Biotech disrupters shake up the drug discovery business

In the second of a four-part series on healthcare, we look at how competition between Big Pharma, Chinese biotech and Silicon Valley is transforming the landscape of drug discovery.

9 minute read

microscope with lab glassware, science laboratory research and development concept

When Craig Chase was diagnosed with a rare form of blood cancer, his doctors in the US gave him little hope of recovery.

After three years of unsuccessful treatment, Chase learned about a Chinese biotech firm named Genscript, which was building on advances in Chimeric Antigen Receptor T-cell therapy (CAR-T), a leukaemia treatment, to fight a wider range of cancers. Taking a chance, he travelled to China. In a hospital in Nanjing, Chase’s cells were removed and re-engineered to combat the disease, before being reinserted into his body. Within six weeks his cancer was cured.1

Chase’s remarkable story illustrates the way high-tech treatments are reshaping the landscape of global medicine. Increasingly, innovations in drug discovery and treatment are the work of smaller biotech companies – many of them based in China – rather than the US and European pharmaceutical giants that were once relied upon to break new ground.

According to a recent report from consultancy Deloitte, R&D returns among large-cap pharmaceutical companies fell to 1.9 per cent in 2018, the lowest level in nine years. This decline is partly due to the capital-heavy nature of the research involved: it now costs an average of US$2.1 billion to bring a new drug to market.2 As patents run out and political pressure builds over drug pricing and the US opioid crisis, Big Pharma faces squeezed revenues.

At the same time, smaller, specialist biotech companies are outperforming. Despite even higher development costs than the pharmaceutical giants, these firms are achieving average returns of 9.3 per cent on new assets, as they target lucrative niches.3 Many are building on recent advances in genomics, focusing on treatments for rare genetic diseases that are much better understood since the human genome was mapped in the early 2000s.

So, as innovation in medicine becomes more globally dispersed and unpredictable, how can investors in the sector best position themselves?

China’s biotech revolution

The industry is using its understanding of the human genome to drive better-targeted drug discovery

“There’s a lot of innovation happening right now, with the industry using its understanding of the human genome to drive better-targeted drug discovery,” says Stephanie Niven, global equities fund manager at Aviva Investors. “But most of this activity is occurring among smaller biotech companies, which are now much better positioned to take these discoveries through to commercial launch than they were in the past. It’s one reason I’m not bullish on big pharma at the moment.”

The Chinese biotech sector is seeing a particularly notable wave of innovation. China is now the second largest pharmaceuticals market globally, behind the US. Although generics currently predominate – between 2006 and 2015, China only introduced 19 new drugs to market, compared with 196 in the US4 – this could be set to change.

Niven argues China is fast transitioning from a ‘copycat’ market in new drugs to a ‘fast-follower’ market, with Chinese companies snapping at the heels of Western counterparts in devising new treatments. It will not be long before more are developing entirely original assets and treatments, like Genscript. Beijing-based biotech firm BeiGene, which specialises in the development of oncology molecules and has poached staff from cutting-edge US rivals such as Genentech, is a likely candidate for future innovations, with promising PD-1 inhibitors (a front-line cancer treatment) in its pipeline.

There are two major drivers of innovation in Chinese biotech. The first is data. Because China has looser rules surrounding sharing and use of patient information, Chinese firms have access to far more data than their Western counterparts, while rapid advances in artificial intelligence (AI) are enabling them to sift it for patterns.5

The second is government funding and regulation. China is pumping billions into research and development: total R&D spending topped US$291 billion in 2018, or 2.18 per cent of GDP, and the government is targeting higher spending of 2.5 per cent of GDP this year.6 It is seeking new treatments for diseases such as diabetes, which are becoming prevalent as the population becomes older and more affluent; Beijing’s latest economic plan commits to building 10-20 life-science parks dedicated to biomedicine by 2020.7

Meanwhile, regulatory changes are incentivising companies to focus on new treatments. The government has introduced a centralised procurement process for drugs known as 4+7 bulk tendering (after the number of cities in which the pilot scheme is taking place), which has lowered prices for the most-common treatments. This is promoting a ‘two-tier’ market in which generic drug-makers focus on volume and companies with cutting-edge research teams chase higher margins.

