A recent Wall Street Journal article that raised the possibility of Biogen as the target of another huge pharma buyout cited the lack of productivity as a major driver of M&A in the pharmaceutical industry. The authors made the point that, given the size of companies today, a single garden-variety blockbuster hardly moves the needle.
The increasing need for new drugs is intense. The industry can only go so far with growth through hyper-inflated pricing and mega-M&As. At some point pharma has to figure out how to make more drugs more efficiently, or face major dislocations like business-destroying price controls. It is the hope of new blockbuster drugs that keeps government regulators at bay.
An obvious place to look for help is the venture community—Bruce Booth of Atlas Ventures pointed out in a recent blog that venture capital is doing well, and is positioned to do even better in the future. Yet despite relative plenty in the bio-venture community, pharma suffers from a shortage of drug candidates.
A recent Silicon Valley Bank report noted that large corporations have dramatically increased pre-clinical acquisitions in the last three years under the pressure of limited supply and competition from IPOs. Early acquisitions force pharma to take more risk and spend more of their operating budgets on development over a longer time than buying post-phase II, where they can more efficiently deploy large-scale resources.
What Booth didn’t say explicitly is that providing only a limited supply of drug candidates in the face of increasing demand is a key element in the venture investment model. The quickest way to kill industry profits is to try to put too much money to work. Losses in over-capitalized “vintage years” over the last two decades have left institutional investors (e.g. pension funds) with little appetite for experimentation with new managers and more funds.
With a limited supply of new firms coming into the business, venture’s ability to expand to meet demand is inherently constrained. A 2011 white paper by Kevin Lalande of Santé Ventures explains why the size of early-stage funds is not likely to grow substantially in the near term, despite attractive returns: Life sciences venture does not scale.
Fund size is restricted by exit valuations for portfolio companies; Lalande estimates that, given the high attrition rate of drug development projects, a life-sciences fund should be no larger than 1.0 to 1.5X the average exit value. In bio-pharma, exit valuations are limited by the stage of development. No matter how good the phase II data, a product-candidate is not going to command Facebook returns. So successful early-stage venture firms are not likely to greatly expand the size of their funds or portfolios.
In his blog, Booth pointed out, “There are only a handful of firms that do early stage biotech.” Yet in the era of precision medicine, pharma needs vastly more drugs. Pharma has not been able to profitably expand their own R&D—in fact, many have cut back budgets—and venture has limited capacity or incentive to scale its R&D. Hence the blockbuster problem.
Pharma understands it must expand its early pipeline of prospective drug candidates, as reflected in the growth of incubators like JLabs and Lab-Central and pre-competitive research consortiums (here, here, and here). But large corporations must do more than simply sow seeds. While products will emerge from incubators, expanding the number of startups without increasing the supply of capital and drug developers needed to shepherd them through phase II will leave a lot of good technology short of clinical proof-of-concept needed to qualify for commercial development.
To have a meaningful impact on the supply of new drugs, pharma needs more outside managers, funds, proof-of-concept companies, and products in the industry pipeline—in short, a more robust entrepreneurial community. Pharma has to work with external developers in ways that preserve their independence, initiative, creativity, and energy, while substantially expanding the scale and scope of the sector.
Incubators like J&J’s JLabs do this for research teams that can operate on a shoestring. However, early clinical costs are an order-of-magnitude greater than pre-clinical studies and don’t lend themselves to bootstrapping. Start-ups require infrastructure (i.e. labs); proof-of-concept companies require capital and management.
Large corporations have to find ways to fill gaps in the external development pipeline. Programs like JLabs encourage startup teams to take risks, and to explore new territory with the opportunity, but not the obligation, to partner with the sponsor. Pharma needs similar business models to help entrepreneurs attract more resources, and to complete proof-of-concept opportunities.
As explained earlier, new venture managers are unlikely to attract institutional backing on their own. By sponsoring new early-stage funds and partnering with portfolio companies, pharma can provide access to the experience and resources of a large corporation—intellectual infrastructure, if you will. Arrangements like buyout options can enable start-ups to forge close working ties with a potential acquirer over time as products and technologies progress in the clinic. The support of a large partner enhances the prospect of timely exits and strengthens a team’s ability to attract capital and resources. Like with incubators, the goal should be to enhance creative energy without co-opting the independence or initiative of the entrepreneurs.
Though organic growth through innovation is not likely to improve the next quarter’s earnings (or executive bonuses), it must become a first-tier priority if pharma as we know it is to survive. The entire organization has to focus on sustainable development. More than simply “working closely” with entrepreneurs, large corporations have to integrate R&D seamlessly with the external community over the entire spectrum of development. To expand the industry pipeline on sufficient scale, pharma has to embrace the entrepreneurial business community as a partner in innovation.