Think Long Term and Win Big With Small Biotechs: Hugh Cleland
Published: Sep 24, 2012
Source: George S. Mack of The Life Sciences Report (9/24/12)
BluMont Capital Portfolio Manager Hugh Cleland has taken a venture capital and private equity approach to investing in public companies, some of which have penny-stock market caps in the $5–15 million range. The idea is to invest in small- and micro-cap stocks without facing redemption risk, and to employ a hands-on approach when helping innovative companies create and realize value over the long term. In this way time becomes the friend—not the enemy—of companies looking for scarce capital in a risk-averse world. In this exclusive interview with The Life Sciences Report, Cleland shares the names of a handful of small companies that could return tenfold or greater multiples to investors.
The Life Sciences Report: Are your investors exclusively Canadians?
Hugh Cleland: Yes. Our funds currently are registered for Canadian investors only. That will likely change with our next fund, however.
TLSR: Are the holdings exclusively Canadian?
HC: No, they are not, and they don't have to be. But I do restrict myself to companies domiciled in North America.
TLSR: In a video interview you did with Biotechnology Focus in June, you said that you learned some important lessons while running a traditional long-short hedge fund in the past. What were those lessons? What is the weakness of this traditional money management model?
HC: I think 2008–2009 taught all money managers important lessons. Obviously, many fund managers were put out of business through redemptions. That is particularly true of managers focusing on small-cap and micro-cap stocks, since liquidity went almost to zero during that time. Many managers responded by abandoning the micro-cap and small-cap asset class.
But I enjoy that asset class. And the long-term returns to that asset class are so high (as demonstrated by the 2010 Ibbotson study on the returns to illiquidity) that we decided to come up with a structure that would allow me to manage micro- and small-cap stocks while avoiding the risk of being redeemed into oblivion in bad markets. We decided that a private equity/venture capital structure and approach was the best way to go. Using that structure, we launched the BluMont Innovation PE Strategy Fund LP (BIPES) on Jan. 31, 2011.
TLSR: Does that approach give you control over the life cycles of the companies in your portfolio?
HC: I wouldn't put it that way. But a primary feature of the structure is a six-year term with no redemptions, which allows us to focus on helping companies create and realize value over an appropriately long time horizon, as opposed to constantly being worried about the next quarter, or being subject to redemptions. We take a large position in a company and work with it to bring new and important skill sets to boards and management teams: Each of the top six positions in my two funds have seen such additions. We also apply ourselves to initiatives, such as securing analyst coverage for our core positions and developing important connections within industries.
With the BIPES fund now up 50% since its inception date, results seem to be bearing out the hypothesis that this structure and approach is right for investing in publicly traded small and microcap stocks.
TLSR: Hugh, are you purchasing restricted shares and getting warrants with your fund investments?
HC: It depends. I am permitted to buy either open-market stock or to participate in private placements or financings of various types. Warrants are definitely in the portfolios. We value our warrants at intrinsic value in BIPES. Unless a share price is above the strike price, there is no value in that fund for purchase warrants. Certainly, purchase warrants can be additive to returns. My preference is to provide capital to companies with financings because that is one way to help a company create and realize value.
TLSR: You said that the holding period for your investors is six years. When one of your positions is taken out, do you return that capital to investors, or do you reinvest it?
HC: Our approach is modeled almost directly on the venture capital or private equity structure. When we sell an investment, we typically return the capital to our investors; we do this in lieu of a redemption feature. For example, we made a 5% distribution in March 2012, representing the sale proceeds of one of the positions in the fund.
If we make an exception to our distribution policy, it is usually because an existing portfolio company is doing a follow-on financing. If an existing portfolio company is doing a follow-on financing, then we can use the proceeds from selling a portion of a position to invest in that financing. But the intention is to be completely out of all positions by the end of six years. Years four, five and six of BIPES are when we expect to realize gains in our positions.
TLSR: Theoretically, investors are in your fund for six years. Obviously, some positions will be liquidated in that period of time. But a six-year period implies turnaround, correct?
HC: Actually, all positions will be liquidated within the six-year timeframe—exactly like a private equity or venture capital fund. The timeframe allows us to participate in turnarounds, but it doesn't mean that we are participating in turnarounds. My objective is to make money for my investors by investing in secular growth companies that have a sustainable competitive advantage. Sometimes I look at secular growth companies that are in turnaround mode, but that is not necessarily what I am looking for.
