Weekend thoughts: this time IS different for busted biopharm, part 4 (a firmer call to action)

This post is part 4 in my series on busted biotechs. Part 1 of the series, which you can find here, goes over some history and hypotheticals on the busted biotech thesis. Part 2, which you can find here, goes through why I think this time is better than historical opportunities and implores shareholders to reach out to boards with their views on value maximization. Part 3, which you can find here, goes through two very different examples of busted biotechs playing out and reviews the TSVT proxy. On top of the first three parts of the series, I’d also encourage you to listen to my podcasts on Keros (KROS; disclosure: long) and Sage (SAGE; disclosure: long) for two real time examples of the types of opportunities in the space. I think those are two of the absolute best examples of the types of opportunities I’m seeing in the space…. though I will admit that I am clearly talking my book when I encourage you to listen to those podcasts / say they’re the best examples!

As I mentioned in part 3, part 2 was supposed to be the end of this series…. but three things made me want to write more. They are:

1. There’s been two really interesting and divergent examples of corporate events in the space

2. TSVT’s proxy came out, and I was rather shocked by the background

3. I’ve had so many shareholders reach out to me with different thoughts / questions / pushback on my thesis.

I addressed points 1+2 in part 3; today I want to dive a little further into point #3. Let’s jump in.

Since I’ve started discussing the broken biotech thesis, I’ve had so many investors reach out to discuss them. While admitting this is a very biased audience, I’ve yet to have a single investor reach out to me and say, “hey man, I think you’re wrong; these companies are creating huge value through R&D and should go full speed ahead on the cash burn” or “you’re way off; these things are not as cheap as you think / are not trading for well below liquidation value.”

But I have had multiple people reach out to me and our conversation is something along the lines of, “I own a few percent of a few different biotechs, and I completely agree with you that the corporate governance in this space is a complete disaster and I would love it if you kept applying pressure here because it is desperately needed…. but I personally can’t do anything about it because if I speak up I’ll get a reputation as an activist and I won’t be able to participate in private fundraising / PIPE rounds going forward.”

I have a little internal joke that I tell myself whenever I’m giving someone unsolicited advice. There are three things that are really easy to tell someone else to do (but not so easy to do yourself!):

• Go on a diet / lose weight

• Write a check / spend money on something

• Manage their business differently

I mainly tell myself that little joke when I’m watching or reading about a sports team; it’s easy to tell ourselves that if we owned our favorite team we’d be better owners. Of course we’d spend an unlimited amount to sign star free agents, luxury tax and economics be damned! And we’d obviously always invest into state of the art facilities; every piece of the business would be absolutely top tier / no expense spared. The fact the current owner isn’t running the team with a completely open checkbook is just another sign that they’re a nincompoop / completely incompetent cheapskate…. but I suspect we’d all be a lot more frugal than we tell ourselves if we were the ones actually writing the checks!

Similarly, it’s really easy for me to sit here and tell someone who owns several percent of a biotech or three “hey man, you really should break your long standing business rules against public activism/ suggestivism and push these things to maximize value.” They’re often looking at the biotechs and investing as repeat games; they’ve been investing biotechs for years and they want to keep doing it going forward, so they’re looking to maximize their reputation / optionality for the future. In contrast, I really don’t care about biotech specifically, and I just (very selfishly) want this current round to work because I think they are so cheap / such a generational opportunity. Again, it’s very easy to tell someone else how to run their business, particularly when you’re telling them to run their business differently in a way that would benefit you personally!

That said…. I still think my friends’ arguments fall flat, and that these shareholders should think about running their business differently and aggressively pushing these busted bios to a more shareholder friendly mindset.

Why?

These shareholders are effectively saying “I know this company is being run sub optimally, and we’d all be better off if a shareholder / activist stepped in and forced them to course correct…. but I’m not going to do that myself because I want to maintain optionality in the future.” That’s a very “repeat game” mindset; you may lose this short term game (i.e. the biotech you own continues to light money on fire) but you keep flexibility / optionality alive for future games (you don’t get the activist reputation, so future conversations with management teams are less awkward / you get invited to write PIPEs).

My push back would be this: what repeat game are you playing that pushing these firms harder is really removing your optionality?

