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Applying the Venture Capital Model to Public Companies: Hugh Cleland

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Hugh Cleland Hugh Cleland has been testing his theory that life sciences companies can be had cheaper as stocks than as private venture capital investments—and that theory has been working out for him quite well over the past two years. In this interview with The Life Sciences Report, Cleland, portfolio manager and executive vice president at Toronto-based BluMont Capital, talks about his best small- and micro-cap ideas and also shares the "core/farm team" approach that he takes in his smaller, more conventionally structured fund.

The Life Sciences Report: In your letter to investors dated Oct. 12, you highlighted performance data for the BluMont Innovation PE Strategy Fund I, which showed a total return from the beginning of the year to Sept. 30 of +30.75%. How was October?

Hugh Cleland: The BluMont Innovation PE Strategy Fund I takes a venture capital/private equity approach to publicly traded stocks. That fund was up 3.46% in October. My more conventionally structured fund (it has monthly liquidity) is called the BluMont Northern Rivers Innovation Fund and it is now up 22.19% year-to-date as of Oct. 31, after rising more than 5% in October.

TLSR: Due diligence is important to you. Do you always meet management personally before you invest in small- and micro-cap companies?

HC: I meet with management multiple times before investing, but that is just one element of my due diligence process. In a step I consider even more important, I vet the company with my advisory board and network of field experts. My advisory board is comprised of a group of very successful scientists and entrepreneurs, including Harlan Waksal, the co-founder of ImClone Systems LLC, which was acquired by Eli Lilly and Co. (LLY:NYSE) in 2008 for $6.5 billion ($6.5B). There is also Tony Holler, the co-founder of ID Biomedical Corp., which was bought by GlaxoSmithKline (GSK:NYSE) for CA$1.7B. Another is Gordon Glenn, who is the former CEO and chairman of SXC Health Solutions, which has been renamed Catamaran Corp. (CTRX:NASDAQ) and now has a $10B market cap.

TLSR: Since so many don't make the grade, do you recommend that retail investors steer clear of micro-cap biotechnology and medical technology names?

HC: If retail investors are going to participate in micro caps in general, and in micro-cap healthcare specifically, they need to be honest about their risk tolerance and only allocate money that they can afford to lose. Retail investors should also take a basket approach—they should not put all their eggs in one basket. If possible, develop a network of experts, but do your own due diligence as well. Pay attention to balance sheets and cash needs as much as you can. It's not fun to get blindsided by financings or companies running out of money.

TLSR: Is dilution a major concern in these very small stocks?

HC: Financing and dilution are a big part of the micro-cap world. Investors have to keep that in mind when dealing with small companies. These factors should be a part of an investor's strategy when considering the micro-cap space.

TLSR: The other side of the dilution coin is that companies need capital to grow, correct?

HC: Yes. It is best to enter into a financing that meets the capital needs of a company and propels it through significant value-creation milestones. Retail investors don't always have that opportunity. For them it's a matter of looking at the cash balance of the company and being comfortable with the idea that it has enough cash to see it through the process. Or, an investor can enter after a financing, when he or she knows the company is in a position to meet its milestones and won't be subject to further dilution. Cynapsus Therapeutics Inc. (CTH:TSX.V; CYNAF:OTCPK) is doing that now, and is expected to close a CA$7 million ($7M) financing by the end of November. Because it uses the U.S. Food and Drug Administration's (FDA) 505(b)(2) regulatory approval pathway, instead of the standard phase 1-2-3 new drug application (NDA) process, its capital needs are much smaller. Raising CA$7M might seem painful for existing investors because the company's market cap is just CA$6.9M, but without that infusion, Cynapsus is not going anywhere. It won't be in a position to create any value.

TLSR: That leads me to a question about one of your holdings, IntelGenx Corp. (IGX:TSX.V). In your recent newsletter, you voiced some frustration that a reasonable valuation has not been achieved, even though the company's major depressive disorder product, Forfivo XL (bupropion, an extended release, once-daily version of GlaxoSmithKline's Wellbutrin XL), is approved and on the market. Is it possible that the 505(b)(2) process hasn't become a trend for investors?

