Why China's Cooling Innovative Drug Sector Refuses to Lower Valuations

The Bursting of the Innovative Drug Bubble: It May Be Late, but It Will Not Be Absent.

“A four-year-old biotech company in the oncology space is reportedly counting down to its closure.” One day in late March, this statement on WeChat Moments struck a nerve with many, piercing through the veil of silence. It has become an open secret that institutional investors are pulling back from innovative drug development, just one year after such investments were the hottest trend.

Recalling the period when IPOs under Chapter 18A of the Hong Kong Stock Exchange began to break their issue prices, a founder of a new pharmaceutical company noted that venture capital firms, which had once flocked to his door, became far less frequent in their visits. He had left a multinational pharmaceutical corporation where he had served for many years to establish an innovative drug startup several years ago. His 2021 was filled with endless rounds of meetings and receptions. However, after the Spring Festival of the Year of the Tiger, he grew increasingly anxious: on one hand, each step forward in the already launched pipeline required substantial funding; on the other, investors became hesitant and reticent when it came time to make investment decisions.

An investor who has long been engaged in early-stage investment in innovative drugs also confirmed this to VCBeat. This year, a large number of innovative drug projects he had previously invested in have entered Series C and Series D financing rounds. Both he and the founders have clearly noticed that institutional investors have become more cautious and are investing less frequently. Meanwhile, both investors and entrepreneurs have begun to lower their valuation expectations to some extent. “I estimate that valuations have dropped by at least one-quarter to one-third,” said the investor. However, VCBeat later learned that few innovative drug projects in the primary market have actually adjusted their valuations by such a margin; instead, most projects have chosen to wait.

China’s Innovative Drugs Seem to Have Reached Their Most Perilous Hour, But Is That Really the Case?

Professional investors specializing in innovative drugs are feeling the approaching winter just as keenly as the founders of biotech startups. Behind them stand their investment committees. Initially, they continued to scout various innovative drug projects as usual, but after identifying promising opportunities, they encountered unexpectedly greater hurdles in closing deals. “Sometimes, the role of an investment manager is akin to that of a middleman; whether projects sourced on the front lines ultimately secure funding depends on the investment committee’s decisions,” one investor told VCBeat. “It’s quite a passive position.” He further explained that for projects with high valuations, the likelihood of gaining approval from investment committees has now become slim to none.

As the highest decision-making body within a venture capital firm, the Investment Committee (IC) is typically responsible for determining the firm’s capital planning, investment strategy, investment principles, investment objectives, asset allocation, and the overall plan for its investment portfolio. A vertical media outlet once interpreted venture capital as follows: The VC business model is built upon a hierarchy where cognitive asymmetry sits at the top, information asymmetry in the middle, followed by the manifestation of various detailed capabilities in fundraising, deal sourcing, and post-investment management. If investment managers are on the front lines, optimizing the firm’s operational details, then optimizing the top-level cognitive asymmetry falls within the purview of the Investment Committee.

Compared with specific analytical dimensions such as the innovativeness of technological pathways and the popularity of targets, the Investment Committee places greater emphasis on the competitiveness of proposed investment projects in subsequent transactions. In other words, technologies that are not favored in the secondary market are unlikely to gain approval from the Investment Committee. This has been corroborated by the robust performance of the innovative drug sector over the past two years.

In April 2018, the Hong Kong Stock Exchange (HKEX) amended its Main Board Listing Rules by adding Chapter 18A, “Biotech Companies” (hereinafter referred to as “18A”), which allows biotechnology companies without revenue or profits to submit listing applications. More than a year later, the STAR Market opened its doors, with its fifth set of listing criteria aligning closely with Chapter 18A. Together, these developments spurred a wave of listings and financing for innovative drug projects.