TLSR: What types of healthcare companies are you looking for? Do you lean toward specialty pharma, where you can monetize more quickly? What are your preferences?
HC: In the drug development area, there are really three themes that I like. One is pharmaceuticalizing nutraceuticals. Reliant Pharmaceuticals pharmaceuticalized fish oil with Lovaza (omega-3-acid ethyl esters). Reliant was purchased for $1.65 billion (B) by GlaxoSmithKline (GSK:NYSE) in 2008. Within two years, GSK's sales of Lovaza were over $1B. Amarin Corp. (AMRN:NASDAQ) has continued on that theme with Vascepa (icosapent ethyl). Both Lovaza and Vascepa are essentially pharmaceuticalized fish oil drugs that went through the full phase 1-to-phase 3 process, and are now approved by the U.S. Food and Drug Administration (FDA) for treating very high triglyceride levels.
A couple of my large holdings, Neptune Technologies & Bioressources (NTP:TSX; NEPT:NASDAQ) and Acasti Pharma Inc. (APO:TSX), are pharmaceuticalizing krill oil (omega-3 fatty acids conjugated to phospholipids). Krill oil carries its omega-3s on phospholipids (rather than on triglycerides, as is the case in fish oil), which appears to result in a higher level of efficacy than fish oil, as well as a broader range of therapeutic effects.
Repurposing existing drugs is another theme that I like. Celgene Corp. (CELG:NASDAQ), which repurposed thalidomide for the treatment of patients with multiple myeloma, is a good example. I currently don't have any investments in companies that are repurposing existing drugs.
My third theme—I have at least two investments in this area—is in the FDA's 505(b)(2) pathway, also known as the rapid approval route. This pathway can be used by companies taking an existing drug with hundreds of millions or several billion dollars in sales and porting that drug onto a different delivery technology. Biovail Corp. (now part of Valeant Pharmaceuticals International Inc. [VRX:NYSE]) followed this pathway when it made Wellbutrin XL, a one-a-day version of Wellbutrin (bupropion hydrochloride). IntelGenx (IGX:TSX.V) is my poster child in this area, with eight drugs in various stages of the 505(b)(2) approval process, and one 505(b)(2) drug that will be commercially launched this fall, having received FDA approval in November 2011. I would like to discuss IntelGenx in more detail later.
I like these three themes in healthcare because the toxicity risk is essentially avoided in all three, and efficacy risk is often significantly mitigated, particularly in the 505(b)(2) pathway.
TLSR: Hugh, let's talk about the krill oil companies, Neptune and Acasti. What is your investment theory on these companies? Why would an investor want to own one over the other?
HC: I actually own both, both professionally and personally. Each company appeals to a different type of investor. Biotech specialists tend to gravitate to Acasti, which is a pure play on developing a phospholipid-omega-3 drug for treating high triglycerides and/or very high triglycerides. In fact, Dr. Harlan Waksal, co-founder of ImClone Systems, joined Acasti's management team in July 2011. (ImClone Systems was purchased by Eli Lilly and Co. [LLY:NYSE] for $6.5B in 2008.)
Neptune owns almost 60% of Acasti, but also has rapidly growing sales and cash flow from a nutraceutical form of krill oil. Neptune also owns 90% of NeuroBioPharm, a subsidiary that is focusing on neurological applications of its phospholipid omega-3, such as in the treatment of attention deficit hyperactivity disorder (ADHD) and Alzheimer's disease.
The investment hypothesis for both Acasti and Neptune revolves around the successes of the two pharmaceuticalized fish oil companies, Reliant Pharmaceuticals and Amarin Corp. Amarin received FDA approval on July 26 for its pharmaceuticalized fish oil, Vascepa, and now has a market cap of around $2B (based on 167 million (M) shares fully diluted and a $12 per share stock price). Back in 2009 Amarin was a $40M market-cap company. Reliant Pharmaceuticals had a $1.65B exit to GSK, followed by a ramp in the sales of its drug, Lovaza, to over $1B within two years. Investors have seen, twice now, the really large returns you can get in the pharmaceuticalized fish oil area. Both Neptune and Acasti are trading on those successes, hoping to be "the next Amarin."
Neptune also has value as a neurological opportunity. A variety of studies indicate that omega-3, or fish oil in general, is healthy for the brain, whether for ADHD or age-related cognitive impairment. Neptune is in the process of spinning out NeuroBioPharm, which will pursue these applications. I would argue that no value is being ascribed to NeuroBioPharm in the stock currently. It is essentially a free call option within Neptune.
