RA Capital’s 1H23 Core Biotech Report

Our January 2023 analysis Semper Maior: Time to Reboot Biotech argued that the development-stage biotech industry had found its footing, following one of the sector’s most sustained and painful drawdowns. Now, in our first update to that analysis, we’re happy to report that development-stage biotech remains on solid ground. In the first half of 2023, biotech investors harvested considerable gains from M&A and have already partially redeployed that capital back into what is now a smaller, slightly more highly valued set of promising development-stage companies.

Typical sector analyses focus on past performance (e.g., XBI is up only +0.2% through June 30, despite fluctuating +/- 10% during 1H23). Or they emphasize how many struggling companies are trading below cash (by our analysis, 25% of all development-stage public biotech companies). Or how many biotechs will likely need to finance in the next year (72%). 

But examining the subset of biotech companies that truly matter to the portfolios of biotech specialist investors (i.e., dividing the public biotech Universe into our Core set of biotech companies and a Peripheral set that is not owned by specialists) and weighting them by their valuations shows a much clearer and more promising view of our industry’s prospects.

Looking at the world our way, one sees that the NUMBER of Core biotech companies shrank by ‑10% during 1H23, the total Core MARKET CAP stayed about the same, and their cumulative burn decreased by ‑5% during that period.

More importantly, $52B was returned to Core shareholders via 15 company acquisitions or else turned into returnable capital thanks to two companies, Legend Biotech and Apellis Pharmaceuticals, graduating from the set when their valuations climbed above $10B. 

And finally, the number of Core companies in the financing Danger Zone (companies with less than two years of cash that are trading with a burn/​market capitalization ratio greater than 25%) fell by ‑10% from 169 to 152, but they remain a modest 10% of Core’s total market cap.

If you’re short on time, then you’ve just heard the bottom line.

But if you’re a sucker for data and analysis and game for a few more insights you probably won’t come across elsewhere, read on.

Photo by Lacey Raper

Understanding RA Capital’s Semper Maior biotech sector analyses

This is the second of RA Capital’s Semper Maior biotech series and the first update of the kinds of analyses we introduced in the first article. In that first piece, we broke down all the cash-burning companies in the development-stage public biotech universe by what we called Core (owned by at least one biotech specialist fund) and Peripheral (not owned by any specialists) and then further broke them down by whether or not they were in a financing Danger Zone. 

Importantly, we looked at the weightings of Danger Zone companies as well as other categories (e.g., those trading below cash) relative to the overall Core set to make the case that while there were hundreds of struggling companies, their overall weighting in the sector was small, which is to say that they had already been substantially written down and their further decline would not weigh much on the sector’s performance or specialists’ performance. 

Our January piece was not intended for those small, struggling companies, to whom it would offer no comfort. We wrote it for the broader audience of potential biotech investors, including generalists and specialist fund LPs, who might be intimidated by reading other biotech sector analyses that emphasized its number of struggling companies and ignored their low weighting in the portfolios of the specialist investors that companies count on for funding.

The bottom line then was that development-stage biotech as a whole was well positioned to achieve continued positive performance thanks to cash-rich strategics acquiring promising companies to replenish their own pipelines, injecting cash into the ecosystem.

TABLE 1: The Big Data Table

Composition and characteristics of our biotech Universe and its Core and Peripheral sub-sets at the start and end of 1H23. We also include data on how well capitalized companies in these sets are. Where you see percentages in parentheses, they are telling you what the market cap weighting is for a particular set of companies as a proportion of the total market cap of that group. For example, there are 79 Core companies trading below cash, whose market cap represents 4.1% of the total market cap of the Core set.

Six months on, we have updated our data (substantively captured in Table 1) and make the case here that our thesis has been playing out and will continue to play out. We also examined what drives changes to the number of companies in our Core and Peripheral categories as well as those in the Danger Zone. Biotech is highly dynamic, as you’ll see. We argue that the changes here are evidence of a learning engine that is constantly assigning different weightings and resources to projects of varying value and probabilities of success. That engine is something to be nurtured by protecting the foundations of basic science and the market-based, patent-defined incentive framework that’s kept it humming for decades.