HC: That is absolutely right. But I believe that among pharmaceutical companies—and generics companies in particular—the 505(b)(2) pathway is going to become increasingly popular because it allows them to either repurpose existing drugs into new indications, or take existing drugs and put them in a new delivery vehicle that is more patient-friendly or more efficacious. Part of the reason a big valuation is not ascribed to a company like IntelGenx is that the 505(b)(2) pathway isn't well known yet among investors. As it becomes more broadly accepted, both within industry and within the investor community, you will see valuations moving up on a secular basis over the next one to five years.

"If retail investors are going to participate in micro caps in general, they need to be honest about their risk tolerance and only allocate money that they can afford to lose."

Let me give you an example of a 505(b)(2) company that is somewhat similar to IntelGenx, but that has a much higher valuation. Supernus Pharmaceuticals Inc. (SUPN:NASDAQ) has a valuation in the $300M range, as opposed to the $35M or so for IntelGenx. Supernus has a management team that Wall Street is comfortable with, and top-tier biotech venture capitalists as investors and board members. In my opinion, IntelGenx can earn that confidence and can achieve a valuation similar to Supernus after it hits a few more milestones, such as filing an abbreviated new drug application (ANDA) for its project with Par Pharmaceuticals, and filing an NDA for its migraine drug. Both filings are expected in Q1/13. Even a $200M valuation for IntelGenx would put it well above $3/share; $3/share also happens to be the price target set by analyst Ram Selvaraju of Aegis Capital after IntelGenx launched its first drug on Oct. 9.

TLSR: You cover other companies with interesting prospects. Go ahead and talk about one.

HC: Let me mention Lpath Inc. (LPTN:NASDAQ), which I am looking at right now. It was brought to my attention over the summer by Ram at Aegis Capital. I'll be digging into it more over the coming months, but it looks very promising. The company just filed a shelf registration, so I would expect to have the opportunity to enter via a financing sometime this year or early next year, and I expect to take at least a small position that way. Lpath already has a reasonable cash balance, and it also has a strong partner in Pfizer Inc. (PFE:NYSE), so the financing will give investors even more confidence that the company will have the capital it needs to create the expected value.

TLSR: Lpath has just migrated from the Bulletin Board to the NASDAQ, a regulated exchange. Has that given it new credibility?

HC: That is very helpful. And the fact that Lpath involves a monoclonal antibody makes it ideal for analysis since I have monoclonal antibody expertise on my advisory board, in the person of Harlan Waksal. Erbitux (cetuximab) a monoclonal antibody developed by Harlan, now sells more than $2B/year for Lilly. Lpath's lead indication is wet age-related macular degeneration (AMD).

I have deep familiarity with macular degeneration due to my participation in the $0.20 unit financing for iCo Therapeutics (ICO:CVE) in November 2011. Diabetic macular edema (DME) is the lead indication for iCo. My advisory board was very enthusiastic about iCo for a variety of reasons, and the $0.20 unit, which was led by management and board members, has worked out very well, with the stock now trading good volume at around CA$0.70. If the phase 2 DME trials go the way we think they will, the stock should go significantly higher, likely into the $2–4 range. But it is not without risk.

TLSR: You mentioned Cynapsus. Did you have anything to add with regard to the company?

HC: Yes. Cynapsus is timely to revisit because it has had two very significant developments since we last spoke. In August the company announced that it had been awarded a US$950,000 ($950K) grant from the Michael J. Fox Foundation for Parkinson's Research. That's great independent validation for a tiny company like Cynapsus. But perhaps even greater validation came on Oct. 29, when Cynapsus announced its drug candidate, APL-130277 for Parkinson's disease, was recognized as one of the Top 10 Neurology Projects to Watch in 2012 by a joint selection committee that included Dr. Harry Tracy (an authority on pharmacological interventions for brain diseases and the editor of the biotechnology publication NeuroPerspective). As a result, Cynapsus will be presenting APL-130277 at Elsevier's Therapeutic Area Partnerships meeting, to be held Nov. 28–30 in Boston.

