HBM Healthcare Investments — Strong results show success of strategy

The global healthcare sector has a number of structural drivers underpinning the strong growth of recent years. An increasing understanding of disease processes means many previously fatal conditions can now be treated or managed, but this presents its own challenges; across the world, ageing populations are leading to greater demand for healthcare services, with increasing need for treatment in areas such as Alzheimer’s disease. In addition, there are opportunities for healthcare companies to serve the growing middle class in emerging economies, through the development of lower-cost generic drugs and by widening access to treatments and medicines via the internet. A more accommodative regulatory environment in the US and Europe is helping to get new treatments to market, and providing an environment in which drug companies feel encouraged to innovate.

However, as shown in Exhibit 2 (left-hand chart), while returns from healthcare and biotechnology indices have been strong over the past five years, they have also been volatile. This is particularly true in the more innovative area of biotech, where share prices can rise or fall sharply on binary (positive or negative) outcomes from clinical trials. At the same time (right-hand chart), valuations of biotech companies (based on 12-month forward P/E ratios) are well above those of the broad US equity market, in spite of the recent market correction. Often at negative turning points in stock market cycles, generalist investors – who may have been enticed into healthcare stocks because of their strong performance – retrench into cash, bonds or less volatile equities, which can exacerbate any correction in the sector, although this may provide opportunities for more specialist healthcare investors with a better understanding of the clinical outlook for companies. A further layer of protection from volatility may be afforded by an allocation to unlisted companies, which – while they may be more risky from an operational perspective, as they may be at an earlier stage of development – are not subject to swings in investor sentiment.

HBM Healthcare Investments (HBMN) began life in 2001 as HBM BioVentures, a biopharmaceutical-focused private equity investor. It has been listed on the SIX Swiss Exchange since 2008 and is managed by Zug, Switzerland-based HBM Partners. Over time it has evolved into a diversified portfolio of private and public companies and private equity funds, with holdings from around the world and across a spread of healthcare sectors. While listed companies currently make up the majority of holdings, many of these are companies that began as investments in the private portfolio.

The fund uses the MSCI World Health Care index as a reference benchmark for performance measurement. However, given HBMN’s significant holdings in unlisted companies, the index is an imperfect comparator. Because the private companies are generally only revalued on significant events such as follow-on funding or a major clinical data release, their performance will be less volatile than that of listed holdings. As a further partial hedge against equity market volatility, HBMN has a short position in an ETF following the NASDAQ Biotechnology index, covering c 20% of the listed portfolio.

HBMN’s primary investment objective is to achieve capital growth. However, in line with a number of peers, it recognises that investors favour income as well as growth; as a result, the fund has a high distribution policy, paying out c 5% of its NAV (mainly funded from capital profits) each year.

HBM Partners CEO Andreas Wicki and CFO Erwin Troxler note that value creation continues to be strong among HBMN’s holdings, underpinned by the two recent initial public offerings (IPOs) from the private portfolio (Y-mAbs Therapeutics and Principia Biopharma), as well as a strong pipeline of clinical catalysts in both the private and public portfolios.

The managers expect the pace of investment in HBMN’s private portfolio to pick up, and they are targeting new opportunities of c CHF100m pa over the next few years, in part to replace holdings lost from the private segment owing to a higher-than-expected rate of IPOs and merger and acquisition (M&A) activity in recent years. While HBMN tends to continue to hold companies that move from the private to the public portfolio via IPO (currently c 29% of the listed portfolio by value began as private investments), M&A can mean the fund loses exposure to companies the managers had hoped to hold for the long term. Wicki notes that with many public companies having performed strongly until the recent period of stock market weakness, acquirers tend to get more value from buying smaller, private companies. As such, the managers see what they describe as a normal pace of M&A activity targeting companies in the $1-3bn range, but less activity at the higher end, in spite of companies’ having more available cash as a result of US tax cuts. Wicki attributes this to the boards and management of larger companies tending to feel any potential bid is too low. He gives the example of oncology-focused biotechnology company Tesaro, where a rumoured bid at $150-180 when the shares were at c $140 failed to materialise; following a poor product launch and competitive pressure from a rival ovarian cancer drug with better clinical data, the share price corrected substantially and now stands at c $30. HBMN continues to hold Tesaro, however, as the managers say its long-term clinical prospects remain favourable.

