Guest Post: The Next Feeding Frenzy? VCs Rush Toward Diagnostics (!?)

Steve Dickman is the CEO of CBT Advisors. He blogs about biotech, VC and personalized medicine at Boston Biotech Watch. Interested in guest blogging for In Vivo? Drop us a line here.

There was a time not long ago when no amount of persuasion could have made most venture capitalists do a diagnostics deal. The reasons abounded: markets were too limited; margins were too low; and the number of potential acquirers too small. So imagine our surprise when the most upbeat session of this year’s c21 investor conference in late May was a panel discussion focused on – you guessed it – molecular diagnostics.

If this is not a feeding frenzy, then at least it seems to be a period of high marketability for private diagnostics companies seeking acquisition exits. Session chair Bill Kreidel of Ferghana Partners described four sell side diagnostics assignments his firm is working on for which multiple bidders had appeared.

What sells? Proprietary content, improvements in speed or sensitivity/specificity, robust datasets, and large markets. Who are the buyers? Clinical labs like Labcorp, naturally, but also instrumentation companies in the imaging business like General Electric that “see diagnostics cannibalizing some of their revenue” and are trying to capture it back, said panelist Dion Madsen of Physic Ventures.

The advent of acquirers such as GE has caused venture firms to change their tune. The three venture capitalists on the panel certainly weren’t diagnostic neophytes. Madsen, Dr. Rowan Chapman of Mohr Davidow Ventures, and Dr. William Gerber of Bay City Capital have all made numerous investments in diagnostics and personalized medicine including Tethys Bioscience and CardioDX, clinical lab companies that recently reached commercial status.

And there have been some impressive diagnostic exits driving venture interest. Switzerland-based HBM Partners, for instance, announced last September that it had earned a 21.6x multiple on its investment in Brahms, a Berlin-based diagnostics company acquired by Thermo Fisher.

But the information asymmetry that led to that deal has begun to recede now that investors have woken up to the opportunity. Still, in today’s market, where the environment is driven by cost constraints rather than spending, the locus of value is shifting earlier, toward diagnosis and away from treatment. In other words, knowing in which patients a therapy will work is as important as knowing whether it will work at all.

One common approach is for a company to walk into a VC firm and say “We are the next Genomic Health”, a Nasdaq-listed company (ticker GHDX) with OncotypeDX, a commercial breast cancer test, as if that were an appropriate role model. But Genomic Health, its stock down 25% in the last quarter, is not only not a role model, it’s a bad example, Madsen said.

“We still get companies saying they will be the next Genomic Health and we say, we don’t WANT you to be that!” emphasized Madsen. Gerber, whose fund did not invest in that biotech, added “Their first study was published in ’04 and it’s six years later and they are just about to break even!”

Circumstances have drastically changed both for IPO exits and for reimbursement in the interim. At the moment, an IPO is an unlikely dream for companies that do not have tens of millions of dollars in revenue. And reimbursement is complicated by both the murky regulatory situation and the unlikely circumstances that allowed the company to get reimbursed at unprecedented levels. “Breakeven [for Genomic Health] is predicated on a $3,000 price point,” Kreidel observed, “not something most diagnostics companies can aspire to”--except, we would argue, in oncology.

Adding to the complexity is a lack of clarity on the regulatory front. At the rate the Food and Drug Administration is moving it will be 2011 before companies offering algorithm-based tests like OncotypeDX have a clear path forward. (When will the regulations arrive? “There are as many answers to that question as there are consultants in Washington,” quipped the fourth panelist, Bruce Cohen, CEO of VitaPath Genetics.)

So VC-backed companies are working on building proprietary content strong enough to stand up to any level of regulatory scrutiny. What does content mean? (See here for a blog post explaining Madsen’s views on the subject and his criteria for what makes a “doable deal” in diagnostics.) Put simply, “content” is the unique ability to make a diagnosis or link a drug to efficacy in a particular patient in a reproducible way.

Three quick examples of the content-driven, data-intensive approach:

• VitaPath Genetics, a Mohr Davidow portfolio company developing a cheek-swab test for spina bifida risk early in prior to pregnancy. It ran a 2,100-subject study to validate its test and hopes to go commercial by 2011 on a modest $15 million.


• On-Q-Ity, a Boston-area company invested in by both Physic and Mohr Davidow is another example. To develop a commercial test to inform physicians when to treat cancer aggressively or even which chemotherapeutic agents to deploy, On-Q-Ity will require an “intensive analysis of tumor samples” and a “huge bioinformatics exercise,” he said.
  


• A third company, mentioned but left unnamed by Kreidel, has apparently achieved a remarkable level of sensitivity and specificity in predicting ovarian cancer, an area of huge unmet need where a better test would help thousands of women avoid surgery – and help insurers avoid paying for it.

