Micro-cap stocks suffer from all sorts of ills. They are often illiquid, and companies can be unable to raise new funds under reasonable terms, if at all. Investing in these equities requires extraordinary expertise and experience, and that is where micro-cap investment banker Richard "Dick" Huebner excels. In this interview with The Life Sciences Report, Huebner, a senior managing partner with Denver-based GVC Capital, discusses the downside and the upside of micro-cap biotech investment, and the desirable characteristics risk takers should be looking for in very small companies.
The Life Sciences Report: GVC Capital is a licensed broker/dealer focused on investment banking for smaller capitalized public companies. You are a member of the GVC commitment committee, which means you have to sign off on banking deals. In some ways, that makes you the ultimate analyst, because as a banker you must be well aware of risk. Speaking from an investor viewpoint, and aside from the obvious strategy of diversification, how does an investor mitigate some of the risk of investing in micro-cap companies?
Richard Huebner: It's not an easy question to answer, but I'll give it my best shot. I think it's important to properly evaluate both the risk and the opportunity. In evaluating both, you try to find balance: If you're taking greater risk, you would like to have a commensurate amount of opportunity on the upside.
Sometimes we do deals, such as nursing home notes, that are secured by a second mortgage placed on the nursing home, and we get a small ownership stake in the deal. That has a lesser degree of risk than if we were to do a straight equity deal in a new biotech company. In the case of a nursing home deal, we may be willing to take an overall projected return of 20–30%, whereas if we're looking at a biotech deal, where there's the possibility of a 0% return and loss of all principal, we'd like to have the opportunity to make a 20–30x return. By quantifying the risk and potential reward, you can mitigate risk by investing less money in a riskier opportunity.
Some investors have firsthand knowledge of a specific biotech service, technology or product—for example, a doctor or a researcher may have some greater knowledge in a particular field—and that may help them evaluate the risk. Other investors, like us, may rely on outside parties within the field to evaluate opportunity and risk.
Here at GVC, we're contemplating using a technology that was developed at the University of Tennessee for evaluating the ability of individuals—CEOs or founders or a management team—to do what they represented they would do in executing a business plan. The analysis is based on three fairly short tests, and gives you a three-dimensional profile of the individual. It has been used for hiring extensively in the past. Art Boulay, the CEO at Strategic Talent Management, utilizes the technology to give him the information he needs to build confidence in an individual's ability to execute.
TLSR: Your firm prefers to do secondary offerings versus initial offerings because investors can see the liquidity, or at least marketability, of a company's shares. In addition, there would be ongoing transparency via quarterly filings, the Security and Exchange Commission's (SEC's) 10-Qs and the annual 10-K. Can you tell me what red flags investors should look for in 10-Qs? More specifically, what subtle red-flag tip-offs have you been able to pick up over the three decades you've been in the securities industry?
DH: It's not complicated. I look for whether expenses and revenues are as the company forecasted or stated in investor presentations. Largely, it's about holding management accountable for having deployed the capital provided in a financing as directed when soliciting the funds. Was the capital used or spent as had been represented? Also, I look to see if management executed and attained the results it sought with those funds.
Many times, promises aren't spelled out in the 10-Q, but are in an investor presentation. Many of those presentations are now filed with the SEC in Form 8-Ks.
TLSR: You obviously have longstanding relationships with buyside people, whether small-cap mutual fund managers or small hedge fund managers. Sophisticated small- and micro-cap investors expect to be diluted with secondary offerings. Do these investors generally follow on with new investment, or does dilution scare them off?
DH: It's not so much about whether dilution scares them off. Deciding whether to do a follow-on investment depends on several factors. Primarily, for these managers, it comes down to whether management teams have delivered on what was promised, and whether the expectations of the money manager were met. Each subsequent financing is viewed as a new investment opportunity. A subsequent investment decision may be influenced by a portfolio's size, the size of position within the portfolio, exposure to an industry with other portfolio holdings, and the expectation for the company going forward. Managers also evaluate liquidity in the shares before committing new investment capital. It's our belief that, in most of these instances, if a company performs, then market awareness will become greater and shares will become more liquid over time.
TLSR: How do you get a handle on how much money you can raise for a banking client? Are you able to get indications of interest from investors ahead of time?
DH: We have sometimes used company presentations as a way to gauge potential interest prior to structuring a deal. Also, we might want to get feedback from interested parties as far as deal structure, existing issues within the company, its management, its corporate governance and its policies and procedures. Feedback from potential investors also helps with development or maturation of the business plan and the structure of a financing.
I have a pretty good idea of what my investors' appetite for a deal will be, so we can usually give a company a minimum that we'll be able to raise. In more cases than not, we come up with a structure with a pretty wide range. We might structure a deal with a $1 million ($1M) minimum and a $2M maximum, because we don't know how much additional interest we'll get above the minimum. When determining a minimum level in a capital raise, we look at, and balance, the amount we believe we can raise and the needs of the company.
TLSR: Do you have to give out warrants with these secondary offerings?
DH: It strictly depends on the opportunity. We've been able to do many as straight equity. Sometimes you have to include warrants to entice investor interest. It really depends on how the opportunity is perceived, and how people perceive company management's ability to execute.