In geographical terms, most healthcare – and particularly biotech – funds are heavily weighted to the US, where the majority of listed healthcare companies are based. While HBMN has a c 75% US weighting, the managers are actively increasing exposure to Asia as part of a well-balanced and diversified portfolio. Wicki describes the strategy as “building a portfolio of Asian champions”, principally through private equity fund investments and co-investments alongside funds, although also via direct investments, such as the recent purchases of Singapore medtech distributor Cure Everlife and Chinese online pharmacy and healthcare platform Guangdong Jianke Pharmaceutical. The managers see significant growth potential from Asian companies. “In the US, emerging biotech companies took 20-25 years to become big biotech companies. In China, it is happening a lot faster,” says Wicki.

Investment manager HBM Partners has two teams of professionals – many of whom have a life sciences background – covering private and public markets. HBMN invests across both areas, in companies covering the healthcare and biotechnology spectrum. The teams meet weekly to share information on market and clinical developments.

HBMN’s managers generate investment ideas from diverse sources, including their own global industry networks, as well as third-party analyst output and industry conferences. Although listed companies currently make up around two-thirds of the portfolio, the private portfolio is arguably the driving force behind the strategy. Some 36% of gross assets (across individual companies and funds) is currently invested in private companies, with a further 19.2% of the total (28.9% of the listed portfolio) held in companies that began as private investments. Most of the private portfolio is valued at cost, giving significant upside potential in the event of a takeover or IPO, although valuations may be adjusted in response to further funding rounds, the entry of strategic investors (as was the case recently with Sai Life Sciences), or clinical data releases. Listed company valuations are based on the latest share price, and therefore are likely to be more volatile (although the investments themselves may be less risky at an absolute level) than the private investments.

The portfolio is managed with a long-term outlook, although holdings may exit the portfolio as a result of M&A. So far in 2018, new investments have been concentrated in the private portfolio, to rebuild the allocation following the public market debuts of holdings such as Apitnyx, Y-mAbs Therapeutics and Principia Biopharma. Given the current high proportion of holdings in the listed portfolio, HBMN has taken a short position in an ETF tracking the NASDAQ Biotechnology index, to provide downside protection in volatile equity market conditions. The position covered around one-fifth of the public portfolio at 30 September 2018.

HBMN’s portfolio is diversified by geography, clinical focus and development stage. Investments in developed markets are usually made directly, with private equity funds more often used to gain exposure to areas such as Asia, where it may be harder for the portfolio managers to assess individual private companies.

At 30 September 2018 there were more than 90 holdings (across private and public companies and funds) in the HBMN portfolio, with the top 10 positions making up 32.5% of total assets. This was a marked fall in concentration from 47.0% a year ago, largely attributable to the takeover of largest holding Advanced Accelerator Applications (AAA), which made up c 15% of the portfolio at 30 September 2017. Eight of the current top 10 holdings were held in the portfolio a year ago.

Exhibit 3 shows the breakdown of the portfolio by clinical focus. Major changes over the past 12 months include a 14pp fall in oncology (again, largely attributable to the takeover of AAA), and the introduction of a new ‘orphan disease’ category. The fall in exposure to respiratory diseases is principally a result of poor share price performance from Vectura after another delay in approval for its generic version of asthma medication Advair, while the rise in central nervous system disorders has been assisted by a quadrupling in the share price of BioArtic following positive Phase II trial data in Alzheimer’s disease. HBMN has reduced its holding by one-third but is still sitting on a substantial profit.

The main changes in geographical exposure (Exhibit 4, right-hand chart) over 12 months to 30 September 2018 were a 4pp fall in the UK (where Vectura is the sole holding) and a 4pp increase in the US. From a development stage perspective (left-hand chart), the most notable change was a 6pp fall in Phase III and a 6pp rise in Phase II.

