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In: Opinions & Features

4.22.16 | Forbes

By Steve Brozak

To read the entire article on Forbes, please click here.

This week Goldman Sachs announced that its profits fell 60% in a single quarter and blamed a volatile market that’s hit it across business lines.  While the fundamentals of the American economy may seem sound, this is the kind of event that investors should look out for as they plan new investments in the market, including the biotech industry.

Goldman was the latest in a crescendo of abysmal bank quarterly earning reports kicked off by JP Morgan which was down 6% and Citigroup Inc. which was down 27%.

All three banks cited similar reasons for their quarterly decline – trading revenues and volatility that rocked across business lines.  With investment banking deals and M&A at a standstill, a slowdown in the financial sector threatens repercussions throughout industries.  Behind the scenes biotech is impacted in very profound ways.

The financial industry can react very predictably when markets stumble.  During major selloffs, trading volumes decline sharply and stay flat.  Revenues from trading provide a major source of revenue for many banks.  With investors out of the market, investment banking deals for public companies – another large revenue driver for banks – also suffer.  You would assume in a down market with companies at lower valuations that a bank’s M&A business would pick up, but that would be too rational.  M&A is an alchemic art that’s all about willpower and timing.  The failure of  Pfizer Inc.’s $160 billion acquisition of Allergan plc will cost several banks – including Goldman Sachs Group Inc., JP Morgan Chase & Co., and Morgan Stanley – up to $240 million in banking fees alone.

Market slowdowns hit bank bottom lines immediately, making the reactions of bank leadership just as swift and predictable.  One of the first actions banks take is to withhold annual bonuses, followed by across the board employee layoffs, which are not announced to the public.  Right now this is all happening very quietly at large and small banks to protect against a long downturn and to improve numbers next quarter.  This causes top level bankers and research analysts to begin looking for new options, setting off a migration and further crippling a bank’s operations.

The tumult in the banking sector right now matters to a weak biotech market in a stalled recovery.  The biotech IPO and secondary markets are nonexistent as dealmakers search for signs of life.

Any research or deal progress being made will halt as banking personnel across wealth management and investment banking divisions are let go.  As junior and senior portfolio managers leave, portfolios are rebalanced and unwound, causing selloffs in the stocks of small and midcap biotechs who are probably actively seeking investment for R&D dollars.  As their prices continue to stagnate and decline, investors will continue to be wary of the small and midcap space.

Invariably, companies will turn toward the debt markets for much needed support.  But borrowing money is rarely advisable for small and midcap R&D stage companies.  Others may have no choice but to shutter as their cash reserves dwindle and they begin to breach debt covenants or violate public listing requirements, jeopardizing their status as public companies.

Whether you sympathize with the plight of Wall Street or not doesn’t really matter, because Wall Street provides the incredible liquidity required to fund science at these companies.  The biopharma complex exists through vital interactions with Wall Street, and if both systems falter at the same time – taking their eyes off of one another, so to speak – then important science and medical progress also falters.

Darwinian law doesn’t necessarily apply to biotech, even though many naively believe good science is somehow an unstoppable force that always finds a way to reach the market.  Very few successful biotechs began researching and developing the drug and indication they ended up commercializing.  A company that implodes over a failed lead candidate may have a blockbuster buried along its pipeline.  The nature of discovery is based on a chain of good guesses and serendipity.  The monetization of discovery requires patience in the face of trial and error, a virtue not often found on Wall Street, and capital.  Therefore, a breakdown in our banking system, even for a few quarters, will slow the pace of research and discovery as management teams in both sectors become distracted by what is going on in the markets and their inability to tap liquidity.

What To Watch For

While Fed rate policy will play a large role in how banks perform in the long-term, breakthroughs in clinical R&D and M&A transactions are the near-term catalysts that could drive the biotech financial markets.  With the Pfizer acquisition of Allergan now on ice, we will have to see how those leftover M&A dollars are put to use.  Allergan has already made a series of business development announcements on the heels of the terminated deal with Pfizer. But it’s not only Allergan and Pfizer that could buoy the market.  There are plenty of other companies in the wings that could launch the large and substantial deals required to beget other deals, drawing investors back into biotech’s cooling waters.

With biotech hedge funds underperforming already, further disruption of Wall Street not only means less capital flows, but also fewer financial personnel informed about the biotech and healthcare markets.  With banks quietly cutting their ranks combined with defections of specialists to industry, fewer experts will be able to bring investor attention to positive outcomes when they happen in the sector and transact critical deals.

For now, when they aren’t thinking of disappearing bonus checks, bankers are tuned in on the secondary market as banks begin to attempt fund-raises.  Until then, we’ll have to see if biotech can produce a result that reminds investors why they invest in the sector in the first place.