Why the biotech party is winding down

(Fortune) -- For three decades, biotech drugmakers have led a charmed existence. Unlike their Big Pharma peers, biotechs - companies such as Amgen (Charts, Fortune 500), Genentech (Charts), Gilead Sciences (Charts) and Genzyme (Charts) - have never had to fret over future competition from generic versions of their medicines.

That's all likely to change in a few months, as the U.S. government prepares to usher in a new generation of biotech copycat drugs or "biosimilars". The new rules represent a sweeping change in the biotech sector, and will present the most significant challenges to biotech medicine makers since their inception 30 years ago. Many drugs from the first wave of biotech approvals two decades ago - such as Genentech's human gorwth hormone Nutropin and the company's human insulin - are approaching patent expiration, while consumers and insurers are demanding inexpensive alternatives to biotech drugs. As a result, Congress and the Food and Drug Administration are under pressure to fashion a new regulatory pathway for federal review and approval of "biosimilars".

The U.S. government has done something similar before. With passage of the Hatch-Waxman Act in 1984, Congress created a process by which would-be generic drugmakers could challenge existing patents and seek approval to market cheaper, bioequivalent versions of branded drugs.

But Hatch-Waxman doesn't apply to the biologic drugs that biotechs develop. By their very nature, the biologics differ from the chemical compounds made by traditional pharmaceutical companies, and therefore require a separate set of rules. For starters, biologics are manufactured in a living system, either in a micro-organism, or plant or animal cells. Many biologic drugs are produced using recombinant DNA and are made up of very large, complex systems of molecules. That makes them extremely difficult to replicate.

A biosimilar, therefore, is not a molecule-for-molecule copy of a biotech drug, but only a close approximation of the original medication. As part of the new framework, the FDA would be charged to determine whether the biosimilar is similar enough. That is, whether the new "copy" produces comparable outcomes when used to treat patients.

Biotech drugs, of course, represent big money, and are the fastest-growing segment of healthcare spending. In 2006, sales of biotech remedies grew 20% to more than $40 billion worldwide, according to market research group, IMS Health. Biosimilars add a new wrinkle to the business. In the world of Big Pharma, the introduction of a generic competitor can siphon sales by as much as 80% within a year. Generics are usually priced 15% lower than the original. If there is more than one generic competitor, the price can fall by as much as 60% or more.

G. Steven Burrill, CEO of Burrill & Company, a biotech venture capital firm, believes the government faces a huge dilemma in its quest to cut healthcare costs while also maintaining incentives for innovation. "It's the new technologies of biotech that are moving us toward better preemptive and predictive medicines - the very medicines that will reduce healthcare costs. So far, the government's approach has been schizophrenic."

Burrill notes that biosimilars change the entire risk/reward equation for biotech investors. "This will have a bad effect on the capital markets that fund biotechs," he says. "Anything that reduces the potential reward for those capital markets could be devastating for the industry."

Biotech companies will be forced to adapt to other changes. With a limited time of exclusivity, they will need to rethink product development cycles, ramp up marketing plans, and develop more sophisticated regulatory departments. This sea change is already well underway in Europe, the world's second largest market for medicines. Last Friday, the European Commission made a move that suggests Europe is far ahead of the U.S. in creating a marketplace for generic biotech drugs. It allowed Novartis to begin marketing a biosimilar version of Amgen's popular red blood cell booster, Epogen. Last year, Novartis became the first company to gain approval to market a biosimilar - the human growth hormone, Omnitrope - in Europe. After a special FDA review, it also gained approval in the U.S.

Even so, the U.S. is still struggling with the exact shape of the coming regulatory regime. And the clock is ticking. A new legal and regulatory framework could be ready by as early as January. But before that happens Congress and the industry will need to reconcile a number of differences. One proposal being hashed over in Congress, the "Biologics Price Competition and Innovation Act of 2007," was approved by the Senate health committee last June. The House has yet to take up a companion measure. Under the Senate bill, the originators of a biologic drug would get 12 years of market exclusivity before a competitor could apply to produce a biosimilar. To win approval, the competitor would have to conduct at least one clinical trial to establish that its drug isn't meaningfully different from the original.

There are many sticking points. The Biotech Industry Organization is pushing Congress to grant originators 14 years of patent protection. And the industry lobbying group is also pressing to have patients' doctors - rather than pharmacists - determine whether a biosimilar can be used interchangeably with the brand-name original, hoping to prevent too big a blow to biotech firms' bottom line.

While these issues are far from being finalized, it's clear that biotech's idyllic, protected youth is coming to a close.