“The winners from this process will be innovative drug-makers, as the price cuts for new drugs won't be as severe as those for generic drugs,” says Flora Chang, credit analyst at S&P Global Ratings in Hong Kong.

The system now favours the first-mover of an innovative drug or biosimilar if they are priced competitively

“Thanks to improving patent protection, the system now favours the first-mover of an innovative drug or biosimilar if they are priced competitively. Reforms like the expedited drug approval process and inclusion of innovative drugs on the national drug list are all geared towards this. On the other hand, the 4+7 bulk tendering should lead to consolidation among generics firms. Newly rising biotech firms should benefit the most from the policy tailwind and it has become easier for them to get funding over the past two or three years,” Chang adds.

The intellectual property regime may be improving, but IP protection still lags behind the US. This may actually give Chinese firms the edge over their American rivals in drug discovery; the academic Mariana Mazzucato has argued that too-rigorous patent enforcement and extension is a barrier to innovation in the pharmaceutical industry.8

Big pharma strikes back

Losing ground in innovation, western pharmaceutical multinationals are seeking a foothold in the fast-growing Chinese market. British-Swiss multinational pharmaceutical company AstraZeneca recently invested in the International Life Sciences Innovation Park in Wuxi, southeast China, a government-sponsored hub for biotech research, hoping to gain early visibility into new discoveries.9

Other firms are forging partnerships with Chinese companies that have track records in drug development. Shortly after Craig Chase’s cancer treatment made headlines around the world, Johnson & Johnson announced a US$350 million partnership with Genscript to share the costs and profits of CAR-T treatments in the US and China.10

As well as tapping into the Chinese market, big pharmaceutical companies have sought to acquire smaller biotech firms at home as a way of replenishing their drug pipelines. A wave of M&A has swept the US pharma industry as a result: in January, Eli Lilly acquired Loxo Oncology, which develops selective medicines for “genomically defined” cancers, for US$8 billion. And five months later, Roche agreed to pay US$4.8 billion for Philadelphia-based start-Spark Therapeutics, a specialist in gene therapies for conditions such as haemophilia (although completion of the deal has been held up due to regulatory concerns).11

For existing investors in these companies, blockbuster acquisitions of this kind would have led to outsized returns: shares in Spark Therapeutics leapt more than 120 per cent in late February when news of Roche’s interest first broke, according to Bloomberg data.

Concentration risk

Nevertheless, investing in small biotech can be risky. Not all biotech firms in the US or China are trailblazing innovators and new drugs may fail to make an impression.

Take antibiotics. Despite attracting financing from investors, governments and charities concerned about the rise of ‘superbugs’, biotech firms specialising in antibiotics are struggling; partly because they lack the marketing budgets to commercialise new drugs and partly because hospitals are reluctant to pay more for antibiotics with niche applications. Such problems led to the demise of US biotech start-up Achaogen, which filed for bankruptcy in April.12

This points to a key problem with small biotech: concentration risk. Many drugs fail at the clinical trial stage and given that these companies tend to have only a few assets in their portfolio at any one time, a failure could be catastrophic for their businesses. Transparency is an issue, especially in China, where companies like Genscript have been accused of making exaggerated claims for the efficacy of their treatments (the company denies this).13

Biotech valuations in China are relatively high, and investors’ ability to judge whether a new drug is going to be successful or not is very low

“Biotech valuations in China are relatively high, and investors’ ability to judge whether a new drug is going to be successful or not is very low. All of these companies will say that phase one and phase two testing is going well, but your ability to analyse it and understand their prospects with the data you're given is quite poor,” says Will Ballard, head of emerging market small-cap equities at Aviva Investors.

