Annual Report and Accounts 2015/16

Vectura Group plc

27 May 2016

Vectura Group plc

("Vectura/the Company")

Annual Report and Accounts 2015/16

In accordance with the Listing Rule 9.6.1, a copy of the following document has been submitted to the UK Listing Authority.

- Annual Report and Accounts 2015/16.

The document has been submitted to the National Storage Mechanism and will shortly be available for inspection at www.morningstar.co.uk/uk/NSM.

The Annual Report and Accounts 2015/16 are available on the Company website at www.vectura.com.

In accordance with DTR 6.3.5, extracted below from the Annual Report and Accounts 2015/16 is a management report in full unedited text which contains the Statement of Directors' responsibilities and principal risk factors for the Company. References to page numbers and notes in the exact refer to those in the Annual Report and Accounts 2015/16. A condensed set of financial statements were appended to Vectura Group's preliminary results announcement issued on 26 May 2016.

-Ends-

Enquiries

About Vectura

Vectura is an independent pharmaceutical product development company that focuses on the development of inhaled pharmaceutical therapies for the treatment of diseases that affect or can be treated with drugs that act on the airways (airways diseases), incorporating inhaled device formulation and clinical development. This segment of the pharmaceutical market includes significant indications such as asthma and COPD, in addition to a wide range of other indications including cystic fibrosis, pulmonary fibrosis and other diseases of the lung.

Vectura has eight(1) products marketed by partners with growing global royalty streams and a portfolio of drugs in clinical development, a number of which have been licensed to major pharmaceutical companies. Vectura has development collaborations and licence agreements with several global pharmaceutical and biotechnology companies, including Hikma (through its wholly-owned subsidiary, West-Ward Pharmaceuticals), Novartis, Sandoz, Baxter, GSK, UCB, Ablynx, Grifols, Janssen and Tianjin KingYork Group Company.

 (1) Advate® came off patent at the end of January 2016. Vectura does not expect to receive any material royalties from that product during its financial year ending 31 March 2017, or thereafter.

For further information, please visit Vectura's website at www.vectura.com.

Unedited extract from Annual Report and Accounts 2015/16

Statement of Directors' responsibilities

The Directors are responsible for preparing the Annual Report and the financial statements in accordance with applicable law and regulations.

Company law requires the Directors to prepare such financial statements for each financial year. Under that law the Directors are required to prepare the Group financial statements in accordance with International Financial Reporting Standards (IFRSs) as adopted by the European Union and have also chosen to prepare the parent company financial statements under IFRSs as adopted by the European Union. Under company law the Directors must not approve the accounts unless they are satisfied that they give a true and fair view of the state of affairs of the Company and of the profit or loss of the Company for that period. In preparing these financial statements, International Accounting Standard 1 requires that directors:

• present fairly the financial position, financial performance and cash flows of an entity;

• make judgements and estimates that are reasonable and prudent;

• properly select and apply accounting policies and then apply them consistently;

• state whether the Group financial statements have been prepared in accordance with IFRSs as adopted by the European Union;

• present information, including accounting policies, in a manner that provides relevant, reliable, comparable and understandable information;

• provide additional disclosures when compliance with the specific requirements in IFRSs are insufficient to enable users to understand the impact of particular transactions, other events and conditions on the entity's financial position and financial performance; and

• make an assessment of the Company's ability to continue as a going concern.

The Directors are responsible for keeping adequate accounting records that are sufficient to show and explain the Company's transactions and disclose with reasonable accuracy at any time the financial position of the Company and enable them to ensure that the financial statements comply with the Companies Act 2006 and Article 4 of the IAS Regulation. They are also responsible for safeguarding the assets of the Company and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.

The Directors are responsible for the maintenance and integrity of the corporate and financial information included on the Company's website. Legislation in the United Kingdom governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions.

Directors' responsibility statement

We confirm that to the best of our knowledge:

• the financial statements, prepared in accordance with IFRSs as adopted by the EU, give a true and fair view of the assets, liabilities, financial position and profit or loss of the Company and the undertakings included in the consolidation taken as a whole;

• the Strategic report includes a fair review of the development and performance of the business and the position of the Company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties which they face; and

• the Annual Report and financial statements, taken as whole, are fair, balanced and understandable and provide the information necessary for shareholders to assess the Company's position and performance, business model and strategy.

Risk and risk management

We operate within a complex regulatory environment, which is subject to change, and the nature of pharmaceutical development exposes us to a number of risks and uncertainties. Our ability to meet our goals and objectives may be affected by a number of these risks, which could impact our strategy, business model and operating environment.

We have developed and implemented a risk management process which is designed to ensure that significant risks are identified, assessed, managed and reported to relevant stakeholders in a concise and timely manner to inform and support decision making.

