Germany's Biotech Bust

Public markets around the world are down; Germany's Neuer Markt is also out. The demise of the exchange once hailed as Europe's most promising will hit more than just Germany's listed stocks. It affects the country's private sector, too, where young companies—and their investors—are frantically seeking ways to weather the storm.

If you had told enthusiastic investors in Germany's Neuer Markt during the heady days of 2000 that within three years the exchange would be dead, they would probably have laughed at you. The Neuer Markt, drawing in tens of Germany's fresh young biotechs, was hailed as the pan-European growth market, and companies flocked to join its ranks (see "Germany's Growth Story," START-UP, January 2001 (Also see "Germany's Growth Story" - Scrip, 1 Feb, 2001.)).

Yet next year the Neuer Markt will indeed cease to exist. Having lost 95% of its peak value and all investor confidence, the German stock market authorities, in September, finally announced plans to pull the plug on the Neuer Markt.

Currently listed stocks such as Evotec AG, Medigene AG and GPC Biotech AG (see Exhibit 1) will be amalgamated into the main Deutsche Börse, which will thereafter comprise two key segments, Prime and Domestic. Final details of the new set-up aren't yet clear, but the two segments will have different reporting standards and requirements, and both will have sub-sectors, probably based on industry groupings (see Exhibit 2).

Some market commentators fear that the exchange's closure will mean Neuer Markt-focused funds—of which there are many—will be wound up, forcing constituent stock prices down even further.

Others, however, envisage little change at all, pointing out that it's the market structure that's changing, not the stocks themselves. Stefanie Philipp, pharmaceutical and biotechnology analyst at HSBC Trinkaus & Berkhardt in Düsseldorf, believes that funds will simply redefine their investment criteria to reflect the new market structure and are unlikely to sell holdings en masse. "If you're holding Neuer Markt listed stocks now, it's because you want to own those companies. Nothing has changed with the companies so why would you just suddenly want to sell?" she asks.

The demise of Germany's growth market is hardly a good advert for holding Neuer Markt stocks in the first place, though. And uncertainty surrounding the proposed market structure changes also blackens the prospects for Germany's already cash-starved private biotech sector.

No Way Out

With no obvious exit route if and when the IPO market does re-open, those venture capitalists that are still around are unlikely to put any new funds into Germany's private companies. "It's not clear whether there will be a market on which German biotechs can list in the future, which doesn't inspire us with confidence to invest," sums up Rolf Mathies, managing partner and co-founder of VC firm Earlybird.

Other German investors, many of whom moved into biotech investing during the height of the last—and Germany's first—biotech boom, have withdrawn from the sector completely. These include many of the big German investment banks such as Deutsche Bank, Commerzbank and Hypovereinsbank. Those companies still investing in biotech are focused on managing their existing portfolios at the expense of new opportunities. German-US VC firm Techno Venture Management (TVM), for example, invested in five new German biotech companies in 2000, but only one last year, and none at all in the German sector this year.

The uncertainty surrounding the likely exit opportunities in the German market has forced many VCs to focus their investments on companies with international operations. "We're looking for companies with activities in markets like the US and the UK, where more experienced public investors are likely to return more quickly [to the biotech sector] and hence provide exit opportunities," says Earlybird's Mathies. In-keeping with this strategy, Earlybird's only new biotech investment this year will be in a German company with a US presence, reveals Mathies.

Investors' extreme caution on Germany is hurting young companies seeking their first rounds of VC funding as well as anyone needing to raise money over the coming year or two. "Those [companies] that do not already have blue chip investors on board," predicts Mathies, "will find things especially difficult."

All the more so since Germany's biotech sector hasn't experienced this kind of cash-crunch before. "These companies have grown up in times of plenty and just don't know how to deal with the tougher times," observes one investment banker.

As a result, few of Germany's newly formed biotechs are likely to survive. Karsten Henco, PhD, former CEO of Evotec—one of Germany's survivors, thanks to aggressive M&A, but with problems of its own nevertheless—believes that only about 50 of the 350 or more new biotechs created in Germany since the country began its BioRegio program in 1996 will be around long term.

Many more will go bankrupt. Particularly vulnerable are those companies with less than six months' worth of cash. Functional genomics plays Mermaid Pharmaceuticals GMBH , GenProfile AG and transgenic mouse company mice and more GMBH are already casualties.

Others might participate in the wave of M&A which investment bankers and industry executives predict (along with more bankruptcies) over the coming few years in Germany and the rest of Europe.

M&A: Good in Theory, Hard in Practice

M&A is a familiar call from investment bankers during bleak markets. But while it makes sense to bring together companies with complementary assets that, alone, lack the critical mass to attract investor interest, much of Europe's biotech sector remains resistant to consolidation.

Most of the private early-stage players in Germany are run by founding scientists reluctant to hand over their technology, and the business that they've been so involved in creating. Current conditions make M&A even less attractive, at an individual level, since it's a bad time to be out of a job.

As a result, M&A tends to happen either when things have become so desperate there's no alternative, or when management obstacles are, for one reason or another, removed. IsoTis NV and IsoTis SA's recently proposed tie-up was possible, in part, because IsoTis needed a new CEO, its own having announced his decision to go back into research. As a result the top slot at the merged company was free for Modex's CEO to fill [See Deal]. (See "IsoTis and Modex Take the Offensive," In Vivo Europe Rx, October 2002 (Also see "Isotis and Modex Take the Offensive" - In Vivo, 1 Oct, 2002.).)

