The challenges of investing in life science and biotech

Investing in life science companies is challenging as the pace of progression in life science and biotech innovation is progressing exponentially, with exciting breakthrough products and technologies revolutionising the diagnosis, management, and treatment of diseases.

However, even the very innovative companies in this space must work hard to attract investment and, despite the significant sums of capital that flow into the sector, there are many segments of the market that are underserved.

For investors, this can be a challenging sector. Some start-up companies will need tens of millions of pounds before it has a marketable asset or can attract a larger company to acquire it. The scientific unknowns can be significant, and then the product must be commercialised and brought to market with all the risks that brings.

Mike O’Connell, CEO at Isosceles, welcomed to our recent iFD Community event to share their thoughts on the challenges and rewards of investing in life science companies:

In this article, we focus on the investor’s viewpoint and present the CFO’s perspective in the article below.

Question: First of all, who is BGF?

BGF (Business Growth Fund) is one of the UK’s most active investors in small and mid-sized businesses. An established and independent organisation, it has £2.5bn to support a range of growing companies – early stage, growth stage and quoted.

They support a broad range of companies across the life sciences sector. The current BGF portfolio spans diagnostics, MedTech and digital health, as well as services, software and tools supporting therapeutic development.

Over the last three years, BGF has invested around £120m in 35 life science companies.

Tim Rea has been an investor with BGF for four years and has experience across various technologies as an investor, entrepreneur, interim executive, board member, and mentor.

Question: We use the terms life science and biotech interchangeably, but is there a difference, and where do the real investment opportunities lie?

The life science category covers a wide range of activities, and we define it quite broadly to cover the spectrum of activities that ultimately impact healthcare. For us, this covers medtech, diagnostics, innovation in pharma services and biotech. Biotech specifically refers to companies focused on developing new drugs, often with one or more new drug candidates being progressed through pre-clinical and clinical trials.

To help us understand this technically complex sector’s different commercial elements, investment opportunities, and challenges, Tim broke the sector down as BGF sees it into the patient’s journey:

Diagnostics

The first step in today’s healthcare system is usually to diagnose what is wrong. This sounds obvious and simple, but diagnosis is often tricky. This is often a difficult investment category; investors are typically cautious about diagnostics, and we generally see a significant funding gap. Early-stage companies are often supported by high-net-worth individuals but often struggle to find support beyond that. The companies that breakthrough with significant revenues then become attractive to Private Equity (PE) firms.

Treatment

Once the problem is diagnosed, the obvious step is treatment. In today’s healthcare systems, treatment tends to be in the one-size-fits-all category. There is significant innovation in this category in the form of new medicines and in the form of medtech innovation applied directly to patients or to enable surgeons to perform every more complicated procedure with higher rates of success.

Emerging investment opportunities

As investors in life science companies, we are primarily focused on tracking the changes taking place in this sector and the emerging investment opportunities around:

Pre-symptomatic identification of issues (i.e. instead of waiting for something to go wrong and diagnosing, perhaps we can predict what might go wrong?)
monitoring (if there is a high risk of something going wrong, how do we keep an eye on it?)
Precision diagnostics and prognostics (beyond macro diagnosis, we can increasingly identify the precise nature of the issue in an individual patient and predict the likely progression of the disease)
Precision medicine (armed with patient-specific insights, can we move to customised treatment with the right drugs at the right dosage?)

Today, we need to appreciate that there are some broadly categorised diseases like diabetes, dementia, asthma, and COPD. This broad categorisation isn’t helpful because it doesn’t inform treatment pathways or prognoses. Within the next 10 years, we will be able to give a much finer diagnosis, and this stratification will better inform treatment, care, and prognosis.

Question: What makes an attractive proposition when looking at investing in life science opportunities?

BGF has deliberately taken an investor-led view when analysing investment opportunities. Tim has seen too many scenarios in the past when certifiable experts, who are extremely useful and important but also biased in their area of interest and knowledge, lead you down the wrong path from an investor perspective.

BGF takes this bias away by breaking down the proposition and focusing on the underlying assumptions regarding the tech and the need.

