With Pharma Ready to Pare Portfolios, Project Financing Funds Make Their Pitches

Drug firms need to find good homes for hundreds of early-stage experimental compounds that ideally they could claw back once new developers demonstrate proof-of-concept. New project financing funds are clamoring for those assets, but first they must convince LPs to invest in unproven financing models, deal with pharma's accounting demands, and negotiate deals with asset-holders that will provide a decent return.

The biggest drug firms say they're ready to outlicense their extra assets, all the while still looking outside their walls for good compounds to help fill their pipelines. Could funds that marry private equity and outsourced development be the answer pharma is looking for?

By Alex Lash

In the midst of consolidation and restructuring, drug firms need to find new homes for hundreds of experimental compounds that, ideally, they could bring back after Phase II proof of concept. They have plenty of options.

Sensing opportunity, new project financing funds are coming out of the woodwork. But they must overcome several hurdles to convince big pharma to sell them assets – and eventually buy them back.

Some of the obstacles include LP reluctance to invest in life sciences, big pharma's accounting needs, its demand for quality data, and perhaps most important, big pharma's negotiating leverage bolstered by mountains of cash.

The "first generation" funds launched five years ago have left observers skeptical whether new variations on the theme will work.

Like many of its drug-industry brethren, Bayer AG's Bayer HealthCare AG says it's ready to find good homes for the bounty of drug candidates it can't develop itself. That's what Bayer head of global drug discovery and executive committee member Andreas Busch, PhD, told IN VIVO last month as he stood beneath a swirling, blue blown-glass sculpture suspended from the ceiling of his firm's new US Innovation Center in San Francisco's biotech-friendly Mission Bay neighborhood.

Busch didn't say "bounty," actually. He said Bayer has "an excess" of Phase I molecules, and it wants to find the right partners to "move the portfolio forward," a phrase he preferred to "outlicensing."

Who those partners will be remains an open question. "Our primary assumption will be we'll provide the molecules, and by that time they will have cost forty to fifty million dollars apiece," said Busch, speaking about preclinical costs. "In other words, we've already made a significant contribution. At the end of the day it's about moving our portfolio forward, and we'll do whatever's necessary to do so. Sharing the risk and combining expertise would be helpful."

The research center will open by the end of the year after Bayer moves 65 scientists across the San Francisco Bay from an older facility in the industrial town of Richmond. The 210,000 square-foot building was originally meant for Pfizer Inc.'s biotech discovery center, a commercial crown jewel for Mission Bay. Those plans fell through with Pfizer's takeover of Wyeth, leaving city officials and developers scrambling. [See Deal] But what one drug company couldn't use, another could, and it made for an appropriate venue to discuss the reality Bayer and other drug companies are facing: they have dozens of assets that they can't or won't develop because of mergers, R&D restructuring, or fear of Wall Street punishment for a flabby bottom line. Who will develop the assets, some perhaps discovered in Bayer's new San Francisco research center, that big pharma can't keep in-house? And on what terms?

A new wave of private-equity financiers say project financing is the answer, and they're jostling to be pharma's developer of choice, especially in the development space from late preclinical to proof of concept. But they face plenty of hurdles. Pharma has other options, such as spinning out compounds into venture-backed start-ups, or risk-sharing deals and joint ventures with other big pharma. The new funds also must convince limited partners to commit to an unproven life science investment model at a time when 10-year venture returns are dismal. The unremarkable performance of their private-equity predecessors Symphony Capital and Celtic Pharma isn't much of a calling card, either. What's more, this new wave of funds must structure deals that satisfy the asset sellers' balance-sheet needs. It's a delicate dance, one often punctuated by the funds asking pharma to contribute not just molecules but cash, as well.

"There's not a traditional VC fund or PE fund that doesn't want pharma capital," says Ellen Lubman, group director, strategic transactions at Bristol-Myers Squibb Co., and formerly with project financing fund Celtic Pharma. Limited partners are decreasing allocations or shifting them elsewhere, making pharma's cash piles all the more attractive.

