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We believe a combination of factors is providing a potentially robust tailwind for the global biotech market. In our view, the sector’s fundamentals are better today than at any point in the recent past, with accelerating innovation leading to groundbreaking new therapies and with high-quality companies maintaining strong balance sheets that leave them well-resourced to support future growth. Ample corporate cash coffers and the likelihood of falling interest rates have bolstered the environment for mergers and acquisitions (M&A) in the public market, and biotech valuations remain attractive. Here, we detail the reasons for optimism, along with a few potential risks to the bull case.
Today, small- and mid-cap biotech companies are the vanguard of biopharmaceutical innovation, accounting for two-thirds of the industry’s research and development (R&D) pipeline, with steadily growing share.1 We are seeing significant advances made across key therapeutic areas, including oncology, neuroscience, and for rare and autoimmune diseases. Growing expertise in precision small molecule inhibitors, antibody-drug conjugates (ADCs), cell therapy, and genetic medicines has enabled the industry to make tremendous progress in treating disease. Our research indicates that scientific progress with these enabling technologies has been unequal across the opportunity set, with biotechs — even smaller players — with proven technology platforms better able to identify and incubate innovative therapeutics.
In our view, pre-profitable, publicly traded biotechs are capitalized better than in the past. The strongest balance sheets are concentrated in companies with the highest-quality assets. This subset of companies has benefited from the increasingly selective market for secondary financings that began in mid-2021. Since then, while the number of secondary rounds of fundraising for biotechs has remained relatively steady (save a spike in the first quarter of 2024), the average size of each raise has grown considerably (Figure 1).
This juxtaposition indicates that the market is mainly allocating capital among a few higher-quality companies. This cash infusion will enable leading biotechs to support their operations for several years without the need for additional capital.
Figure 1
Thanks to perennial patent cliffs, when profits from proprietary drugs wind down as patients switch to less expensive generic offerings, big pharma companies continually need to replenish their revenue through acquisitions. Across the 14 largest global pharmaceutical companies, more than US$300 billion in annual revenues will lose patent protection by 2030 and need to be replaced.2 At the same time, the cumulative financial capacity of those big pharma companies is estimated at over US$500 billion, which could replenish innovation pipelines for these companies.3 As Figure 2 shows, deal volume has steadily increased, and deal value rebounded in 2023 from the depressed levels of the previous two years. While biopharma M&A activity tends to ebb and flow, long-term trends suggest that M&A will continue to be a major contributor to biotech returns, with pursuing disruptive therapeutic innovation standing to benefit the most.
Figure 2
While concerns about potential negative impacts of US drug-price legislation may weigh on the market for the time being, we anticipate that small- and mid-cap biotechs will continue to be a relative safe haven, compared to their big pharma counterparts. Provisions of the US Inflation Reduction Act of 2022 (IRA) effectively created a system of mandated price reductions for certain drugs; however, cuts to net realized prices — post discounts, rebates, etc. — may be more benign than feared. Moreover, the focus of cuts will likely remain on legacy pharmaceutical products for years to come.
This situation could create another indirect tailwind for smaller biotech players, as larger pharmaceutical companies that see profit declines from their legacy products should have added incentive to fill those shortfalls via M&A. Finally, many biotechs stand to benefit from the law’s caps on patients’ out-of-pocket expenses, removing a major barrier to utilization of higher-priced drugs.
Active investors have benefited from the rebounding dispersion of stock returns within the biotech sector. Since the recent lows of 2022, the performance differential between top- and bottom-decile stocks within the SPDR S&P Biotech ETF, a proxy for the biotech market, has widened (Figure 3). Attractive industry valuations further enhance the favorable environment for active biotech investors, in our view, with the same biotech ETF trading at a 40% discount to its early 2021 peak, as of 30 September 2024. Coupled with strong upside potential from market leaders, widening dispersion underscores the value of experienced active investment management, which can potentially increase the opportunity to achieve significant positive returns for clients.
Figure 3
While all these reasons support our optimistic outlook for the biotech industry, we acknowledge that the intensity and timing of big pharma M&A is difficult to predict, and we could be wrong about timing of recovery or insulation from drug-price reform. Overall, however, we believe the combination of strong industry fundamentals, an accelerating pace of innovation, a supportive financing backdrop, and attractive valuations make biotech ripe for a bull run over the next 12 months. In our view, given widening dispersion across the industry, an active management approach, grounded in both fundamental investment research and scientific knowledge, continues to be the most promising way to approach investing in the biotechnology market.
1 IQVIA Pipeline Intelligence, December 2022 and IQVIA Institute, January 2023. | 2 CenterView Partners. | 3 Wellington Management estimates.
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