Jim Miller
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Venture capital is the lifeblood of early-stage biopharmaceutical companies. Start-ups and companies with promising preclinical
drug candidates rely on venture funding to get them to proof-of-concept—that point, usually after completing a successful
Phase 2A clinical study, where companies can expect to get a big licensing deal or be acquired outright by a major biopharmaceutical
company.
In the wake of the current global financial crisis, venture capital has become increasingly hard to come by, however, and
the situation could get worse in 2009. The problem has been especially difficult for biopharmaceutical companies looking for
new investors: venture capitalists (VCs) are holding on to their cash to make sure their current portfolio companies have
adequate funding to advance their most promising compounds. Further, the VCs are reluctant to allow new investors into their
current portfolio companies because at the low prices at which early-stage companies are being valued these days, their current
equity positions would be diluted too much.
Still, the biopharmaceutical industry could fare better than some other sectors in 2009, according to the National Venture
Capital Association (NVCA). In a survey of its members conducted in late November and early December of 2008, the NVCA found
that 92% of VCs expect total venture investment to decrease in 2009 versus 2008. However, 58% of VCs expect investment in
biotech to either grow or remain stable next year, while 42% expect it to decrease.
VCs will face problems raising funds and liquidating investments, according to the NVCA survey. Most expect institutional
investors to reduce their commitments to venture capital in the coming year, and there is concern that some limited partners
will not be able to meet current commitments. An overwhelming majority of respondents (72%) expect the IPO market to remain
closed in 2009 and 87% expect transaction values to decline. Most expect returns on VC investing to decline over the next
10 years.
TOUGH YEAR FOR CROS
Because early-stage companies are dependent on contract research organizations (CROs) for most of their development activity,
and because they typically take compounds only through proof-of-concept, the venture capital downturn will hurt service providers
that focus on preclinical and Phase 1 services, including toxicology testing, process development, and small-scale manufacturing.
This is especially true for the many small- and mid-size CROs whose customer base is comprised primarily of the venture-backed
companies. Even market leaders in early development are feeling the pinch. In late December, Covance reported that its fourth
quarter 2008 toxicology and clinical pharmacology revenues were down from what was expected.
Covance blames two developments for its disappointing outlook. One is a slowdown in new projects coming from smaller biopharmaceutical
companies. Projects from smaller biopharmaceutical companies are usually one-off engagements, and they depend on the flow
of new projects to replace completed projects. With funding down, those replacement projects aren't forthcoming. Those engagements
only account for 10–20% of Covance's volume, but the slowdown is enough to hurt the company's overall performance.
The bigger concern for Covance are the project delays coming from what the company termed "strategic clients," i.e., the major
biopharmaceutical companies, some of which have dedicated space contracts with Covance. Although the company expects many
of the delayed projects to proceed in 2009, it does not expect its dedicated space clients to exceed their contract minimums
in 2009 as they have in past years.
Despite the near-term uncertainty, large CROs and contract manufacturing organizations (CMOs) like Covance and Lonza are well
positioned in the long-term. That's because their core customers are increasing the share of their development activity that
is outsourced. In 2008, for example, Eli Lilly and Company effectively outsourced all of its toxicology testing to Covance
while Novartis outsourced much of its biopharmaceutical process development and clinical manufacturing to Lonza under long-term
contracts.
Most major pharmaceutical companies have established global sourcing units that are pursuing strategies to reduce outsourcing
costs by standardizing processes and reducing the number of vendors that must be qualified, audited, and managed. These programs
started five years ago and resulted in companies reducing the number of CROs they work with by as much as 80%. The major CROs
and CMOs are well-positioned to be selected as preferred providers thanks to their large-scale, abundant capacity, and financial
strength.
Things don't look so good for the small- and mid-size CROs and CMOs, however. With the major biopharmaceutical companies consolidating
their vendor base and the early-stage companies having trouble raising cash, the small service providers are facing a rapidly
shrinking market. Many entered the market only recently, attracted by the growing pipeline and ample funding for early-stage
companies. They have minimal business development and marketing experience, haven't created brand equity and long-term relationships
with better-funded companies, and are not well-capitalized. We expect a number of them to disappear in the downturn.
A NEW NORMAL?
What is normal in the foreseeable future is likely to be very different from what was normal in the recent past. The global
financial crisis has changed investors' perception of risk and undermined their confidence that they can manage it. Major
institutional investors are indicating that they plan to reduce their allocation venture capital in coming years. VCs will
have a tougher time getting an attractive return on their investments so long as IPOs remain scarce and valuations are low.
The new normal will consist of somewhat fewer opportunities than the industry has been used to, but it will lead to a smaller
but healthier and more capable CRO and CMO industry.
Jim Miller is president of PharmSource Information Services, Inc. , Springfield, VA, 703.383.4903, jim.miller@pharmsource.com
