Kilkenny Capital

Taking a fundamental look at biotechnology

Stuart Fieldhouse
Originally published in the December 2006/January 2007 issue

The biotechnology sector is usually most closely associated with venture capital, and is not often trotted out as a useful arena for investment activity by hedge funds. But Chicago-based Kilkenny Capital has been making a living out of pursuing a long/short trading strategy specialising in biotechnology stocks. Founded in 1995 by Michael P. Walsh and Bessmer Venture Partners, Kilkenny now has over $200m under management (it launched with amere $2.5m), and bases its investment management strategy on a proprietary valuation methodology that uses probabilities to gauge whether or not biotech products will be successful. It is currently managing three funds, and two separately managed accounts, and reckons its strategy can cope with another $300m before it would have to hard close.

Unlike VCs, Kilkenny is investing in listed biotech companies, and sees the extraordinary volatility of the biotech sector, coupled with the significant fundamental value creation it offers, as perfectly suited to a long/short strategy. “Rationally- speaking, you need information,” says Walsh. “In private markets, there is no fair pricing mechanism. In public markets, you get a liquid market and a better idea of what one should pay for innovation.”

Kilkenny’s edge comes from its in-depth knowledge of the biotech sector. It argues that generalist investors are setting the price of biotech securities, and will often not appreciate the true value of some of the shares they hold. Hence, a value opportunity emerges. Biotechnology continues to offer investors the same attractive fundamentals in its listed format as it does in the private space: it is an increasingly important segment of the US healthcare industry, itself representative of 16% of US GDP. Biotechnology firms also enjoy up to 20 years of patent protection and regulatory protection helps them to fend off competition.

Biotechnology proved a robust sector to be invested with during the bear market of 2001-02, and Walsh’s experience is that the market can be very wrong on the fair pricing of securities in this sector. “We do our valuations the same way as an acquirer,” he explains.

Kilkenny is not in the business of buying into a stock within six months of an IPO, and instead waits for the flood of initial interest to wane until there is a good proportion of stock outstanding. Walsh sees the firm as a buyer of illiquidity and seller of liquidity: once a stock goes to 50-60% outstanding, he starts to get interested.

“If everyone wants to own a stock, what are the chances there is more good news to come?” Walsh asks. “If the market is paying low prices for high growth opportunities, then we’re happy to take the other side of that trade. If we see increase in fundamental value coupled with mis-pricings, we want to be long, especially if the market is not pricing in the opportunity set. But for every position in the portfolio, we have to give our best guess as to why the market is making a mistake.”

He sees a lot of high growth biotechnology companies being mis-priced coming out of year two post-IPO. In terms of the short side of the book, he accepts that in this market it can be difficult to find the borrowing, but tends to focus on pricing rather than fundamentals when it comes to locating his shorts. “It is more important to believe in a probabilistic way of thinking,” Walsh says. “We have to ask ourselves how we can make money on all the potential outcomes from a trade.”

Because Kilkenny is focusing on an industry that defines itself via its innovation processes, it is relying on the information curve to help it to assess whether a company’s core products will be viable within the healthcare environment. Such opportunities do not exist in other industries. Walsh makes the comparison with the oil exploration business, where most of the innovation opportunities are contained within the share price of the major energy players, and therefore not easily exploitable, if at all. Another industry with similar dynamics is the movie world, but here would- be investors are curtailed by the lack of public investments.

Bearing in mind that more than 80% of potential biotech products fail, and that two of three approved products never pay back development costs, and you can see why a manager like Kilkenny has to be acutely aware ofwhat chances its portfolio companies have of striking gold dust. There are simply too many duds in the market to take a blanket approach and expect to make money.

With mainstream investing, probabilistic investing is simply not enough to beat the market, but in biotechnology, at least for the time being, and for a manager with enough of a feel for the fundamentals of the industry, it is.