Provenance

First, they look at the provenance. Was this ‘thing’ developed in response to a perceived need and a problem, or, as often happens, someone doing research says, “I’ve come up with something interesting. I wonder if it’s useful?” The latter can be tricky because you find yourself on a long journey trying to fit it somewhere. When evaluating a proposition, the provenance question can provide a useful first filter to tell you whether or not something smells right. Just because it is a Cambridge spin-out doesn’t mean you should trust it, but it is a good place to start.

Validation

Once they’ve understood the provenance, BGF then breaks it down into a list of up to 20 key things that BGF would need to validate or understand in order to be confident enough to invest.

The art is determining what these 10 or 20 things are. Sometimes BGF draws a line once they get the first five or six things done from their list and are confident enough to engage formally and issue a term sheet. At this stage, BGF is committing to some level of investment in the process, can comfortably negotiate around the terms and pricing and complete the remainder of the due diligence.

Expert opinion

The validation process is complex because you cannot talk to an expert. You usually need to speak to several. From experts, you get a set of opinions, and you must look at the context of those opinions. If someone says, “it’s the worst thing possible, and it will never work” (and in life science, this is common), they might be saying it because they have another, preferred way of solving the problem. In other areas, you might stop the deal based on negative feedback from an individual expert, but in life sciences, you must get everyone involved in the opportunity comfortable with the fact that you are triangulating different opinions.

For example, we have been excited about genomics and genomics providing the answers to all our problems for the last two decades. But over the past five to seven years, many people have concluded that while it gives very useful information, it does not answer all our questions. It might be a good starting point for screening, but there is now a school of thought that says the answers might best be found on the proteomics side. If we can measure, monitor and assess the proteins, we can take an objective view because that’s biology happening in real-time at the protein level (and that is IF we can monitor and assess the proteins!).

All of this reflects the fact that fundamentally we know extraordinarily little about biology. Although we know an astounding amount, we are only scratching the surface, and we must bear that in mind when digging into these investment opportunities.

Question: When the total addressable market is half of humankind, how do you value an early-stage biotech business that could be worth billions or nothing if it does not work?

A key tool is risk-adjusted NPV. It is not the answer, but it is a good reference point.

We also look at transaction comparables.

What are buyers looking for?
At what stage will they engage?
What do they tend to pay for comparable companies?

BGF can then determine a comfortable value zone. We have been in a period where most companies are at the upper end of that value zone, and many are beyond what we consider reasonable. The market is currently correcting, and we are starting to see expectations come down to more reasonable levels.

Question: With the development of COVID diagnostics and treatments over the last two years, is more money being thrown at these companies now?

We need at least another year of perspective to know the net impact of COVID.

As an example of where we might see an impact, consider the massive problem with antimicrobial resistance or drug-resistant pathogens, responsible for one million deaths in the last twelve months and projected to grow significantly over the coming decade. We are in need of new compounds to fight those pathogens, as well as careful stewardship policies. Unfortunately, very few investors are interested in this category because the financial dynamics are not good enough, so the economic framework does not work. We recognise the problem but are not investing in the solution. BGF’s thesis is that this has got to change; otherwise, it is projected that the number of deaths due to antimicrobial resistance will rise to 50 million a year by 2040. Post-COVID, we know what a healthcare crisis costs and will hopefully be more sensitive and attuned to investing to avert future crises ahead of time.

It was miraculous that we were able to develop the COVID vaccines and testing regimes at the pace we did. That could easily have taken five to seven years, and we would be in a completely different place.

As a residual effect, we think that the COVID experience will result in a higher-level government investment in the sector, which will undoubtedly positively impact the wider life sciences sector and investors like BGF.

Question: Do you find the ease or difficulty of gaining funding correlates to the severity of the medical issue the company is trying to tackle?

If it is a serious problem close to home, investors will engage. This goes back to the challenge that Tim discussed earlier in this session regarding the funding gap in the diagnostics area. Investors are typically cautious about diagnostics, but early-stage companies tend to be well supported by high-net-worth individuals and angel investors who might be motivated by a family member, friend, or acquaintance’s health experiences.

We have talked about the founder’s passion, but investors are equally passionate.

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