TLSR: Acasti is 60%-owned by Neptune. Does Neptune report Acasti's numbers on its top line?
HC: Acasti is a biotech company with very little revenue to speak of, and a cash-burn to support its clinical trials. Because Neptune owns more than 50% of Acasti, it consolidates Acasti's results. Unfortunately, consolidating Acasti's almost-zero revenue and clinical trial expenses with Neptune's rapidly growing revenue, cash flow and earnings from nutraceutical sales seems to confuse many investors because it disguises the cash flow and earnings that Neptune gets from selling its nutraceutical krill oil, and obscures the important fact that Acasti is a separate and independently financed entity that raises its own money to fund its own clinical trials.
TLSR: Neptune owns 90% of NeuroBioPharm. I think we all understand that nutrition can have an effect on ADHD, but I wonder if investors believe more serious cognitive disorders, such as Alzheimer's disease, can seriously be addressed with nutraceuticals.
HC: We don't know yet for sure. The studies we have seen on fish oil, krill oil and omega-3s so far have looked at just nutraceuticals, as opposed to pharmaceuticalized nutraceuticals. Most of those studies indeed seem to show improvement in cognitive function, whether it's in patients with ADHD or age-related cognitive decline, but we definitely need more data.
The spinout of Acasti has been quite successful in a number of ways. It has allowed Acasti to be valued as a separate entity, which in turn has allowed Acasti to raise money as a stand-alone venture to fund its phase 2 trials (currently underway). Funding for its pivotal phase 3 trials is expected to be raised on NASDAQ after its phase 2 results are published. NeuroBioPharm, I expect, will be spun out publicly, similar to Acasti, sometime in the next 12–36 months. I expect NeuroBioPharm will then raise its own money so it can independently finance the studies it would like to pursue.
TLSR: Hugh, both Neptune and Acasti have decent market caps, at $245M and $155M respectively. They can be owned by small-cap mutual funds to create demand for shares. Neptune is up 69% over the past six months, and Acasti is up 52%. Do you feel they have a lot of upside left?
HC: Absolutely. And you don't have to rely only on me for this view: Two U.S. analysts (Dr. Joseph Pantginis of Roth Capital Partners LLC and Dr. Elmer Piros of Rodman & Renshaw LLC) have picked up coverage with buy ratings within the past 12 months. Roth's 12-month target is $10-plus.
The way I look at it, Reliant and Amarin show what can happen with companies in this area in a fairly short period of time. Assuming that Acasti's clinical trials show a best-in-class fish oil, it would be reasonable to expect a market cap of more than $2B for the company after it publishes its phase 3 results. Going from below $200M to above $2B in the space of two to three years is nothing to scoff at. If we end up seeing data that is even more interesting, such as meeting an "unmet medical need," we could see even greater upside. With Neptune owning approximately 60% of Acasti, and having entered into a strong secular growth path for its nutraceutical sales, it would be credible to see Neptune's market cap grow in a similar fashion over that timeframe. I look at both Neptune and Acasti as having tenbagger-plus potential over a two- to five-year timeframe.
TLSR: You also own penny stocks. There is a totally different dynamic involved in owning stocks like these. For instance, you own Cynapsus Therapeutics Inc. (CTH:TSX.V; CYNAF:OTCPK), which has a $6.7M market cap. Could you talk about your investment theory here?
HC: Cynapsus is a 505(b)(2) pathway company taking an existing injectable drug, apomorphine, and moving it onto a thin film strip for sublingual delivery. Apomorphine is used to treat the freeze-up episodes that as many as 70% of Parkinson's disease patients experience at some time. A significant number of patients experience very serious freeze-up episodes quite frequently. Given that the drug is already approved and that toxicity and efficacy are not in question, a lot of risk has been taken off the table. That's one of the reasons I like Cynapsus specifically, and the 505(b)(2) pathway generally.
Although Amarin did not use the 505(b)(2) pathway to get FDA approval for its drug, I think the financial market strategy Amarin employed is a great model for many existing biotechs. Back in 2009, Amarin raised $70M on a $40M pre-money market cap, which was enough to fund the company through to completion of its pivotal phase 3 trials. That $70M allowed the company to attain the $2B market cap it has today.