M&A born out of desperation doesn't usually solve either company's problems for long. "You can't strap two bricks together and call it a float," warns Andrew Clarke, a fund manager at Reabourne Technology Investment Management Ltd. Yet this type of activity is the reason M&A has such a bad track record—and in turn puts others off.

What's required for successful M&A is a product or technology fit, or some other complementary needs. In Isotis' and Modex's case, Modex brought a Swiss listing, along with management and commercial experience, to IsoTis' stronger technology base. "The idea is that by putting two companies together, you cancel out their weaknesses," says Helmut Schühsler, PhD, managing partner of TVM's life sciences team. But even with the best of intentions, M&A is still tricky to pull off, as exemplified by the recent collapse of MorphoSys AG and British Biotech PLC 's merger talks.

Since there's been so little M&A in Europe so far, many feel it's up to investors to encourage such activity. Consolidation may dilute investors' holdings, but so too would pouring more money into a company for which there's no alternative exit.

Moreover, VCs are often in a better position to identify suitable M&A candidates than the company managers themselves. Although, as Schühsler points out, "we don't actually manage companies so we can't force them into M&A—we can only encourage managers to take the right course of action to enhance shareholder value," such encouragement is more order than mere advice, however, given that the VC's usually have majority status.

Indeed, Schühsler's "encouragement" played a large part in the merger last June of two of TVM's portfolio companies, Curacyte AG and VitaResc Biotech AG [See Deal]. Merging two companies within the same portfolio is an obvious place to start, since VCs are best situated to understand how well the firms fit. Curacyte had good management and lots of cash, but only a very early stage pipeline, says Schühsler, while VitaResc had later stage products but little cash and needed strong management. Putting the two companies together "was a no-brainer," he says.

Schühsler doesn't believe that there'll be too many more of these "no-brainer" mergers, however. Firstly, there are few situations where one VC firm has the majority stake in two complementary companies within its portfolio. Moreover, such intra-portfolio deals raise conflict of interest concerns from other investors in the companies. Deals where one company wins at the expense of the other are much more likely (for example, the merger between DeveloGen AG and HepaVec AG in October 2000, where Develogen effectively took over its smaller compatriot [See Deal]), but much more difficult to get done, concedes Schühsler, because of all the management, technology- and product-fit issues. Nonetheless, TVM is promoting discussions between its portfolio companies and is also talking with other VCs about the possibility of inter-portfolio deals.

Alternatives to M&A

Those companies not wishing to merge—nor facing pressure from investors to do so—are looking instead to licensing, partnering or collaborative agreements.

Signing a research agreement—as, for example, Santhera Pharmaceuticals AG did with Eli Lilly & Co. , and U3 Pharma AG with Evotec [See Deal]—is unlikely to generate much cash, though. To do that, companies must have an asset others want—and are prepared to pay for. Struggling US biotech company Spectrum Pharmaceuticals Inc. got out of its financial hole by licensing cancer drug satraplatin to GPC—an exception in the German sector in being cash rich, and acquisitive [See Deal]. Few of Germany's early-stage, platform-focused firms have anything nearly as valuable as Phase II candidate satraplatin to bargain with, however. And even if they did, they'd be unlikely to get much for it. Buyers know they don't have to pay top dollar for assets if they're acquiring from a company in trouble. Yet given the choice between selling cheap and surviving, or going under, biotech companies have little real option.

Buying Time

Those companies with enough cash in the short term are resorting to massive restructuring programs as a way of buying time. MediGene, for example, after the failure of lead compound etomoxir for congestive heart failure in June this year, has decided to focus its activities on its oncology programs. To reduce cash burn by up to $10 million each year, the company is trying to spin off its now non-core cardiological drug discovery program into a new company, Genovation, and bring in strategic partners and financial investors as co-developers. MediGene recently announced Evotec as its strategic partner in Genovation, but has yet to secure any financial backing for the new company [See Deal].

Many other companies, like private gene transfer company Amaxa GMBH, are being forced to cut staff, despite this being a last-resort measure in Europe due to employee-friendly labor laws. (See "European Biotechs Resort to Layoffs," In Vivo Europe Rx, September 2002 (Also see "European Biotechs Resort to Layoffs" - In Vivo, 1 Oct, 2002.)). Even more established players, like Evotec, are feeling the pinch. Much of the company's revenues come from servicing contracts with biotech and pharmaceutical companies—both of which are cutting back spending. Evotec issued a revenue and profit warning in mid-October and announced cost-cutting plans and lay-offs of its own.

For most of Germany's biotech companies, buying time will only delay the crunch—not put it off entirely. "Many of them [biotech firms] shouldn't have gotten funding in the first place," says one market commentator, "we need to weed out those companies too weak to survive."

Things are likely to get worse before they get better. Private markets won't recover before the public markets do, and this is unlikely to happen in Europe before the US. If and when an upturn does trickle through to Germany, it probably won't be a fast, or strong one, given the structural uncertainty of the markets themselves, and the extent to which investors' confidence has been shaken. As such, Germany's biotech sector—on younger, more fragile legs than the US sector to begin with—looks headed for a harsher shakeout than the industry anywhere has ever seen.

—by Hazel Dawson

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