Cross-Over Investors Key Players in Health Deal Boom
(A version of this Health Alert was published by Forbes.)
Silicon Valley Bank has published its mid-year report on the state of financing in biotech, medical devices, and diagnostics. The key take-away is that both private financing and exits continue to be strong. One development in the structure of the market that has made deals easier to move through the pipeline is the rise of cross-over investors. These are mutual funds or hedge funds (usually investors in listed securities) which are increasingly investing in private health deals.
Last November, fellow Forbes contributor Bruce Booth noted that cross-over investors had been growing in importance in biotech since 2012. The SVB report confirms similar activity increasing in devices and diagnostics. SVB does not propose why public investors are increasing their participation in private deals. (I would hazard it might be a search for yield in a very expensive stock market. Whether investors in those mutual funds and hedge funds appreciate the liquidity risk they are undertaking, I’ll leave for others to explore).
In biotech, SVB reports 13 of the top 15 private financings (by valuation) had cross-over investors. Although later to participate in device and diagnostic deals, cross-over investors are increasing their participation in those sectors as well. For both devices and diagnostics, four of the top 15 private financings had cross-over participation.
Having cross-over investors on the capitalization table for a company’s private financing rounds makes it easier to follow with an Initial Public Offering (IPO). Other public investors are more likely to have confidence that the cross-over investors know the stock well and will stay involved. IPOs with cross-over participation were priced at higher valuations than those without, but also outperformed post-IPO.
This has a further consequence (“optionality” in SVB’s language) that trade acquirers are also more likely to take-over private companies at earlier stages, because they can more easily sell it when the time comes. As a result, both IPOS and take-overs have increased. SVB counted a total of 42 exits in the first half of 2015, versus 25 in the first half of 2013. SVB notes that Medtronic, despite still digesting Covidien, continues to buy smaller companies, too.
So, the biotech, medical devices, and diagnostics industries continue to boom. However, there are significant and persistent public policy risks:
- Reimbursement: The British National Health Service has stopped paying for 25 lifesaving drugs, primarily for cancer. The reason? They only treat 8,000 patients in Britain. Drug companies are hoping to profit from a new world of personalized medicine, where drugs are precisely targeted at small populations. Government health systems are unlikely to manage this transition well. Nor will the U.S. be immune: Politicians of both parties are sensitive to public demands to control prices for new therapies.
- Health insurance mergers. Currently announced health plan mergers have a high risk premium, and powerful lobbying forces are trying to block them. However, should these combinations succeed, more concentrated market power among payers will lead to more price pressure for drug makers, device makers, and diagnostic firms.
- Patent protection. The big growth opportunities are in Asia and other emerging markets. However, ensuring that intellectual property is protected in many of these markets continues to be an uphill fight. Negotiations for the Trans-Pacific Partnership are largely hung up by some countries unwillingness to afford adequate patent protection to innovative companies.
On the other hand, there is significant movement in the right direction on regulatory policy. The U.S. Senate will hopefully take up the good work done by the House of Representatives in the 21st Century Cures Act. This reform would fundamentally change the behavior of the Food and Drug Administration, allowing innovative therapies to come to market faster. Although the House version has a suspicious financing mechanism, the FDA reforms will benefit both investors and patients.
Even without legislation, the FDA has improved its performance, approving new therapies faster. Recognizing the global nature of health markets, it has piloted a single audit program for device manufacturing facilities in collaboration with regulators in four other countries – apparently too fast for companies to get on board!
Clearly, investors view the net effect of these risks and opportunities as positive, resulting in yet another very good year for health care deals.