Applying the Amarin model to Cynapsus means that, in an ideal world, the company would raise enough money now (about $12M) to get it all the way through to FDA approval. As it is, Cynapsus is raising $500,000 ($500K) to $1M to bridge it to this larger round, while a number of biotech funds do due diligence. I put a small amount into this bridge, and am doing what I can to help in other ways. The bridge for Cynapsus parallels the $2.6M bridge that Amarin raised in 2009, providing big funds the time they needed to do due diligence for Amarin's $70M round. If Cynapsus can raise the money it needs, I expect it will create shareholder value in the $100–300M range within two to three years.
As far as drug development is concerned, Cynapsus is low risk. The biggest risk is financing at this point. If a large fund comes along to remove the financing risk, I expect the company will be well rewarded.
TLSR: Cynapsus' estimate is that peak sales of its sublingual apomorphine product, APL-130277, could range from a low of $360M annually to a best case of $1.6B. Why are we looking at a $6.7M market cap today?
HC: There are two primary reasons. The first is that investors know Cynapsus may end up licensing its drug to a larger player, thereby giving away part of its drug's value. But, clearly, if Cynapsus' drug achieves the anticipated level of sales, we'll see a market cap of well over $100M regardless of whether the drug is licensed out.
The biggest issue for this company, as it is for many companies in micro-cap land, is the financing risk: Without capital to create value, value isn't created. That is the second reason Cynapsus' shares are so cheap. Once the larger round is complete, I would expect shares to gap up and stay up, as investors will then have visibility on the value creation. I look forward to raising a second "private equity" fund so that I can once again be in a position to provide capital that unlocks value.
TLSR: What's the next company you'd like to talk about?
HC: IntelGenx is the company through which I learned about the 505(b)(2) pathway, and why that pathway is so attractive to me. It's a drug delivery company that takes existing, commercialized drugs and ports them onto different delivery modalities, making them better from a patient compliance perspective or from a time-to-onset-of-action perspective. The existing drugs the company is working with have commercial revenues in the hundreds of millions to several billion-dollar range.
IntelGenx is about to launch its antidepressant drug, having received FDA approval in November 2011, and has a pipeline of eight drugs being developed via the 505(b)(2) pathway. The company is a table-pounder, simply on the basis that it has an approved drug and a market cap of only $30M. It is truly one of the most dramatic valuation disconnects that I am aware of. Full disclosure: Funds that I manage control about 12% of the company.
A migraine drug called rizatriptan is a good example of one of IntelGenx's pipeline drug applications. The time to onset of action of a migraine medication is very important. If the medication is delivered in time, it can cut a migraine off at its knees and save the patient from an ugly 12–36 hours. On the other hand, if a patient pops a pill and it takes 45 minutes to kick in, a migraine may get the foothold it needs to overwhelm the medication.
IntelGenx is moving rizatriptan onto a thin film strip. The time to onset of action for a drug delivered via sublingual strip is much faster than for the pill form. Annual sales of prescription migraine drugs on a global basis are probably more than $5B; annual sales of rizatriptan were over $600M in 2011. If IntelGenx can introduce a better form of the drug, cutting the time to onset of action in half or more—or even if the film cuts it by a third—doctors and patients will be very attracted. IntelGenx's drug could gain market share quickly in the migraine medication area. In another example, the company is moving an erectile dysfunction drug onto a strip. You can imagine reasons you may want quicker onset of action with that.
The bottom line from an investor perspective is that, as of the close on Aug. 3, 2012, the stock is lower than it was before the company's antidepressant received FDA approval on Nov. 11, 2011; lower than it was before its December 2011 codevelopment and commercialization deal with Par Pharmaceutical Inc.; and lower than it was before the announcement of a commercialization partner for its antidepressant. I would argue that at $1.00 or lower, the only thing an investor is paying for is the antidepressant, meaning that you are getting the entire thin-film delivery platform and eight pipeline drugs for free.
I suggest that investors check out the analyst report published two weeks ago by Ram Selvaraju of Aegis Capital Corp., initiating coverage on IntelGenx with a $2.50/share, 18-month target. Ram is known as one of the few analysts willing to pick up coverage on sub-$50M market cap companies—as long as he thinks that he can make investors significant returns. One of his more notable sub-$50M initiations was Amarin, back in 2009, when it had a market cap of about $40M.
TLSR: Your next company?