There are other, less hazardous ways for investors to access the growth of innovation in biotech than investing directly in the companies themselves. One route is to target companies that help smaller firms to capitalise on their R&D breakthroughs through outsourcing services.

“Outsourced providers of clinical trials – clinical research organisations (CROs) – have been growing fantastically well on the back of the success in small biotech. Smaller biotech firms depend much more heavily on outsourcing businesses than big pharma companies, which have the capacity to run trials themselves, so investing in CROs is a good way to gain exposure to exciting innovations,” says Niven.

“Contract development and manufacturing organisations (CDMOs) are also performing well – these are companies that manufacture drugs on behalf of the small biotech firms that discover the assets but don’t have the capability to produce them in-house.”

Big tech vs big pharma

Over the longer term, technology could enable large-cap pharmaceutical firms to regain an advantage in drug discovery. The likes of Glaxo and Roche are hiring thousands of data scientists as they look to harness developments in AI to give them an edge over smaller firms.

AI can be particularly useful in identifying suitable patients for clinical trials as companies concentrate on ever-more specialised genetic niches, potentially reducing the capital intensity involved in drug discovery. But some AI specialists argue the business models of big pharmaceutical companies are not conducive to new breakthroughs, as they are geared towards developing and commercialising existing drugs.

The CEOs of most of the big pharma companies, they're not scientists; they come from the finance department or the marketing department

“If you look at the CEOs of most of the big pharma companies, they're not scientists; they come from the finance department or the marketing department,” said Demis Hassabis, founder and CEO of DeepMind, an AI-focused technology company owned by Alphabet. “What does that say about the organisation? It means that what they're going to do is try and squeeze more out of what has already been invented, cut costs or market better, not really invent new things – which is much more risky.”14

Hassabis is not an uninterested observer: technology companies are targeting drug discovery as a lucrative new market. At a conference in Mexico in December 2018, DeepMind demonstrated its algorithms could beat scientific experts in predicting how proteins would develop. While further progress is needed, the tool could eventually be used to identify new drugs. An arm of Facebook’s machine learning division is also working on protein sequencing.15

Aware of AI specialists’ strengths in this area, pharmaceutical companies are rushing to forge new alliances. In April 2019, AstraZeneca agreed a partnership with BenevolentAI, a UK-based start-up that specialises in identifying potential new treatments for kidney disease.16 This follows a 2016 tie-up between IBM Watson and Pfizer to collaborate on immune-oncology research.

Just as with the threat from innovative biotech firms, big pharma is responding to the AI-powered insurgents by following a well-rehearsed strategy:  if you can’t beat ‘em, join ‘em.

References

  1. ‘Healthcare: Cancer breakthrough leads China’s biotech boom,’ Financial Times, April 2018
  2. ‘Unlocking R&D productivity: Measuring the return from pharmaceutical innovation 2018,’ Deloitte, 2018
  3. Ibid
  4. World Health Organisation data
  5. ‘China’s great leap forward in biotech,’ Nikkei Asian Review, October 2018
  6. ‘China’s funding for science and research to reach 2.5 per cent of GDP in 2019,’ South China Morning Post, March 2019
  7. ‘Biotech booms in China,’ Nature, January 2018
  8. ‘Big Pharma is hurting innovation,’ The Washington Post, October 2018
  9. ‘AstraZeneca leads in the development of a new International Life Science Innovation Park in China,’ press release, April 2019
  10. J&J press release, December 2017
  11. ‘Roche’s $5bn Spark acquisition held up as regulators seek details,’ Financial Times, June 2019
  12. ‘Antibiotics biotech firms are struggling,’ The Economist, May 2019
  13. ‘China’s Genscript jumps after denying faking allegations,’ Financial Times, September 2019
  14. ‘Inside DeepMind's epic mission to solve science's trickiest problem,’ Wired, August 2019
  15. ‘AI drug hunters could give big pharma a run for its money,’ Bloomberg, July 2019
  16. AstraZeneca press release

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