Together these developments give me a significantly higher degree of confidence that Cynapsus will be able to raise the money it needs. If the drug is as big as the CEO believes, the company could very well be worth more than CA$200M in three to five years. And remember, the company’s capital requirements are much lower because it can use the 505(b)(2) pathway, not the typical NDA pathway.

TLSR: You're not put off that the company has a CA$6.9M market cap?

HC: The market cap in and of itself never concerns me. It's really about whether a company has a drug with a high probability of making it to the next value-creation milestone and through the development process. Does it have the right management team to move it along? Does it have the capital it needs? Those issues concern me.

"Financing and dilution are a big part of the micro-cap world. Investors have to keep that in mind when dealing with small companies."

For me the market cap is almost irrelevant, except in relation to where I think the future market cap will be if the company is successful. I'd rather invest in a company with a $7M market cap with the potential to be worth $100M in two to three years than in a $2B company that can be a $4B company in two years.

TLSR: Is there another company in your portfolio that you can speak to?

HC: I sit on the board of directors at VentriPoint Inc. (VPT:TSX.V). It is a timely story because we are very close to making a filing with the FDA for a pulmonary hypertension indication for the company's VMS diagnostic ultrasound device. After that, it's three to six months to likely FDA approval. At that point the company would be transformed, and we would have a whole different menu of possibilities on our plate.

TLSR: VentriPoint has a very low $17M valuation. Do you think investors look at the company's software and intellectual property as something that can be driven around fairly easily? Why do you think investors haven't taken a serious look at this company?

HC: A number of different aspects of the company are either not understood or are misunderstood. One is the Piecewise Smooth Subdivision Surface (PSSS) technology for diagnostic imaging, an approach that simply has not been employed before, at least as a clinical application. This platform technology can be applied as an overlay to a variety of imaging modalities to improve them in one way or another. The first indications VentriPoint has chosen involve right heart analysis, but we believe we will be able to expand into numerous other indications as time passes, including left heart analysis.

Probably the biggest concern, from the investor perspective, is that the company doesn't have FDA approval yet. Once we have FDA approval and the technology is commercialized in the U.S., investors' perceptions will be transformed—and that should only be a few short months away.

The company has approval to sell in Canada and Europe, and it is making some sales in those markets. But it is often the case that clinicians in Canada and Europe look for FDA approval before widespread adoption occurs. Nonetheless, we are pleased that VentriPoint's Angelo VMS systems are now being used in 24 sites in Europe and Canada. Feedback from researchers and clinicians has been strongly positive as to Angelo VMS' utility in diagnosing several conditions of the right heart. The preliminary data has been excellent, and that suggests FDA approval is likely.

TLSR: You referenced iCo a bit ago. What strikes me about iCo is that it has an antisense molecule for neovascular disorders of the retina resulting from diabetes, and also has a monoclonal antibody, also for sight-threatening diseases. In addition, the company is developing a new delivery system for a very old antifungal drug, amphotericin B, for life-threatening disorders. Aren't these separate technologies a lot for this little company to tackle?

HC: Yes. But frankly, the only one I have paid attention to in my analysis—and my reason for purchasing the company—is the DME indication, which is now in a phase 2 trial. Again, there are parallels to Lpath. Perhaps I shouldn't, but I look at iCo as a single-indication company right now.

TLSR: Hugh, you own Neptune Technologies & Bioressources (NTB:TSX; NEPT:NASDAQ), and you also own Acasti Pharma Inc. (APO:TSX), a majority-owned subsidiary of Neptune. The companies are tied together in development of krill oil products for high serum levels of lipids. They are not micro caps. And last week, an explosion and fire occurred at Neptune's production facility in Quebec. What is your expectation for the future of Neptune and Acasti?

