China's Innovative Drug Sector Faces Tough Choices Amid Capital Winter

Editor’s Note: This article is republished from PharmaCube, authored by He Mu. Republished with permission by VCBeat.

“The cold wind cuts like a knife, using the earth as its chopping block and all living beings as its meat. Snow flies across ten thousand li, turning the vast sky into a great furnace that melts all creation into silver.”

This is the opening passage of Gu Long’s *Little Li’s Flying Dagger*. Unlike internet giants, the founders of China’s emerging biotech companies are predominantly scientists, few of whom are likely avid readers of wuxia novels. Nevertheless, if they were to read this passage today, they would likely feel an immediate resonance with its chilling undertone.

All industries are weathering a capital winter, and the pharmaceutical sector, which enjoyed immense prominence in the past two years, has not been spared; indeed, it has felt an even more biting chill than other sectors.

Since the somber departure of “Uncle Bi” mid-year, bad news in the pharmaceutical sector has come one after another. The Hong Kong-listed biotechnology sector, initially held in high regard, saw emerging stars such as Ascletis and Hua Medicine break their IPO issue prices, with Innovent Biologics being the only one struggling to hold on. The A-share pharmaceutical sector suffered successive blows from policy changes: under the “4+7” volume-based procurement program, not only did Lepu Medical lose its bid, but even Betta Pharmaceuticals and Tigermed, which were not directly involved in the bidding, saw their stock prices hit the daily limit down. WuXi AppTec was embroiled in a scandalous controversy; gene testing became associated with He Jiankui, subjecting BGI Genomics, valued at RMB 20 billion, to widespread mockery; Raas Blood Products, a highly volatile stock, saw its market value halved. Among companies with market capitalizations exceeding RMB 100 billion, only Hengrui Medicine remained standing, having briefly touched a valuation of RMB 300 billion in the first half of the year. If even these blue-chip stars fared so poorly, there is little need to discuss the rest.

With the secondary market in such a dismal state, the primary market can hardly remain unaffected. Upstream investment institutions are facing a fundraising drought, while domestic pharmaceutical companies are struggling to keep their own heads above water. Downstream exit channels are blocked: Hong Kong-listed stocks are breaking their issue prices, the U.S. Nasdaq is trending downward, and projects such as IDO and Sting are failing with alarming frequency. To make matters worse, the trade war has added to the chaos, leading to tighter restrictions on U.S. IPOs for Chinese companies. As a result, entrepreneurs have suddenly found that the investment institutions they face have changed dramatically: those they haven’t met are hard to schedule; those they have met have grown cold; those who expressed interest in issuing term sheets have changed their minds; those who issued term sheets have lowered valuations; those who signed term sheets have slowed down the process; and those who signed share purchase agreements have backed out of the deals.

Compared with new drug R&D companies, CROs seem fortunate, after all, they have cash inflows. However, are CROs truly that optimistic? When domestic pharmaceutical companies experience shrinking performance, when new drug R&D companies face a funding drought, and when clients are short of money, who will pay for new drug development? Not to mention that the "4+7" volume-based procurement has completely changed the project initiation logic for generic drugs. The approval documents and technical assets held by some CROs have significantly depreciated, and even CROs themselves are encountering financing difficulties.

Next door, the TMT sector squandered cash recklessly for years, leaving behind a shambles—not to mention outliers like ofo. Yet a careful review of the myriad developments among China’s innovative drug companies in recent years suggests they may not be much more innocent than their TMT counterparts.

Since the NASDAQ listings of BeiGene and Hutchison China MediTech in 2015, enthusiasm for new drug development within China’s investment community has surged, with substantial capital flooding into the sector. Companies from diverse backgrounds—including internet, real estate, department stores, and mining—have pivoted to invest in pharmaceuticals. Conversations are dominated by buzzwords like PD-1 and CAR-T, perceived as more prestigious than internet-era jargon such as “platforms,” “closed loops,” “ecosystems,” and “O2O.” Scientists have suddenly found their research value skyrocketing. Across both industry and academia, and among returnees and domestically trained researchers alike, word has spread rapidly that there is an abundance of naive capital eager to invest.

Thus, by modifying a few functional groups and amino acids, one can claim to be Best in Class;

Thus, one or two individuals from the R&D departments of foreign pharmaceutical companies would select a few drug candidates and claim to be among the global top three.

Thus, overnight, more than a dozen CAR-T companies emerged, with each founder claiming to have engaged in cordial conversations with Carl June.

……

It is not a bad thing for the industry to be in the spotlight, as it can attract broader social resources and attention. Even if some unprofessional or semi-professional companies are involved, there is no need for excessive concern. As long as the industry remains healthy, valueless companies will eventually be eliminated, while valuable ones will inevitably rise to the surface in the long run.

However, the industry’s troubles truly began when even genuine professionals became swept up in the frenzy, allowing expectations around valuations and financing to detach from reality.

In recent years, China’s pharmaceutical innovation sector has indeed seen the emergence of a cohort of world-class talents with capabilities and visions spanning both China and the United States. These individuals have begun to establish their entrepreneurial ventures domestically. With the support of capital, they are poised to achieve significant success in due course.