TLSR: Is it preferable to use a syndicate to get multiple broker/dealers involved?
DH: Certainly, larger deals frequently use syndicates. Unfortunately, in the micro-cap space, so many people have their own projects, and trust their own due diligence and not necessarily anyone else's, that they don't want to open their books to other dealers. There isn't as much collaboration or syndication of deals in the micro-cap space as we would like.
TLSR: Could you talk about some companies, please?
DH: Sure. We have not had a banking relationship with MusclePharm Corp. (MSLP:OTCPK) since the offering we discussed in our last interview, but I've kept current with the company. The stock price has moved up substantially since we did an offering in February 2013 at $4/share. The stock is now trading at just under $11/share. The company's public announcements have been good, and the revenues have continued to grow, with about $105M on the top line last year. The company has made progress toward profitability.
This year the company's top-line guidance is in the neighborhood of $175M. Personally, I had some concerns about that because MusclePharm started with a really good Q1/14 of about $50M, and had some marginal profitability associated with that. However, the company didn't change its guidance of $175M after Q1. It said it may have down quarters going forward from that level because it had experienced extraordinary new order growth for a new product line, which had Arnold Schwarzenegger's name on it. It didn't think that this would carry through in subsequent quarters. I was concerned about quarter-to-quarter profitability, and I'm not sure everybody appreciated whether that profitability would be sustainable.
The company has not uplisted from the bulletin board and pink sheets, but I suspect it would like to move to a larger market so it has greater investor awareness and acceptability.
MusclePharm has definitely proven itself a very capable marketing machine. It is very good at anticipating what products the market will be looking for, and it has been able to grow its sales. I know the company has done a substantial amount of work on corporate governance, and processes and procedures. I'm hopeful that MusclePharm will be able to attain sustained profitability in the near future.
TLSR: MusclePharm shares are up 91% over the past six months. Is that because of insider buying?
DH: When investors see that the people within management of a company believe in the opportunity and are willing to invest in the company, it's always a reassurance to the marketplace. But in this case, it's more that the company has been able to deliver on its quarter-over-quarter and year-over-year top-line growth guidance. Again, delivering on what you say you're going to do is something that investors look at favorably, and it gets reflected in your stock price. MusclePharm does need to get sustained profitability, and I think any down quarter could bring a loss. The company, in my opinion, still needs better cost controls.
TLSR: It seems the nutritional supplement business is very dependent on endorsements by famous people, athletes in particular. You mentioned Arnold Schwarzenegger. MusclePharm also has the deal with Colin Kaepernick, quarterback of the San Francisco 49ers. Is this business, in fact, dependent on these names?
DH: I think endorsements can have a substantial impact. Arnold Schwarzenegger's endorsement, and the product developed in his name, have been a substantial boon to the company. I'm not sure that Colin Kaepernick has had near the impact. The company has also announced a deal with Tiger Woods. Should Tiger be able to return to his prominence in golf, that might have a significant impact on sales. Additionally, the Ultimate Fighting Championship sponsorship has been of great value to the company in driving sales.
TLSR: Dick, how is MusclePharm differentiated from so many other nutritional products companies? Can you put your finger on something that stands out?
DH: CEO Brad Pyatt has always expressed a commitment to staying with those ingredients that are legal. This is where so many of these companies seem to trip up. A lot of companies have run into issues where they utilize a banned substance to keep one step ahead of the competition as far as the performance. Pyatt has made representations that the company will stay within the guidelines and use only those ingredients that are recognized as permissible by the U.S. Food and Drug Administration (FDA). I think that if the company does that, it can avoid a pitfall. The company has also devoted a fair amount of resources to the science behind the performance of its products. Pyatt is doing an excellent job of marketing.
TLSR: Could you go to the next name?
DH: We have done two private offerings for VolitionRx Ltd. (VNRX:OTCPK), one just recently, in September, at $2.50/share, and one in mid 2013 at $1.50/share. The company has performed, and management has done what it said it was going to do, which has given me the confidence to do the raises.
The company has a diagnostics platform based on the Nucleosomics technology. Nucleosomes are protein cores with DNA wrapped around them, like thread on a spool. Epigenetic marks on these structures can be thought of as signatures, which can be identified from a drop of blood. VolitionRx has shown us, in the lab and in a recent human blood sample trial, that it can detect cancer in patients from a tiny sample of blood. Further, as a result of markers on the nucleosomes, the diagnostic can determine what type of cancer an individual has.
In the U.S., we use the colonoscopy as the diagnostic for colorectal cancer (CRC), and it is 93% accurate. Exact Sciences Corp. (EXAS:NASDAQ) has come out with a new test, Cologuard, which is a feces-based diagnostic that is proven to be 92% accurate. Another feces-based test is only about 60% accurate—not Exact Science's test, but based on the same science. The less-accurate feces test is sent out free of charge to the citizenry in the U.K. following their 50th or 60th birthdays. The government pays for the tests, but only gets about 50% compliance, meaning only 50% of the people are willing to handle their own feces, put it on a piece of cardboard and send it in for a test, even though there is no charge to the individual.