The answer I’ll most frequently hear is “we want the optionality to invest in private rounds or PIPEs in the future.” And that falls pretty flat to me: all of these companies are trading at ~half of cash, and many of them have obviously valuable assets on top of their cash. No one is ever going to write a private check into a company again if valuations stay anywhere even close to today’s levels; how can anyone ever invest into PIPEs if the downside scenario is every dollar will be lit on fire / looted by management. It’s really hard to write an NPV positive check if you have to assume a downside scenario where every dollar will be destroyed (particularly when you start factoring in that if management teams have carte blanche to burn every dollar on the downside, you have to assume that they’ll be very generous with their salaries / bonuses / science projects on the upside, further diluting shareholder returns!). Thus, getting these companies to do what’s rational and not destroy themselves is an extinction level event for the space; there’s simply no investment that can be made into these going forward if this situation isn’t fixed.

I’d have one other form of pushback, and I think it fits well with the game theory theme. The investors I’m talking to who are scared to push management teams are worried about their actions today affecting their ability to participate in a repeat game tomorrow…. but I’d argue that taking bold / aggressive steps today could really improve the investor’s future game selection. Consider poker: would you rather play at a table with ten of the best poker players in the world, or a bunch of college kids who have been drinking for five hours and live of a trust fund? You’d probably find the later much more profitable than the former.

Now take investing in PIPEs. Say you’re considering investing in a PIPE a year or three from now, but the management team looks at your track record and says “O, you went activist on that company that had $300m in the bank and was intent on lighting it all on fire; we don’t want your money.”

Isn’t that positive self selection from an investor standpoint? Do you really want to back a management team that is worried about their stock trading for a third of cash and being forced to do right by shareholders? Don’t you want a management team who would support that? “Hey, you forced them to liquidate that thing, and we totally get it. We would have returned the capital the moment our lead drug failed.”

IDK, maybe I’m being too naive. But if going activist to prevent a company from self-immolating and wasting all of their money is a gating factor for writing a check in the future to some of these companies, I’d suggest you don’t want to invest in those PIPEs anyway. Again, the examples I’m talking about today are not some borderline case where maybe the company should be sold or it’s a really close call if a drug should be supported or not. I’m talking about companies that historically raised hundreds of millions of dollars on the promise of an innovative lead drug, saw that drug fail, and now seem intent on spending all of that cash at insanely negative IRRs because they think spending that cash is their god given right, shareholders be damned.

Let me give one more argument for why investors should take a more aggressive stance when it comes to these busted bios, and it’s actually the simplest argument of all: money talks.

Many of the companies I’m talking about are trading for huge discounts to their cash or liquidation value purely because of corporate governance concerns. Going in and removing that corporate governance discount can generate huge alpha / returns. Maybe doing so will make it more difficult to get into a PIPE round in the future… but if you can remove the corporate governance discount, then many of these stocks would go up 50-100% overnight¹. Those returns mean that any future check you can write into a PIPE is bigger; so if you unlock a few of these and they all go up by 50%, suddenly your portfolio would be much bigger. Maybe now you could handle writing a $15m PIPE check, while a year prior your PIPE check size would have been $10m…. and that ignores any additional fundraising that might be possible if you have a few of these unlock and drive 50%+ returns and some new investors hand you capital…. What I’m driving at is this: the extra money generated from unlocking a few of these would almost certainly allow for bigger PIPE checks in the future, and those bigger checks might open more doors than the “hey, this guy forced an obviously bad actor to rationalize” reputation would close.

Anyway, let me leave you with this: the response to my first articles on the opportunity in the busted biospace has been great. I haven’t had a single shareholder reach out and say they really disagreed with me; in fact, I’ve had tons of shareholders reach out and say they fully support the thesis…. but several are hesitant to get their hands dirty for fears of future repercussions. I totally get that, and I don’t mean to be flippant…. but if you’re not going to push companies when they’re all trading for a fraction of liquidation value and they all seem intent on lighting it on fire, when are you going to push a company? I’m not saying to make the move lightly, but I’d encourage everyone to look at the opportunity set and state of the industry with fresh eyes and push these companies as hard as possible to do what’s right for shareholders. I think the situation today demands some old rules to be broken, and to be completely honest I think a lot of the “repeat” issues that existed in yesteryear would be flipped on their head and benefit someone who took bold action now.