The Universe contracted

At the start of 2023, there were 656 US-listed public development-stage biotech companies under $10B in market capitalization in what we called our Universe set. These same companies began the year worth a combined $325B and increased in value by 14% through June 30 (this includes the companies that were acquired as well as Legend and Apellis, both of which graduated by surpassing $10B market capitalization, and excludes any companies that entered the Universe set during that time period).

Photo by NASA

While it might be tempting to think that this means that the Universe performed well, we have to account for financings and reverse mergers, which increase a company’s valuation even if its share price stays the same. 

Because there were so few newcomers to the set (we count five IPOs and five companies going public via SPAC) but many delistings and acquisitions, the number of companies in the Universe shrank by ‑5% to 620 during the first half of 2023, and those companies are now worth a combined $321B, ‑1% less than the Universe’s total value at the start of the year. 

The number of companies trading below cash shrank by ‑29% from 214 (33% of the Universe) to 153 (25% of the Universe). This seems like a meaningful improvement until you notice that those companies only represented 5% of the Universe’s total market cap in January 2023 and now represent 4%, suggesting that an already small problem merely got a bit smaller. Besides, while some companies ceased to trade below cash because their share prices went up, others just burned their cash down below their market caps, so we don’t really know about the viability of those companies unless we look closely at each, and yet that’s not the focus of this analysis.

As we did last time, let’s home in on the companies that matter to biotech specialists, the ones we call Core.

The Core set represents about 89% of the Universe’s valuation but only about 56% of its companies.

Just think how crazy that statistic is; if nearly half of all development-stage biotech companies (i.e., all the Peripheral ones) failed, we’d have to endure endless headlines about the poor health of the sector, and people would worry about the catastrophe all that failure represents for drug discovery and development. And yet it would have no direct effect on the portfolios of any biotech specialists and likely very little effect on our sector’s most promising drug candidates. Similarly, if those Peripheral companies all were acquired at a 100% premium, that too would have no direct impact on specialists. Indirect spillovers in either case, stocks trading down or up in sympathy? Sure.

That’s particularly relevant to biotech specialist fund LPs, who no doubt wonder how sector news impacts their investments. The answer is ​“it depends and might not matter in quite the way you think.” And yet, there’s actually nothing radical about this insight; investors have long dealt with indices’ inability to truly reflect a sector’s health or the prospects of any particular investment strategy. We’re just quantifying the magnitude of the skew between the whole biotech Universe and the Core set that really matters to us and our peers.

The shrinking biotech Core

Photo by Trust ​“Tru” Katsande

Figure 1 shows that there are 40 fewer Core biotechs at mid-year 2023 than there were at the start of the year. Only five newly public companies joined Core (two companies via IPOs and three via SPACs), and 17 companies joined from the Peripheral set when specialist investors acquired shares. These additions did little to offset the Core exodus: 15 Core companies were acquired, three pairs merged (resulting in net reduction of three), 16 delisted, and 26 switched to the Peripheral camp after the specialist investors who owned them exited their positions. Legend Biotech and Apellis Pharmaceuticals graduated from the Core set by climbing above its $10B market cap boundary (congrats to both!).

FIGURE 1: How the Core Universe Evolved Since 2022

Core dynamics (movements in and out of the set) during 1H23. Note that ​“Core to Peripheral” means that a company became Peripheral because those specialists we track for purposes of calling a company Core sold all their shares. Inversely, Peripheral to Core means that at least one specialist on our list showed up as holding that stock, turning it into Core and removing it from the Peripheral set. There are two companies that ​“Traded out of the MC (Market Cap) Range,” which means that they climbed above the $10B limit we use to define the Universe set (and therefore are neither Core nor Peripheral).

