Rod Wong – Empty Rooms: Innovation in Biotech at RTW (Capital Allocators, EP. 310)

27:14And typically this could span, call it five years, until you get three baggers, five baggers, 10 baggers, and then they make it on that top 10 list. So a lot of what we think about is we're ultimately always looking for something that has the potential that can be added to that list. What do the losers look like? It's actually one of the biggest learnings that I've had in terms of, if you're to say, since I started as a PM, what have I changed about the strategy? The losers are, at a basic level, we play in a binary space and that's part of the business. We're wrong. high 30s, 40 % of the time, 40 some odd percent of the time.

27:54But the key is making those losses as small as possible. And you'll see at the top of the losers list, one key theme, which is that even when we thought we were fundamentally right from our analysis on a name, we've gone up against savvy management teams that then find a way to capture or realize value despite the fundamentals being against them. So like our second largest loser was actually a short position against a company called Map Pharma. They're developing a single-use inhaler for migraine. And the very short version of the story is our research said that they can't manufacture this stuff.

28:28It's very, very hard to make inhalers with a single puff in them work. And we've done all this diligence, and we're 99 % sure. I don't want to sound like a crazy person, so I'll say 99, not 99.9. But we were very confident. You couldn't manufacture it, and so it can't be approved. And we were short in size. And they sold the company at Allergan. And we didn't even give up then, by the way. After they announced the deal, we tried to get an audience with Allergan at the time and tried to convince them of why it couldn't be approved. And there wasn't much interest in that message. The deal closed and the drug got rejected a month later and got rejected two more times after that, I think.

29:06So one big lesson in the losers was do not underestimate what savvy business people are capable of. One adjustment that we made as a result was on our shorts, we slashed the max position size. There's different levers that'll drive stocks. And particularly in this space, you think about just the science and so that binary nature of approval. Then you've got the business, the market they're selling into. And then as you just introduced, there's this management element. When you're assessing a position, how do you think about each of those and the interplay between them? I think the honest answer is we've always been very analytically focused.

29:46So the probability, the size of the opportunity, and then related to that, the valuation piece. I like to say if Warren Buffett were to ever invest in biotech, development stage biotech, maybe he'd use the framework that we would use. Now, of course, I know he never would. But I use that analogy just to make the point that we're fundamentally value-oriented and we are looking for asymmetric risk reward. The trick is that you have to overlay that we live in a probabilistic business or one that's binary. So we've always been very focused on those variables. I will say that on the management piece, I kind of make it very simple.

30:25I put things in three basic buckets. Low percentage of the time management that is so stellar that you think they can take a very marginal product, right? They can sell ice to an Eskimo and there's drugs like that. And they can find a way to get it across the finish line and make it commercially successful. And there's certainly drugs like that. Then the other extreme, also a low percentage of management teams, is those that will screw it up. The execution, and that's extremely frustrating for analytically oriented people. And then the middle bucket, which is most, which is that you have good management, solid management, knows what they're doing, and it's really about supporting them just to maximize the odds however we can.

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32:01Learn more at srsaquium.com. That's S-R-S-A-C-Q-U-I-O-M.com. And now, back to the show. I'm curious how you think about the changing nature of your probability assessments. You say like your winners ultimately are the ones you've rode all the way, but there's new information that's coming up all the time. So how do you go about making those decisions? Yeah, it gets into a little bit of the portfolio manager and trader part of the job. And I think the way we do is pretty simple. We just consider each point in time almost kind of like you're re-underwriting the investment, right? So no matter where an investment is trading or where it's been marked last, you're thinking about then what is the next step in terms of key event, probability around that event, and then the asymmetry around that event.

32:56Now, there is for sure some art to this, right? It's dependent on top-down things like what kind of market environment you're in. As an example, kind of the worst part of the bear market sell-off this cycle, Q2 of last year, you could have been right on everything, right? Call the event right. Day the news comes out, the stock trades down because it's a source of liquidity like everything else in biotech that quarter. So you got to factor in those elements. That's part of the art. And then even in regular markets, you have to think about, okay, so I know it's a 10x if it's 100 % probability and makes it to the end of the rainbow.

