Biotech's Unlikely New Pal

Can private equity manage its big risks and far-off returns?

In an era of $45 billion private equity deals like the one for energy giant TXU Corp. (TXU ), those worth less than $1 billion rarely merit a mention. Yet a $670 million deal on Feb. 22, led by New York private equity firm New Mountain Capital, is a milestone in the cash-starved world of biotech. The foray, which merges Seattle-based Ikaria Inc. with a spin-off of Germany's Linde Group Inc., marks one of the biggest moves by private equity in the sector—and signals that more may be in the works.

At first blush, private equity and biotech make for an odd marriage. The biotech industry is famous for unstable cash flows and massive research-and-development budgets that produce many more flops than blockbusters. Private equity players aren't known for their patience, either, and successful drugs often take decades to come to market. No amount of financial engineering can speed up the science. Still, some private equity players think they can earn big returns in the sector, even though it means investing in R&D. Says Bryan Roberts, managing general partner at Venrock Associates, a Menlo Park (Calif.) venture capital firm involved in the Ikaria deal: "[Private equity is] buying into the vision of biotech."

Part of that vision may be recognizing a potential exit strategy: Big Pharma buying their biotech assets. The big boys are running head first into a crisis as more than 70 major drugs lose their patent protection in the next few years, including Pfizer's (PFE ) cholesterol reducer Lipitor and BristolMyersSquibb's blood thinner Plavix. That could leave a potential hole of up to $100 billion in lost sales by 2011. So some stalwarts are making huge bets on tiny biotechs. Last October, Merck & Co. (MRK ) paid $1.1 billion (a 100% markup from market value) for Sirna Therapeutics Inc. (MRK ), a public company with just $5 million in sales. Its most advanced project is still in early testing.

So far private equity is going after businesses that have a steady cash stream or finding ways to create new flows. That's why New Mountain fused Ikaria, a pure research outfit working on treatments using gasses such as nitric oxide, with a Linde unit called INO Therapeutics. INO has sales of $160 million from a product that helps critically ill newborns breathe—money that will help the newly combined company offset the cost of developing other therapeutic gasses.

Another play: finding outfits that provide services to biotech scientists and thus don't have huge research tabs. On Feb. 13, New York-based Avista Capital Partners paid $210 million for BioReliance Corp., a unit of Carlsbad (Calif.)'s Invitrogen Corp. (IVGN ) that provides safety testing and other services for 600 biotech and pharma outfits. "They're doing critical functions for other companies but not taking on the product risk," says Thompson Dean, a managing partner at Avista.

Such biotech treasures could be plentiful for private equity. Stephen Evans-Freke, managing general partner at Celtic Pharmaceutical Management, a private equity firm specializing in the sector, estimates that half of biotech's 300-odd publicly traded companies have a market value of less than $250 million—a size that makes it tricky to raise extra cash. On top of that, there are 1,000 or so privately held biotech enterprises, many of which have been struggling to pull off a public offering since the 2001 market crash. "A number of companies are all dressed up for an IPO party," says Evans-Freke. "Yet there's no party to go to."

With little respect from the public markets these days, some biotech companies are welcoming private equity. Australia's Peptech Ltd. banked $17 million in sales in 2006 and figures royalties from its technologies should rev up revenues by $100 million more over the next few years. But while its stock is languishing on the Sydney exchange, Peptech has piqued the interest of some U.S. private equity firms. Says its chief executive, Dr. John C. Chiplin: "If the public markets won't value Peptech fairly, maybe the private markets will."

By Arlene Weintraub

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