For instance, in the inaugural 2021 issue of its “HKEX and Biotech” newsletter, the Hong Kong Exchanges and Clearing Limited (HKEX) noted that despite significant volatility in capital markets due to the COVID-19 pandemic, listings in HKEX’s healthcare sector demonstrated strong resilience and attracted considerable market attention. Throughout 2020, the Hang Seng Hong Kong Listed Biotech Index (up 49.5%) outperformed the Hang Seng Index (down 3.7%). Strong secondary-market enthusiasm has made innovative drug projects appear highly certain in the eyes of investment committees, enabling wave after wave of innovative pharmaceutical companies to secure financing and subsequently go public.

However, novelty alone is insufficient to sustain long-term prosperity. By the second half of 2021, people would shake their heads whenever companies listed under Chapter 18A and the Fifth Set of Listing Rules on the STAR Market—particularly those in the innovative drug sector—were mentioned.

These fledgling publicly listed companies suffer from low stock liquidity. Taking December 27, 2021, as an example, 29 biotechnology companies with the “-B” suffix had trading volumes of less than HK$10 million, among which 11 recorded trading volumes of less than HK$1 million.

Late-stage innovative drug companies have been forced to opt for discounted IPOs. In February 2022, Lepu Biopharma set its IPO issue price at HK$7.13 per share (equivalent to RMB 5.78), which was lower than the RMB 6.70 per share valuation during its Series C financing round less than a year earlier. This move reflects Lepu Biopharma’s urgent need to alleviate cash flow pressures by accepting a discounted listing. Although this marked the first case in the four years since the implementation of Chapter 18A of the Hong Kong Listing Rules where an IPO was priced below the Series C round valuation, many other IPOs over the preceding six months had already resulted in pre-IPO investors ringing the bell at a loss. Meanwhile, the stock prices of numerous other innovative pharmaceutical companies have plummeted, falling back to valuations comparable to their Series B or even Series A financing rounds.

“Primary market financing is actually highly correlated with the secondary market; sentiment transmits very quickly now, and the market has become extremely cold,” another investor told VCBeat. “There is considerable uncertainty across the board, reminiscent of early 2020, with concerns about whether an economic crisis will materialize and how international policies may shift, leading investors to act more cautiously.” In contrast, projects that remain relatively distant from the secondary market—such as synthetic biology, exosomes, gene therapy, and regenerative medicine—are more likely to gain approval from investment committees.

Investments often hit a wall at the final investment committee decision, leading smart investment managers to naturally shy away from innovative drug projects.

“Investors cool down quickly; a sudden setback can dampen everyone’s enthusiasm, while a single piece of positive news can reignite frenzy—this is the nature of investing.” After regaining his composure, this investor candidly admitted that securing financing becomes exceedingly difficult for companies lacking clear commercialization prospects. In fact, as the investment fervor for innovative drugs subsides, more investors are rethinking their methodologies for investing in China’s innovative drug sector. The majority of them told VCBeat that the first half of innovative drug investment has concluded, and the second half is now underway.

“This is a normal pattern in industry and investment development. Only by going through a complete cycle can Chinese innovative pharmaceutical companies and investors become sufficiently professional and mature,” said Song Gaoguang, Partner at Northern Light Venture Capital. In fact, during earlier interviews, many investors told VCBeat that China’s innovative drug sector would enter a period of short-term pain, with some companies lacking differentiation and strong clinical capabilities facing the brink of collapse. Current developments have indeed validated those initial judgments; however, amid the onslaught of the COVID-19 pandemic and the vigorous promotion of biopharmaceutical industries across various regions, the timing of this process was delayed, while its intensity has become more pronounced.

In the second half, investment decisions for innovative drugs will be based on a more comprehensive and multidimensional understanding of project value. For instance, in the past, an innovative drug project would secure a valuation exceeding RMB 1 billion once its product entered clinical trials, and this valuation would at least double upon advancing to Phase II clinical trials. Under the overwhelming emphasis on speed, close scrutiny of the clinical data itself appeared less critical. As the endpoint of the R&D phase approaches, greater weight is assigned to factors such as the pace of regulatory approval and commercialization risks. Truly valuable innovative drugs must demonstrate significant improvements in efficacy and safety in head-to-head comparisons with existing therapies, along with clear clinical advantages and well-defined underlying technological barriers.

