Drug Baron

An Open and Shut Case: The Madness of the IPO window


As biotech companies queue up like lemmings on a cliff top to hurl themselves through the ‘IPO window’ while its open, DrugBaron tried (and failed) to understand the mentality of public market investors who shun biotech assets for years, and then suddenly buy anything (or so it seems).

The trigger for many, if not all, of these companies to go public has not been new data, or any material change in the value of their assets, or indeed anything specific about the company at all.  Instead, it’s simply the opening of the window.

If you have a good team (or even a team that looks good), a viable asset and a swagger, you can raise money on the public markets in 2013.  Last year, similar companies – even the very best companies – had no such opportunity.

Such is the current enthusiasm for biotech stocks, these same public market investors promptly drive the price higher, netting a decent return for the anchor investors.  Such a demand cycle is clearly self-sustaining with bankers and investors eagerly looking for the next trick.

Eventually – and if the current headlong dash to join the IPO queue is sustained, then soon – supply will exceed demand, and since the prices had little to do with the actual underlying enterprise value of the companies prices will drop precipitously.

When that happens, and investors are burned, the binary switch in their brains will flip back to the ‘off’ position and the window will slam shut for a further indefinite period.

Such wild swings of sentiment are bad for the industry, and are driven by unrealistic negative sentiment in the closed periods and unrealistic positive sentiment in the open periods.  What we all need is a healthy – and above all sustained – dose of realism.

Reliable access to the public markets for biotech companies would make a big difference to the business model of drug discovery and development outside of global pharma companies.  But this kind of feast followed by famine is damaging even in the feast phase – because at least some of the companies going public in 2013 will turn out to be duds.  And the number of eventual failures that do make it to market is only increased by the apparent loss of stringency that accompanies a bubble.

Sadly, the behavior of markets in respect of biotech IPOs is only symptomatic of a deeper ill in modern free-market capitalism: the dissociation of stock price from enterprise value.  Almost all the short term fluctuation in stocks is driven by human psychology – its not about what I think a company is worth, but about what I think the other market participants will judge the value to be tomorrow.

More than 90% of all the capital playing the public markets is traded on these short term fluctuations.  Derivatives and ultra high frequency trading are all tools that emphasise the importance of market fluctuations (based on sentiment) rather than on changes in the enterprise value.

The solution is quite simple: a reduced tax on dividend income and an increased cost of trading.  Some economists argue that ideally the cost to trade should be zero, so that prices most accurately reflect the current average perception of value.  But DrugBaron disagrees: low trading costs lead to shorter term, sentiment-based trading at the expense of longer term allocation of capital to more productive (and hence more valuable) users.

Of course, such solutions lie entirely outside the biotech domain – wholesale changes in the way governments regulate public markets are required.  And without them, its hard to see when the madness of an IPO window oscillating between wide open and firmly shut will end.  I guess, as with any bubble, the skill is first recognizing it as a bubble (though I doubt anyone could mis-call that) and then calling the moment when sentiment will turn – and avoid buying just before the peak.

In the meantime, good companies, average companies and even a few bad companies will exploit the feeding frenzy.

  • patrick

    Sadly, the behavior of markets in respect of biotech IPOs is only symptomatic of a deeper ill in modern free-market capitalism: the dissociation of stock price from enterprise value.

    How is the dissociation of stock price from enterprise have to do with “modern free-market capitalism”? The USA i would assert doesn’t even have free-markets at all, but rather heavily government-regulated ones.

    Enterprise value is market cap + debt – cash. And fundamentally, how do you know that stock prices are dissociated from enterprise values? Value is subjective.

    • davidgrainger

      The US does have free markets – in the sense that the prices of assets are set by market economics. Yes, of course there is government regulation but that is designed (though it is only partly successful) to prevent manipulation of the markets, for example through insider dealing.

      The problem isnt that the markets are not free – it is that market economics fails to do what it was established to achieve (and what, in days gone by when trading was slow, difficult and expensive, it did achieve) which is the efficient allocation of capital.

      The reason it fails is because the timescales of the trader and the corporate value-builder are different. You can make more of a profit (if you make the right calls) trading in and out on intra-day variation than by waiting for your pick of a good company to do well and build capital value, or to return that value to you through dividends.

      And the point I was trying to make is that intra-day price volatility cant be related to real value of the enterprise, since most days the true value of such large enterprises dont really change. What is changing is the PERCEPTION of true value. And trading on changes in perception doesnt help allocate capital efficiently.

      Raising the cost of trading (or introducing more benefits for longer holding periods) would help redress this balance. This in turn would lead investors to seek investments that allocated capital to more profitable rather than less profitable activities (rather than to operations that are perceived to be under-valued today versus tomorrow). For sure, there is a disadvantage: rapid trading and short-selling increase the speed with which the market price changes as perception of value changes. But this has gone too far (as the rise in ultra fast trading shows) and sets up these unstable oscillations of which the opening and shutting of the biotech IPO window is just one example.

      People running real businesses would be better served if trading frequencies were tempered (through introduction of incentives or taxes). Everyone would benefit – except the successful high frequency traders!

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  • http://www.hollyip.com/ Suleman Ali

    Herd behaviour is an incredibly entrenched quality of the investor/money community. There are many naïve investors out there and there are many financial organisations whose profits depend on taking money from them and investing it into areas like biotech. These financial organisations don’t really care about the long term or their clients’ money. That cannot be changed easily.

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  • Helmuth van Es

    I have been amazed by some of the companies that went public recently, others I am not so cynical about but what I am indeed worried about is the blow the biotech industry as a whole could get once 1 or more of these stocks go down the drain. The industry does not need this especially not now, we need a reliable, sustainable source of capital that can fund true innovation in drug discovery and development. What does the future hold for us you think?

    • davidgrainger

      Thanks for your comments.

      I dont think its too hard to read the future – just look at the past. History is already repeating itself. As you say, its a certainty one or more of the recently IPO’d stocks will fail a key trial milestone (as pre-revenue healthcare companies always will). 90% of the value will disappear overnight (which is what makes such stocks unsuitable for the public markets in the first place). Then public market investors will remember the pain exceeds the short-term bubble-driven gains and the IPO window will shut indefinitely again.

      Right now, I dont see any hope for pre-revenue life science companies getting stable and sustained access to public markets – even when they justify such status (as some of them surely do).

    • davidgrainger

      Helmuth, we are about to see what happens when “one or more of these stocks go down the drain” with the Prosensa failure. Prediction: the window closes again, even for much better suited companies. Prosensa was never (in my view) a suitable candidate for public markets, simply because (as events have proved) all the value was locked up in the turn of a single card.