One big pharma business development executive tells IN VIVO that a dozen unsolicited proposals for project-financing funds had come in during the weeks before our interview. Most of the new funds have yet to reveal themselves publicly. They feature various structures, sometimes investing solo, sometimes enlisting venture capital syndicates. Some are open to bringing big pharma firms on board as investors, perhaps giving them options on the molecules they develop. All have one thing in common: they insist that their lean, mean, virtual team – often populated by former biopharma executives and buttressed by a CRO of choice – can source, develop, and sell drugs faster and more cheaply than a big pharma or biotech could do, killing the failures and returning profits to their limited partners more quickly.

Talaris Does It Backwards

Cheaper drug development has been an industry ambition for years, but this crop of development funds think they can further reduce infrastructure costs and make bloodless go/no-go decisions that even a "virtual" biotech has trouble with. "A shiny building doesn't add any value," says Derek Lee, corporate development officer of Talaris Advisors in Hopkinton, MA. "VCs haven't had a turnkey solution. Even with their virtual biotech model, when the team is done, everyone is sitting around with a high burn rate waiting for the business development guy to sell the assets. Our model enables our team to say no, to fail quickly as well as win quickly."

Unveiled late last year, Talaris has an unusual strategy. It won't raise its own fund until it shows LPs it can source compounds that other investors value. First it's building two portfolios of assets grouped by therapeutic area: dermatology and CNS. Lacking cash, Talaris is offering asset holders equity, milestones and royalties, but no up-front fees. Once it accrues the portfolios, Talaris plans to offer them, with four to six compounds each, to venture investors and develop them through Phase II proof of concept. The investors' cash will pay for the clinical work, which Talaris' service business will perform. (The service business must also find unrelated clients to bring in cash; it has four so far.)

If the portfolios attract VCs and make clinical progress, Talaris feels it will have a strong case study to take to LPs as it tries to raise its own $100 million to $150 million fund that it would invest side-by-side with two venture firms in subsequent portfolios, says Lee.

The dermatology assets are on board, based on a platform technology Talaris licensed from an undisclosed biotech source, Lee says. The biotech will get milestones and royalties and an insignificant piece of equity in the "derm co.," as Lee puts it, which is currently structured as an LLC holding company. He says Talaris can get the compounds through Phase IIb for $35 million in two and a half years. The second portfolio comprises CNS projects; Talaris is currently in licensing negotiations with an asset holder.

Once POC data is in hand, the goal is to attract aggregate up-fronts across each portfolio for at least $75 to 100 million. More is obviously better, but at that baseline, Lee says, "It's enough to cover costs and take a modest gain off the table, with investors still able to participate in the earn-outs," a strategy that medical device start-ups and investors have had to embrace in recent years Meanwhile, the services business has eight employees working on four development programs for clients. One is NMPI LLC, a virtual biotech. The other three are larger biotechs with failed compounds that Talaris thinks it can turn around.

Another fund, not quite ready to announce itself, is aiming to raise $150 million to $200 million and sign up two pharmaceutical company investor-partners, says its lead partner, a pharma and venture capital veteran based on the East Coast. The pharmas will get option rights on a percentage of the portfolio based on their financial contribution, but they won't be obliged to contribute their own outlicensing candidates. Like Talaris, this fund hopes to have about 25 molecules in its portfolio. It plans to buy preclinical assets about a year away from IND and sell after producing Phase I or Phase IIa data, says the partner.

A third hopeful fund, also not ready to go on the record, is likewise pursuing about two dozen early-stage assets. "The question is how many bets can you place on the table, and at early-stage you can place lots of bets," says the third fund's founder, who aims to raise $500 million with at least one strategic pharma partner. "People who understand the preclinical and translational medicine bit can mitigate the risk pretty well."

All the funds IN VIVO interviewed, whether on the record or still in the shadows, stressed not just the curricula vitae of the people involved but their willingness, as the third fund manager says, "to roll up their sleeves." Pampered pharma executives not accustomed to checking their own email or printing their own documents need not apply.

