For these investors, going public is more important as an avenue for achieving a liquid exit and generating returns for their investors. Despite Lord Hill’s good intentions, reforms supporting long-run development of the entire biotech ecosystem in the UK are far more important for keeping biotech companies here.
Dual-class share structures are irrelevant to most biotechs
The Hill review recommends further developing dual share-class structures – ostensibly to “provide a way for the founder of the company to continue to be able to execute their vision”.
Tech founders are integral to their company’s prospects of achieving product/market fit, and so their control of the business is critical for value creation. This is why dual-class share structures are so attractive for them. For example, Will Shu looks set to take advantage of this in Deliveroo’s imminent listing which was announced not 24 hours after the review’s release.
By contrast, biotech companies’ value is far more asset/IP-centric. Value is created by de-risking products through a structured regulatory process that leads to marketing approval – and ultimately revenue. Given the risks in this process, venture capital is a major source of funding; VCs will therefore own most of the shares when a company lists. Further, professional management teams with specialist skills are required to translate biotech ideas into medical products (eg with manufacturing challenges being critical). Biotech founders therefore typically only have a small percentage of the cap table, making dual-class structures essentially irrelevant.
Rebranding is a poor substitute for long-term biotech ecosystem support
Inclusion in market indices is attractive for any company and its shareholders: the fact that index-tracking funds and many active managers then need to buy your stock is highly value-enhancing. Only companies in the Premium listed market segment are eligible for the UK FTSE index series, but many smaller companies can’t afford to meet the requirements (nor the fees). Lord Hill identifies this as a disincentive for smaller companies to list in the UK. He therefore proposes a rebrand that might allow companies to accept voluntary guidelines demonstrating their high standards, encouraging index providers to include them.
However, for the biotech sector, this rebranding is unlikely to attract (as Lord Hill puts it): “An increasingly large cluster of like-minded companies that would generate its own momentum and also attract others to join [which] would lead to greater research coverage, additional liquidity and improved pricing.
The US biotech ecosystem is orders of magnitude larger in terms of research coverage, liquidity, number and size of companies, funding sources and M&A opportunities. Getting to critical mass is a multi-decadal process and will require far more government funding for the sector. Even in the leviathan US biotech market, the state remains by far the largest supporter of biotech R&D. On this front, the UK is mostly moving in the wrong direction and rebranding a market segment would be trivial by comparison.
Proposed changes to free-float requirements are one rare bright spot
Current FCA rules require >25 per cent of a company’s shares to be made freely tradable upon listing. Lord Hill’s review recognises this as a major deterrent to going public in the UK. The rule sensibly exists to support secondary-market liquidity, however analysis by the LSE as part of the review indicates little correlation between liquidity and free-float percent across major global exchanges.
Liquidity seems to fall only once free-float gets below 10 percent. Lord Hill recommends decreasing the free-float threshold to 15 percent, alongside increasing the threshold above which institutional investors are excluded from counting towards the free-float (from 5 percent to 10 percent). He also proposes exclusion for locked-up investors for a short period post-listing.
All of these are positive incentives. Given many fast-growing biotechs count institutional VCs as their majority investors, they’ll be thinking about how to manage their cap tables to optimise the listing/exit process from a very early stage. It’s also a big reason for engaging in the pre-listing crossover rounds that bring in a slate of institutional investors. These new investors are seeking a fillip on the listing, and the old investors can achieve a managed reduction in their cap table presence to facilitate their liquidity.
Lockups are good for preventing a rush for the exits upon listing, but typically last no more than six months. Including locked-up holdings therefore makes sense in incentivising listing in the first place.
Eye-catching SPAC proposals risk engendering a race to the bottom
Special Purpose Acquisition Companies (SPACs) have exploded in popularity in recent years. This is partly a result of the vast, ongoing, fiscal and monetary stimulus that has supported substantial financial market liquidity seeking a return in the face of rock-bottom interest rates.
Essentially, Lord Hill does not want London to be left behind in the fierce competition for listing and if this method supplants IPOs elsewhere, then it should be available here too. The review cites the fast allocation of large amounts of capital as the reason for SPACs’ popularity. The risk here is the lower governance burden that this implies. SPACs may well be more attractive to companies that would not be able to withstand the rigour of the IPO process.
If the availability of SPAC vehicles is the main reason a company opts for a particular market, then that exchange could end up self-selecting for lower-quality assets. Yet for biotechs, the ecosystem into which they’re listing is more important than the method, so the vehicle’s availability won’t be enough to stop high-quality companies going to the US in pursuit of greater secondary-market liquidity.
Wider financial ecosystem reforms are more important than changing LSE requirements
Lord Hill concludes with a comment regarding broader reforms that could support an improved UK listing environment. However, they’re not coupled with any explicit recommendations. This is unfortunate, as these factors could play a more powerful role in developing an ecosystem which keeps biotech companies here. The MiFID-II changes that unbundled equity research from trading commissions have led to a significant decline in coverage of smaller companies.
Lack of coverage means investors are less able to make informed decisions jeopardising secondary-market liquidity. Lord Hill rightly recommends that the FCA should prioritise reforms to this regime since a deeper pool of secondary market analysis is crucial for liquidity. Building a UK biotech ecosystem is not just about VCs’ ability to exit. They also need to raise and deploy funds so the next generation of biotechs can grow up here, employ and upskill local talent, support infrastructure investment and generate the home-turf M&A opportunities that are so sorely lacking. Lord Hill suggests allowing direct-contribution pension funds to invest in higher-risk and lower-liquidity asset classes such as venture.
This is one of the best things that could be done for the sector. It would massively diversify the investor base into venture – particularly with a long-term horizon consistent with the often decadal timelines of biotech commercialisation. This would be a game-changer for the job-creation, risk-sharing and retirement-planning goals that were the impetus for the review in the first place.
Finally, a suggestion to offset any post-pandemic increase in corporation tax with “big R&D/investment relief to actively encourage companies to invest more in the long-term” is precisely the sort of direct support that enabled the US to get to where it is. Many of Lord Hill’s recommendations are welcome. However, it’s these latter aspects – less directly related to listing mechanics – that will have the most impact. In the long run, it’s the entire ecosystem that needs to change if biotech companies are to stay.
This blog was originally published in Private Equity Wire 29 March 2021.