If we consider the Core set of companies that started 2023 (including the acquired companies and Legend and Apellis), this set would have appreciated in value by 15%, versus a 10% gain for Peripheral and a 14% gain for the Universe overall. It’s possible that Core grew more than Peripheral for various reasons (including raising more money proportionately, for example), but it’s at least partly because nearly all the lucrative acquisitions came from the Core set (e.g., Albireo Pharma, Amryt Pharma, Bellus Health, Chinook Therapeutics, CinCor Pharma, CTI BioPharma, DICE Therapeutics, Iveric Bio, Prometheus Biosciences, Provention Bio) whereas the Peripheral had only two tiny acquisitions (both take-private deals, not acquisitions by strategics).

Who’s driving down my stock? Is that even the right question?

There’s a story to tell in examining companies’ movements between the Core and Peripheral camps. 

Of the 26 companies that transitioned from Core to Peripheral, 14 saw their share prices drop by more than ‑20%, many due to negative clinical data. But seven saw their share prices rise more than 20% during 1H23. In two cases, Core companies rocketed up over 100% on good data … and lost their specialist investors. That’s perfectly okay! Not being considered undervalued by specialists can be a mark of success. And in the case of the 17 Peripheral companies that picked up at least one specialist shareholder and became part of the Core set, four had share price increases of 20% or more and eight had share price decreases of ‑20% or more.

Maybe you’ve heard people explain that a stock is dropping by saying that someone is selling it. We’ve always struggled with that one because every share that is sold is also being bought. And here we have evidence that stocks can go up or down while either picking up specialists or losing them. Correlation is not causation.

Selling or buying is not the ​“cause” of a stock’s movement. There can be a lot of shares traded at a single price for a long period of time. A share price’s movement reflects a shift in how investors think about a company’s value, with the one caveat that it only reflects the views of those investors who are even thinking about the company. Shares trading is just how that change in perceived value is communicated to the rest of the world. 

That may seem confusing or at least a trivial abstraction until one considers private companies. In the case of private companies, their values also change in the minds of investors. But until a share is traded, it’s hard for everyone to see that the company’s value has changed. That’s why, in the absence of a daily market telling private companies how investors value them, those companies should try to conduct proper price discovery on themselves while they still have the cash to adjust course. One strategy is to make good use of investor directors on their boards, as a number of experienced biotech board members and executives teach in one of our Gateway learning modules.

Peripheral served as a farm team

Although the value of the companies that started 2023 as Peripheral climbed by 10% during 1H23 and a net four companies joined the Peripheral set (expanding it by 1%), the value of the final Peripheral set of companies as it stood at the end of 1H23 was ‑12% smaller. That might seem odd but we think it’s a sign of totally rational dynamics between Core and Peripheral.

Photo by Harrison Steen

In 1H23, 17 Peripheral companies transitioned to Core (Figure 2). Their average market capitalization was ~$1B (median ~$200M). By comparison, the 26 companies that transitioned from Core to Peripheral had an average market cap of slightly more than $300M (median ~$100M). In other words, specialists are taking the more valuable companies from Peripheral in the hopes that whatever value they have will further appreciate while selling off lesser valued Core companies, often after a major setback, thereby depositing them into the Peripheral set. So the data tell a story that makes sense. We’re always a little suspicious when that happens, so we’ll keep an eye on these dynamics in the future to see if they continue to make sense.

FIGURE 2: How The Peripheral Universe Evolved Since 2022

Peripheral dynamics (movements in and out of the set) during 1H23. Note that ​“Core to Peripheral” means that a company became Peripheral because those specialists we track for purposes of calling a company Core sold all their shares. Inversely, Peripheral to Core means that at least one specialist on our list showed up as holding that stock, turning it into Core and removing it from the Peripheral set. 

M&A: A powerful potential driver of returns… at current valuations

In the biopharma ecosystem, M&A is a natural part of the cycle of life. There are few sectors where M&A is more common and expected; big pharmas have long acknowledged their symbiosis with small biotechs, making no secret of their intention to acquire the best of what they had to offer.