Talaris and its ilk, following in the still-fresh footsteps of private-equity players like Celtic and Symphony Capital, have nailed down few firm commitments. One reason is competition. The biggest drug firms have plenty of landing spots for their outlicensed products. For example, Pfizer and AstraZeneca PLC have spun out molecules into venture-backed start-ups, Pfizer and GlaxoSmithKline PLC formed a new joint venture, ViiV Healthcare , that combines their HIV pipelines, and three firms have struck development deals with Flexion Therapeutics Inc., a venture-backed start-up founded by the Eli Lilly & Co. veterans behind that firm's experimental Chorus development project. ( See "Flexion Exploits Big Pharma as Discovery Supplier," IN VIVO , January 2010 (Also see "Flexion Exploits Big Pharma as Discovery Supplier " - In Vivo, 1 Jan, 2010.) and "GSK And Pfizer Join Forces In New HIV-Focused Venture," "The Pink Sheet DAILY," November 3, 2009 (Also see "GSK And Pfizer Join Forces In New HIV-Focused Venture" - Pink Sheet, 3 Nov, 2009.).) When Flexion talks to big pharmas about candidates on their outlicensing lists, says Flexion CEO Michael Clayman, "there'll be direct competition" with the private equity funds. (Clayman says, however, that four of the five compounds in his portfolio were not on any official list; his team found them through their personal connections.)

Big Pharma Learns To Let Go

A few years ago outlicensing was a dirty word at big pharma. Suspicion ran high that any molecule an outsider wanted to fund was probably worth keeping in-house. Why share the potential rewards, the thinking went, especially with a financier whose access to capital was more expensive?

There was also the cost of time and people power to put outlicensing deals together, not just for the business development teams but for scientists preparing molecules for license or sale.

But in the past five years big drug firms have undertaken profound reorganizations. Thousands of layoffs and the megamergers of 2009 dominate the landscape; several companies have sold or outsourced significant portions of their R&D infrastructure, such as Lilly's sprawling facilities and services deal with Covance Inc. in 2008. [See Deal] The need to jettison infrastructure varies from one company to another, but in general big pharma is learning to let go.

"It's now part of our culture to externalize a portion of our pipeline year after year," said Bristol-Myers Squibb vice president Martin Birkhofer last month during a BIO conference panel dedicated to outlicensing.

"What's the best home for those assets is very specific to what rights the owners want to retain," Ernst & Young global biotechnology leader Glen Giovannetti tells IN VIVO. "In a joint venture you're inherently sharing downstream economics. In a VC-backed spin-off you often retain equity shares in the new company."

A major factor in a pharma's externalization decisions is how it accounts for the outsourced assets. Many firms sensitive to Wall Street want to get the assets off their books, which means their development must be done at arm's length, not always easy when the pharma wants to keep options for bringing assets back in. There are methods, says Giovannetti, but "P&L sparing is hard to do."

No problem, says Talaris CFO Lee. "There are a range of structures we can do, such as pooling their assets with other assets," all managed by a third-party team with third-party capital. "That's off the books," says Lee.

Certain therapeutic areas might lend themselves more readily to private-equity buyers, says Giovannetti. Indications that require thousands of patients in late-stage trials are less likely to be attractive, as private-equity firms operate on shorter time-to-return assumptions than their venture counterparts.

A private equity investor who wants a return in three to five years on a pool of a few hundred million dollars, at most, will be reluctant to pay for big trials. Furthermore, Giovannetti says, it's hard to justify fat payouts for products that will require the big-pharma buyer to run massively expensive Phase III trials. Biotechs and their investors are adapting to this harsh reality as pharmas use their leverage to force structured earn-outs, even in acquisitions. ( See "Biotech Backers Are Learning to Live with Exit by Earn-out," START-UP , March 2010 (Also see "Biotech Backers Are Learning to Live with Exit-by-Earn-out " - Scrip, 1 Mar, 2010.).)