33:32But what proportion of that 10x should something be valued at or trade at, at the different steps along the way? And there are exercises you can do, right? There are comparables analysis that you learn in business school and as a young banker to help frame that up. And then there's also some judgment and then you got to overlay the macro environment. So those are the things that we kind of layer on top to size positions dynamically over time. A couple of things you said relating to portfolio construction, that when I piece it together in my head, I scratch my head a little bit. So one is that the conviction leads to concentration.

34:11The other is that these probabilities can change over time and you need to be a little bit dynamic. And then the last is where you started, which is this is a really volatile space at the stock level. What does a portfolio look like over time? Well, I'll tell you how we're positioned right now, for example, and generally speaking. In our flagship fund, we're about 70%, a little bit north of that, net long. We are 90 some odd percent invested, so on the long side. So our gross exposure, if you add long and short, is not that high, right? It's like 90 by 20. And so you net with 70. That is not that atypical for us.

34:51I would say our outer bounds are net of 30 and net of 90. And then the high end of gross is probably like 150. So that's what it looks like just by the numbers. I would say a very important element that we haven't touched on yet is our best ideas, this conviction piece, our very best ideas. And sometimes we don't even have one that reaches this level in a given year, but we are willing to take up to a 5 % loss if we're flat out wrong. So we have to use the art and guess what the worst case scenario is, both fundamentally and factoring in the market environment. We've been relatively disciplined about that.

35:30So you see on that top 10 losers list that we've only had a couple positions that lose us more than 5%. If you have those kinds of guideposts in your mind, then you can kind of start to see how the portfolio falls out from that. So we'll have larger positions that are 5 % to 10 % plus of the portfolio. That must mean that those larger positions have some kind of base business value support. They sell a drug on the market and we're playing for the second drug. And then you have a number of positions that are sub 5 % because there's a lot of single product development stage companies, and the downside is 90 % or 100%.

36:06And those positions almost universally will be less than 5%. There's some strategies where 10 % position any kind of buy-to-company commercial stage or otherwise would seem like an enormous position. For that reason, it is a special strategy, and it is a fair amount of concentration. How have you changed the way you thought about the number of positions and the trading as you've grown your assets over time? It's evolved around the edges. What I just walked through fundamentally hasn't changed. But what has changed, I would say the biggest piece is on the tail. So 80 % of our business approximately is public.

36:44And the portfolio looks exactly like what I just described. But now 20 % is private. And in that private bucket, we're doing mid-to-late stage venture-type investments. We call it crossover, right? In biotech. And then we're doing some early stage company creation, series A types of investments. So we've essentially added a farm team over time, which consists of those private investments, right? A typical year, we're doing 10 to 20 of those in total. So the goal of that, of those private investments, you get from the name. We call it a farm team. So the goal is actually that they go public and then we continue to re-underwrite.

37:19And from that farm team, we're looking for people to bring up into the majors. The nice thing about that process is it gives us even more time to do deep diligence, waves and waves of diligence, and also to get to know management teams and know what bucket they're in and get comfortable with them so that ultimately we feel more comfortable making a 5 % or a 10 % position. I would say that's been the primary change in the portfolio over the last handful of years, which is just that direct consequence of the growth of the private business. When you cite the statistics of predicting drugs in that like 60 to even 70 % success rate, that's even higher than what you'd expect outside of the biotech life sciences investing.

38:02So how do you think about the trade-off of concentration to make a big bet in a volatile space anyway, versus, hey, if you have this hit rate, maybe you should have a more diversified book? Part of the challenge is that high probability investments, or at least by our assessment, they don't grow on trees. you'd probably have less volatility in terms of a strategy if there were more of them. So the individual idiosyncratic losses and wins would be smaller. It'd be a smoother kind of return profile. But the reality is, yeah, there's 50 drugs approved a year in the United States. So there's not that many.

38:36And then you've got to find the ones that are misunderstood, mispriced and all that. So we are willing to tolerate a bit more vol idiosyncratically to just focus on kind of those high probability investments. When you're doing your research with your team, what are the things that you get conviction in or the signposts of that conviction, both that you think the drug's going to work and that you have a differential view from the market? It's a very straightforward question.