This section provides an overview of our risk management process, the key risks currently faced by the business and the actions that we have taken to mitigate them. Not all the risks identified as part of our risk management processes are detailed in this section; instead this report focuses on the risks that the Directors believe are the most important and material to the business. As with all businesses operating in such a dynamic environment, some risks may not yet be known while other low level risks could become

material in the future.

Objectives of the Vectura risk management process:

• to ensure that the risk appetite of the Board is embedded throughout the organisation and fully understood by those who are responsible for managing risk and making key decisions across the business;

• to identify and assess the likelihood and potential impact of the risks that Vectura faces in the execution of its strategy and the operation of its business model, and ensure that appropriate mitigating actions and controls are in place such that the residual risk is aligned to the risk appetite of the Board;

• to control systematic risks within the organisation by maintaining and improving a system of internal controls to manage risks in decision making, legal contract management, quality and regulatory processes and the processing of financial transactions; and

• to ensure that identified risks are reported to relevant stakeholders in a timely manner to facilitate effective decision making.

Our principal risks and uncertainties

During the year, a robust assessment of the principal risks facing Vectura has been carried out. These include the principal risks that could threaten the execution of Vectura's strategy, achievement of objectives, future performance, business model, solvency and liquidity, and are outlined below. Some of these risks are specific to the Group and others are more generally applicable to the pharmaceutical industry or specific markets within which Vectura operates. The risks are considered within the timeframe of three years, which is the same time period that has been used in the Viability Statement. The Viability Statement takes into account the principal risks. The underlying analysis that has been performed has included stress testing of different scenarios of these principal risks.

Certain risks, notably risks 2, 4, 7, 9 and 10, are risks that have been newly identified or escalated to be principal risks in the past year and reflect the dynamic nature of the risk environment in which Vectura operates, as well as the ability of our risk management system to detect and respond to such changes.

A number of principal risks from 2015 have also been de-escalated or are no longer relevant.

Strategic risks

1. Product exposure to generic competition before anticipated patent expiration date could erode value of on‑market branded products or future value of development programmes

Trend - 2016: No change; 2015: No change

Generic drug manufacturers seeking marketing approval for products protected by Vectura or partner patents could be successful in attacking the validity or enforceability of Vectura or partner patents. This would result in the product being exposed to generic competition before the anticipated expiration date of the patent, materially affecting Vectura's revenues or the anticipated value of programmes currently in development.

Other competitors routinely challenge Vectura patents, which could impact on current and future revenue streams if successful.

Mitigating activities

Vectura owns a portfolio of patents and patent applications and is the authorised licensee of other patents. Dedicated internal resource, supplemented with external expertise where required, continually reviews the intellectual property landscape relevant to our products, development programmes and manufacturing activities. Risks are communicated to the business and any challenges to Vectura patents are rigorously defended. The IP team ensures that changes in patent laws and regulations are incorporated into processes for obtaining, maintaining and enforcing global patent protection.

Processes are in place to ensure that patent applications are filed in a timely manner and are prosecuted diligently. Robust processes are in place to automate patent renewals. Internal controls are in place to avoid disclosure of patentable material prior to filing patent applications to protect know-how.

2. Third-party patents could limit the Group's freedom to operate (FTO)

Trend - 2016: No change

A third-party patent could be granted with broad claims that read on to a Vectura technology, device or product, which could result in Vectura or a partner potentially having to take licence, or even being unable to commercialise a product, materially affecting Vectura's future revenues.

Mitigating activities

The Group is very diligent in carrying out freedom to operate searches to identify potential third-party IP. In some cases this responsibility is with Vectura partners, with appropriate strategies and action plans agreed with Vectura partners where necessary.

3. Corporate inexperience of late phase development could result in delays to programmes or missed financial targets

Trend - 2016: No change; 2015: No change

The Group has not previously taken a product to market on its own; however, it is now focusing on a number of late-stage wholly owned development programmes which may ultimately provide the Group with the opportunity to self-commercialise. Failure to complete development activities to plan may impact the Group's ability to bring products to market on time, which may further erode the potential value of such programmes and would hinder the Group's ability to deliver its stated strategy.

Mitigating activities

Individuals with the necessary skills and experience have been recruited into the Group to lead and oversee the development of the Group's late-stage assets. The Group continues to work with a network of experienced consultants and contractors who provide additional support and expertise as required. The changing resource requirements of the Group are fully considered as part of the people strategy in place.

The Group has an established governance process to oversee the conduct and delivery of all development programmes and to ensure that any potential changes to the development plan or budget are identified and discussed in a timely manner such that mitigating activities or actions can be put in place as required.

