). This group is largely a clone of big pharma. Companies like Amgen and Gilead have become more “big pharma” Many committees, many “search and evaluation” licensing people who often shop but don’t buy.
3. Mid-sized biotech (~30). This group is likely more nimble. They are usually generating revenues and either newly profitable or about to be. They are likely better equipped to take risks. This segment would make a great buyer group because of their size and decision-making dynamics, but oddly enough, they are often the preferred target of M&A by group number 1 or 2 above. Since pharma and big biotech is more risk averse, the idea of buying a $10-15 billion company is attractive, because the product either already works or is likely to work. The announcement of the Biohaven deal on May 10^th makes this point.
4. Smaller biotech (~150). This group is even more nimble but also in a more precarious While they have decision-making framework that is positioned to take risks, the impact of a bad decision could be dramatic. A $4 billion market cap biotech that decides to buy a $1 billion one is a big decision, especially if it consumes precious cash resources on a going forward basis.

 

Can or will buyers and sellers meet?

 

While the fundamentals for an M&A blossom are present, all experts acknowledge that there needs to be a moment of capitulation by both the seller and the buyer. Unfortunately, the boards of most sellers are staring at 52-week high stock prices that are much higher than current stock prices. Stock prices have continued to fall precipitously in recent months, making the problem worse. As time goes on, these boards will come to grips with valuation realities – especially as their cash and options dwindle.

 

Let’s think about the mentality of the buyer. If you are a big pharma or big biotech mid-level executive, you are inherently risk-averse and career-preservation oriented. Will I go to management to request $750 million to buy a company for $9/share when it has dropped to $5/share? How do I know it won’t go lower? What if the product fails? Would I lose my job? If there are some mid-level managers with this courage, are they the exception or the norm? Exacerbating this problem is just the sheer number of opportunities. There are over 600 small cap biotech targets. If we are generous and include the smaller cap buyer set with market caps between $500 million and $5 billion, there are a little over 200 buyers. Does the buyer set have the tools to pick the right companies? Will they have the will to do so?

 

I would argue that the likelihood of pharma and big biotech stepping into the breach largely depends on the culture set by the top executives at big pharma and big biotech. This probably depends on how secure top executives feel in their jobs. A secure management that encourages proper risk-taking could ripple down. One executive suggesting a “string of pearls” approach of making ten $500 million to $5 billion acquisitions could make waves across the industry. Whether this courage will lead to a buying spree of large numbers of small cap companies or small numbers of mid cap ones like the Pfizer/Biohaven deal will depend on the mentality of the top executive team. We could argue that the greatest values will come in the small cap arena since they have lost the most value. A large number of smaller bets could be wise if pharma can pick well.

 

Aren’t Great Companies Bought, not Sold?

 

They say that great companies are bought, not sold. Looking into the details of the recently announced Biohaven deal makes that point. BHVN had a stunning launch of their migraine medicine, NURTEC – becoming the number one drug of its category. This is a tremendous feat for an independent biotech company. Even with its success, the take-out premium this morning appeared modest at 78%, for a takeout price of $148.50. This implies some level of capitulation on behalf of the board of the seller. BHVN share price had seen $145-150 in the last six months and the takeout premium was only 33% above the 3-month rolling share price average, so it is surprising that BHVN board wouldn’t require a premium from that level. At the same time, Pfizer paying a 78% premium on top of allowing for the spin-out of earlier stage assets is encouraging to see. Clearly, Pfizer is making good on its public commitment to do deals. They made a small cap acquisition of Reviral, a private company, for around $500 million a month or so before. The cash flows from COVID vaccine sales are finally being put to work.

 

While we largely subscribe to the anecdote that “great companies are bought, not sold,” it may be that in the small/micro-cap arena, the needs of the Desperate may be what breaks the dam. The recent Checkmate Pharmaceuticals acquisition by Regeneron is an encouraging example. Checkmate went public in August of 2020 at $15/share. It opened below issue price and saw issue price only briefly thereafter. For all of 2021 and 2022, it traded in single digits, until it was acquired by Regeneron for $10.50/share in cash or a 333% premium. The board of Checkmate capitulated, accepting a take-out price lower than the IPO price. The management of Regeneron capitulated, paying an out of market premium greater than 300%, for a deal that on an absolute basis was a bargain from the point of view of Regeneron management. Obviously, the management of Regeneron was able to sort through the many under-valued alternatives to find Checkmate that fit its portfolio and had a high likelihood of success in Regeneron’s hands.

 

Whether a small cap accepts a Checkmate-style deal will depend on the alternatives. If the company is going to hit the wall in terms of cash, like the state of many of the Desperate described above, they would be more apt to consider all “strategic alternatives.” For the Strong described above with more time, they are more likely to wait to see if market conditions improve, if their pipeline progresses, or if revenues are generated. The Weak companies with less than 2 year’s worth of cash are in a tenuous situation, in my view. They have enough time to let things mature but not enough time to see things all the way through. The good management teams and boards of these companies will likely create value. Others will eventually find themselves in the land of the Desperate. Whether this group enters the takeout fray may depend on whether the buyers believe they have enough probability of success and therefore can pay a big enough premium to make it worth everyone’s while.

 

Fit is Important

 

The reality is that cheapness of assets is not the sole indicator of whether a smaller biotech or big pharma company buys a small cap biotech company. There must be a “fit” in terms of pipeline or potential commercial footprint. The earlier the stage of the company, the more that fit is important since these assets will likely require continued investment going forward. These research groups in big or mid cap pharma/biopharma are having to make their own rationalization decisions in terms of going forward spend. Even if the asset has a low purchase price, the buyer needs to have high conviction on probability of success and fit. This is why companies like Pfizer traditionally buy companies like Biohaven where the products are well-validated, the fit is clear, and the buyer can substantially influence the going forward outcome (usually this is done in the commercial phase).

 

Pfizer’s move May 10^th with Biohaven and with Reviral in April may be a predictor of things to come – balanced across earlier state and late stage. If other top management follows suit, Michael Yee’s vision might come to pass. Smart, aggressive buyers will end up with real bargains and value-drivers, even if they have to pay above average premiums. Courageous boards will recoup losses by selling. Others will go long by not selling and holding out for the big win. In the end, the fundamentals of the biotech industry have never been better (genetics/sequencing, targeted therapies, new modalities, smarter trials, broadly positive regulatory environment, etc.). In the long run, staying focused on companies with high quality science and likelihood of success and benefits for patients will pay off. While an M&A boon is not necessary to this value creation in the long run, it would certainly accelerate our path.