39:10but yeah the answer is actually big i mean i think at the end of the day what it's about is about doing different types of exercises research or analytical type exercises that you're confident are going to be predictive of the future right that's the name of the game and it depends on the investment type the situation and where the misunderstanding is So, I'll give a couple of different examples. Sometimes the misunderstanding is people don't understand statistics. And so you can have edge by doing it properly. So there was a wave a bunch of years ago of constipation drugs in development. And the endpoint for constipation studies is how many bowel movements you have.

39:57Obvious. Because that's the goal. And the nature of drug development tends to be when you progress from early stage trials to late stage trials, the regulatory agencies like FDA make you do longer studies. Initially, you don't have that much safety information. You don't have a lot of toxicity data. And so they're like, okay, test it for a month. Do your phase two for a month. And then when you prove yourself, it looks like an interesting drug. Then in your phase three, we want you to do six months, right? Because we want to be sure that it's safe. So in constipation, the way this plays out is people do proof of concept studies over a month.

40:30And you would have these drugs that would have really, really impressive p-values, right? So if you gave that data to a statistician, they would tell you the phase three has 99.999 % of being successful. And then you saw all these phase threes fail. And we're like, what's wrong? And I can't definitively tell you the answer, but I can tell you what we did. And I can tell you my hypothesis. We studied all these historical constipation trials, going back into the literature. And we found that phase twos, a lot of them work, and phase threes, they all fail, every single one. So empirically, we said, actually, the statistician is wrong.

41:09It doesn't matter how great the p-value in phase two, the phase three failure odds are high. In hindsight, I'll tell you what my intuition tells me, and this is just a hypothesis, which is that constipation patients are real human beings, and they're willing to take their placebo for a month, right? But when they can't go to the bathroom for a month, they walk into the Duane Reade, the CVS. There's a whole aisle called constipation beds. And what you saw in phase three was exactly that. There is this big placebo effect, okay? Anyway, very long story to say. So we spend a lot of time studying, looking for statistical trends and anomalies, things that we can take advantage of in data.

41:51And a lot of it's not just theory. You have to gather data and you have to really understand it and understand what you can actually predict. Now, opposite example, much briefer story, is on the commercial side. We were known in the early days of making some investments in rare disease companies. With rare disease products, when you launch, oftentimes there's tons of uncertainty. You don't know if there's going to be no patients out there with the disease or way more than people expect. And we've got very good at doing exercises by, for example, counting patients at certain centers, by knowing how to use insurance data, more recently knowing how to use genetic data from public databases, and using that to conclude what the outcome was likely to be, that it's going to be way smaller or way bigger, continues to be a huge source of edge for us.

42:42Because that work is, it's not, it doesn't take a genius to do it, but it takes a lot of effort. As you look at the universe of companies from development stage businesses to a couple of larger ones, do you have views on where companies are structurally advantaged or disadvantaged in this entire process of this long development cycle process? Right now, one of the dynamics that's happening in the space is that pharma, which pharma has been kind of between a couple of major patent expiry waves. So about 10 years ago, there was a big wave, Lipitor, the antidepressants, all these big drugs went away.

43:24And then there is this wave of breakthroughs in cancer, you know, the PD-1s, for example, K-Trudup, Devo, a lot of people are familiar with. It has a period of relative growth for the industry. And now in the back half of this decade, again, you're going to have these big patent expirations that's on higher revenue basis. So there is tremendous pressure in the industry for those companies to try to mitigate those patent expirates and do deals. So I would say those biotech companies, so the targets, the ones that have the best seat in the house are the ones that are developing drugs that have the potential to move the needle for a pharma.

44:04So it has to be a blockbuster drug and is in a strategic area or disease or technology that fits into pharma portfolios. Those are the kings in this cycle. Even in a tough market, capital availability for those companies is good. And valuations are pretty good. The ones that have the worst seat in the house are the opposite of that. One particular example that we find kind of interesting is that companies that actually have succeeded all the way through development and they're getting ready to launch a product, but that product is a sub$1 billion peak sales product. Could be pretty big, like half a billion.

