The Best of Times, the Worst of Times

"These are strange times, when we are healthier than ever but more anxious about our health," writes Roy Porter in his wonderful book, The Greatest Benefit to Mankind: A Medical History of Humanity (Harper Collins, 1987). Today, the same can be said about the health of the biotech industry, which has never been as vibrant and successful in its 30 years, with more than 120 approved products, more than 300 in development, and around 2,500 companies in existence today. The sector has appreciated to the largest market value in its history, with an aggregate market capitalization of around $350 billion in mid-2006. Current demographic trends in the industrialized world favor the healthcare sector, in particular a wealthier, aging population wanting optimal quality of life and willing to pay for it.

Unpredictability and uncertainty in the pharmaceutical markets, regulatory framework, and business environments, however, has lead to anxiety among investors in the drug sector broadly, including biotech. The financial markets have also been changing drastically, especially with the ascent of hedge funds (now $1.3 trillion under management), as major players in public markets.

Responding to these conditions, public investors such as mutual funds and hedge funds are investing over ever-shorter time horizons and in stocks that have good liquidity, so as to be able to trade easily. This is good news for larger biotech companies with product revenues and meaningful quarterly earnings reports. But, so far, only 20 to 30 of these stocks, including Genentech, Amgen, and Gilead, represent the majority of investment dollars.

The remainder of biotechs, which represent the majority of companies, face ever-higher hurdles for capital. But two general investment strategies are emerging around these companies, bringing attention and dollars in different ways.

The first strategy, being pursued by a number of public investors and which has been building, is betting that major clinical, regulatory, and business milestone news events will drive the share price value. This emphasis on short-term trading by hedge funds around biotech news, although often very profitable, leads to great stock price volatility and added instability for biotech companies. Public companies can best insulate themselves from this volatility by not doing two things: over-promising on news or over-hyping data. These strategies will only hurt stock in the long run as well as affect credibility.

A second strategy, being embraced by a few investors, both public and private, involves buying a sizeable share position at an attractive value, such as via a PIPE (private investment in public entity), which brings companies cash while investors get shares generally at a reduced market value. Holding these positions over a longer time horizon often benefits the companies and investors and allows the inherent value of the enterprise to increase as the programs mature over time.

These types of investments allow patient investors to concentrate on fixing and repositioning existing drug candidates, assets, and companies that have encountered problems over the years and that the market has discounted. They also help companies by getting long-term investors on board who will invest more money, though at a lower price; this allows a company to focus on product development while maximizing options in difficult times. The yin and yang of investments such as hedge funds and PIPEs may offer a way to assuage current anxiety about biotech while satisfying Wall Street, early funders, companies, and ultimately, the population's expectations for the sector.

Paul J. Pospisil, is the founder and managing partner of Aduro Capital, a healthcare-focused investment management firm, and Aduro Partners, a strategic advisory business, both based in New York City.