Financing the Future of Pharma

Science is the lifeblood of pharma, of course. But these days, science isn't just what you produce in your own labs. It's what you can license, buy, partner on, or gain through acquisition. Which means that, increasingly, deals are the lifeblood of pharma.

On the one hand, that means nothing much has changed: Science is science whether you do it yourself or buy it. On the other hand, it changes everything, because science-via-deal has its own rules, its own ecology—and its own arithmetic for offering a return.

The simple narrative is that Big Pharma is in need of products, and biotechs are in need of cash. But how is the equation for innovation changing—and can pharma keep up? To explore the new landscape, Pharm Exec invited an all-star lineup of executives from industry and the world of finance to debate and discuss the issue. What follows is an edited transcript of that discussion.

PATRICK CLINTON (editor-in-chief, Pharm Exec): Pharma and biotech depend on one another for drugs and capital. Is this equation changing?

ADELENE PERKINS (EVP and chief business officer, Infinity Pharmaceuticals): Biotech has come into its own, particularly in oncology. Look at Amgen's and Genentech's sales, which exceed that of the next eight players. Recently published data showed, for the first time, the number of entities FDA approved by biotech crossed the 50 percent threshold. This shows that biotech can do it more on their own.

Adelene Perkins, Infinity

THOMAS HOFSTAETTER (SVP, corporate business development, Wyeth): We have to get the facts straight. Biotech is not biologicals. It's simply not true that Big Pharma pipelines are empty and everything of value is in biotech. There's an issue across the whole industry and it's that the failure in biotech is just as high as in pharma. When you look at what's really attractive in the pipeline, you come up with 30, 40 compounds, and two-thirds of these belong to Big Pharma.

Thomas Hofstaetter, Wyeth

FREDERICK FRANK (vice chairman, Lehman Brothers): When it comes to deal-making, most people think two-dimensionally about Big Pharma and the little guys. But an important part of the equation is the venture companies that fund this incredible repertoire of small companies. They are, obviously, investing to get a return. So when you superimpose that with the yin and yang of the IPO market, you see that the exit strategy between the bankers and the investors is what's driving the market.

Frederick Frank, Lehman Brothers

ALEX SCOTT (VP, business development, Eisai): Pharma companies are beginning to interact with venture firms as often as they do with biotechs. That leads to transactions, like our acquisition of Morphotek. It started as a licensing discussion but went quickly to an acquisition because of the relationship with venture capitals.

Alex Scott, Eisai

JOANNA BREITSTEIN (executive editor, Pharm Exec): What are the most striking features of today's alliances?

CLINTON GARTIN (vice chairman, investment banking division, Morgan Stanley): Competition. People need products, which drives price up. If you look at the average premium across all industries, it's about 28 percent right now. It's closer to 40 in healthcare. That tells you something about the pursuit of assets in this business.

HOFSTAETTER: Deal values are going up. Even if you strip out the "bio-world" dollars and look at the committed stuff like up-front payments, it makes you ask, How does that work for them?

MICHEL DE ROSEN (CEO, Viropharma): Some companies do deals with the focus on net income. Other deals focus on stock price. A deal may sometimes have no—at least immediate—accretive impact on your bottom line, but your P/E will change positively. I remember going through that kind of experience in the 1990s, when I was CEO of Rhône-Poulenc Rorer and it acquired Fisons in England. We did a reasonable deal, not a great one, but the Street got excited because it showed we were a player, and our stock price went up.

Michel De Rosen, Viropharma

TONY FARINO (US life sciences advisory services leader, PricewaterhouseCoopers): Some deals have been less than successful because many companies make decisions without understanding how the market—meaning payers—will assess and value the innovation. This partially explains why several compounds introduced over the last 10 years haven't met market potential. Companies are realizing that innovation cannot be defined just in the lab. It has to be defined in the marketplace.

BREITSTEIN: Given pharma's pipeline, why haven't there been more deals?

ANNETTE GRIMALDI (managing director, life sciences, Jeffries & Co.): M&A activity was quite strong in 2006, a little less according to the statistics in 2007, but still on pace. I think the IPO market has impacted that.