44:43And before the bear market, that would be a very exciting investment. But the problem with a half a billion dollar peak sales drug, and even worse, if it's not in a strategically important area, that company has got a terrible situation because you have to raise$200 to$300 million for the next 24 months to launch that drug. And in this market environment, people are so risk averse that they don't want to take that risk. And it's hard to find$200 to$300 million. dollars. So those are losers in the environment. And those are the kinds of situations that we think selectively you can find really interesting opportunities.

45:19But if you can help solve that problem and increase the odds that they can successfully launch and achieve that peak sales estimate, then you can really create a lot of value. You mentioned the opportunities and challenges of a listed vehicle. What have been the trials and tribulations of that entity? It's been a really interesting adventure. There are a lot of really positive things about a listed fund. I think the challenge is that UK in general, and then specifically for listed funds, there's not a deep audience and there's not a lot of liquidity for that. So that's one challenge for sure. The other is it's not a familiar product for people.

45:57So a lot of people now want to allocate to biotech, but they're just not familiar with that structure. And some folks, They don't want something that's marked to market every day. So there's just some interesting dynamics that make it a little bit more challenging in some ways. But I really do think the strengths of the vehicle are such that it's worth us to continue to invest in it. What's the competition like for RTW? The industry has grown a ton. And asset management firms or investment firms have grown with the industry. But that said, it's still a pretty small business, right? Small ecosystem.

46:38So I don't know the exact number, but healthcare dedicated firms that are managing meaningful amounts of capital, like north of a billion dollars is probably a dozen plus or minus, something like that. You complement that with some bigger pools of capital at platform firms or generalist firms. But you add that all up and it's a short list. Everyone on that list does it a little bit differently. I think the things that have differentiated us are a lot of the things that we've talked about. We're not just full lifecycle, but we also have the flexibility and the creativity to financially support companies in all kinds of creative ways, whether public-private, stock, royalty, licensing, transaction.

47:18I think that differentiates us. And then I think just the way we've kind of structured and organized our team is differentiating. I think the companies that we work with like interacting with a team that looks like that because it actually looks more like their own teams. But at the end of the day, one of the really nice things about our business is that this was a very, very small business even 10 years ago. Not only was the list even shorter, but the firms were tiny. So the culture that developed in our ecosystem was one that we worked together to get things. So most of us are friends with some portion of the rest of us.

47:51And the culture is to default to not be competitive, but try to be collaborative. And that spirit, I think, has stayed relatively intact, even as the firms have grown. For some of the firms that haven't made it and have come and gone, what are some of the lessons that you've learned of mistakes that others have made? One of them is the transition that we talked about from small to scalable. People always said, oh, you know, the firm's actually way riskier when you cross a billion dollars. And before I went through it myself, I didn't understand it. And now I really get it. It's very hard, especially when the wiring of your leadership, everything that's gotten them to that point are the same things that will cause their business to fail.

48:35So being a lone wolf, not embracing teamwork, not embracing structure. I think that's one key thing that's caused firm failure. I think another key thing is falling in love with science and not doing the risk management part of the job properly. You know, there's a saying, right? Doctors can't balance their checkbooks. Of course, there's some truth in a lot of sayings. And there's truth in that one. A lot of people get into this business because they are passionate about science, number one. And that's true of a lot of the folks here too. But it's tricky to bring both of those things together and have discipline, especially with risk management.

49:16But even if you've sized things appropriate, to have a very sober view, objective view of truly what is the worst case, easy to say, hard to do. So that's caused a lot of failure. So as you look out after this significant retraction in the space, what opportunities are you most excited about? The innovation that we're seeing, especially in drugs, is very broad. We see a ton in cancer. Cancer is always the number one area of drug development. It's obvious high amount of need is the number two killer in the United States and other developed countries. But now with information in the form of genetic drivers, we're redefining cancer into what it actually is.

49:57Not just pointing out that, hey, you have cells that are growing when they shouldn't be. That's cancer. And then pointing out where they found it. Oh, lung cancer. If you think about it, it's so archaic to refer to a disease that way. So now cancer is being redefined into its genetic drivers. That's unleashed a ton of opportunity and innovation. And you have all these new tools like even chemotherapy, for example. The problem with chemotherapy has always been that there's a lot of collateral damage. It kills tumor cells, but it kills you too. And now you have things like antibody drug conjugates, which can improve what we call the therapeutic index by getting that delivered to the tumor cell.