HC: VentriPoint Inc. (VPT:TSX.V) has a platform technology in medical imaging. I sit on VentriPoint's board of directors. VentriPoint has an overlay technology that can be applied to most existing imaging modalities, and improves the quantity and quality of information physicians can glean from ultrasounds, magnetic resonance imaging (MRI) or X-rays. The first applications being pursued by the company are overlays to ultrasound for right heart imaging in tetralogy of Fallot and pulmonary hypertension. Those two markets alone have over $1B in market potential. There are at least 10–15 other indications under development by doctors and researchers in North America and Europe. In our business model, we do not have to fund any of them until we want to go to the FDA.
With approval to sell already granted in Europe and Canada, and strong expectations for FDA approval for at least one of the two current indications expected by year's end, I consider VentriPoint to be a low-risk/high-reward opportunity.
TLSR: There is a lot of two-dimensional (2-D) and three-dimensional (3-D) modeling going on. What is novel here?
HC: In the case of pulmonary hypertension, a practitioner can take 2-D ultrasound images and overlay information from the VentriPoint system, which essentially follows dots on the heart to create a 3-D image of the moving muscle. It's particularly difficult to see the right heart area, where neither ultrasound nor MRI get particularly good images. The information from VentriPoint's technology overlay is as good as or better than that from an MRI image for diagnosing and charting treatment for pulmonary hypertension. In addition, MRI is an expensive procedure that takes many machine and man hours, whereas the VentriPoint ultrasound overlay procedure takes about 10 minutes. If you can get the same—or better—information in significantly less time and with significantly less cost than with MRI, healthcare systems are going to choose the cheaper, faster method.
TLSR: You also own iCo Therapeutics (ICO:CVE). Tell me about it.
HC: I invested in a financing for iCo back in November. About $1M of the financing came from insiders, and $200K from one of my funds. The company has three different compounds, but the one to pay attention to is iCo-007, which is for diabetic macular edema (DME), or diabetes-related blindness. It follows the approval of Lucentis (ranibizumab) for DME, which is a monthly injection into the eye that has been massively successful. In the case of iCo-007 (an antisense inhibitor targeting C-raf kinase mRNA), a phase 2 study with some interim data is expected this year, and full results in 2013. It appears that patients can go three to six months between injections with iCo's treatment. From a patient perspective, that is much more desirable than a monthly injection.
After also participating—but to a smaller degree—in the financing that occurred last month, we are waiting for the key data before adding more capital. But we expect the stock to be revalued upward as the key dates approach.
TLSR: Is there one more company you'd like to speak about?
HC: One that I would like to get on people's radar screens is Senesco Technologies Inc. (SNT:NYSE). This company is developing a platform technology for addressing cancer. The company may have discovered a trigger for apoptotic (cell death) cascades in cancer cells that does not trigger apoptotic cascades in healthy cells. That would be a holy grail for treating cancer. It is in the clinic now, in a phase 1b/2a trial. After some initial delays, a clinical update from June 4 suggests that enrollment is back on plan, and initial results are encouraging. The upside in this case is enormous—maybe 50-fold—but downside is effectively zero. I usually don't get involved in such high-risk, binary situations, but the upside is so huge, and the team involved so credible, that I have given Senesco a 1–2% position in both of my funds.
TLSR: Hugh, thank you.
HC: Thank you for your time.
Hugh C. Cleland is an executive vice-president and portfolio manager at BluMont Capital Corp., based in Toronto, Canada. BluMont Capital acquired Northern Rivers Capital Management, which was founded by Cleland in May 2001, in January 2010. Cleland currently manages two funds for BluMont: the BluMont Northern Rivers Innovation RSP Fund (available on FundSERV), and the BluMont Innovation PE Strategy Fund I, which takes a private equity approach to the management of publicly traded small- and micro-cap technology and healthcare stocks. Cleland worked at Interward Capital Corp. from 1998 to 2001, originally as an analyst and later as associate portfolio manager specializing in technology equities. In 1997–1998 he was research associate to the senior telecom services analyst at Midland Walwyn Inc. Cleland earned a bachelor's degree with honors (1997) from Harvard University, and earned his CFA designation in 2001.
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1) George S. Mack of The Life Sciences Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following company mentioned in the interview is a sponsor of The Life Sciences Report: Cynapsus Therapeutics Inc. Streetwise Reports does not accept stock in exchange for services. Interviews are edited for clarity.
3) Hugh Cleland: I personally and/or my family own shares of the following companies mentioned in this interview: Neptune Technologies and Bioressources Inc., Acasti Pharma Inc., IntelGenx Corp., Senesco Technologies Inc. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.
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