In a trial with 938 samples tested with VolitionRx's NuQ test, which only needs about a quarter of a drop of blood, NuQ was found to be 84% accurate in determining individuals with colorectal cancer. Now, 84% is not 92%, but I believe 84% is pretty high for a test that's probably going to be priced at $50 or $60 versus Exact Sciences' test, which is about $600 and requires patients to handle their own feces. Moreover, VolitionRx's test can be done in conjunction with other blood tests, since so little blood is required. You just indicate that you'd like to have a test for colorectal cancer. Given the cost and ease of a blood test, it is likely that an individual will be tested with greater frequency, thereby increasing the overall accuracy of the results of the blood-based tests.
One thing that's important about the trial results with regard to colorectal cancer is that the test was just as accurate for stage I cancer as it was for stage IV cancer. That's important because, in general, if a cancer is caught in stage I, you have a 74% chance of survival over five years, whereas with a cancer caught in stage IV, you have a 6% chance for survival over five years.
TLSR: When will NuQ be available? What's its current status?
DH: Currently, trials in Europe are being performed for colorectal cancer. I think that will lead to the test being approved in Europe, possibly in 2015, with the possible start of sales in late 2015. In the U.S. the test would have to be approved by the FDA, and then approved for reimbursement by Medicare, Medicaid and insurance companies. VolitionRx has not yet begun that process. A 14,000-sample trial will follow the 4,800-sample trial, and if those achieve the same results as the 938-sample trial, and if the company achieves a $50 or $60 price point, which I have every reason to believe it can, I would think that FDA approval would come within the next three or four years. I also think the test would have a really good shot at being reimbursed by insurance.
TLSR: Dick, you mentioned prostate cancer earlier. Where is that in the pipeline?
DH: Prostate cancer also has a screen, the prostate-specific antigen (PSA) test, which is done via blood draw. It's only about 68% accurate. In early October, VolitionRx announced that it is beginning trials at the MD Anderson Cancer Center in Houston for its blood-based test for prostate cancer. This would be the first trial that the company has done in the U.S.
There aren't really any screens for cancer beyond prostate and colorectal. VolitionRx has also had success with a blood-based screen in its lab with lung, pancreatic and breast cancers. The company thinks its blood-based test might be applicable in as many as 20 cancers. I think there's huge opportunity here. There's still a lot of risk, because VolitionRx doesn't have an approved product, but it is close in Europe. The company, over the course of the three years that I've followed it, has done what it said it was going to do. And it has done that without much capital. In its history, VolitionRx has only raised about $15M, and approximately half of that money has come from officers and directors of the company.
TLSR: Dick, last time we spoke you mentioned Omni Bio Pharmaceutical Inc. (OMBP:OTC). Did you want to update it?
DH: GVC has participated in several capital raises for Omni Bio over the years. We have raised approximately $13M for the company over a seven-year period of time. Unlike Volition, which is a diagnostic company, this is a drug company. Drug companies obviously need more money, and take a longer period of time to achieve ultimate success. Omni has announced that it raised a couple million dollars this year, but that was not done through GVC. It was pretty expensive capital, and I think the company balance sheet reflects that.
The company has moved forward and initiated trials with its recombinant alpha-1 antitrypsin therapy (AAT Fc) in graft-versus-host disease (GvHD), but it is going to need a substantial amount of money going forward to further its trials and take the next steps. The therapy also may have applicability to type 1 diabetes, refractory gout, arthritis and other inflammatory diseases.
TLSR: Dick, we're looking at a company with an $8M market cap. Would you imagine at least twice that much has been invested into Omni Bio?
DH: Yes, I would say about $15M has been invested.
TLSR: I wonder if Omni Bio wouldn't do better as a private company, so that it can get out of the spotlight and get to its knitting. For a company with this kind of market capitalization, reporting every quarter is very onerous. Have you thought that way?
DH: In retrospect, knowing that it's been public since 2009, I'm sure the company would say that it would have preferred to deploy the $2–2.5M cost of being public toward its research and additional trials. Concurrently, probably $11–13M of its $15M has been raised in the public market place, and I don't know that the company could have raised that kind of money privately.
It would take a pretty deep pocket for Omni to go private now. Our experience is that it's very difficult to find somebody to take that kind of risk. It would require a huge amount of time and capital commitment. You're looking at a project that could take seven to 10 years, and maybe $150–200M in capital commitment, to complete. Big pharma is not willing to take that risk any longer; it would rather just acquire a company or joint venture with it once the science is proven through Phase 1 or Phase 2 trials. For guys like me, who deal in the micro-cap space, it's hard to find a party that might be willing to take a company like Omni private—to commit that type of capital and wait that length of time to monetize the investment.
TLSR: I'm looking at a letter dated Oct. 2 of this year from Omni Bio's CEO, Bruce Schneider. There didn't really seem to be a milestone that investors might look forward to. Did you have an idea of what catalyst there might be to move these shares?
DH: I don't think the company currently has the capital to get to a milestone. It may have news as it relates to its GvHD trial, and I think the majority of investors would view that as a great thing. But it's still early, and it's not a big trial sample.
TLSR: Dick, thank you.