Photo by Kace Rodriguez

While it’s well known that strategics have a lot of cash, we prefer to look to their Free Cash Flow as a measure of their collective M&A firepower. Figure 3 shows that it would take only 2.7 years of strategics’ FCF to acquire every single Core biotech company for a 100% premium. That’s how small the target set is compared to the resources of the giants doing the shopping.

By that metric, the biotech development-stage Universe and especially its Core subset are cheaper now than in the recent past, well below the peak of 2020 and only higher than the lows of mid-2016, the last major biotech downturn before the current one. And if biotech valuations don’t pick up and new companies don’t enter the Core set, then as strategics’ FCF grows in the coming years, the acquisition ratio will fall further and become only more attractive.

FIGURE 3: The Sector’s Acquisition Ratio — Years of Strategics’ Free Cash Flow to Acquire Smid Cap Biotechs for a 100% Premium

M&A conditions are favorable based on how few years worth of strategics’ Free Cash Flow it would take to acquire the whole Universe or just the Core set for a 100% premium, which is what we call the sector’s Acquisition Ratio. We did not calculate the Core values for YE2016 or 2017 – 2019 because it’s tedious to do so and it’s enough to eyeball the trend evident in the Universe data. MY2023 values correspond to the current data as of the end of 1H23. 2024 – 2025 rely on sell-side projections of biopharma free cash flow to project what the acquisition ratios would be in future years if current valuations remained the same.

So it’s both heartening and not surprising to see in Figure 4 that 2023 is on track to becoming one of the biggest years on record in terms of the number of deals done, the total value of the development-stage companies acquired, and the transaction premiums paid (in dollars). Note that since we are focused on the Universe of public biotechs below $10B in market capitalization, our data are not skewed by mega acquisitions like Celgene and Seagen.

FIGURE 4: M&A Dollars Flowing into the Biotech Universe

2023 M&A transactions are outpacing 2022 in both value and deal count, likely fueled by how relatively inexpensive the sector remains. The faded extensions of the 1H23 bars reflect a simple doubling to convey what the values would be if the M&A we have seen in 1H23 were to continue through the rest of 2023.

We think this pace of M&A is sustainable and rational because conditions remain similar to what they were in 1H23 and reflect the basic truths that big biopharmas are really big, very well capitalized and, as always, in need of replacing revenues they are constantly shedding due to genericization (and, eventually, Medicare negotiation). This is a feature of the Biotech Social Contract, not a bug. Small companies are the source of a considerable amount of innovation and the pool of these companies is small compared to the growth needs of the strategics. 

It’s worth drawing attention to the shorter light blue bars in Figure 4. These capture the total dollar value of M&A premiums; that value is what makes M&A compelling. Premiums are typically 50% to 100% higher than the last trading price (we estimate the average M&A premium to be around 70%). 

That collective premium added up to about $11B in 1H23, which represents a 3.4% gain on the $325B valuation of the biotech Universe at the start of 2023. Of that $11B premium, 98% flowed to Core companies (close to the 99.5% historical average; see Table 2), which represents a 3.8% return on the $283B value of the Core set at the start of 2023. That’s a pretty good source of alpha (excess returns) over just six months.

It sure would be a shame if misguided FTC policy made this M&A harder. That might cool investor interest in biotech, don’t you think? And yet, that’s what the current administration is proposing. Anyone who hopes to see capital flow to the biotech Universe therefore has a stake in the government issuing sound policy around how M&A is regulated. 

More Core?

We have so far designated companies as Core if even one member of what we considered to be our peer set of specialists appeared as a shareholder. So what about companies with two, three, or more specialists?

Is more Core more better?

Photo by Kalen Emsley

For example, we observed in our January analysis that while 86% of acquisitions by deal count occurred in the Core set, 98% of the M&A dollars flowed to the Core set (and actually 99.5% of M&A premium), despite Core comprising only 59% of the companies in the total Universe. Specialists’ ownership seemed to tag the companies that were more likely to be acquired. 

