China biotech: End of the boom

In the second half of 2020, private equity investment in China biotech surged to USD 3.9bn, a threefold increase on the first six months and more than the combined 12-month totals for 2018 and 2019. This heady pace of deployment continued through 2021, buoyed by expectations of strong policy support for healthcare generally and a steady stream of IPOs in Hong Kong.

Then, earlier this year, it stopped. Having reached an all-time high of USD 2.6bn in the last three months of 2021 – a record-setting period for private equity across Asia – investment slipped to USD 1.7bn in the first quarter of 2022. The running total for the second quarter is USD 419m, according to AVCJ Research. Deal flow is down by nearly half from the previous three months.

“The height of the excitement was probably when one of our companies, New Horizon Health, went public in February of last year [raising HKD 2bn, USD 258m]. It was more than 4,000 times oversubscribed,” said Nisa Leung, a managing partner of Qiming Venture Partners.

“Private market valuations have been coming down slowly since the end of last year. Right now, I think the market is just completely oversold. If it's a good company, it’s probably raising money at a flat valuation [to the last round]; if it's so-so, they might have a hard time.”

Deterioration in private market valuations reflects earlier sell-offs in the public markets. The Hang Seng Healthcare Index and the MSCI China Health Care Index have both fallen around 50% in the past year. Well-known stocks like Suzhou Basecare Medical and Genor Biopharma had market capitalisations of HKD 2.7bn and HKD 11.3bn, respectively, in early 2021. Both are down 90%.

The correction is not isolated to China. The XBI, which tracks US biotech stocks, has fallen more than 120% from its January 2021 peak. The steepest part of the drop has come in the first half of 2022, coinciding with public market weakness across all sectors and regions.

“NASDAQ is down 30% since the beginning of the year, which we haven’t seen in the past three decades. At present, going off-risk is the major trend – and biotech is a high-risk, high-reward asset class,” said Min Fang, a managing director of Warburg Pincus who focuses on Asia healthcare.

Valuation vortex

The public market correction has created a strange phenomenon. Valuations are not only below those of pre-IPO rounds, but also Series C and even Series B rounds, according to James Huang, founding managing partner of Panacea Venture. Put simply, IPOs don’t make sense right now.

Hong Kong emerged as the IPO venue of choice for Chinese companies following alterations to the listing audience in 2018 to permit offerings by pre-revenue biotech players. In the broader healthcare space, more than USD 18bn was raised through 50 offerings between 2018 and 2021, compared to USD 3bn from 12 in the preceding four years. In 2022 to date, four IPOs have generated USD 370m.

One IPO banker in Hong Kong notes that some fund managers and banks have stopped hiring for healthcare coverage or even axed entire teams. Daisy Cai, a general partner and head of China at B Capital Group, adds that Hong Kong’s reforms created a speculative bubble that needed to deflate.

“It was driven by a surge in investment without fundamental due diligence being conducted on targets, including the progress of clinical trials, quantity and quality of pipelines, and commercialisation capabilities,” she said. “One consequence is companies dropping after IPO.”

The scale of damage on the private markets side may only become fully apparent when GPs begin to revise valuations downwards in quarterly reports made to LPs. Already, many companies that failed to list are looking to raise new private rounds to support operations. Investors are advising less mature start-ups to secure funding for at least 24 months in anticipation of a long winter.

According to Qiming’s Leung, many GPs have halted investment and aren’t really looking at new deals. The implication is that biotech players will be starved of capital. Some are being proactive and cutting back drug development pipelines, with vaccine specialist Clover Biopharma recently cancelling an oncology candidate and two biosimilar candidates.

“Through the market adjustment, investors who deployed blindly will return to rationality or withdraw from the market, so it will be survival of the fittest,” said Wei Fu, a managing partner at healthcare specialist CBC Group. “China has even more healthcare funds than the US. There is an oversupply of capital and eventually, it will return to normal.”

Of the funding rounds that have closed this year, some feature atypical structures characteristic of tougher market conditions. For example, drug developer ProfoundBio raised a USD70m Series A extension led by Sequoia Capital China. There were no incoming investors, which means the company’s bargaining power is reduced and incumbents have a lot of leeway on terms and valuation.

In another recent deal, artificial intelligence-driven drug discovery player Insilico Medicine raised USD 60m in Series D funding from a mixture of new and existing investors, plus the company’s founder and CEO. Founder participation might be a pre-condition for raising new external capital at a lower valuation, although it’s usually structured as an equity adjustment rather than a cash injection.

