How M&A could raise biotech's living dead

Some Australian listed biotechs are trapped in a death spiral. Shareholders are reluctant to top up their original investments, while cash burn rates tip them ever closer to the edge of insolvency. But there are bright spots, writes Pete Young

Many of the 70-odd biotechs currently listed on the Australian Stock Exchange are sailing uncomfortably close to the reefs of insolvency.

So estimates Alan Yates, a man with personal knowledge of the perils of piloting a young listed biotech through dangerous waters. His company Integra Medica Imaging slid into administration about three months ago, despite desperate efforts to keep it afloat.

Like almost every other ASX-listed biotech, many of Integra's woes stemmed from forces outside its control.

For example, the tech wreck broke on the world's stock markets hours after Integra listed, halving its share price almost overnight through no fault of its own.

Other observers are more conservative than Yates in their estimates of the number of listed biotechs facing serious difficulties.

Earlier this year, the investor newsletter Bioshares rated companies on an index based on their current spending patterns versus cash reserves. The review highlighted 21 listed biotechs and life sciences companies whose cash reserves left them in a "precarious position".

While the positions of some of those companies has now changed for the better, the underlying message is that the ranks of Australia's publicly-floated biotechs include the corporate living dead -- zombie companies caught between the need to burn cash to develop their products and the need to conserve cash to avoid insolvency.

At the time they floated, they may have underestimated the time and cash needed to convert their IP into commercial viable outcomes, a problem compounded by the obstacles placed in their way by a hostile capital-raising environment.

Several years of negative investor sentiment have blocked them from replenishing their coffers through significant new fund raisings from their shareholders.

Structural deficiency

Listed companies who make new share issues to generate additional funds effectively dilute the stakes of the existing shareholders, which doesn't make the task of convincing them to re-invest any easier, notes bioinvestment specialist David Evans.

He believes the relatively small sum of $AUD3-5 million raised by the average ASX biotech float represents a structural deficiency in the Australian market.

"It wasn't enough to fund the rounds they need to get to the stage where they can start cashing in on their products."

It is a criticism that Integra's Yates agrees with. Integra raised $4.95 million when it floated on the ASX in 2000 -- a sum that Yates in hindsight dismisses as woefully inadequate for the task of bringing its medical imaging software to market.

One alternative strategy -- to douse cash burn and conserve finances by trimming staff, concentrating on core projects and selling off non-essential assets -- has been widely employed.

But taken too far that turns into suspended animation, an unrealistic long-term strategy for a sector developing as rapidly as biotechnology.

The fear is that by the time a company comes out of its self-imposed hibernation to take advantage of improving equity markets, its technology edge will have disappeared.

"The big end of town says if you are waiting for the equity market to ease up, you may be waiting for two or three years," says industry veteran Mel Bridges, chairman of Peptech and a board member of five other biotechs. "For the long haul, you need a lot of cash in the bank to survive."

Apart from attracting fresh funds or going into suspended animation, the only other major option for biotechs struggling with diminishing cash reserves is to combine resources with other players through merger or acquisition.

Global M&A upswing

Globally, M&A activity is on the upswing and Australia in particular presents a wealth of opportunities, according to Mark Saunders, president of Global Markets Capital Group, a US boutique investment bank specialising in M&A deals.

The US saw 122 mergers or acquisitions in the life science and biotech sector during the first quarter of 2003, according to the group's quarterly report. The positive result has been companies with "deeper pipelines and stronger financial positions," it says. The number of biotech participants in M&A activity formed a sharp contrast to the complete absence of biotech IPOs in the same quarter, according to the report.

Global Markets Capital is active in biotech circles here and the Australian-born Saunders was in Sydney and Melbourne in late May working on four M&A transactions. He declined to discuss them but the odds are they involve pairings of Australian and US companies.

One reason for US corporate interest in Australian life science partners may stem from the weak IPO market in the US which is "effectively closed for three years," says Saunders.

For unlisted US companies with substantial cash reserves, that could increase the attraction of marriage to an Australian partner which comes with an ASX listing as part of its dowry. David Blake, co-editor of Bioshares, believes the ASX has solid credentials as a listing environment for biotechs. "It might be one of the better homes for biotechnology in the world," he claims.

It is underpinned by an excellent legal system, the quality of the market is good and "it has a history of understanding risk capital," says Blake.

In Saunders' view, merger or acquisition deals between two listed Australian biotechs are less likely to occur than US-Australian partnerings simply because US companies have the cash.

At the same time, he says, "there is some very good management in Australian biotech companies and the fact the markets have been down isn't an indication of their future success."

Yet the vast majority of biotechs by their nature tend to be in cash burn situations and when equity markets are closed to them, very few options exist apart from M&A.