50:39So oncology, we're seeing tons of innovation. For similar reasons, immunology as well, a lot of unmet need there, a lot of diseases that don't have enough therapies. And then I would say some tissues that have been hard to get to, the brain, the eye, the heart, because of new modalities and their ability to get drugs into those tissues are also seeing significant waves of innovation. So this kind of mega innovation wave gets me excited. The one thing that I think a lot of venture capitalists talk about, which that we are actually less excited about, is that there's a lot of venture capitalists focused on actually what is the next new modality?

51:19What is the 15th and the 16th? As an example, gene editing gets tons of airplay. But our view is kind of actually, we just tripled the list. And this list, like gene therapy as an example, there's a lot of work we could do to make gene therapy better, cheaper, improve the therapeutic index. And I actually think that we don't need to increase the number of modalities at all. If we just focused on improving what we have, this new updated list, I think that would last the industry 10 to 20 years. What are you most concerned about? You know, I think one of the things I'm most concerned about is payers and the pressure that we're seeing on paying for innovation in drug development.

52:08That's probably my number one long-term concern. I think there's short-term things like, for example, you know, COVID actually had a major impact on how the FDA functions. They moved heaven and earth to get those vaccines and the first handful of drugs approved, it burned a lot of people out. And so you had tremendous turnover at FDA and there's a whole training process and all these things. And when you're training a lot of new people, things shift more in a conservative way. Because if you're handed the manual, you don't have the judgment and experience to be not paying attention to the manual yet.

52:42So I think the FDA is going through that process on a short-term basis. But I think the pricing concern is a big one. We think about at the firm different ways where we can be advocates for innovation. I think there's more work for us to do there because I really do think there's a misunderstood narrative out there that folks need to do a better job in our industry of helping to correct. How do you think about positioning the firm to take advantage of the opportunities that you see coming over the next five, 10 years? Well, I think now we have the team that's in place. We have the capabilities that we care about.

53:22So I think now it's really about executing against it. So of course, from a sourcing perspective, we got to find those opportunities. I think it is a wonderful time because the cost of equity is so high to then also wear our deal-making hats and all the building, transacting capabilities that we have built and put those to good use. Because some companies, their capital needs now are so large relative to their market cap, because a lot of things have very small market caps, that you can't solve their problems with a deal that's just like an equity offering. The rough rule of thumb is you can do an equity offering for like 10 % to 20 % of a company's market cap at any given time.

54:07But some companies need 3, 4x that amount of capital. So to be able to go to a company and say, we can bring together multiple pieces of a deal so that you have the capital that you need to launch your drug or to run your phase three trial, we have the capabilities now at the right time for this tough moment in biotech. Rod, I don't want to let you go without asking a couple of closing questions. What is your favorite hobby or activity outside of work and family? I have a kind of a straightforward life. I just like doing things that are physical. I don't have one single sport that I love, but I do a little bit of a lot of different things.

54:46That's probably my number one thing. I'd say hobby-wise, I have a lot of guitars. And based on the number of guitars I have, you'd think that I'm an incredible guitarist. I'm basically a beginner intermediate guitar player, but I love learning the guitar too, clears my head and, you know, it gives me some connection to music. What type of investment do you gravitate to like a moth to the flame? You know, I think things that I describe as lock and key have always been kind of things that we've just, just feel like we can bet on, right? So like, if you know that a tumor is caused by this mutation, or if you know that this rare disease, they are missing this gene.

55:27And if you can express the protein that's missing or replace it, that's probably going to work. And as simple as it sounds, we continue to make investments like that and they continue to be very rewarding and have high odds. What's your biggest pet peeve? I think from an investing perspective, it's what we talked about when, and this is the analyst in me, when we just see a drug that has so much promise, but we're in one of those rare instances where the team that's taking it forward, you don't have confidence in. It's really frustrating. At least now we have more ways to help improve the odds.