“When the market is very bad, having a founder join a funding round could be a demonstration of confidence. At the same time, the founder doesn’t want to be heavily diluted at this valuation so he might be happy to invest his own money,” another start-up founder told AVCJ.

Fast followers unfavoured

Investors are responding to the changing market conditions in two ways, according to Colin Yu, head of China life sciences at KPMG. They are moving towards earlier rounds and they are avoiding the fast-follower space and focusing on truly innovative drug developers. The latter means swapping mature targets with low entry barriers, often sourced overseas, for pre-clinical ideas found in labs.

To some extent, this represents a reversion to standard global practice. Wayne Shiong, a partner at China Growth Capital, observes that biotech investment in China over the past decade has been more about capital markets than traditional venture capital. Plotting a route to an IPO took precedence over identifying innovative targets or accumulating early-stage technology.

“So-called innovation in the previous decade was not real technological breakthroughs, it was just about R&D involving clinical trials or combination treatments. The recent capital markets adjustment has brought back the value of VC investment and the search for innovation,” said Shiong. 

China Growth Capital established a biotech team two years ago and is still actively scanning university projects for early-stage investment opportunities.

Fast followers have also lost their appeal following intervention by China’s National Medical Products Administration (NMPA). Clinical research guidelines were issued that require more of new drug development. “[They are] focusing on really innovative drugs and rejecting duplicate investment in crowded areas like CAR T-cell or PD1 therapies,” said KPMG’s Yu.

Vaccines based on RNA technology that can be used against COVID-19 are a priority area. China has yet to approve distribution of the BioNTech vaccine and four locally developed mRNA vaccines are in clinical trials. The most advanced candidate, ARCoV, recently returned to phase one after phase-three tests were derailed by serious side effects, according to one investor.

Meanwhile, a newer generation of start-ups is tackling mRNA side-effects. Therorna specialises in circular RNA technology, which is described as more stable and longer-lasting than the liner RNA used in most mRNA vaccines. It is hoped this will result in fewer side effects. The company recently closed a USD 42m Series A round led by MSA Capital.

This followed a USD 120m Series B for InnoRNA led by CDH Investments and China’s Renaissance’s Huaxing Healthcare. The company focuses on lipid nanoparticle (LNP) technology – the foundation for carrier vehicles that protect mRNA from degradation and aid intracellular delivery. LNP is widely considered a bottleneck of mRNA research.

Early-stage first-in-class or best-in-class drug developers are not only announcing new rounds, but their valuations are largely intact. Competition for these deals remains intense. “When a US dollar investor has little hesitation on price, a renminbi fund may quickly step in and offer term sheet,” said another investor, specifically referencing the novel drug development space.

A recent CNY 500m (USD 75m) Series A for HeliXon, a one-year-old start-up specialising in AI-driven protein-based therapeutics, saw 5Y Capital assume the lead investor role. A healthcare-focused partner at a large GP expressed surprise at the valuation, suggesting that 5Y had copied Tiger Global Management’s approach of deploying first and thinking about the valuation later.

For its part, 5Y claims that expansion into biotech didn’t happen easily or recklessly, and was in fact underpinned by a recognition of the transformative power of new drug discovery methods. "Our entry into life sciences came from the accumulation of knowledge in AI and cloud computing over a long period,” Richard Liu, a founding partner at the firm, told AVCJ earlier this year.

Monetisation matters

AI-based drug discovery platforms have proliferated in recent years, but to many, that’s the easy part of biotech. Execution and commercialisation present more significant challenges. New entrants claim they can accumulate the necessary skill sets. MSA, for example, has recruited a seven-strong healthcare investment team, all with PhDs and post-doctorate degrees in medicine.

“People with strong learning ability can pool resources and leverage internal experts and external scientists for reference. Even if you’re coming from a purely TMT [technology, media, and telecom] background, you can expand and excel in healthcare investment if you have that learning ability,” said Jenny Zeng, a managing partner at MSA.

Sometimes, new and established healthcare investors work on the same deals, each contributing their own expertise. Last year, MSA and FreesFund joined healthcare specialist Lilly Asia Ventures in an angel round for Pyrotech Therapeutics, which targets small molecule inflammation and oncology treatments. Zeng describes it as one of China’s first homegrown first-in-class drug developers.

