Introduction

Science is mostly black and white. Either it works or it doesn’t. This binary feature also found its way into the business model of most biotechs which tended to have a focus on a single biotechnology. For investors and founders (who are the biggest investors) of such biotechs, the outcome is also binary - either the technology makes it to the market with roughly 5% of the chance, resulting in high multiples or it fails, resulting in full loss of initial investments.

If a person invests in just a single biotech hoping the investment would work out, from portfolio perspective, it is an awfully bad portfolio. Even if the expected return is positive, the high volatility of such investments would discount the risk adjusted return to almost nil. This probably applies generally to start-ups hence people say it takes an unusual amount of drive and belief to be a founder.

How can investors rationalise investing in biotechs then? The answer lies with the magic word: diversification.

Traditional Diversification

Diversification is said to be a free lunch in finance. It is true. There are only two levers behind risk adjusted return. One is the expected return, and the other is the volatility. Diversification doesn’t increase expected returns. In some cases it reduces expected returns, when the portfolio manager dips into subpar quality assets to hit a particular number of holdings due to fund size or other constraints imposed by the fund mandates. However, diversification can reduce the volatility for sure as long as the assets are not perfectly correlated with each other. For perfectly independent assets, the volatility of the portfolio would be reduced by the factor of square root n where n is the number of holdings. It works better for biotechs than traditional techs because traditional techs are highly correlated with each other while the fundamental technologies behind different biotechs are entirely different, making the outcomes as independent as you can get (this turns out to be not true but is out of scope for this article).

For investors to get a more acceptable portfolio from an investment perspectives, a basket of independent biotechs should be better than a single biotech. However, this is still not attractive enough as biotechs tend to underperform in the long run based on listed biotechs’ historical performance, according to Andrew Lo’s research Just how good an investment is the biopharmaceutical sector?

In summary, it helps, but not so much. I suspect the reason is because when investors participate in public biotech investments, they are riders and price takers in the journey without any ability to manufacture alphas in the process.

There is one more way to do the diversification, similar to factor integration mentioned by AQR’s paper Long-Only Style Investing: Don’t Just Mix, Integrate

Embedded Diversification

Instead of investors creating a diversified portfolio themselves, maybe someone can achieve it for investors with a curated list of holdings representing the most appropriate opportunities across both public and private sectors.

There are a large number of special situations that can result in high alphas but can’t be captured by passively investing in publicly listed biotechs. Some are below,

• Abandoned asset arbitrage: when large pharmas change their strategic focus, a number of IPs will be shelved with the exclusivity fading day by day despite the science is still promising.

• Quality diligence: there is only so much an investor can do on a highly complicated area like biotech. A lot of assets in front of investors probably have issues with IP or the early results are already showing signs of weakness but those issues may not be picked up. Specialist investigators would be able to perform this type of screening effectively and filter out low quality biotech assets.

• Operational efficiency: the commercialisation of every biotech is said to be different, yet shares many things in common. For the same process, it probably makes sense to figure out the best way to do it and adopt it repeatedly as opposed to reinventing the wheel in every biotech.

• Firesale: early stage of biotech is known as the death of valley. The runway is tight and diligence takes long. There could be perfectly legitimate biotechs encountering an unfortunate chain of events resulting in its liquidity issues. Those times could be great opportunities for investors to snap up good assets at very attractive price.

• Merger and restructuring: for anyone who works in biotech for long enough, merger and restructuring is inescapable. When merger and restructuring happen, assets get consolidated and some assets could be simply dumped. This is great time to pick up assets in the hands of the wrong people with extremely attractive terms.

The list is by no means exhaustive but hopefully this gives an idea of the opportunities that investors don’t have access to when engaging in traditional diversification in biotechs.

Contrary to traditional biotechs that focuses on a single technology, there is a rise of portfolio biotech companies that are holding different assets through their subsidiaries. Those include Roivant, Bridge Bio etc.

Are they executing in a way that captures alpha? It remains to be seen but I will come back with some deep dives of them in the near future.

Bye for now!

Fred Yu