Annette Grimaldi, Jeffries & Co.

Most people see M&A as something that is countercyclical with the public market. But in my experience, it's often been the opposite. For companies to combine, they both need to be happy with their valuations at that point in time. What tends to happen is that, rather than sell themselves when the market is difficult, biotechs tend to do small, unhappy, diluted financing to tide them over until a more opportune time.

DE ROSEN: There are many reasons for the lack of deals: One is that what is for sale is not good enough and what is good enough is not for sale. Other issues include price; social or government issues; and the clinical, scientific, and regulatory uncertainties that make it very difficult to predict if the product will become huge or be a zero.

There's also this tension between the critical mass companies want to build and the focus they want to keep. It is sometimes tempting to combine a company that is focused on one area with a company that is focused on another, but very often, it does not make sense. And then there are the huge egos.

In recent years, there's also been too much money available. When a lot of money is available, companies don't need to combine. It seems likely to me that in 2008, and maybe onwards, there will be less money available and, therefore, more pressure on companies to combine than there was before.

GARTIN: There's also a low personal appetite for risk. There is very little down side in not doing a deal. If you don't pull the trigger on spending money, you don't get fired if the company does well and you have not bought it.

WALL STREET PERSPECTIVE

BREITSTEIN: Wall Street typically has a short-term perspective. How does that impact deals?

DE ROSEN: When my company was looking to acquire a drug called Vancocin, we had difficulty in raising money—people on the Street were skeptical. It was only after six months that they saw that it was a good deal. The point is, you can't judge after one day, one week, one month. You need one or two years to know.

FRANK: There is no such thing as short-term and long-term. It's only shorter and shortest. I always say to CEOs, If I ran a major pharma company, I wouldn't report quarterly. With 10 to 12 years for product development, quarterly reporting is irrelevant. Now, biotechs can't do that because they need Wall Street. But the last time a Big Pharma did an equity offer was in 1975. So why do they pander? Because it's tied into the likely retirement status of the CEO.

TODD DAVIS (managing director, Cowen Healthcare Royalty Partners): But the massive majority of companies—maybe not in terms of market cap, but in terms of number—do need capital. It is very difficult for a company with a 10-year drug development cycle to raise money from a fund with a one-year lockup. But the private equity structures that are out there now actually match up much better with the development lifecycle of companies' products.

LES FUNTLEYDER (healthcare strategist, Miller Tabak): Hedge funds have also been growing in popularity, at least until recently. When you have to put up monthly returns, thinking of 10-year valuations approaches irrelevant. It's almost over-thinking.

From a short-term perspective, pharma has an ongoing news flow, and tend to be very liquid stocks. That is why you see sometimes volatile moves in even the bigger stocks. It didn't used to be that way for Big Pharma, which tended to drift around in price. That's a statement of where capital is now.

BARBARA RYAN (managing director, Deutsche Bank): In 1994, an investor may have thought, "Merck is a low-rate stock. It's not going to go bankrupt. They pay good dividends. What could go wrong?" And all of a sudden, Merck pulls Vioxx off the market, and the stock is cut by a third. The market says, "Wait a minute, if I want that, I can own a biotech stock." And by the way, if the biotech product works, it's a three-bagger, it's a five-bagger.

Barbara Ryan, Deutsche Bank

There's no shot for Merck to increase like that. It has investors questioning how impactful pharma's pipeline can be. Can a more robust pipeline make up for Lipitor's shortfall? I mean, Pfizer's exposure in terms of patent expiration as a percentage of revenue isn't really different than any of its peers.

VALUE-BASED PRICING

CLINTON: High prices have been one way that industry makes drugs for smaller patient populations profitable. Do you think this will continue?

FUNTLEYDER: Price trends are unsustainable. Fundamentally, payers will not continue to pay for biologics or specialty compounds at the current prices unless there can be some way to demonstrate value. And in some cases, we may find that the industry may be undercharging.

FARINO: The industry has to start focusing on how it can contribute to driving down that global cost of healthcare. With the creation of innovative medicines, the industry can begin to shift the debate from price. It has to recognize that it is a key part of the healthcare-cost solution.