In recent years, innovative drugs in China have been excessively hyped by capital. As a result, many companies have developed increasingly inflated expectations regarding corporate valuations and financing, which is not a positive development. It is important to recognize that innovative drug R&D is a relay race that requires steady, step-by-step progress. Angel investors, venture capital (VC), private equity (PE), the secondary market, and Big Pharma each contribute value at their respective stages. Although there may be occasional fluctuations, valuations generally do not deviate significantly from fundamentals. Consider this: if pre-clinical assets were valued at Phase II levels, and Phase II assets at post-market levels, who would ultimately bear the burden when the final stage arrives?

Regrettably, such scenarios have become all too common in China’s innovative drug sector over the past two years. Many domestic innovative pharmaceutical companies boast pipelines that fall far short of their NASDAQ-listed counterparts, yet their valuations are already several times higher. Many founders, being returnees from overseas, recognize that this fervor is largely irrational; for instance, they would laugh at the notion of Hengrui Medicine’s market capitalization surpassing that of Takeda and Teva. However, when faced with similar situations involving their own companies, many choose to turn a blind eye. Such misalignments may be tolerable during a bull market, as there are always buyers willing to take over. But now that we are in a capital winter, it will likely be far more difficult to sustain this game of inflated valuations.

Are High Valuations Really as Desirable as They Seem? Not Necessarily. Unless the intention is to cash out and exit immediately after securing the funding, the value enhancement brought by high valuations remains nothing more than an illusion—like flowers in a mirror or the moon reflected in water.

ofo’s valuation did soar, but apart from Zhu Xiaohu, who exited during the liquidation, neither the founders nor the investment institutions reaped any significant benefits. Most founders of innovative drug companies are scientists driven by a sense of mission: “I want to develop this drug and bring it to market.” Yet, without even securing an Investigational New Drug (IND) application approval, they insist on valuations of RMB 300–500 million and refuse to budge. Ask yourself honestly: Would any VC firm or Big Pharma company in the United States accept such a valuation?

Some founders say: “My insistence on valuation is primarily to maintain control of the company and facilitate its better development.” Let’s run the numbers. Suppose a founder currently holds a 40% stake in a company seeking RMB 30 million in financing. If the pre-money valuation quoted by investors is RMB 150 million, but the founder insists on RMB 200 million, how much does the founder’s post-financing ownership percentage differ between these two valuations? In the former case, it would be 33.33%; in the latter, 34.78%. You read that correctly: even with a one-third increase in pre-money valuation, the difference in the founder’s post-financing ownership stake is just over one percentage point.

By clinging to high valuations, especially during a capital winter, what might be missed? Less capable firms lack funds, while top-tier investors, even with capital, are exceptionally cautious, leading to diminished investment appetite. Insisting on high valuations at this juncture will either scare off investors from the outset or ultimately result in a reluctant breakdown of negotiations. However, enterprises cannot operate without funding and must continue their search. The market outlook for the coming year is likely to be even less optimistic. Such an approach delays funding by at least three to five months, but more significantly, it risks missing crucial development opportunities. After all, industry valuations have already declined compared to six months ago; on what basis can one assume that 2019 will be more optimistic than the present?

I once worked at an IVD company that had positive cash flow and appeared more optimistic than new drug R&D enterprises. However, it ultimately rejected an investment because the two parties failed to agree on a valuation between RMB 150 million and RMB 200 million. A year later, while its peers that started at the same time are now planning for an IPO, this company is struggling even to pay salaries.

Cycles are normal fluctuations in the economy. As Guan Zhong stated, “Only the wise do not struggle against poor harvests; they understand the cycles of abundance and scarcity, taking from surplus to replenish deficits.” Over centuries of Western financial history, economic cyclical fluctuations have also been the norm. Even today’s highly celebrated internet giants suffered from the bursting of the dot-com bubble in the early 2000s after the frenzied speculation of the late 1990s: Sina’s stock price fell below its IPO price, Sohu’s share price plummeted from $13 to $0.80, and NetEase lost 90% of its market capitalization within a year. The entire internet industry did not recover its vitality until around 2005.

Many people compare China’s innovative drug industry to the internet sector of the 1990s. If this analogy holds, then the current capital winter facing innovative drugs is akin to the bursting of the dot-com bubble in 2000. The downturn itself is not fearsome; after the chaff is separated from the wheat, truly outstanding companies will inevitably rise from the ashes like a phoenix. However, for enterprises seeking to survive this winter, it is essential to maintain a clear-eyed understanding of the environment. Secure reliable investment institutions, lower expectations, prioritize cash flow, live within your means, and advance step by step. Above all, avoid becoming immersed in the illusory valuation bubbles of the past.

One wonders whether Dai Wei, the once unyielding figure who stood firm against capital pressures during ofo’s heyday, has ever read The Catcher in the Rye. If he has, then as he now faces long queues of customers demanding deposit refunds, he might recall this line: “The mark of the immature man is that he wants to die nobly for a cause, while the mark of the mature man is that he wants to live humbly for one.”