Navigating The Learning Curve

Back when debt was cheap and public markets were relatively receptive to biotech offerings with strong clinical data – it was only three or four years ago – two project-financing models held center stage. Both were multi-product experiments, but they began with very different aims. Symphony Capital plucked molecules from publicly traded biotechs, formed new companies to move the assets forward through Phase II, and structured step-wise buyback schemes for the biotechs that would guarantee Symphony a fixed but comfortable rate of return. The longer the biotech waited to buy back the assets, the higher the price. The model assumed that the biotech's share price would be buoyed by positive Phase II data, creating cheap financing to buy back their assets one, two or three years down the road. If they didn't, Symphony would take full ownership of the drug candidates.

Symphony created seven vehicles in all and invested more than $400 million in aggregate. The titles riffed on the biotech partner names (Symphony Dynamo for Dynavax Technologies Corp., Symphony GenIsis for Ionis Pharmaceuticals Inc., Symphony Evolution for Exelixis Inc.). But with public markets indifferent to good clinical news, the buyback cash hasn't been forthcoming. Only one venture has provided a solid return: Symphony's $75 million to help develop three compounds from Isis turned into $120 million in cash and stock and eventually a 70% internal rate of return. ( See "Symphony's Project Financing Model Adapts," IN VIVO , January 2009 (Also see "Symphony's Project Financing Model Adapts" - In Vivo, 1 Jan, 2009.).) This is thanks to Isis finding high-profile partners for the drugs it bought back: BMS for its PCSK9 program ($15 million up-front in 2007) and Johnson & Johnson's Ortho-McNeil Inc. in metabolic disease ($45 million up-front, also in 2007.) [See Deal] Deals with Exelixis and Guilford Pharmaceuticals Inc. (an absorbed division of Eisai Co. Ltd.'s MGI Pharma Inc.) fizzled when the biotechs elected not to buy back their assets, which Symphony now owns and can outlicense. [See Deal] [See Deal] ( See "Guilford to Receive $40 Mil. to Fund Parkinson's/ED Drug Development via Investment Deal," "The Pink Sheet DAILY," June 21, 2004 (Also see "Guilford To Receive $40 Mil. To Fund Parkinson's/ED Drug Development Via Investment Deal" - Pink Sheet, 21 Jun, 2004.).) In two other investments (Alexza Pharmaceuticals Inc. and Dynavax) Symphony sold its stake in the new companies mainly for stock which has since appreciated. [See Deal] [See Deal] Its final two deals had much larger equity components up front as the fund tacked in the shifting market.

At the other end of the range, Celtic Pharma launched in 2005 with the aim of adding cheap debt – talk about different times – to investor cash to buy biotech assets already in development, pushing them through Phase III and into the arms of big drug firms hungry for near-commercial products. Led by Stephen Evans-Freke, a biotech financing pioneer, and John Mayo, best known in Britain for his role in the collapse of the blue-chip conglomerate Marconi, Celtic soon cut its ambitions for a $1 billion fund down to $400 million, $250 million of which was debt.

The founders also soon split, each putting together a follow-on fund sporting a spin on the Celtic name. Evans-Freke recruited former Pfizer bigwig Peter Corr, PhD, to build a second asset-based fund called Celtic Therapeutics. Mayo's side, now called Celtic Pharma Holdings (CPH), abandoned the asset-financing model altogether and moved instead toward acquiring companies it could buy outright as sole investor. Mayo's colleague Stephen Parker, PhD, tells IN VIVO they moved away from asset financing for several reasons, including scale; keeping biotech teams intact around their assets let CPH stay lean and go after earlier-stage work. (Like nearly all other project financiers, CPH learned from the first fund's efforts that big-pharma buyers prefer to buy compounds at the end of Phase II, not Phase III.)

The original Celtic fund, which Evans-Freke said in early 2008 would see successful exits in 2008 and 2009, has had little success. One exit was predicated on the approval of a pain drug Diractin (ketoprofen), which never arrived. Celtic's funding of Inspiration Biopharmaceuticals Inc.'s hemophilia drug rFix led to Inspiration's deal with Ipsen this January and what Parker terms a "partial exit," with Celtic still holding significant equity. [See Deal] ( See "Finding Inspiration: Ipsen Builds Fourth Specialist Franchise with Hemophilia Deal," "The Pink Sheet" DAILY, January 21, 2010 (Also see "Finding Inspiration: Ipsen Builds Fourth Specialist Franchise With Hemophilia Deal" - Pink Sheet, 21 Jan, 2010.).) It has not yet found partners or buyers for its edema treatment, Xerecept (corticorelin), which failed a Phase III trial that Parker says Celtic inherited, nor for two addiction-treatment compounds or its four dermal-delivery compounds.

