Market sentiment for biotechnology stocks might be tepid, but big pharma continues to swoon over functional genomics. The sector has dominated pharmaceutical merger-and-acquisition activity this year. Thursday's announcements that Eli Lilly (NYSE: LLY) has cut a deal worth as much as $500 million with Isis Pharmaceuticals (Nasdaq: ISIP) and that Pharmacopeia (Nasdaq: PCOP) intends to buy Eos Biotechnology for $197 million are just the latest in a string of deals involving functional genomics firms. Readers will recall that functional genomics was one of Red Herring's Top 10 Trends for 2001.

The great promise of functional genomics is that it will improve the persistently low rate of successful clinical trials of drugs, by accurately predicting how a drug will behave in a patient. This is not to say that functional genomics provides all the answers -- just that it provides better ones.

Other notable genomics deals include Merck's (NYSE: MRK) purchase of Rosetta Inpharmatics for $620 million; Vertex Pharmaceuticals's (Nasdaq: VRTX) $592 million purchase of Aurora Biosciences; and Celera's (NYSE: CRA) $174 million purchase of Axys Pharmaceuticals (Nasdaq: AXPH).

Collaborations between big pharma and functional genomics firms have stepped up, too. In addition to Lilly's deal with Isis, German chemical giant Bayer made an $85 million equity investment in CuraGen (Nasdaq: CRGN) in January. In addition, Bayer and CuraGen inked a deal for the discovery, development, and commercialization of small-molecule drugs for the treatment of obesity and adult-onset -- or Type 2 -- diabetes, which could eventually be worth $1.5 billion. With its cholesterol-lowering blockbuster, Baycol, just pulled from the market for safety reasons, Bayer needs this deal to produce -- and fast.

All told, functional genomics deal flow for 2001 could top $5 billion.

TESTING ANXIETY The value proposition for all the companies writing checks for functional genomics capabilities is simple. It's all about predictability. Yes, time and cost savings in drug discovery matter, too, but nothing saves more time and money over the long run than boosting your odds of success in the drug development phase of clinical trials. One of the reasons that an average of more than eight out of ten drugs fail in clinical trials is because a product's side effects and efficacy profile in a human being have been maddeningly difficult to predict using in silico testing -- computer-based testing of drug compounds -- and testing under animal models.

For example, faced with the prediction that a lead compound will likely prove too toxic to clear Food and Drug Administration muster, the senior scientist who runs the research-and-development effort for this experimental drug will still have to make a tough decision about whether to pour more money and time into it in hopes of eliminating that pesky toxicity issue. There is, alas, still no substitute for sound human judgment.

Broadly speaking, functional genomics is the business of plying nifty genomics tools like gene chips, mass spectrometry, gene profiling software, micro-arrays, microfluidics, supercomputers, and human genome data in the service of drug discovery and development. Specifically, functional genomics tools increase the efficiency and accuracy of processes such as figuring out what causes, say, normal pancreatic tissue to become diseased. Once the probable culprits are identified as likely drug targets, researchers can use the same tools to evaluate the likely therapeutic potential of a range of drug compounds.

Feeling pressure to crank out an experimental therapy that will be unlikely to fail in clinical trials, drug companies increasingly are looking for ways to take some of the trial-and-error out of this crucial phase of drug development. Increasingly, they are turning to functional genomics firms for help.

"Everybody needs these [functional genomics] capabilities now," says Barr Dolan of Charter Ventures, which invested early on in Eos. "Pharmacopeia already had most of the pieces in place to get into the drug development business. Functional genomics was the piece they were missing."

Eos was already very much an upstart on the rise. Its cofounders come from the dominant gene chip firm Affymetrix; it has focused on antibodies, which have become a huge success story in all of biotechnology (Rituxan and Enbrel, two of the top-selling drugs in all of biotech, are based on antibodies); and it has compiled a strong library of the genomic traits of key disease classes like cancer.

Likewise, Rosetta Inpharmatics has a respected management team headed by CEO Stephen Friend. What Rosetta, Eos, Isis, and others lacked, however, was easy access to capital during this downturn. There was no imminent danger of running out of capital, but they now are all in a considerably safer position relative to their brethren, which have been among the hardest hit in this down market.

GOOD FOR THE GOOSE "The deals we're seeing around functional genomics are good for both sides," says Patrick Heron, a venture capitalist at Frazier & Co. who specializes in life sciences. Mr. Heron is quick to point out, however, that this wave of interest in functional genomics firms is not the result of low valuations alone. Nor is it a matter of big pharma simply deciding that it needs to get serious about gaining access to functional genomics. "In fact, the Rosetta deal was not cheap. If Merck had just wanted access to this company's technology, it could have cut a license deal," says Mr. Heron. "These days, big pharma wants integrative technologies in-house. None of these deals would be happening if the senior R&D guys didn't believe that functional genomics is the wave of the future."

Big pharma has already made huge investments in stand-alone genomic tools like DNA chips and genome-data mining algorithms, but thus far has yet to figure out how to turn it all into a tangible product. The bet is that functional genomics is the next logical investment.

Consequently, Mr. Heron and others believe it is highly likely that there will be even more functional genomics deals announced over the next 6 to 12 months, or at least until the IPO window opens again.

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Market sentiment for biotechnology stocks might be tepid, but big pharma continues to swoon over functional genomics. The sector has dominated pharmaceutical merger-and-acquisition activity this year. Thursday's announcements that Eli Lilly (NYSE: LLY) has cut a deal worth as much as $500 million with Isis Pharmaceuticals (Nasdaq: ISIP) and that Pharmacopeia (Nasdaq: PCOP) intends to buy Eos Biotechnology for $197 million are just the latest in a string of deals involving functional genomics firms. Readers will recall that functional genomics was one of Red Herring's Top 10 Trends for 2001.