A:

The strength in the IPO market is an important indicator of liquidity, risk appetite and innovation in the drugs sector. Drug companies are under pressure to continually release new medicines to replace old ones that lose their patent protection. Many newer companies with promising drugs in development go public to raise capital so they can have funds to continually research, innovate and complete approval processes.

When young companies are easily able to go public and find demand for their shares despite their uncertain prospects, it is a good sign of liquidity and risk appetite in the sector. While drug companies spend heavily to develop new products, they can be unsuccessful in developing large enough products to replace old, blockbuster drugs. This is the major source of stress for drug companies.

With innovations in biotechnology, the cost of drug development has significantly decreased. With an increased understanding of the human genome, tests that once cost millions now cost thousands. Sophisticated computer equipment allows for virtualization of many processes that were once performed in the laboratory. Of course, at some stage, lab work is necessary but the trial and error part of it has been eliminated. This has also increased competition in drug development as barriers to entry have been reduced.

The strong IPO market makes it cheaper to raise capital and can spark cost inflation, as there is intense competition for talent. Established drug companies may find their most talented people being lured away by new companies offering equity or competitors offering more lucrative pay packages. This is one of the drawbacks of a strong IPO market, as costs can be expected to rise, eating away at profit margins. Talented employees may also leave to start their new endeavors when funding is easily available.

On the brighter side, these IPOs become another avenue for companies in the drugs sector to pick up promising treatments in development. Essentially, they are able to outsource the early stages of development in which the most risks and uncertainties are involved. However, a strong IPO market reflects liquidity and risk appetites in the sector. In one way, this is not good for drug companies as they have to pay higher multiples to purchase early stage companies due to this bullish sentiment and demand for assets. In this type of environment, it is not possible to find bargains.

One moderating factor is liquidity and risk appetites also end up driving multiples and valuation higher for entrenched players in the drugs sector. Therefore, the currency they use to make these transactions, their own stock, is also higher in value. Additionally, strong IPO markets are a reflection of consistent performance and promising innovation. Thus, drug companies' balance sheets are expected to be strong with healthy cash reserves when the IPO market is strong.

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