As much as the next generation of project financing funds stands to benefit from pharma's need to fill late-stage pipelines at lower development costs, they must overcome a good deal of big-pharma skepticism (critics would call it inertia) related to the progress of past efforts.

One big-pharma executive, who asked not to be named in order to speak candidly, questions whether a group of financiers and former pharma execs, no matter what their pedigree, can move a drug more cheaply and efficiently through a phase or two of clinical trials and come out with robust data. "If somebody can do it a couple times and it works, these funds could take off," the executive says. "But why in my right mind would I give a drug to a group of guys who've never worked together and ask them to develop it to proof of concept? We might spend more money than anyone else, but that's because when we get ready to go into man, it's fully baked."

Will A Project-Financing Company Lead The Way?

Some investors think so. Flexion CEO Clayman credits Brad Bolzon of Versant Ventures, which led Flexion's Series A round in October, with the vision of turning Lilly's Chorus project into a stand-alone company. The operative word, though is "company," because the fund structure had too many limits, says Bolzon: "More and more we're in an environment where pharma is asking for more data and more assurance than ever before. [Getting to] proof-of-concept might not be enough. You might need to take a drug through Phase III to understand its relevance in the marketplace. Only taking [a program] to POC, IIa, or IIb study with no alternative, puts you at the whim of the buyers or partners. It's important to have the resources to control your own destiny."

That has led to a specialty pharma strategy in which Flexion keeps some compounds for itself and runs affordable Phase III trials on its own. Intra-articular administration of an osteoarthritis treatment is top on their list.

Despite all the talk, no PE fund has convinced a big pharmaceutical firm to give up control of its assets, unless you count the one-off deal that TPG/Axon Capital and Quintiles Transnational Holdings Inc.'s venture arm cut in 2008 with Eli Lilly for two late-stage Alzheimer's compounds. Of the two funds dedicated to project financing, Symphony Capital partnered only with public biotech firms, and Celtic's three permutations have sourced their material from low-profile biotechs. When ex-AstraZeneca CFO Jon Symonds joined Goldman Sachs in 2008 the scuttlebutt was that Goldman would launch or invest in a fund to develop early-stage clinical compounds sourced from pharma, but that talk disappeared when the economy tanked. (Symonds is now CFO of Novartis AG.)

With all the assets to shake loose – a mantra one hears more and more these days is "more compounds, fewer companies" – there's little doubt private equity will help move drugs forward in the clinic. But the dance currently underway is mainly being led by the big drug companies. They have the cash. They hold the assets. And while LP enthusiasm for life sciences remains dampened and public market clamor for new biotech stocks remains dim, Big Pharma will continue to have the deal leverage. One fund manager says emphatically, "Acquisitions need to be entire. Structured acquisitions of our products is something we're not interested in," but when it was pointed out that most private or clinical-stage biotechs have to settle for structured acquisitions these days, a trend not likely to go away soon, the manager says that for projects that don't find a buyer by the expected time, the fund will be willing to "act like a normal VC, lead a Series B and invest through Phase II."

Then again, acting like a normal VC is what project financing is meant to avoid in the first place. That's no knock on this particular fund manager; others invoked the need for flexibility, too. But it speaks to the unsettled drug industry landscape right now. Everyone knows new financial models are necessary, but no one knows what they'll turn out to be. With plenty of ideas but little cash, the project financing funds need to find a model that makes Big Pharma a happy supplier of assets and a willing buyer at the other end. With their cash, market leverage, and many outlets for divesting excess capacity, however, the big drug companies can wait for terms that make sense for their own balance sheets, which isn't good news for upstart funds trying to thread the financial needle of a model that's never worked before.