How to identify biotech diamonds in the rough – Investment Week

While it may seem valuations are likely to stop falling at this level, this is not necessarily the case in biotech. Typically, these early-stage companies are yet to have a product approved, and they subsequently rely heavily on external backing to fund the development of new treatments.

This makes these sorts of companies particularly risky prospects for investors in the biotech space. However, among companies whose values have dropped 70-80% from their peak levels in the spring of 2021 are some gems, with compelling science and sound underlying business fundamentals.

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Given the darkening macroeconomic outlook, identifying these diamonds in the rough requires an in-depth understanding and analysis of the funding outlook for early-stage biotech businesses.

Banks generally do not lend to development stage biotech companies, as the nature of their business is deemed too risky and clinical trials are far from cheap. The majority of funds are raised through private series rounds, IPOs, and future secondary rounds, as this type of equity funding is cheaper and has fewer strings attached. It also generally means companies can retain control of their assets.

In recent years, it was relatively easy for early-stage biotech companies to raise money.

The IPO market was booming, and many firms took the opportunity to raise excess capital while the market was hot. This was a sensible approach, as things can turn very rapidly and funding can dry up fast, as has been proven in recent months.

Investor appetite for biotech IPOs has now dried up, and many biotech companies fear not being able to raise equity finance, or at best, with stock prices at current levels, being forced to raise money at low valuations, thereby diluting current shareholders.

Companies with limited access to equity finance are faced with a tough decision. It is considered unethical to halt a clinical trial, but some companies choose to stop or delay pre-trial clinical programmes to preserve capital. If there are doubts on the efficacy of their lead asset, they may start to explore potentially riskier second tier assets, burning yet more cash.

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Companies may also seek to partner their assets or regional rights with larger biotech or pharmaceutical companies. While this means losing a proportion of the potential value, it provides them with cash up front and extends their runway, enabling them to continue developing treatments. Others may sell out in full, as these situations are a magnet for larger companies seeking to pick up distressed assets at knock down valuations.

Companies resorting to option financing such as convertible notes or at-the-money instruments tend to be in a fairly desperate financing position, as these are generally considered the most expensive and least attractive sources of finance.

With early stage funding options dwindling, investors in the biotech space may be tempted to avoid riskier development stage businesses and opt instead for larger-cap stocks with profitable products already on the market.

However, this could mean foregoing potentially significant returns. The earlier stage biotech firms boast the most exciting new cutting-edge therapies with the potential to form the next generation of medicine.

Investing in companies trading at an EV at or below zero takes great discipline, experience, and cautiousness. One of the key metrics to evaluate is a company's cash burn rate', which refers to the future cost of programmes the business is committed to, versus the time it will take the firm to reach a clinical trial read out.

This stage is critical for early-stage biotech players, as reporting positive drug trial results boosts the chances of a successful capital raise at a higher valuation. Avoiding companies that will need refinancing within the next two years is a good rule of thumb to follow.

There are other key factors to consider. The management team's quality and experience are also vital, as investors must be satisfied the team can withstand tough market conditions and present an attractive proposition to potential funders.

Additionally, the ownership of the company is important. If a company is supported by professional investors, known for their skillsets and deep pockets', risk is considerably mitigated.

Even if a company is sufficiently well financed and managed, the underlying science behind its innovations must be of top quality. Our approach with these higher-risk assets is to build a small toe in the water' position to start with, and add to it incrementally as the company proves itself and our relationship with the management team deepens.

Marek Poszepczynski and Ailsa Craig are co-investment managers of the International Biotechnology Trust

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How to identify biotech diamonds in the rough - Investment Week