After a significant amount of M&A activity in the portfolio (the takeover of AAA in Q318 was followed by three more transactions in Q119 [ending 30 June 2018], with ARMO Biosciences taken over by Eli Lilly, AveXis acquired by Novartis, and private company TandemLife/Cardiac Assist bought by LivaNova), HBMN’s managers have been busy deploying the proceeds, mainly in new private investments. A US$10m commitment to private equity investor C-Bridge Capital has so far been deployed in two direct co-investments in early-stage companies in China, with $3m invested in in-licensing specialist Everest Medicines in Q119, and $2m in Nuance Biotech in Q219. Four new direct private investments were made in Q119: Sublimity Therapeutics, an Irish company developing a treatment for ulcerative colitis; Corvidia Therapeutics, an AstraZeneca spinoff conducting Phase II trials in chronic kidney disease; iTeos Therapeutics, a Belgian immuno-oncology company; and Singaporean medical device distributor Cure Everlife.

In Q219 (ending 30 September 2018), a further four new private investments were made (not including the co-investment in Nuance Biotech): Guangdong Jianke Pharmaceutical (a $15m investment), China’s leading online pharmacy/healthcare platform; Cardialen, a US medical device specialist focused on cardiac arrhythmia; Galera Therapeutics, which is developing a compound to alleviate oral mucositis, a common side-effect of radiotherapy; and Principia Biopharma, which is developing small-molecule drugs for oral administration to treat a variety of cancers and immunological problems. Together, these 10 new investments in H119 represented commitments of c CHF87m (based on 25 October exchange rates), of which c CHF16m is yet to be drawn.

Among the more significant developments in Q219 were the IPOs of Y-mAbs Therapeutics (a new private investment in October 2017) and Principia Biopharma. HBMN topped up its stakes in both companies as part of the IPO process and both performed very well following flotation: at the end of September 2018, Y-mAbs was HBMN’s largest listed holding, valued at CHF80m versus an investment of CHF32m, and Principia had increased in value from CHF19m to CHF36m.

HBMN’s NAV and particularly its share price performance have been impressive over the 12 months to 30 September 2018, with total returns in Swiss francs of 26.2% and 60.8% respectively, compared with 15.9% for the MSCI World Health Care index (Exhibit 5). This has been driven in large part by M&A activity and the IPOs of several private companies in the portfolio, with HBMN’s share price rising by more than the NAV as investors have backed the successful execution of the fund’s public/ private strategy. While NAV performance in the latter part of the period has trailed both the benchmark and the NASDAQ Biotechnology index, the fund has a strong record versus both indices over three and five years (Exhibit 6). At a stock level, contributors to recent performance include the takeovers of listed companies ARMO Biosciences and AveXis and private company TandemLife (together generating c CHF100m in profits for HBMN), and the successful IPOs of private holdings Apitnyx, Y-mAbs Therapeutics and Principia Biopharma. Other factors included a recovery in the share price of Pacira Pharmaceuticals, positive trial data for BioArctic, and a revaluation of private Indian company Sai Life Sciences, after a US private equity investor took a significant stake.

Having traded broadly at a discount of between 20% and 30% from autumn 2009 to autumn 2017, HBMN has seen a marked narrowing in its discount to NAV over the past 12 months and briefly reached a premium of c 1% in late September. At 26 October 2018, the shares traded at a discount of 7.0% (based on the 15 October NAV), which compares with a one-year average of 11.2%, and longer-term average discounts of c 21-27% over three, five and 10 years. HBMN’s managers say demand for the shares has been boosted by a series of successful IPOs and M&A from the private portfolio, which stand as evidence of the validity of the fund’s approach, as well as the fact that its principal Swiss-listed peer, BB Biotech (BION), has been trading on a double-digit premium. (BION has also rerated substantially in recent years, thanks in part to its high distribution policy, as well as inclusion in a number of European indices.) Troxler and Wicki say they have seen an increase in buying interest from both larger shareholders and smaller retail investors.