56:05Which two people have had the biggest impact on your professional life? Don't make me choose. At each stage or each job, I've been really lucky and I'll have like one or two mentors that then I'll carry forward in my life. So my first boss, Eric, he's just such a great example as a human being and as an academic. My second boss, Wayne, his ability to hone in on what is important and then do deep, deep work is to this day, I mean, he's one of the great ones. at DK, Scott and Tom, business builders, pulled me out of my minutia and made me think about bigger picture, risk and macro. But one person that wasn't my boss, but was a colleague and mentor, Kevin Tang, about 10 years older than me, he really showed me the possibilities to influence and build.

56:58And we did some deals together when I was just dipping my toe into that. and I really learned an incredible amount from them. What was the most challenging moment in your career or life? Professionally, I would say my toughest moment has to be 2011. So we launched this place in 2009. I lost our biggest client. Our assets went from small to two-thirds smaller. And it was tough. So one, we had to decide to keep going. My CFO took on two part-time clients. to keep the doors open. We actually, I think our first office was maybe 2 ,000 square feet, maybe even less. And we took on two subletters so that we could pay the rent.

57:44We let a couple people go and we only had a few people. Very, very challenging. But, you know, I actually have really fond memories of it now, obviously, since we've done better since. And actually, the folks that came in and subletted now have become lifelong friends. and they've been fortunately successful too. That was a difficult time. For you to get through that period of time after you've cut the costs and kind of make it to the other side, what do you remember that allowed you to do that? When young folks ask me what they should think about, you know, before considering to start their own thing, I always give this example, which is that like you can't plan that things are gonna go up in a straight line.

58:30There's no straight line in anything. So if you're going to make a decision based on planning, plan for a not straight line and don't make it a two-year plan, make it a five or a 10-year plan. That's number one. And then number two, don't do it for bad reasons. And a bad reason is if the only reason is to make money. And for me, the most important reason I was able to persist was because in that moment, the glass half full view was I'm my own boss. And that was very, very important to me at the time. And as long as I can pay my bills, pay the rents, I loved my job, I enjoyed what I was doing each day, then that worst case scenario, that's okay.

59:11So it wasn't that I was going to turn this thing around and we're going to be a great success. Especially at that point, you're always at your least confident and you really can't plan for success because it looks so far away. It's the obvious things. Be passionate about what you're doing, enjoy it for what it is, and plan for the long term. What teaching from your parents has most stayed with you? You know, my parents were of the generation, and maybe it was just their style, where they gave you a lot of personal responsibility and you had to figure stuff out. I think in hindsight, that was huge.

59:45And then I'd say the other thing, my dad specifically, he always told these stories about his childhood. and most of the stories were some version about him ignoring authority and then doing something bad and then some somehow coming out on top like uh there's one he he um forged his mom's signature said that he had to be out of school for because he was sick when he wasn't sick he didn't go to school for a month and then eventually and he would just go to the beach and hang out and then eventually he got busted. They held him back, but because he was such a bright kid, he took the test. He was in Hong Kong and you take these A-levels and whatever.

1:00:27It's very test-driven. Took the test and then skipped the grade that he was held back from. Anyways, so those kinds of stories always like, I think imprinted in me, this faith in yourself, think for yourself. And then once you're confident, don't let people get in your way for better or for worse. I think that it's really put a very strong independent streak in me. Rob, what life lesson have you learned that you wish you knew a lot earlier in life? Early on, I think I had some talents and skills and I gained confidence from that. But I did have some very lone wolf type of personality attributes because of that.

1:01:08And I wish I had learned the value of teamwork and to embrace that even sooner than we did. We did it when we needed to. But because I realized that to really accomplish things that are big, to really have a bigger impact, you can't do it alone. You have to do it with people. It actually requires way more self-confidence to do that. Because you have to be okay with welcoming people in that know way more than you do about different things. And you have to have... You got to be sure enough in yourself, right, than to be able to work with those people in a way that's positive. Ron, it's great to catch up.

1:01:48And thanks so much for sharing this story of this incredible success and opportunity. Yeah, no, thanks a lot. Thanks for having me. Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com, where you can access past shows, join our mailing list, and sign up for premium content. Have a good one and see you next time. Thank you.