By Winston Black, CEO, SWK Holdings
The Federal Reserve’s decision to raise interest rates to fight inflation – currently around 8% a year – has changed risk and reward for investors facing rising commodity prices raw materials and a pandemic that has changed consumer habits. As interest rates rise, some investors are choosing to reduce risk in their portfolios by turning to short-term, inflation-linked bonds. Market volatility sends risk-averse investors to the exits. “Trash bonds” – though rarely used by life sciences companies – could act as a proxy for riskier borrowers as bond prices have fallen and yields have risen through much of 2022.
While life sciences companies are in a period of great innovation, they have not escaped the upheaval in financial markets, knocking out the sector’s equity funding, as a leading ETF down more than 50% shows. since September (See Chart 1 below). Research from Jefferies & Co. pointed out that 128 biotechs in early May were trading below their cash position, but take that number with a few grains of salt or a few micrograms of the latest molecule in development. The money is for clinical trials and should be considered with how quickly it will be spent. That said, investor sentiment is clearly bearish toward much of the cash-consuming life science sector.
Chart 1: The S&P Biotech ETF (XBI) fell more than 50% between early September and mid-June. During the same period, the decline of the S&P 500 was much less pronounced.
Biotechnology and other life science companies will need to be creative when it comes to raising capital. The cost of issuing shares for companies is much higher than it was at the start of 2021, posing a new challenge for executives and boards of directors as to how and where to invest or raise capital. While some IPOs are underway, some have come with warrants that can become dilutive for current shareholders and at valuations well below the 2021 peak. Although not all life sciences companies are solvent, those that are should consider alternative financing solutions to avoid equity dilution.
Credit markets have had broader implications for life science companies seeking to borrow, regardless of where the borrower falls in the spectrum of credit quality. Yields on higher-rated short-term debt rose. For example, yields on one-month Treasury bills – which are considered the “risk-free rate” in many fixed asset valuation models – rose more than a percentage point to 1.121% from 0. .05% for the cumulative period to date. from mid-June.1 Triple-C-rated high-yield bonds — speculative, high-credit-risk junk bonds — are yielding around 14.434%, near a 52-week high, compared to a 52-week low of 6.304%, the data shows. on ICE Data Services High Yield Bonds.2
So, with the broader financial markets serving as a backdrop, here are some of the results we anticipate in the life science financing market.
Mergers & Acquisitions: Big pharma and big medtech still have strong balance sheets to take advantage of opportunities to invest in their own pipelines or expand their pipelines through licensing or outright acquisitions. For example, Pfizer is paying $11.6 billion to acquire Biohaven Pharmaceutical Holding’s migraine drug business with its “existing cash.” Despite the rise in rates, they are still low in historical terms and could make sense for transactions likely to generate returns above the cost of capital. While Special Purpose Acquisition Companies (SPACs) raised funds with ease in 2019 and 2020 and eagerly targeted biotech companies, some are facing delays in closing deals, or SPAC sponsors have to repay l money they collected. Some may try to close deals before their respective deadlines.
Synthetic royalty contracts: These agreements may provide funding, but the life science company or patent holder trades a portion of a product’s benefits for immediate funding. The advantage of this arrangement is that it does not dilute equity and often comes with fewer covenants than senior debt. It also offers creative financing options for ‘platform companies’ that might have several derivative product options from an existing technology. In this circumstance, the finance company and the life sciences company are married to the success of a product.
Convertible debt: Bonds that could be converted into shares could also present a creative financing solution. The main considerations in this approach relate to the liquidity of the stock, the strike price of the conversion and the terms between the borrower and the lender. The coupon on these tends to be lower than that of secured debt, but the stock must have adequate trading volume to ensure the bonds can be converted. Strike prices for these securities have traditionally been at a 25% premium to the current share price, but issuers may be apprehensive about issuing a security tied to a depressed oil price. stock.
Pacts: Given the robust capital markets of 2021, some lenders have been quite lax on their terms to compete in a competitive, low-interest market while having raised plenty of capital to deploy. A few failures could affect lending in the life sciences sector. In today’s market, one would expect lenders to want greater protection and deploy stronger underwriting to mitigate their risk exposure with greater controls around leverage ratios to guard against defaults.
Will there be a settlement of accounts?
There is now accountability after a lot of investment poured into life sciences to fight COVID-19 and fund promising new platform technologies. It has been quite easy to raise funds from venture capitalists, SPACs, private equity, IPOs and strategic buyers interested in the life sciences sector. When a SPAC was able to offer a startup enough funding to skip a few fundraisers, it changed the dynamics of the industry.
An indicator on the state of the market is expected to arrive in the second half of 2022 and early 2023. Many of the financings closed in late 2021 and early 2022 were designed during the go-go periods of early 2021. Deals that saw the day during this period will have to navigate significantly changed capital markets, where changes in interest rates, trading conditions and declining equity valuations could make redemption and/or refinancing problematic.
For boards, management, and shareholders, there needs to be an understanding of the intrinsic value of the business relative to the stock price or the valuation of a new round of investors. Importantly, policymakers should not base the assessment on the inflated 2021 metrics.
With interest rates rising and no positive news flowing, the market momentum for funding life science companies is no longer where it was pre-COVID-19. It has become comparable to what it was before the financial crisis of 2008. The struggle will be to continue to fund innovation and to determine which scientific developments will reach the market. This will never change, regardless of the financial market.
- https://www.wsj.com/market-data/bonds?mod=md_home_overview_bonds_main (Accessed June 13, 2022)
About the Author:
Winston Black has been named CEO of SWK Holdings Corp. in January 2016. He was then appointed to the Board of Directors in August 2019 and appointed Chairman in November 2019. Prior to joining SWK, he worked for PBS Capital Management, LLC, an investment management firm. a company investing in pharmaceutical royalties and healthcare stocks, which Black co-founded in 2009. Prior to PBS Capital, he held various financial roles focusing on biotechnology and healthcare after earning MBAs with honors from Columbia Business School and London Business School and earning a BA in Economics from Duke University, where he graduated with honours.