Priming themselves to take advantage of an M&A initiative may require the senior management echelons of Australian biotechs to change some of their mindsets, Saunders says. In particular, they need to open their minds and jettison any false pride.

"On the assumption that their science is good, they must be open to ideas that previously they might not have liked. Many are academically based and the tendency for academics is to hoard their knowledge and make harsh judgements on their close competitors."

The real world

In the M&A world, where close competitors often make the most useful partners, both those qualities are counter-productive.

"They have to come out of their academic closet and get into the real world, which may mean working with someone who may be a close competitor."

Secondly, an M&A deal must make sense both in the scientific and finance sense, Saunders says.

"It is not a matter of putting one company that hasn't got cash together with one that has... there must be real synergies.

"For example, if they are both working in the cancer field, even if one is in drug discovery and the other in genetics, that is good synergy because it is easier for the market to understand.

"The truth is that investors in biotech tend to be interested in [areas such as] Parkinson's, Alzheimer's and heart diseases so the fit has to be pretty close."

Trying to find that fit between platform technologies is a task that M&A specialists approach with caution, he says. "You've got to be careful of the phrase 'platform technology' because it was invented by companies that weren't sure of their main technology and are hoping for an exit strategy if the first barrel misfires."

Saunders concedes that the Australian market may be too thin to be a plentiful source of working capital for biotechs in need of more money.

"But it is possible to repackage a company and take it into the US to a variety of funds that will then purchase their securities," he argues.

In terms of M&A activity between US and Australian biotechs, the largest deal to date has been the $US161 million all-cash takeover bid for Sirtex Medical by drugmaker Cephalon. Launched in April, the bid struck a snag when it was rejected by Cephalon shareholders on May 27.

Back from the brink

Successful examples of all-Australian mergers include the September 2002 pact that saw previously suspended diagnostics company Analytica return to life as a part of listed biotech Psiron.

Another back-from-the-dead performance has been staged by Western Australian laser vision biotech Q-Vis. Put into administration late last year, Q-Vis is being recapitalised to the tune of about $2 million and will be relisted with future development of its technology proceeding as a joint venture with another WA company, Customvis.

The plan to resurrect Q-Vis' technology was accepted at a March meeting of creditors, according to a spokesman for administrators Ferrier Hodgson. The proposal to refloat the company, with financing arranged by Ascent Capital, will be put to shareholders in mid-July.

Other ways for drug development biotechs to raise working capital outside the sharemarket are being suggested but achieving them will require longer time frames and the cooperation of government.

An ingenious alternative to a merger-based revenue exercise is being attempted by listed biotech AquaCarotene, whose dipping cash reserves placed it at the top of the Bioshares endangered list.

The company, focused on the production of natural betacarotene, a food colouring agent and antioxidant, has excavated growth and extraction ponds as part of its production facilities. Now it is looking at sub-leasing mining rights for sand and gravel extraction as a means of creating a subsidiary revenue stream.

Setting up alternative financing mechanisms while keeping a tight hold on cash burn is a "balancing act that isn't an easy one to manage, and no one has a magic wand," concedes AquaCarotene CEO Donald Smith.

But like most of today's listed biotech, he might agree with the mantra of Integra's Alan Yates: "This market is going to recover, so let's have a little faith."

Trials and tribulations

The time is ripe for the biotech sector and government to open a dialogue about sharing funding risks for Phase II human clinical trials in drug development.

Among those promoting that view is bioinvestment specialist David Blake.

The number of Phase I trials now being run by young Australian drug development companies is likely to translate into "four or five" Phase II trials next year, he says.

But each of those trials may absorb $20 million or so -- and where that money will come from remains a cloudy question, according to Blake.

Given current share market realities, the possibilities are remote that young biotechs looking for those sums will be able to raise them from their investors. Nor can they turn to the big pharmas who traditionally have provided support in that area, Blake argues: "Two years ago, pharmas would have been interested in Phase I trials. Now they want to see good Phase II results [before committing themselves to support]."

The obvious answer is for government to enlarge its role, Blake suggests.

If government can fund mining projects or agricultural industry projects as being in the national interest, a good case can be made for extending similar support to Phase II drug trials, he argues.

Blake notes the federal government is already helping early-stage IP development through programs such as the R&D Start grant scheme and injecting tens of millions of public dollars into venture capital initiatives such as the pre-seed funds.

It now needs to follow through by extending similar support to later stages of the drug development cycle, Blake says. "It is time for a sea change in how the government thinks about its contribution to the long-term prospects of the industry," he says.

"When markets have difficulties in meeting risk requirements, sometimes it is the place of government to ask if it is worthwhile in terms of a sector-wide payoff for it to make a contribution."