GRIMALDI: I don't think either biotech or pharma has formulated a coherent and consistent way to justify prices. If the industry doesn't take a proactive stance on why a certain pricing is justified, then others will do that for it.

HOFSTAETTER: That's not reality. You can't even get a drug approved these days in Europe and other countries without showing the value proposition. In the United States, you have to do that for managed care. We don't develop a single drug without a pharmacoeconomic perspective behind it.

GRIMALDI: Do you think you do a good job of that?

HOFSTAETTER: Well, let me put it this way: Enbrel's pricing is the same everywhere in the world. Europe has accepted the same price as the United States.

PERKINS: Pricing based on therapeutic value is fraught with implementation difficulties, but we have to find ways to do that. It ensures patients can try drugs without the huge financial exposure until they see how it works. So, for those people that it works for, Enbrel should be priced at five times a certain cost. For people that it doesn't [work for], they should not be charged.

RYAN: In many respects, pricing is a function of competition and value to patients. So the way to take the air out of the bubble with respect to biologics is through biosimilars. Because of the huge barriers to entry with investment in biologic manufacturing, you are not going to have the same kind of bloodbath in terms of the penetration of generics. But, by the same token, it will be interesting to see what happens when Roche gets on the market with Cera because, in reality, it's a follow-on drug [to Epogen]. How does managed care take advantage of that, even though it's more of a branded generic?

GARTIN: The price of some products is an impediment to acquisitions. If a small company sells a drug that costs $250,000 a year, that may not attract a lot of attention. But if that same product is owned by a large company, it will.

FRANK: There are dangerous consequences to this equation of pricing. This paradigm is such that research will only get done on potentially very large products. Therefore, you have to push [small projects] back to universities and so forth, as sort of tax-free philanthropy. That gets hairy.

HOFSTAETTER: We must get to a stage again where regulators and society at large accept that no benefit comes without risk. FDA asking for more outcome data—to an extent never before heard of—is driving up the length of development and drug prices. This is not sustainable, and it needs to come back to normal. One way of getting there is addressing the waste in the system. We have to make an effort to distinguish between responders and nonresponders.

A QUESTION OF MODEL

BREITSTEIN: What type of deal structure makes the most sense for emerging pharma these days?

GRIMALDI: There's no one-size-fits-all strategy. What is constant is that there are periods of receptivity and less receptivity in the public and private markets, so companies have to be innovative when it comes to how they finance themselves. There are all sorts of ways to plug the gap if the traditional types of financing aren't there—royalty financing, collaboration with Big Pharma, M&A.

DAVIS: The length of time these companies have to be funded is much longer, which has also created some innovation around private financing for private companies. IPO now is really just an interim financing for the venture companies. It's not an exit. They don't have enough liquidity, and it usually takes several more years to get to a point where Big Pharma would be interested in it.

PERKINS: There is also now recognition of biotechs getting products all the way through development and to market, which leads investors to say, "Why don't you keep it yourself?"

So why don't we? As a young company, you have two assets—equity and product. It's really important to think about the right balance of when to partner and when to use equity. If you use 100 percent equity, there is tremendous dilution, recognizing that some products will fail and will carry that dilution forever. It's very expensive to do equity alone.

CLINTON: How are deal terms changing?

GRIMALDI: There have been just a handful of innovative collaborations. For instance, Genentech and Roche and Theravance had an interesting transaction structure. But most deals follow a preset formula, with a fairly standard list of deal terms. If you are looking for a specific product, you'll do a collaboration. But if you want to have that "R" keynote [as in R&D] to it, it makes sense to start with a product collaboration, and perhaps later acquire the whole company.

Now, there have been some bold R-oriented acquisitions that have gone counter to that point. Think about Sirna. Or that a lot of the antibody acquisitions were quite early stage and certainly focused on technology.

PERKINS: Across the board, younger biotechs are willing to share the risk for a larger piece of the return. With our relationship with AstraZeneca [on MedImmune], we both put in 50-50 and we have a 50-50 worldwide profit share. There are a lot of deal structures like that, where a young company is no longer willing to take a milestone, but because of access to capital, is willing to invest. I see that continuing.

BREITSTEIN: How could companies do deals better?

