Biotech's Boon Or Bane?

Hedge funds are providing financing where VCs won't. But there are strings attached

Cash-starved biotech companies have what might politely be called a complicated relationship with hedge funds. Consider the tensions that built earlier this year between troubled vaccine producer Chiron Corp. (CHIR ) and its third-largest shareholder, hedge fund ValueAct Capital. On Mar. 15, the clash between Chiron Chief Executive Howard Pien and hedge fund manager G. Mason Morfit came to a head. At issue: the proposed sale of Chiron, in Emeryville, Calif., to Swiss drug giant Novartis (NVS ), which is up for shareholder approval on Apr. 12.

From his fund's San Francisco headquarters, Morfit fired off a letter to Chiron's board declining a formal invitation to meet with Pien -- unless the CEO would concede that Novartis' offer to pay $45 a share for Chiron was "not acceptable." If not, Morfit wrote, he thought Chiron's CEO should be "replaced." Five days later, Morfit wrote that he rejected Pien's personal e-mail invite to get together. "We have reviewed many times the rationale for the merger... and see no purpose in discussing [it] further," Morfit wrote in correspondence filed with the Securities & Exchange Commission. Through an e-mail from a company spokesman, Pien declined to comment on the exchange. Says Morfit: "We believe the business was turning around, and Novartis is seeking to get all the upside."

The battle between biotech CEO Pien and hedge fund manager Morfit illustrates the strains caused by a change: Hedge funds are increasingly becoming major financiers and shareholders of biotech companies. In this role, some funds act aggressively to boost share prices, in contrast to other situations in which hedge funds sell short, meaning they make bets that shares will fall. In development-stage biotech companies, the funds are stepping into a void created by the industry's traditional backers, venture capitalists, who are growing reluctant to pour millions of dollars into outfits that can take decades to generate marketable products, if they ever do. Biotechs received $3.5 billion in VC funding in 2005, down slightly from 2004.

So biotechs are jumping into bed with hedgies more than ever before. They're doing so via private investments in public equities (PIPES), or deals in which shares are sold to private investors, sometimes at a discount to the public share price, and through other stock and debt offerings. The amount of capital raised by biotechs through PIPEs alone, rose to $2.4 billion in 2005, vs. less than $1 billion in 2002, according to life sciences merchant bank Burrill & Co.


The money can come with strings attached, however. Sometimes hedge funds sell their shares immediately to lock in a quick profit, which depresses the stock price, potentially causing public investors to believe the company is in trouble. Some stock offerings are followed by bursts of short-selling, as word of the discounted deal spreads to traders who smell blood at a struggling company and go in for the kill. And sometimes, stake-holding hedge funds aren't content to sit idly by as a company struggles. They might object publicly and make other moves to undermine management.

Most biotechs know the risks to public shareholders, and yet they proceed with PIPEs and other types of private placements anyway, in the belief that their scientific breakthroughs will one day create shareholder value. Consider Novavax Inc. (NVAX ) of Malvern, Pa. On Mar. 21, it sold $38 million worth of stock at a 12% discount to 15 investors, most of which were hedge funds, to finance the company's development of an avian flu vaccine. Two days later, the stock tanked 12%, to a level just a penny below the discount price offered to the investors, before gaining back 3% by Mar. 28. Rahul Singhvi, Novavax' CEO, says he doesn't know why the share price fluctuated so. "We had to get money," says Singhvi. "We have such good prospects for the avian flu vaccine. As long as we have financial resources and we can do what we say we can do, the stock will ultimately do well." Hedge funds, he says, "are a necessary evil."

But are they so evil? Some experts argue that hedge funds are the perfect white knights for biotechs, whose financial prospects are so unpredictable. Clinical trials fail. Investor anger grows. Executives seek more money for research and development. Accusations are traded back and forth. "[Biotech] lends itself to speculation," says Michael M. Membrado, a New York attorney who advises early-stage companies on private placements. "The funds in private placements are in the business of speculation and do well in that arena."

The allure of hedge fund money is so strong that it seems to be enticing many biotech companies to go public earlier than they otherwise might, experts say. Some small startups that can't attract enough investment banking interest to pull off an initial public offering are even merging into shells of failed public companies to raise funds. "This is a big trend that we haven't seen before," says Alan G. Walton, a general partner at Boston-based VC firm Oxford Bioscience Partners. He estimates that 40 biotechs will reverse-merge into shell companies in 2006, up from 28 in 2005, and that 90% of the money raised in this fashion comes from hedge funds.

Given the risks they're assuming, some hedge funds say their occasional decisions to sell a biotech company's stock right after they have helped it to raise money makes financial sense. "You get into situations where a stock hasn't gone up, or has gone slightly down, and a company comes back and says, 'I need more money,"' says Mark A. Angelo, founder and president of hedge fund Cornell Capital Partners in Jersey City. "So you say, 'I'll give you the money, but I'm going to sell what I already have because I don't have endless amounts of capital."'


Biotech CEOs understand this reality. In fact, some aren't even worried about short-selling. "I can't lose sleep over people shorting my company's stock," says Vijay B. Samant, CEO of San Diego-based biopharmaceutical company Vical Inc. (VICL ), which raised $22.6 million through a private placement last October. "I just think of how I can keep my program growing and creating good news. Shorting the company's stock is irrelevant."

Other CEOs are even signing on to deals that could end up giving hedge funds big chunks of their companies if their share prices plummet. Last fall, stem cell researcher and developer Advanced Cell Technology Inc. (ACTC ) raised $18 million by agreeing to sell to investors a convertible debt security that the Alameda (Calif.) company might have to pay back in stock or cash in the next three years. "The [deal] in some circles would be considered toxic," admits CEO William M. Caldwell IV. But "we have confidence in what we're doing. It was a lot of incentive for investors to come into [what] in our case is a developing-stage company."

Still, plenty of CEOs see hedge funds as a nuisance. Chiron clearly isn't enthused about its dealings with ValueAct Capital. And Ontario-based Biovail Corp. (BVF ) has filed suit against a research company it alleges works in conjunction with short-selling hedge funds to drive share prices down. Biovail shareholders on Mar. 24 filed a class action.

Even biotech darling Genentech Inc. (DNA ) in San Francisco, which boasts proven products and strong revenues, is wary of hedge funds. CEO Arthur D. Levinson lost his cool when a hedge fund manager seemed intent on shaking up the company's recent daylong meeting in New York for investors and Wall Street analysts. Thanks in large part to its blockbuster colon cancer drug Avastin, Genentech's stock has been soaring. But during a question-and-answer session, the hedge fund manager, Howard Flinker of Flinker & Co. in New York, said a physician acquaintance "heard that deaths from Avastin are higher than what recent publicity says." Levinson shot back: "Are you with a hedge fund?" Flinker answered yes.

But he pointed out that he didn't even own Genentech shares. So what was Flinker doing at the meeting in the first place? He declined to comment.

By Emily Thornton and Arlene Weintraub, with Susan Zegel in New York

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