So here’s my call to action: if you’re a shareholder in one of these busted biotechs, reach out to them². Let them know that they cannot continue to run a business with the stock trading a 50% of net cash and the company pursuing hopelessly negative IRR science projects. It’s shareholders money, and it should be returned if there’s no risk-adjusted profitable way to invest it³. It doesn’t matter if you own 1 share or 10% of the company; let them know they need to do what’s right, reduce burn, and return capital to shareholders, and if they do not you will vote against every director and support any other director who will. These companies are not going to save themselves; the only way to fix the situation is to let them know that shareholders demand it.

PS- I think this whole “call to action” is made particularly urgent by the TSVT proxy I mentioned in part 3. I can’t tell you how much that proxy bothered / disturbed / scared me; after TSVT announced their deal, almost every investor I talked to said you could not comp it to any of the other companies I’m talking about because a years long restructuring had led to the board and management team just being completely aligned / clear that a sale was the only path forward for TSVT (i.e. TSVT had good corporate governance, so you could not comp it to all these companies that get huge corporate governance discounts). And I would have generally agreed (I had an unfortunately small position pre-deal!)…. and I think with the benefit of hindsight we can see we were all wrong. The proxy reveals that the company came close to doing multiple deals that would have been, at best, suboptimal versus selling to BMS (and, more likely, would have been quite NPV negative). If a company that every investor would point to as aligned / had gotten the memo could come that close to shooting themselves in the foot multiple times, what hope is there for a generic biotech where insiders own almost no stock? I’d suggest the TSVT example shows there’s no hope / no chance of a good outcome without a ton of prodding and pressure from shareholders. So practice good shareholder engagement and make your thoughts known!

PPS- There’s apparently a new fund forming that will try to work with companies to unlock that trapped cash; welcome to the party! I hope they are incredibly successful, though I am worried that the fund is going to run headfirst into a lot of the governance issues I’ve discussed here. Will be interested to see how they do!

PPPS- I’ve mentioned the lack of insider buying in the sector a few times throughout this series, but I wanted to end the series by again highlighting it…. it’s just insane how little insider buying there has been in these companies as the whole sector has imploded. I’m tracking dozens of companies trading far below net cash; talk to any of their management teams and they’ll tell you they’re going to be great stewards of shareholder capital and they would never spend a dollar on negative NPV R&D / every project they fund is just incredible science with insanely positive ROI…… but, if they really believed any of that, wouldn’t they be buying their stock hand over fist when it’s trading below cash? If you offered me the chance to buy a cash box at 50% of cash and told me I was fully in control of what was done with that cash, I’d be selling my kidneys to buy stock. Yet that’s exactly the set up at all of these busted bios, and I can’t find a single one that has had anything more than a token insider buy (and even token insider buys are few and far between). Words are cheap; I’d heavily discount anything a management team told me when their actions (or lack thereof) so clearly show you how they’re thinking about spending cash and creating shareholder value.

1. Several of these stocks are trading at well under 50% of cash, so going up 100% might actually be understating things!

2. I’ll note this: I’m not trying to form a group with anyone, but I do believe in shareholder rights. It’s completely fine if for some reason you own shares in a company trading at half of cash and think they should spend all of that cash on science projects. If that’s the case, reach out to the companies and let them know that!

3. One important consideration I feel I’ve undersold in this series: corporate overhead. Say you’ve got a company whose sole asset consists of $200m in cash on its balance sheet, and they announce a deal to buy a drug for $100m. Is it possible they got a deal and the drug is actually worth $150m and they created standalone value in a vacuum? Unlikely, but absolutely possible! But the company has no other asset, and now they need to toss on a ton of overhead (public company costs, paying top execs and board members, etc…. to say nothing of hiring a sales force or R&D team!). Once you start dinging the company for all of those costs, you why it’s so difficult for one of these cash shells to justify anything other than liquidating; even if they can find a really good deal, it’s unlikely a deal could create enough value to overcome that enormous G&A drag!