As recently noted in a Wall Street Journal article, some private equity (PE) firms have begun partnering with pharmaceutical companies, though in a manner far from traditional. Instead of buying nascent fledgling biotech firms outright, these PE companies have begun providing supplemental financing for R&D budgets in return for a cut of future profits, mimicking a model long-used in Hollywood for film production and, with so many similarities between the two from a financing point of view, it’s easy to see why they’ve opted for this path.
Billion Dollar Baby
When a movie is being produced, costs are immovably front-loaded. Actors must be paid salaries, advertising budgets must be created and spent to ensure the movie is promoted, and all the background work that goes into “movie magic” like lighting, editing, special effects all must be paid for before a dollar of revenue ever hits the books. In fact, with all these up-front costs, it’s not entirely uncommon for overruns in the production phase to sink a film before it ever makes it to the silver screen. While there are costs after the tickets are sold, these tend to be much, much smaller.
Similarly, in drug development, R&D costs tend to be front-heavy. First, years of intensive lab research must be conducted, with highly paid specialists designing and developing new drugs. After this, there are numerous time-consuming and costly drug-trials, many of which end up yielding nothing at all, and all of which must be paid for before the company is allowed to begin selling their drug and recouping their investment.
Many people complain that movies have become more formulaic, with sequels, prequels, and remakes dominating the box office. Disney’s Marvel films are undeniably popular, with The Avengers in 2012 raking in over $1.5 billion worldwide in theatres, though they are hardly the most original pieces of entertainment. On the other hand, more original productions often don’t make it big, in part because they can’t attract the same kind of financial backing that their formulaic blockbusting brethren can, and many unique films struggle to attract enough of an audience to break even. That’s not to say they can’t make it big, as clearly illustrated by Moonlight’s dramatic win for Best Picture at the 2016 Oscars in the face of very stiff competition.
Again, this is mirrored in the world of pharmaceutical development. The risks associated with developing a “new and improved” version of an existing, well-selling drug are considerably smaller than the outright development of a new one. Consider how many different versions of Advil or Tylenol there are, in comparison to entirely new kinds of painkillers being brought to market. On the other hand, brand new drugs can reap enormous rewards for the companies that dare to develop them, even if the risks of doing so are considerably higher.
For a Few Dollars More…
But what has been the catalyst in all this, encouraging PE firms to invest outside their usual channels? First, it’s no secret that valuations are high, meaning that deploying cash in more traditional manners is more expensive, making many possible acquisitions no longer worth the risk. Competition for companies that do provide a good value proposition is also very fierce, as large corporations sit on massive cash piles. To put this money to use, many are pursuing bolt-on acquisitions and are willing to pay top-dollar for the potential synergies and growth on the bottom line these provide. With dry powder piling up at PE firms in the form of undeployed cash, and traditional venues offering fewer opportunities, financiers have been forced to look for alternative ways to provide acceptable returns.
While it may not garner the same audience sizes as Hollywood productions, new PE ventures are clearly action-packed in exciting new ways. The ingenuity of investors can’t be underestimated and, if the current environment of low yields and full corporate treasury war chests continues to march on, we can expect to see more creative solutions and out-of-the-box thinking from savvy M&A firms.