By Ailsa Craig and Marek Poszepczynski, portfolio managers of the International Biotechnology Trust
Following a challenging three years, the biotechnology sector has put in a much more encouraging performance in recent months. Indeed, the fundamentals of the biotechnology industry – from the start of drug development through to the regulatory approval of new therapies – now appear to be in robust health, bringing renewed confidence from investors in the long-term opportunity set.
Trials and equity on the rise
The accelerating pace of innovation in the biotechnology sector can be clearly seen in the number of new clinical trials being initiated. Drug development is a costly process, so the continued growth of clinical trial initiations reflected should be seen as an indication that the sector is in relatively robust health. The number of new clinical trials registered with US government website clinicaltrials.gov has risen every year since 2011 and, if the current annual run rate is continued, 2024 will be yet another record year.
Most biotech funding comes in the form of equity. This is particularly the case for earlier-stage biotech businesses, where the lack of cash flows while drugs are in development mean that debt isn’t a viable option. There is an irony here, because the performance of the biotech sector is actually inversely correlated to interest rates. This is not due to the sector’s reliance on debt funding or the negative influence of higher borrowing costs. Rather, it is a function of how changes to the risk-free rate i.e cost of capital have an impact in analysts’ valuation models. Meanwhile, interest rate changes can also have a bearing on how investors perceive the attractiveness of biotech versus other sectors and asset classes. However, from an operational perspective, they are largely irrelevant.
The availability of equity finance, however, is very relevant to the biotech sector, and here the signs are encouraging. After a relatively barren period for biotech equity finance, private fundings are tracking ahead of the level seen last year. Furthermore, follow-on financings are tracking ahead of the last three years, providing further evidence that investors are starting to have confidence in the biotech sector again.
The IPO window reopens
Perhaps the most widely followed indicator of the health of the biotech sector is the level of IPO activity, as private biotech businesses make the transition to public markets. Although the increasing availability of private equity in recent years and lower valuations in the public markets has meant that businesses across all industries are generally choosing to stay private for longer, IPOs are seen by many as a pivotal moment in the development and maturity of a young biotech business.
There are tentative signs that biotech IPO activity is starting to return, albeit from a very low level. The IPO window for biotech is therefore open, but only narrowly so. We have seen 12 IPOs year-to-date, an increase on last year, but well below the peak during the last biotech boom in 2021. Perhaps the most positive aspect of this is that the lack of equity finance over the last couple of years has also contributed to biotech companies deciding to stay private for longer. In turn, this suggests that companies coming to the market now will be closer to commercialisation and therefore higher quality than those that chose to IPO during the market peak.
Launches set for liftoff
Finally, the end of a positive drug development process comes with regulatory approval and commercialisation. This too is a costly process, albeit lower-risk than drug development, and often involves further capital raising from the biotech behind the successful new therapy. It’s been a slow year for regulatory approvals so far, but this was expected. Oncology and neurology have been the leading therapeutic categories for approvals, although there has also been an interesting uptick in supportive care. Importantly, there are a number of key product launches, product approvals and late-stage clinical read outs in areas such as cancer, oncology and obesity.
Shifting sentiment
In examining the health of the biotech sector, we find a generally positive story. Confidence in the sector appears to be returning, as reflected in higher levels of private and follow-on financing, and tentative signs that the IPO window is gradually re-opening.
It is not a universally positive picture, however, but rarely is that the case. Indeed, if the environment did look universally positive, it would inevitably be reflected in valuations and should be seen as a reason for caution, not optimism. Nevertheless, in the context of prevailing attractive valuations and potential long-term upside, we are encouraged by what we see.
After three years of bear market and consolidation, the entire biotech opportunity set looks in better shape. The evidence suggests that more investors are finding now an interesting time to invest in the sector. Investor attitudes towards biotech are inherently cyclical, and there may be potential for long-term returns to be favourable from this point in the cycle.