Listed on the SIX Swiss Exchange and structured as a closed-end investment company, HBMN has 7.0m shares in issue. Having previously held c 80,000 shares in treasury, the majority of these were cancelled in September 2018, resulting in a par value repayment of CHF1.50 per share to fund the second tranche of the FY18 distribution. Gearing is available through two CHF50m tranches of bonds, maturing in 2021 and 2023, with coupons of 2.0% and 2.5% respectively.

The portfolio manager, HBM Partners, receives an annual management fee equal to 0.75% of NAV plus 0.75% of market capitalisation. A performance fee, equal to 15% of outperformance, may also be paid if the year-end NAV is more than 5% above the high water mark (the year-end NAV at which a performance fee was last paid). A performance fee of CHF15.9m (c 1.4% of net assets) was paid in respect of FY18; the year-end NAV of CHF166.43 will therefore form the new high water mark. We calculate ongoing charges (excluding the performance fee) at 1.24% for FY18 (FY17: 1.5%).

HBMN recognises the appeal of paying an income to its investors, and since FY13 has followed a high distribution policy, under which it pays out 5-8% of its NAV each year through a combination of cash distributions and share buybacks. Historically it has paid a single distribution of c 5% of year-end NAV out of capital reserves in June. Because its remaining capital reserves were insufficient to fund the whole of the planned distribution for FY18, the CHF7.00 payout was split into two instalments, with CHF5.50 paid in June from the reserve and the remaining CHF1.50 in September as a nominal value repayment. Future distributions will also be funded by incremental nominal value repayments, as it is not tax-efficient for HBMN to transfer a larger portion of the nominal value into reserves to fund future distributions. However, it is likely that the schedule will revert to a single payment in June. The FY18 distribution is an increase of 20.7% on the CHF5.80 paid for FY17, reflecting strong NAV performance, and represents a yield of 4.3% on the current share price.

Exhibit 9 below shows HBMN alongside the members of the Association of Investment Companies’ specialist Biotech & Healthcare sector, as well as its fellow Switzerland-based fund, BB Biotech, and Woodford Patient Capital Trust, which is classed as a UK All Companies fund but has c 57% of its portfolio in healthcare companies. The peer group is otherwise a mix of healthcare generalists and biotechnology specialists, and while the majority of funds are overwhelmingly invested in listed equities, four of them (HBMN, International Biotechnology Trust, Syncona and Woodford Patient Capital) have significant investments in private companies.

In performance terms, the more diversified healthcare funds have generally outperformed the biotech funds over one and three years, while over five and 10 years, the picture is more mixed. HBMN has produced the third-highest Swiss franc NAV total return (well above the peer group average) over one year, ranks comfortably first over three and five years, and is fifth out of five funds with a 10-year track record, principally as a result of a very poor period of performance during the global financial crisis. Ongoing charges are broadly average and HBMN may also levy a performance fee, in line with the majority of peers. The fund’s discount to NAV has narrowed significantly, but still remains at the wider end of the range; both BB Biotech and Syncona are trading at double-digit premiums, which pulls the average above par. Gearing is below average, while the dividend yield is above average. Although biotech companies in particular are not known for paying dividends, many of the funds in the peer group – including HBMN – pay out a set proportion of their NAV as an annual distribution, leading to an average yield of 2.2% for the group.

HBMN has a non-executive board, made up of six directors. The chairman, Hans Peter Hasler, and Robert A Ingram both joined the board in 2009. Dr Heinz Riesenhuber is the longest-serving director, having been on the board since HBMN’s launch in 2001. Dr Rudolf Lanz was appointed in 2003, while Dr Eduard E Holdener joined the board in 2008. Most recently, Mario G Giuliani was appointed in 2012. Messrs Hasler, Ingram and Giuliani and Dr Holdener have all held executive roles at pharmaceutical or biotech companies. Dr Riesenhuber was a German MP for more than 40 years and is a former minister for scientific research, while Dr Lanz is a lawyer and corporate financier.