An investor told VCBeat that many institutions now only continue to bolster innovative drug projects already in their portfolios, rarely investing in unfamiliar ventures. They require a comprehensive grasp of all details regarding the technology, team, and market of an innovative drug project. In the earlier phase, innovative drug investment was akin to blind men touching an elephant; investors would often commit capital based on just a single aspect. For instance, during the PD-1 investment boom of 2016–2017, investment firms conducted exhaustive searches for similar projects and frequently made investment decisions based solely on a single factor, such as the founding team’s prior industry experience.

The investment logic for innovative drugs in the first half was characterized by rapid follow-on innovation. This involved globally scouting for innovative drugs with prominent clinical value that addressed major diseases (such as cancer), and rapidly replicating these blockbusters in China before patent expiration by making minor modifications to circumvent restrictions. This process gave rise to the VIC model of new drug R&D, which integrates Venture Capital, CROs, and Scientists. At that time, top talent from multinational pharmaceutical companies left to start their own ventures. Investment institutions intervened at very early stages to accelerate new drug development, thereby attracting additional capital and further propelling corporate growth and valuation increases.

The VIC model has given rise to some of the most important companies in the first half of China’s innovative drug development journey, such as BeiGene and Zai Lab, and has tangibly changed the fate of many patients with advanced-stage critical illnesses. In the past, most breakthrough new drugs for severe late-stage diseases were developed by foreign pharmaceutical companies and launched in overseas markets, taking at least 7–8 years before being introduced to China. During this waiting period, only a small number of patients with sufficient means could access these new drugs through gray-market channels, which were rife with irregularities. Innovative pharmaceutical companies operating under the VIC model have compressed the wait time for these life-saving medications to just 1–2 years. Furthermore, these drugs quickly enter clinical practice after approval, becoming both effective and accessible, as exemplified by the PD-1 inhibitors that are currently shouldering significant responsibilities.

However, in the later stages, the VIC model gradually became distorted. At times, R&D had not achieved genuine breakthroughs, yet valuations had risen significantly. More importantly, compared to the number of industry elites waiting to found innovative pharmaceutical companies and institutions eager to invest in innovative drugs, the pool of novel drugs that could be mimicked was far too small, leading to crowded R&D efforts. When a product was still some distance from commercialization, competitors had already swarmed in, vying for limited clinical resources and sales channels. These operational capabilities are precisely the weak points of entrepreneurs operating under the VIC model, necessitating a shift in the approach to new drug development.

Therefore, the current cooling of investment in innovative drugs is actually a transitional process. Perhaps more important than predicting the future is finding ways to endure.

Surviving is no easy feat for innovative pharmaceutical companies. In fact, prior to this, little consideration was given to how such companies could sustain themselves. Over the past decade, founding or investing in innovative drug enterprises seemed to offer only varying degrees of success, with failure being nearly unheard of. “This situation is problematic. China’s innovative drug industry must undergo trials of survival and elimination to learn how to make strategic trade-offs,” said Song Gaoguang. Chinese innovative pharmaceutical companies, having failed to cultivate a sense of risk awareness, must now effectively address two major crises as risks materialize.

First is the cash flow crisis. Prior to product launch, most innovative pharmaceutical companies have very limited sources of cash flow, which can only be achieved by providing specialized technical support and out-licensing their pipelines.

