Key Concepts
- Private Equity & Credit Concerns: A “reckoning” is underway in private equity due to overvaluation and poor performance, with ripple effects impacting private credit, particularly in the lower mid-market.
- Shift to Private Markets: Capital is increasingly concentrated in private markets, especially tech-heavy private equity, leading to increased competition.
- Biotech as a Mispriced Opportunity: Traditional quantitative models fail in biotech, presenting an opportunity for investors who can apply a specialized framework.
- Biotech Investment Strategy: A three-factor strategy focusing on quality (specialist ownership), value, and peer momentum (based on NIH MeSH classifications) is being employed.
- Long-Short Biotech Approach: A long-short strategy is recommended in biotech due to high idiosyncratic risk and the potential for significant alpha on the short side.
- Dynamic Quant Strategy Development: Successful quantitative investing requires high “research velocity,” intellectual humility, and continuous model iteration.
Private Equity & Credit Landscape
The discussion began with a critical assessment of the private equity (PE) market. Dan from Verdad Capital believes PE is facing a “reckoning” due to past acquisitions at inflated valuations – exemplified by deals in sectors like veterinary clinics (22x EBITDA) and lawn care – which are now demonstrating poor performance. This overvaluation was largely financed by private credit, which is now experiencing increasing bankruptcies, especially among smaller businesses (under $25 million EBITDA). This poses a systemic risk, as the lower mid-market PE sector is heavily reliant on this funding. The number of PE firms has doubled in the last decade, increasing competition and suggesting a potential “Darwinian” shakeout. In contrast, the number of hedge funds has remained relatively flat, indicating a shift in the competitive landscape. Examples like the Hyperion/Meta data center deal illustrate how private credit is used to finance large projects, potentially offloading risk. London-listed private equity funds, trading at 30-40% discounts with high volatility, serve as a cautionary tale. The trend of companies staying private longer, like OpenAI’s $50 billion raise from sources like the Middle East, further illustrates this shift.
Biotech Investment: A New Frontier
Verdad Capital has begun focusing on biotech investing due to the consistent failure of their standard quantitative models in this sector. They are developing a framework to evaluate biotech companies, recognizing the sector’s unique dynamics. The core strategy revolves around three key factors: quality, value, and momentum, adapted specifically for biotech.
The Biotech Valuation Framework
Verdad’s approach to biotech valuation differs from traditional methods. They utilize a modified value metric, using market capitalization (instead of enterprise value) as the denominator to avoid penalizing companies for holding cash. R&D spending is considered a proxy for intangible value. Crucially, they emphasize “specialist ownership” – the percentage of ownership by funds with dedicated biotech expertise – as a key quality metric, reflecting rigorous vetting and scientific understanding. A lack of specialist ownership is viewed negatively.
Peer Momentum Methodology
Traditional stock price momentum is deemed ineffective in biotech due to its event-driven nature (clinical trial results). Instead, they employ “peer momentum,” determined by analyzing the similarity of clinical trials. They leverage the NIH’s Medical Subject Headings (MeSH) tree – a hierarchical scientific classification system – to categorize trials and assess relationships between companies based on their research focus. If peer companies engaged in similar research are performing well, it’s expected that the target company will also benefit, creating a “network effect.” This involves integrating data from clinicaltrials.gov with corporate identifiers, carefully accounting for timing to avoid hindsight bias. The MeSH tree is used to classify companies based on their scientific positioning, allowing for the calculation of “distance” or relationship between them. This data is used to assess both peer momentum and peer value – identifying undervalued companies within specific research areas.
Risk Management & Strategy Implementation
Biotech is a highly idiosyncratic sector with high dispersion and limited correlation between companies. Standard risk metrics are less effective in biotech. While peer momentum demonstrates some co-movement, the residual idiosyncratic risk remains substantial. The median biotech company historically loses money for shareholders, yet the sector as a whole has outperformed, highlighting the importance of identifying successful companies. A long-short strategy is recommended, actively shorting underperforming biotech companies, as there’s significant alpha to be found on the short side – even more than on the long side. Examples of potential short candidates include poorly performing companies with questionable operations. However, the risk of short squeezes triggered by positive clinical trial data is acknowledged.
External Factors & Future Outlook
External factors impacting biotech include increasing competition from China, which is lowering the cost of clinical trials and potentially undermining intellectual property rights. However, a recent period of capital starvation and M&A drought in the sector, coupled with the impending patent cliffs of major pharmaceutical companies, creates a potentially favorable setup for biotech investment.
Quant Strategy Philosophy
The speakers emphasize a dynamic and iterative approach to developing quantitative strategies, prioritizing a high “research velocity” – constantly generating new ideas and challenging existing models. Intellectual humility and a willingness to admit when strategies are failing are crucial, alongside a focus on continuous improvement. Successful quant firms demonstrate consistent name turnover in their portfolios, indicating a proactive approach to identifying new opportunities.
Conclusion
The discussion highlighted a confluence of factors suggesting a challenging environment for private equity and a potentially attractive opportunity in biotech. The private equity market is facing a reckoning due to past excesses, while biotech, despite its inherent risks, offers the potential for significant alpha for investors who can navigate its complexities with a specialized, data-driven approach. The key takeaway is the importance of adapting investment strategies to specific market conditions and embracing a dynamic, research-intensive process.
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