Ailsa Craig and Marek Poszepczynski, Portfolio Managers at International Biotechnology Trust, reveal three major red flags investors should look out for when investing in biotech companies.
Successful investing in the biotechnology sector requires a disciplined approach and painstaking due diligence – it is as much about avoiding the losers as it is about picking winners. Having met thousands of companies over the years, there are certain characteristics we regularly see that will immediately rule an opportunity out as a potential investment.
Management mistakes
A biotech company’s leadership is of vital importance and can ultimately make or break its success. The ability to transition from discovery through to commercialisation requires distinct skill sets at each stage. We often see red flags relating to management teams that could hinder a company’s ability to reach its full potential.
One common issue is scientific founders staying involved for too long. While these individuals are often brilliant researchers, their expertise rarely extends to the capital-intensive and highly regulated drug development process. Transitioning leadership to experienced industry professionals is critical. When founders push back, treating the product as their “baby”, it can deter investors and lead to strategic missteps and poor capital allocation.
Conflicts of interest and incohesion within leadership teams are also red flags. When key executives have close personal relationships – such as spouses or siblings, which is surprisingly common – it raises concerns about governance, decision-making independence, and accountability. Additionally, companies with oversized leadership teams, frequent executive reshuffling, or visible tensions during investor interactions may lack the cohesion needed for efficient decision-making.
Other warning signs include misplaced priorities and overstating past achievements. If a company spends excessively on expensive headquarters, or high-profile branding, it suggests that management is more interested in appearances than fundamentals. Similarly, executives who exaggerate their past involvement with successful drugs should be viewed sceptically. In the tight-knit biotech industry, experienced investors can quickly spot when credentials are overinflated.
Strategic stumbles
A biotech company’s intellectual property (IP) should be its most valuable asset, but not all IP is created equal. It is crucial that a biotech business has a well-defined strategy for realising its value. A lack of innovation, poor strategic focus or a high cash burn rate without clear milestones are all red flags that indicate increased risk.
A key warning sign is a lack of true innovation, with companies developing drugs that offer little differentiation from existing treatments. Without a demonstrable advantage in efficacy, safety, or patient convenience, regulatory approval and commercial success become far less likely. Many approved but unremarkable drugs fail in the market because clinicians are unlikely to prescribe them, and insurers are reluctant to reimburse them. Similarly, biotech firms often chase trends – such as the flood of coronavirus-related assets in 2020-21 – without bringing meaningful innovation. Companies that fail to improve the standard of care in their target therapeutic area warrant caution.
A lack of strategic focus is another red flag. Companies pursuing multiple disease areas simultaneously often lack the necessary depth of expertise and resources, suggesting an opportunistic rather than a well-planned approach.
Weak intellectual property protection is also a concern. If a patent is set to expire soon after a drug is approved, it raises questions about whether the company will have enough time to realise its commercial value and why it has taken so long to reach this stage. Strong, enduring patents are critical to protecting a company’s long-term potential.
We also like to see honesty and transparency in clinical trial reporting. A lack of robust safety data may indicate poor study design or even an attempt to conceal concerning results. Selective data pooling, when companies merge patient groups or trials to create a statistically positive result, is also a red flag – trial data can be manipulated to find a group where a drug had a positive effect, and these companies should be avoided.
Structural shakiness
A company’s financial structure can indicate much about its health and long-term viability. Poorly structured companies often struggle to raise capital efficiently, which may result in a burden of costly debt.
Over-reliance on debt is a key red flag in biotech, a capital-intensive sector where early-stage companies can be years away from generating revenue. While equity raises are the norm, turning to debt or unconventional funding to fund the development phase suggests difficulty attracting investors, potential governance issues, and financial distress.
If a significant proportion of a biotech company’s shares are concentrated in the hands of a single entity – be it founders, a venture capital firm or a corporate partner – it can also raise liquidity and governance concerns ahead of an IPO. Large stakes may misalign interests with public shareholders and create exit challenges. While major shareholders are typically locked in post-IPO, the anticipation of an eventual sell-off can weigh on the share price, with the actual sale causing temporary volatility and downward pressure.
A dynamic process
A red flag does not automatically mean failure and the absence of red flags is by no means a guarantee of success. Meanwhile, circumstances can evolve – leadership teams change, financial structures improve and strategic focus can sharpen over time.
In a complex sector such as biotech, where outcomes can often be binary, the ability to identify these red flags and effectively make informed judgements gives experienced active managers the opportunity to add significant value for investors. A passive approach to biotech investing would result in a portfolio littered with easily avoidable duds, while a structured, disciplined approach can enable investors to quickly focus in on opportunities with a higher probability of success.
Written by Ailsa Craig and Marek Poszepczynski, portfolio managers at International Biotechnology Trust