HC: On Oct. 2 Neptune completed a $34M financing, and at that point the company's future never looked better. (I refer readers to my last research letter for a baseline view on Neptune and other core positions in the BluMont Innovation PE Strategy Fund I that apply the venture capital model to public companies.) Unfortunately, a horrendous tragedy befell the company on Nov. 8, when its plant in Sherbrooke, Quebec, exploded. The human tragedy is first and foremost in this horrible turn of events, with 19 workers injured and three killed. But it is the curse of financial analysts and portfolio managers that we need to somehow put those things aside as we grapple with the business aspects of such tragedies. With that in mind I refer your readers to a comment put out by Elemer Piros of Burrill and Company on Nov. 11.

"I believe the 505(b)(2) pathway is going to become increasingly popular because it allows pharmaceutical companies to either repurpose existing drugs into new indications, or take existing drugs and put them in a new delivery vehicle that is more patient-friendly or efficacious."

For those not familiar with Elemer Piros: He was the #1 ranked biotech analyst in the U.S. in 2010. He initiated coverage on Neptune in August 2012 with a $7 target. The main takeaway from his comment on Neptune following the explosion was very encouraging from an investment standpoint. He ran a hypothetical worst-case scenario, in which Neptune proves unable to produce product for a full year, and found that this subtracted only $0.68/share from his net present value (NPV). Between this analysis, and Acasti stabilizing at levels higher than I was anticipating, I feel better about where Neptune might go when it reopens. Nothing, however, can make me feel better about the human tragedy involved.

Of course, there will be investors that panic out when the stock reopens, but there seem to be a good number of investors looking at this event to provide a compelling entry point.

TLSR: Amarin Corp.'s (AMRN:NASDAQ) Vascepa (icosapent ethyl) for hypertriglyceridemia has been approved by the FDA. Acasti's CaPre (a purified extract from krill oil) is currently in two phase 2 trials for that same indication. Will uptake and sales of Vascepa be a guide as to how much CaPre can be worth?

HC: First, let me say that it was a relief to read in Acasti's Nov. 12 press release that the company's ability to complete its two phase 2 trials, which are now well under way, is unaffected by the tragedy at Neptune's plant.

That said, I would point out that both Amarin's Vascepa and GSK's Lovaza (omega-3 acid ethyl esters) are guides to what Acasti's CaPre could be worth. We know that GSK sold more than $1B worth of Lovaza per year for several years, and that Reliant Pharmaceuticals Inc. (the company that sold and marketed Lovaza) was bought by GSK for $1.65B. We also know that investors have given Amarin a valuation ranging from $1–3B, on the basis of Vascepa being better than Lovaza in phase 3 trials. (Amarin still has no revenue.) If Acasti's CaPre can be shown to be better than Vascepa in clinical trials, you'd expect to see Acasti with a valuation above that of Amarin. Just for fun: A $1B valuation on Acasti would equate to $10/share, and a $3B valuation would equate to $30/share, after taking into account incremental dilution from the NASDAQ IPO required to raise money for Acasti's pivotal phase 3 trials.

An increasing number of investors in Neptune and Acasti are looking at CaPre as potentially better than Lovaza and Vascepa across all the lipid indications—triglycerides, low-density lipoproteins (LDLs) and high-density lipoproteins (HDLs). If that's the case, and particularly if we can lower LDL by more than 6–10%, we will have a real blockbuster on our hands.

TLSR: You mentioned that Lpath was a likely candidate for your farm team. The farm system has been a successful model for the San Francisco Giants, who just won their second World Series in three years. Many of the team's core players have come from the minor league San Jose Giants, affectionately known as the "Little Giants." Tell me about your farm team and how it works for you.

HC: I should first say that the farm team concept is only used in my more conventionally structured LP; I consider just about all the positions in the venture capital/private equity-structured LP to be core. With core positions, I am comfortable taking a five- or six-year view because I believe the companies are on a secular growth path, possessing a sustainable competitive advantage. I am happy to roll up my sleeves and do what I can to help create and realize value for companies I consider core positions. Turnover among core positions is extremely low.