So the new VC recipe goes like this: Find a potential market for which reimbursement is uncertain. Define a plan based on capturing reliable data from the vagaries of human biology. Invest VC dollars to collect the data. Crunch the numbers. Then see what you’ve got.

Hmmm. The risk profile sounds almost like …drum roll, please… therapeutics investing.

But it’s actually better – fewer dollars in, earlier clinical signals. And now, more likely exits with no need for an IPO. No wonder there are more investors than ever in this space. Some of them are likely to go home winners.– Steve Dickman

image from flickr user chamer80 used under a creative commons license

Innovation Is the Pharmaceutical Industry's Only Salvation

We here at The IN VIVO Blog probably get a little bit too caught up in our own blathering. As a tonic, we'll be inviting some outsiders to contribute. As here: to get an investor's point of view on the industry, we asked T. Rowe Price biotech analyst Jay Markowitz, MD to share some of his thoughts.

If the movie Cool Hand Luke were a commentary on the pharmaceutical industry, the most memorable line would be, "what we've got here is failure to innovate." (For an IN VIVO take on Cool Hand Luke and innovation via the JP Morgan Healthcare meeting, click here)

The decline of the drug industry is all the more dramatic in the context of its past accomplishments. Many of the most important advances in health, from HIV to cancer, are attributable to new drugs. And yet in a 2008 survey by USA Today, the Kaiser Foundation, and the Harvard School of Public Health, 44% of Americans had an unfavorable view of the pharmaceutical industry. Only health insurers and oil companies did worse.

The industry's woes boil down to a single cause: inadequate innovation. It is estimated that by 2015, $200 billion worth of branded drug sales may be lost to generic competition. The 24 new drugs approved by the FDA in 2008 was the highest number since 2004; only nine came from multinational drug companies. This meager number can replenish but a fraction of pending lost sales.

The poor record of new drug approvals can’t be blamed on a lack of R&D spending. Last year the major pharmaceutical companies spent over $50 billion on drug discovery and development. If current trends are any guide, the $1 billion estimated cost per new drug now will seem like a bargain in the future.

The industry finds itself in such a predicament because it can no longer go after me-too drugs in such blockbuster categories as ulcer medicines, blood pressure pills, antidepressants, and cholesterol lowering agents. Pharmaceutical companies previously had the luxury of letting someone else take the risk of innovation; if that someone succeeded, the drug company could follow fast with a similar drug that might have some advantages. It paid more to imitate than create. With minimal clinical differentiation of their products, companies needed to spend heavily on marketing to drive sales. But it was more profitable to spend on drug promotion than drug creation.

That equation is changing. Now that cheap generics and multiple branded drugs are available in many therapeutic categories, innovation may end up being all that pays.

To reverse its current plight and not only survive but thrive in the future, industry leaders must accept the gravity of their situation and address its root cause.

First, they must recognize that innovation is more about people than process; it can neither be scaled nor industrialized. Drug companies ought to pare back internal research, foster a more entrepreneurial culture, and be more open-minded about accessing research done by others. Far more productive to divide a $1 billion research investment among ten to twenty small, scrappy, hungry companies than to concentrate in one that is big and complacent.

Second, they need to leverage their strengths in drug development and regulatory affairs. Whereas smaller companies may be more adept at discovering novel drugs, testing them in people and getting them approved put a premium on money, manpower, and experience. Because they are constrained by capital and limited know how, all too often smaller companies make mistakes by under-investing in clinical trials or pursuing needlessly risky approval strategies. Pharmaceutical companies should grasp the opportunity to partner with smaller companies in the middle phases of human testing, thereby providing the necessary money and expertise to minimize the chance that a drug fails because it was developed for the wrong indication or because of poor planning and execution. Good new drugs are too precious to delay or waste.

Third, they should embrace comparative-effectiveness testing and value-based drug pricing to support the argument for first- or best-in-class drugs. Although such a strategy would result in higher clinical attrition, clear product differentiation would reduce the need for sales and marketing. Far better for data, not advertising, to determine which drugs are prescribed.

And fourth, they should not view mega-mergers as a solution. Yes, in the short term, consolidation can increase sales and, by reducing redundant costs, profits. And it can bring new capabilities to the acquirer. But it will ultimately disappoint unless it redresses fundamental problems. For a merger between two big pharmaceutical companies to generate long term value, it must result in more novel drugs than each would have created separately.

From my point of view as an investor, the drug industry -- despite its challenges -- is ideally positioned to translate tremendous gains in chemistry, biology, and genetics into important new medicines that extend lives and reduce suffering. But it must discard its risk-averse and xenophobic culture, embrace the drug discovery work taking place in hundreds of creative, entrepreneurial companies, and recognize that constant innovation is its only hope for sustainable growth. The good news is that there are ample opportunities to succeed. Several pharmaceutical companies are already taking appropriate steps to revive their businesses. But these steps must be bigger and faster.

Jay's views do not necessarily reflect those of his employer, T. Rowe Price, Inc., an investment management company.