12.23.16 | Forbes.com
By Steve Brozak
To read the entire article on Forbes.com, please click here.
We are heading into 2017 with a great deal of uncertainty, but if President-elect Trump governs the nation as he said he would – unconventionally and unpredictably – we may experience a significant uptick in market volatility as foreign governments and global markets react to America’s new stance in the world. In light of this potential volatility, our investment bank – which focuses exclusively on the healthcare sector – has advised its corporate clients to raise money, primarily through debt but also through equity or some combination of both since August.
The interest rate environment, which we see increasing steadily in 2017, has also driven our recommendation, especially after the election of Donald Trump. Prior to the election all indications were that interest rates were sure to rise with each readout of the American economy. Additionally, during his campaign President-elect Trump’s economic platform evolved to include greater government infrastructure spending, less government regulation of business, and easing of domestic and foreign tax rates. Now, post-election, many elements of President-elect Trump’s economic stimulus platform stands a good chance of being passed by the Republican dominated legislature and additional moves by the Fed to continually raise interest rates will undoubtedly help balance inflation in the face of massive government spending.
Last week this view was solidified as the Fed delivered important and somewhat unexpected guidance. Not only did the Fed increase rates by a quarter point, it also indicated it plans to raise rates three more times in 2017, which was news to Wall Street where consensus has been expecting two moves at most.
In small cap biotech, the impact of a rising rate environment cannot be understated. Rising interest rates increase the overall cost of capital as the cost of borrowing increases. For nascent biotech companies which depend, in part, on debt financing to fuel their growth, raising debt will generate a bigger liability because the cost to borrow, whether by banks or investors, will be more. Even equity transactions will cost more as interest rates increase the cost of capital. You don’t have to look far to see how this translates and affects the markets. Just take a look at mortgage interest rates since November 8, which have already increased on average over 50 basis points, decreasing the buying power of potential homeowners while adding tens of thousands of dollars to the cost of a house.
Our advice to qualified biotechnology companies to enter debt agreements was recently validated when Ford Motor Company announced it was raising $2.8 billion in debt on December 5th. Initially Ford sought to raise $2 billion, but investors put in orders amounting to $8.7 billion, which is troubling and a sign of how some investors feel about the U.S. economy. The book for the Ford deal was four times oversubscribed, showing the demand of investors to lock up their cash in what is perceived to be safe long term debt. For Ford and its bankers, it’s a high class problem to have especially in favorable market conditions, but it’s a bad indication for the economy that so much money is searching for a haven. We note, too, that Ford has demonstrated a keen ability to time its issuance of debt. Ford famously raised debt right before the financial crisis, ensuring it had the balance sheet strength needed to endure the market crash when all of the other U.S. automakers were declaring bankruptcy.
Within days of Ford’s announcement, Amicus Therapeutics, a rare disease biotechnology company, announced it was offering $225 million in convertible senior notes. A few days later Sucampo Pharmaceuticals followed suit announcing that it was also offering $225 million in convertible senior notes, and when it went to market the company was able to actually price $260 million. Some will remember a biotech highflier named Dendreon which assumed more debt than it could handle and was forced into bankruptcy only to be bought by Valeant. What people don’t really remember is the significant infrastructure overspending that Dendreon embarked on based on its prostate oncology platform, Provenge. Instead of building infrastructure on a gradual basis that met actual product demand, it approached its product launch on a build it and they will come model.
For every Amicus and Sucampo deal, there are several examples of other small biotech companies that have also focused on shoring up their balance sheets through various transactions, large and small, as they head into an uncertain 2017. Every dollar biotech companies have raised in the last two quarters in a favorable market is a dollar less they will have to raise in a potentially unfavorable market. Even if the market continues to climb in 2017, there is still significant headline risk hanging over the entire pharmaceutical sector as the price debate rages.
To quantify the effect of rising interest rates, we conducted an internal analysis in which we charted interest rate increases to biotechnology performance, looking both at yields on the 10-year and 2-year treasury. While little correlation was observed with 10-year rates over the analysis period, a strong negative trend was observed with more sizable increases in the 2-year treasury yield, corresponding with poorer performance in the biotechnology sector. Of course, our modeling does not necessarily show causality and we conduct technical and historical analysis to continuously balance out the qualitative evaluations we make on the sector. Nonetheless, we think our analysis is supportive of our belief that higher debt financing costs will negatively impact the sector. While the increases in the 10-year yield at lower levels are reflective of a strong and growing economy, which should be to the benefit of biotechnology – a rising tide lifts all boats – the 2-year yield is more indicative of the cost of borrowing for growth companies which frequently raise debt with two to five year tenors.
XBI is the ticker for the SPDR S&P. Biotech Analysis Period March 8, 2006 to December 15, 2016. Return and yields calculated on a monthly basis, rolled daily by market trading days. Each column depicts the average of monthly returns of XBI for all periods corresponding to the associated changes in yield. Data Source: ThomsonReuters. Analysis provided by WBB Asset Management.
Our view and analysis supports the age-old Wall Street mantra: Raise money when you can, not when you have to. I didn’t even have to complete the sentence over lunch the other day with a seasoned biotechnology executive. He finished it for me.
You can see the clouds hovering over the sector in 2017. With the pricing debate not even close to being settled, the relitigation of the Affordable Care Act threatens to bring the cost of healthcare and the affordability of prescription drugs back to the forefront. And there are any number of Black Swans circling the waters (take your pick – from unpredictable Tweets from President-elect Trump to ongoing Congressional investigations of big pharma malefactors), any one of which may lead the sector or entire market downward.
All of this matters, especially when it comes to biotech investing. So what should investors do? Probably the same thing we’re advising our corporate clients; bulk up and maintain cash positions to take advantage of a market pullback. At the very least, remain highly liquid to take advantage of any opportunities the markets may present.
As for biotech during a pullback, management teams with strong pipelines who had the foresight to fortify their balance sheets in 2016 will have an edge over those who did not. This will make it easier for savvy investors, especially those with significant capital, to separate the wheat from the chaff.