"The market cap in and of itself never concerns me. It's really about whether a company has a drug with a high probability of making it to the next value-creation milestone and through the development process."

Of course, core positions don't get that way overnight—every core position started out as a farm team position. Core positions typically spent anywhere from 1–3 years on the farm team before graduating to core status. On the farm team, turnover can be high. Sometimes I take shorter-term (3- to 6-month), catalyst-driven positions for which I will maintain firm upside and stop-loss targets. I typically have pre-set sell targets (and stop-losses) for at least a portion of my farm team positions. The bottom line from a portfolio construction basis is that the venture capital/private equity-structured fund will only contain core positions; the more conventionally structured LP will contain both farm team and core positions, and will act as a "feeder system" for the successive venture capital/private equity-structured funds that I raise.

TLSR: Could you give me some farm team names, and make some very brief comments?

HC: Tekmira Pharmaceuticals Inc. (TKMR:NASDAQ; TKM:TSX) and Allon Therapeutics Inc. (NPC:TSX) are two great examples of farm team positions. Tekmira is an RNAi technology platform story. I bought Tekmira in its unit financing at $2.20 solely as a litigation/catalyst-driven position that appeared to have the odds stacked dramatically in its favor for a positive outcome. Tekmira was alleging license infringement and trade secret/intellectual property misappropriation by Alnylam Pharmaceuticals Inc. (ALNY:NASDAQ). For a company facing such a binary event, there appeared to be unusually high downside protection (low initial valuation, good cash balance, a separate cash-generating business underpinning everything), combined with solid upside potential from a court case in which all the evidence I saw screamed "win" for Tekmira. (The litigation involved allegations of intellectual property/license infringement.)

Now that the company has favorably settled the litigation, I have taken my invested capital off the table by selling about 40% of my shares (while retaining the purchase warrants and the other 60% of the shares), and now I have to dig in to Tekmira's prospects as a drug developer before deciding how to proceed. Along those lines: Doug Loe at Byron Capital Markets, for whom I have a great deal of respect, raised his target to $12.50 on the back of this litigation win. Tekmira is certainly an example of a position that could evolve into a core position.

I established a farm team position in Allon Therapeutics in the $0.25/unit financing, after the company made a presentation to my advisory board. I had been following the company for years before buying. I was comfortable that Allon's change in indication (from Alzheimer's to an orphan neurological disease) was the right strategy, and that being able to invest in a phase 3 company with a $35M market cap provided a good risk-reward ratio for the farm team: On the back of successful phase 3 results, we would likely see analyst targets on Allon moving into the $2.50–5.00 range. On the other hand, a failed trial would see the stock go pretty close to zero. Again, the binary nature of the situation means Allon could never be a large position—at least not until we see successful phase 3 results. Immunovaccine Inc. (IMV:TSX.V) is another farm team position.

Senesco Technologies Inc. (SNT:NYSE) is an anomaly: a core position with a farm team weighting. This company is developing a platform technology for addressing cancer. Management is working on a therapy that—it is hoped—triggers apoptotic cascades (cell death) in cancer cells while leaving healthy cells alone. Because of the dramatically binary nature of this opportunity, it is not possible to give this stock more than a 2% weight, but it is owned in both of the funds I manage. Results to date (both preclinical and clinical) are encouraging: The phase 1b/2a trial currently under way has a reasonable chance of giving us a "complete response" that could propel the stock up tenfold or more. The involvement of Harlan Waksal as chairman of Senesco is one of the key elements in my decision to include the company in both funds. But your readers should be reminded first that this type of stock could be a zero if the trial goes awry, and second to always do their own due diligence (financial and scientific) before purchasing any small- or micro-cap stock.

TLSR: Thanks for your time.

HC: My pleasure.

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 1998–2001, 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 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 companies mentioned in the interview are sponsors of The Life Sciences Report: Lpath Inc., Cynapsus Therapeutics Inc., VentriPoint Diagnostics Ltd. 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 & Bioressources, Acasti Pharma Inc., IntelGenx Technologies Corp., Sensesco 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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