One way to describe the late Baroness Thatcher is to say she realised the assumptions of her era did not reflect fundamentals, and so she fought successfully to change them. Since then, a new set of assumptions — about the ability of financiers to manage risk and generate returns — has also risen and fallen. The government is again asking the questions that Thatcher did in 1979: what are we good at and how does the UK capitalise on it for its long-term benefit? The commercialisation of science should provide an important answer. Instead, it is a field where strong fundamentals are obscured by the out-of-date assumptions and practices of the age.
The UK is nothing short of a gold mine in terms of research. In the field of life sciences, it is second only to the US measured by the number of citations in international journals. An ageing population, global increases in health spending, including in emerging markets, and an active acquisitions market should all drive investment into commercialising this research. Yet only £223m of private investment went into UK life-sciences spin outs in the past five years. Partly as a result of this, it is a gold mine from which worryingly few nuggets are emerging.
Investor caution is understandable. The sector has a poor historical track record, which in turn drives many on-going risk assumptions. These include: first, if you invest in early-stage assets, you should expect most to fail; second, that a lot of capital is required to increase value; third, that the only route to value is growing revenue and profitability; and fourth, that it takes a long time to crystallise value in a sale.
Policy-makers have recognised this investment gap and are trying to close it by offering tax incentives, soft loans and grants to support smaller companies. In a cash-starved environment, it is understandable that scientists and entrepreneurs pursue such grants — but at what longer-term cost to the business? The investment parameters for grants in particular are often focused on short-term goals of revenue-building and employment creation.
The problem with this approach is twofold. First, it only addresses one issue facing an early stage company —the lack of finance. The reality is that scientists and entrepreneurs often need more than just a cheque. Access to senior industry expertise, clear strategic guidance, financial governance, and a road map to value are all equally critical to success. Second, it ignores the fact that value is not necessarily measured by larger revenue or company size but instead by the size of the prospective market. This in turn means valuation can be agnostic to the momentary state of the wider economy – a key strength of pre-revenue investments.
Overlooking these factors may simply align such assets with a risk-heavy model – reaffirming rather than assuaging existing investor risk assumptions. But if these assets are provided with all the critical success factors they need — and capital furthermore introduced gradually in tranches based around key milestones — then risk can be managed and value crystallised in a way that quite defies historical assumptions.
Two recent examples, one from either side of the Atlantic, serve to illustrate this. Both also demonstrate the effectiveness of using special approval processes introduced by regulators to enable quicker and cheaper development of treatments for childhood and rare diseases.
The first is Auralis, one of our investments which took an existing generic childhood epilepsy drug, changed its formulation, and then put it through a new EU approval process known as Paediatric Use Marketing Authorisation. This granted the company 10 years’ exclusivity for paediatric markets. The whole process cost less than £2m, took three years, and generated a 6x return when the company was sold to US based Viropharma Inc.
A second example is Lotus Tissue Repair, which commercialised a treatment for a rare disease using only $3m of an original $27m investment. Only 18 months later, having met key milestones, it was sold on to Shire PLC generating up to 20x return.
Acquisition appetite for these treatments – which benefit from clearly-defined and accessible patient populations – is driven by the fact that in the last four years alone $103bn of annual drug revenue has come off patent. This has created a huge erosion of income for the industry.
In-house R&D facilities have not kept pace with this, not least due to their cost being a burden in the recent uncertain economic times. Instead, big pharma is letting others conduct spin outs and then snapping up the winners. AstraZeneca recently concentrated its UK facilities in Cambridge precisely to be near the local spin-out hubs. As a result of this appetite, crystallisation of value can occur well before the seven-to-ten years perceived time horizon for early-stage investing.
Yet in spite of these realities, the UK financing markets have markedly failed to capture the opportunity. Writing in the FT recently, David Stevenson stated ‘there is barely a biotech sector left in the UK’. This is a parlous state of affairs at a time when the UK is desperately seeking growth and investors desperately seeking returns.
But where should the investment come from? Government funding has largely been ineffective and angel networks often have insufficient capital. This type of investing is still considered too risky and illiquid by the majority of wealth managers, even for the high end of the SIPP market. I expect we are a long way from seeing such exposure being placed on wealth-management platforms, even when accompanied by properly-applied EIS incentives. In terms of institutional money, those venture funds that have the necessary risk mandate from their investors are often themselves structurally unsuited to this market.
The reason is that it requires close management of a small number of assets whereas, to survive, a traditional fund needs several hundred million under management to cover its costs. This can be seen in the relationship of Lotus Tissue Repair and its investor Third Rock Ventures. The agreed investment was to be $27 million – but only $3 million was required to make it saleable. It would be hard to imagine a vehicle such as Third Rock, with several million under management, setting out solely to find $3m deals.
Yet there is evidence that inflation is driving financing away from low-yielding, liquid assets and back towards longer-term equity investment. Perhaps this shift will drive the development of new investment models for emerging life-sciences. If these can embrace market fundamentals, thereby allaying investors’ fears rather than ingraining them, they will create huge value for the UK. It’s what Maggie would have wanted.
Paul Morton is a partner at Aquarius Equity Partners