The big question for any novel drug developer is whether its market size and commercialisation potential can be fully realised under China’s National Reimbursement Drug List (NRDL) regime, which oversees coverage by government-backed insurance plans. Inclusion promises wider distribution but only in return for steep price cuts. Sometimes performance doesn’t match the hype.

Hengrui Pharmaceuticals is a case in point. In late 2020, the company’s first PD-1 treatment – which stops cancer cells from evading immune systems by disrupting protein interaction – debuted on the NRDL. Its market capitalisation soared to more than CNY 600bn. However, revenue and net profit fell sharply in 2021 even though 10 innovative drugs had been approved for commercialisation.

Hengrui is a strong advocate of R&D, putting CNY 6.2bn towards these efforts last year, but it remains to be seen whether innovative drugs can deliver meaningful profit domestically. The annual cost of PD-1 treatment in the US is typically USD150,000; the NRDL has set it at CNY 36,000 (USD 5,360). A biotech CEO told AVCJ that pricing is based on the NRDL’s budget rather than asset value.

PD1 is a fast follower with 75 clinical trial registrations in 2020 alone. For first-in-class drugs that satisfy unmet needs and are considered irreplaceable, pricing is more favourable, said KPMG’s Yu. RemeGen’s RC48, the first locally developed antibody drug conjugate (ADC) – which kills tumour cells while sparing healthy cells – was priced at CNY 250,000 per year, exceeding market expectation.

Moreover, NRDL is not the only commercialization channel. Commercial and municipal insurance programs are another option, with Beigene winning support for a drug that targets cancer in children from an insurance program launched by a medical tourism pilot zone in Hainan province. Hong Zhao, CEO of Hong Kong-listed Sciclone Pharmaceuticals, said he would consider similar routes.

Sciclone is also an example of how commercialisation capabilities can help drive profitability. The patent for Zadaxin, its core product, expired long ago and the company now faces competition from generic alternatives that sell for one-fifth of the price. Yet its market share, in revenue terms, rose from 44.1% in 2015 to 57.5% in 2019, according to Frost & Sullivan.

“We decide for ourselves whether we want to enter medical insurance price negotiations or pursue other commercialization paths. I don't think that the NRDL’s pricing policy will affect innovation by companies,” Zhao added.

Outward bound

It's worth noting that for all the complaints from Chinese biotech start-ups about low profit margins, the affordability of locally-developed products has become an international selling point. The country out-licensed more than 60 drugs in 2020 and 2021. They included agreements between BeiGene and Novartis regarding PD-1 and a T-cell immune receptor. The latter deal is worth USD 2.9bn.

Another milestone was reached in February when a CAR T-cell therapy developed by Legend Biotech and out-licensed to Janssen Biotech was approved by the US Food & Drug Administration for the treatment of certain adult patients.

“China should be a key player in the development of affordable drugs for the world. There are two types of investments in medical care: one supports innovation and solves challenges that others cannot; the other thesis is accessibility. The most successful private equity healthcare deals in China mostly solve the accessibility issue,” says CBC’s Fu.

Most out-licensers are fast followers, suggesting the line between first-in-class and the rest is sometimes blurred. Both have contributed to China’s emergence as the second-largest novel drug developing system globally within eight years.

As to the next big investment opportunities, the appeal of contract development organisations (CDOs) contract development and manufacturing organisations (CDMOs) is routinely cited. Panacea’s Huang and KPMG’s Yu also highlight the potential of medical devices following disruptions to global supply chains. Both segments could be seen as relatively safe plays amid market turbulence.

Fang of Warburg Pincus describes the current headwinds as a cyclical financial markets-driven phenomenon. The structural tailwinds are still there. “China's advantages remain: the accumulation of talent from important roles in global pharmaceutical companies, strong domestic market demand, and special support for medical and drug R&D in recent years,” he said. “The foundation is solid.”

This does not mean that investors will necessarily wait for the cycle to swing back. Fu of CBC asks how anyone can prevail under a herd mentality, sitting alongside 200 other homogeneous investors. Value comes from differentiation, and to some extent, going against the grain.

“The first thing everyone must do is stop themselves becoming homogenous,” he said. “If your performance is decided by the market situation, you are not a good investment institution.”

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• Topics
• Greater China
• Healthcare
• Early-stage
• Expansion
• IPO
• China
• Pharmaceuticals
• CBC Group
• Qiming Venture Partners
• MSA Capital
• Warburg Pincus Asia
• 5Y capital
• China Growth Capital
• B Capital