Q&A with Mike Perrone, Baird Biotech Specialist

The biotech sector still faces an uncertain future and macro challenges that aren’t easily overcome, but a recovery could be in store in 2023. What will it take to get biotech on solid ground once again and which sub-sector will be in the best position to outperform for investors? Mike Perrone, CFA, Biotech Specialist for Baird, shares his perspective.

Q: What is your outlook for the biotech sector in 2023 from both a capital raising and general trading perspective?

Unfortunately we are in a macro-dominated market and the trajectory of the biotech market as well as the pace of recovery in the biotech capital markets will largely be dependent on actions by the Federal Reserve. My expectation is that the recovery is likely to begin once investors see a slowing in the magnitude of rate hikes, will improve further when the Fed stops hiking altogether, and will accelerate as rate cuts are implemented. Healthcare tends to perform relatively well during periods of economic slowdown or recession as the sector is regarded as acyclical/defensive, and in recent months we have seen positive inflows into healthcare broadly given the current weak economic backdrop. As investors get greater visibility into the Fed pivot, those inflows will likely move to more speculative areas of healthcare with longer-dated cash flows, namely pre-commercial biotech. As the overall biotech market recovers, the capital markets will also begin opening, as the publicly traded biotech companies see an opportunity to raise capital at higher valuations and investors gain more confidence in the health of the capital markets. Putting a timeline on all of this is extremely difficult, though with most economists calling for a 50 bps Fed hike at the December meeting, down from the recent 75 bps hikes we’ve seen at the last few meetings, so we could see the first step in the recovery near-term. Inflation data and the speed/depth of the economic pullback will largely determine the pace of the recovery from there. While 2022 is not in the books yet, the XBI is currently underperforming the S&P500 YTD, which would mark the second straight year of underperformance for the XBI, something that has never happened in the 15 years the index has existed. A third straight year of XBI underperformance seems unlikely, especially if the recovery scenario laid out above plays out at some point in 2023.

Q: Which biotech sub-sectors do you think will outperform for investors in the new year?

Perhaps the most impactful event in biotech in 2022 was not a large deal or major clinical readout, but rather the passage of the Inflation Reduction Act (IRA). One portion of the bill gave Medicare the right to directly negotiate drug pricing on select small molecules after 9 years and select large molecules after 13 years. That means that drug companies will be able to maintain higher pricing for large molecules/biologics for four years longer than for small molecules, a big enough delta to incentivize the development of large molecules over small molecules. We’ve already seen some pharma and biotech companies cite the IRA as a reason for culling some small molecule programs. With the biopharma industry already pushing back on that portion of the bill, it is possible that the most onerous provisions get watered down or eliminated before they would take hold staring in 2026, but if the bill remains unchanged, I would expect companies developing large molecules and biologics to outperform those developing smaller molecules. While difficult to break these into sub-sectors given large and small molecules can each be used to target a number of overlapping disease states, this would generally favor the development of vaccines, cell and gene therapies, and immunological products over targeted-oncology drugs.

Q: How are private biotech companies that were planning to go public handling the current closed IPO market?

While some high-profile private biotech companies with well-known management teams and strong venture backing were able to enter the public markets in 2022, largely on the back of insider heavy deals, the IPO market is likely to remain difficult to access for the vast majority of private biotech companies until conditions improves. For those that are unable to go public near-term and who don’t have enough capital to achieve their next major catalyst, options typically include some combination of raising another private round largely through existing investors, belt tightening, and accessing sources of alternative capital such as licensing deals or the venture debt markets. Other more transformative options include reverse mergers with a public shell or a SPAC (Special Purpose Acquisition Company). While all of these options have some additional costs and risks compared to a traditional IPO, if done correctly they allow the company to stretch their cash runway and continue to develop their most advanced assets in hopes that a better financing backdrop emerges in the future.

Mike Perrone, CFA
Mike Perrone is a Managing Director and Baird’s Biotech Specialist. Mike joined Baird in 2010 and spent more than 10 years in Institutional Equity Sales where he focused on developing relationships with healthcare funds with a specific focus on biotech investors. Prior to Baird, Mike spent five years in pharmaceutical sales with Johnson & Johnson, where he worked primarily in the Ortho-McNeil Neurologics division and was part of the company’s Management Development Program. He received a Bachelor of Arts degree in Government and a Bachelor of Science degree in Science Business from the University of Notre Dame, and an MBA with concentrations in Finance, Accounting and Strategic Management from the University of Chicago. He is a Chartered Financial Analyst.