Table 2 shows that if we concentrate down to the companies owned by at least two or at least three specialists (2+ Core and 3+ Core), the share of $11B of M&A premium (theoretically what would be generated from the same amount of M&A activity in 2H23 as we saw in 1H23) would slightly concentrate in ​“More Core” companies, climbing from 3.9% for 1+ Core to 4.2% for 3+ Core. This might be just noise, but what makes the signal stand out a bit more is seeing that the companies owned by only one or two specialists (“1 – 2 Core”) get a return of only 2.3% from M&A premium. We’ll look to future M&A data to tell us if More Core consistently gets more share of M&A returns. For now, it’s still just a hypothesis.

TABLE 2: M&A Data by Core and More Core

Do M&A premium dollars accrue disproportionately to More Core? Maybe. Note that in this table, the Universe is as of June 30^th, 2023. Percentages in parentheses should be understood as a percent of the Universe. So the 207 3+ Core companies are 33% of the 620 Universe companies. We use $11B of M&A Premium in the last row because that’s what it was in 1H23 and we are using it as a plausible number for what might happen in 2H23 to show what the return would be to each market segment. So to calculate the 4.2% in the lowest cell of 3+ Core, we multiply 88% by $11B and divide by $228B. 

But let’s imagine that the effect is real. Should one just own companies that are owned by three or more specialists? Maybe a retail investor could manage their portfolio that way, or even a small fund. But realistically, any large fund has to build large positions over time, often via financings, to amass meaningful holdings of companies that other specialists may or may not appreciate at that point. At the time of one’s first investment, these companies may be Peripheral (or even just private). Also, M&A isn’t the only source of returns in biotech. Stocks can also go up simply from investors better appreciating their value (and maybe wanting to own them ahead of hoped-for M&A). 

Meanwhile, some of us are also hoping that we might enter an era when we might learn to build more companies like Vertex and Regeneron that graduated from the Core set years ago (by exceeding $10B in market cap and becoming profitable) and are now part of the acquisitive class. 

What about privates?

In this analysis, the fates of private companies are really represented by only a few metrics that we didn’t talk much about: the crossing over of private companies via IPOs, SPACs, and reverse mergers. The flow of companies into the Universe could not match the outflow via delisting and acquisition and even merger of two public biotechs into one (that happened five times, collapsing ten public biotechs into five).

Photo by Cezary Kukowka

The Universe will not tolerate a vacuum. It will suck companies into itself from the private side of the sector. Not all of them will win over specialists. In the first half of 2023, there were five IPOs, only two of which went to Core. That’s a slow pace that could easily pick up whenever private company management teams and shareholders align on value with public market investors. Maybe that alignment will stem from private companies running out of runway, public markets becoming less fearful, or an intersection of both. 

Either way, eventually we’ll see better equilibrium and companies proceeding more smoothly along the funding conveyor belt. There’s just not enough private capital to fund all the compelling programs we’re seeing on the private side of the sector. And public investors will eventually find the existing public Universe can’t absorb the capital they want to put to work in biotech. Investing in new issues will eventually make sense, as it has at many times in the past.

We don’t find SPACs to be a credible route in nearly all cases they are proposed, and there are too few situations where a reverse merger makes sense for both parties at the right time for that to become a common crossover path, so we think IPOs are the metric to watch. 

Strategics are capable of front-running the public markets and acquiring what they want from among the sea of private biotechs. But that typically requires the strategics to take on more risk and development cost (onto their P&L) than they are comfortable with, which defeats the whole point of externalizing their R&D to the small biotech ecosystem in the first place. So we don’t think that investors are going to ultimately cede the business of nurturing biomedical R&D to pharma. Soon enough, they will take up more of what’s been their mantle, with more circumspection than in 2020 but also more confidence than in 2022.