However, amid the crisis, neither of these two paths is a sufficiently viable option. The former is constrained by technical platforms and personnel capacity, making it difficult to achieve scale, while the latter is achievable only by a select few innovative pharmaceutical companies with exceptionally strong R&D capabilities. For instance, in the prospectuses of innovative biopharma companies, we often see descriptions of other business revenues derived from technology licensing; however, amounts ranging from hundreds of thousands to several million yuan are merely a drop in the bucket compared to the hundreds of millions typically invested in R&D pipelines. Truly high-value out-licensing deals for Chinese startup biopharma companies remain exceedingly rare. Previously, RemeGen’s $2.6 billion licensing deal with Seattle Genetics for its ADC drug disitamab vedotin galvanized China’s innovative drug industry. Yet, even for RemeGen, a domestic leader in ADCs, such licensing transactions are not common. Furthermore, Qinhao Pharma’s $282 million out-licensing of ex-China development and commercialization rights for its SHP2 inhibitor GH21 to HUYA Bioscience International, and WellBiologics’ licensing of global R&D and manufacturing rights, as well as exclusive ex-China commercialization rights, for its anti-LAG-3 antibody LBL-007, are both exceptional cases among startup biopharma firms.

External financing is undeniably crucial for innovative pharmaceutical companies, and lowering valuations to secure cash flow seems to have become their only viable option. However, despite the tight financing environment, valuation levels have not declined significantly. “Liquidity in the primary market is relatively poor, so discounted valuations are not yet the norm. Nevertheless, it is virtually unrealistic for the valuations of most projects to surge substantially; any increases are generally kept within a factor of one,” an investor told VCBeat.

Therefore, it is essential for innovative pharmaceutical companies to effectively manage shareholder expectations, as whether valuations decline depends largely on factors beyond the companies themselves. Although excessively high early-stage valuations reflected the heightened expectations and financial interests of investment institutions, survival remains the ultimate imperative. This is not difficult to achieve. In 2021, when financing for innovative drugs was booming, the valuation of Phase I clinical trial projects rose from RMB 300–400 million to RMB 1.2 billion. However, investors told VCBeat that if a company’s core product advanced to Phase II clinical trials, its valuation in subsequent financing rounds could still reach approximately RMB 1.5 billion. In other words, even with moderated expectations, investment institutions would not face losses.

In fact, many investment institutions have noticed the cash flow crisis of innovative drug companies and have begun to proactively lower their expectations. “Of course, many investment firms understand the difficulties faced by these enterprises; they also focus closely on cash flow to ensure that projects continue moving forward.” It is understood that early-stage projects at the pre-A or A round have already seen valuation reductions. For example, a pre-A round innovative drug project originally valued at 400–500 million yuan has lowered its valuation to 250 million yuan for fundraising. However, valuations for growth-stage projects at Series B and beyond have hardly decreased.

An investor stated that in a letter to the founders of portfolio companies at the beginning of the year, he specifically urged them to pay attention to cash flow. “We will do our utmost to help enterprises weather the storm, but it is indeed not easy,” he told VCBeat. He noted that beyond the generally subdued sentiment among investment firms, the actual volume of available capital is also shrinking. In 2018, the National Healthcare Security Administration was established, and its inaugural round of national centralized drug procurement pilots was carried out with great momentum. This led to a significant drop in the prices of generic drugs, directing the focus of both capital and regional governments toward innovative drugs. A substantial influx of cash drove up valuations for innovative drug projects. However, this trend has reversed this year, with industrial parks across various regions placing greater emphasis on outcome-oriented investment promotion.

Another crisis that must be addressed stems from insufficient operational and management capabilities. Although this may seem less critical in the face of life-or-death cash flow pressures, it still demands serious attention. As previously mentioned, most leaders of innovative pharmaceutical companies come from R&D or product backgrounds rather than being seasoned entrepreneurs with extensive business experience. When corporate development deviates from the intended trajectory, they often lack the capability to make sound decisions. Poor trade-offs can further exacerbate cash flow crises. More importantly, for innovative pharmaceutical companies that survive this crisis, maintaining competitiveness amid fierce future market competition requires optimizing management paradigms. This includes ensuring correctness in team integration, financing planning, product portfolio alignment, competitive strategy, and operational efficiency. For those innovative pharmaceutical companies truly poised for significant growth, the current cash flow crisis may well serve as a catalyst for strengthening their operational and managerial capabilities.

Therefore, for some innovative drug companies, the present moment is indeed the most perilous. Yet China’s innovative pharmaceutical sector is adhering to the natural order of growth and embarking on a new chapter.