RYAN: Biotechs want to take products to the beginning of Phase III to maximize value, and pharma wants those products at that point in time. But what happened—and Pfizer is one of the more prolific in terms of these kinds of deals—is that almost every one of those programs went backward two or three years because what biotech called Phase III was not Phase III in pharma's mind.

SCOTT: The decision to partner and the interaction between our company and the external company is straightforward. The challenges of getting a deal done and projects successfully integrated are often internal. Companies that get better at this will really succeed over the next five to 10 years. Companies should be able to shift from an internal project to internalizing an external project as seamlessly as a hybrid car shifts from gas to electric without the driver noticing.

GARTIN: The problem is that there are unequal standards, with pride of authorship for internal projects. At the end of the day, an acquisition is simply a different investment in R&D. Companies look at external projects with a sharper eye as to whether they will be more or less successful than the projects they have invested in for years.

CLINTON: Looking ahead, what changes do you predict to pharma's model?

DE ROSEN: We will see a more diversified world, where the most successful companies won't do everything. Look for the model where companies can access discovery and gain development input and support for its marketing efforts in partnership with different institutions.

FARINO: The industry has used the same R&D model for 40 years. This model must change to one where we begin with a much deeper understanding of the underlying pathiophysiology of disease to gain earlier confidence in mechanism of action and safety. We believe such developments will allow for much earlier "live licensing" of compounds into the marketplace with much more focused claims. That can impact how you value products and companies, and how deals get done.

FUNTLEYDER: Those who can balance risk and reward, or at least risk, will succeed. It's about innovation per unit of risk—or however you measure it. And it doesn't matter about cap size. Either you'll succeed, or you'll disappear.

CLINTON: So should Big Pharma get out of research?

FRANK: It's very interesting to look at the relevant strengths of biotech and pharma. There could be a new model, where pharmas don't do "R"—just "D," marketing, and manufacturing—and research dollars are used to acquire products.

HOFSTAETTER: It doesn't work like that.

FRANK: The argument used is if we don't have "R," we can't have "D."

HOFSTAETTER: There's some truth to that. But if you accept that a biotech company should get $100 million for a product, then we could only put about five drugs into development a year, where we put 15 in now. We couldn't afford $100 million for an idea.

FRANK: Maybe it's better to put five better ones in rather than 10 lousy ones.

BREITSTEIN: Can pharma afford to finance its future innovation?

GARTIN: This is an industry where you cannot cost-cut your way to greatness. The most successful companies are those that are the most creative and aggressive about finding new products, whether that's through internal R&D, licensing, or acquisition. And the successful ones will use all three tools.

DE ROSEN: I don't think our challenge is the financing of R&D. There will always be money available to fund that.

HOFSTAETTER: What we forget to mention here is that the profitability of the pharmaceutical industry is still better than many other industries.

FARINO: But the industry is going to remain under great pressure to deliver innovation in a cost-effective way. Unless there is a much stronger focus on prevention and cure rather than palliative treatment, by 2020, the total cost of US healthcare could be $10 trillion. With real information about outcomes and cost effectiveness, I think that the industry can tip the pricing debate.

RYAN: At the end of the day, there is a market—a demand and a return for innovation—that hasn't changed. Companies must innovate and reinvent themselves, because what they sell today will eventually be generic. Pfizer and Merck are both large-cap pharma companies, but today they have very different outlooks.

CLINTON: So what's the way forward?

RYAN: Merck has said, "We took zero risks externally and extraordinary risks internally." But that's all changing. Companies have to become portfolio managers because the best internal opportunity is irrelevant. What matters is that they pursue the best programs in aggregate.

The question seems to be moving away from, can Pfizer spend $1 billion to develop a new drug—because the answer is yes—to should Pfizer spend $1 billion on a new drug? We have been burned with torcetrapib. They now have a factor Xa in development. It is a novel area of science. It seems as if they went out there and said, "We're going to spend this money. Let's find out who has the best program in the area, and where we have the greatest potential for success."

FARINO: It's difficult for any one company to take something into the market by itself. Partnership, in order to drive innovation, is going to become one of the most important factors in the success of any company.