4. Failure to successfully integrate post-merger may lead to increased costs, loss of key personnel, delays in delivering strategic objectives and failure to deliver communicated cost synergies

Trend - 2016: Increased risk

Corporate inexperience in large M&A could result in the suboptimal management of the proposed merger with Skyepharma PLC, resulting in loss of key personnel, cost reduction synergies not being delivered and failure to achieve desired return on capital. Loss of key personnel could have a material impact on the Group's operations.

Mitigating activities

Structured post-merger integration plans have been established to help ensure that the integration is executed successfully. Vectura also has access to, and support from, external subject matter experts. The internal team has grown and the team has gained experience from the successful integration of Activaero.

A range of benefits, including long-term incentive plans, are utilised to encourage retention of key personnel.

5. Loss of, or reliance on, a strategically important partnership may materially impact the Group's current and future revenues and costs

Trend - 2016: Increased risk; 2015: No change

Vectura currently has a number of strategically important partnerships, collaborations and licensing arrangements for the development, manufacture and commercialisation of certain pipeline and commercial assets. Loss of any one of our strategically important partnerships, collaborations or licensing arrangements could have a material impact on Vectura's future prospects.

Vectura has a number of products that are marketed by partners and we are dependent upon those partners for obtaining regulatory approval for, and the marketing and commercialisation of, those products. The marketing and commercialisation strategy taken by a partner could materially impact the level of royalties earned by Vectura.

Vectura is also reliant on suppliers for the development and manufacture of certain devices. Any poor performance of the third parties could delay or prevent devices from being successfully developed and delivered to plan. This could result in key development milestones being missed or associated payments being delayed and could also affect partners' confidence in Vectura's ability to deliver.

Mitigating activities

Vectura has an agreed process for managing and entering agreements and this includes appropriate oversight and approval at Board level. All collaborations are performed under a suitable legal agreement which is assessed by Vectura and its external legal advisors.

Typically, for collaborations a joint steering committee (JSC) will be established, which provides a mechanism by which Vectura can ensure that any joint project team activity is managed appropriately within our standard project management processes.

An alliance manager is identified for all licensing partnerships or contract research organisation engagements.

Vectura has a broad list of disclosed and undisclosed partners, thereby mitigating the loss of any one particular partnership due to strategic and/or operational reasons beyond the control of Vectura.

Operational risks

6. Operational disruption

Trend - 2016: No change; 2015: No change

Events such as fire or flood that lead to significant and prolonged disruption to a research and development or manufacturing operation upon which Vectura relies could result in loss of royalty revenues and contractual liabilities, as well as delays to development programmes.

Mitigating activities

Vectura identifies key suppliers in relation to its business and, where possible, alternative sources of supply are sought where this is economically feasible. Safety stock is also typically held at levels commensurate with the identified risk.

Vectura's asset management approach includes holding duplicate parts and equipment for business-critical machinery. We have established good working relationships with the manufacturers of such equipment and we monitor our supplier relationships to ensure effective and responsive service levels.

Risk contingency is built into product development plans, and Group-wide business continuity plans have been established.

In addition, Vectura purchases comprehensive property damage and business interruption insurance to provide cover in the event of physical disruption.

7. Insufficient management bandwidth due to the proposed merger could lead to operational disruption and missed operational and financial targets

Trend - 2016: Increased risk

The need to continue business-as-usual activities and drive strategic growth at the same time as executing the merger and delivering integration synergies could impose unprecedented time pressure and capacity constraints on management bandwidth and challenge its ability to effectively deliver on all responsibilities and lead to failure to achieve corporate objectives.

Mitigating activities

As described above, structured post-merger integration plans have been established to help ensure that the integration is executed successfully. Vectura also has access to, and support from, external subject matter experts. The internal team has grown and the team has gained experience from the successful integration of Activaero.

Financial Risks

8. Exposure to foreign exchange risk could materially impact the Group's reported results

Trend - 2016: Increased risk; 2015: No change

A substantial proportion of the Group's income from collaborative agreements is received in US dollars and euros but expenditure is predominantly incurred in pounds sterling. To the extent that Vectura's foreign currency assets and liabilities are not matched, fluctuations in exchange rates between pounds sterling, the US dollar and the euro may result in realised or unrealised exchange gains and losses on translation of the underlying currency into our presentational and functional currency of pounds sterling. Such gains or losses may increase or decrease Vectura's operating margin and may adversely affect Vectura's financial condition. In addition, if the currencies in which the Group earns its revenues and/or holds its cash balances weaken against the currencies in which it incurs its expenses, this could adversely affect profitability and liquidity. Increasing royalty revenues and the impending referendum on the UK's membership of the EU will further affect the magnitude of this risk.

Mitigating activities

Where known foreign currency liabilities arise, foreign currency revenue receipts are retained on deposit in the appropriate currency in order to offset the exchange risk on these liabilities. As at 31 March 2016, the Group had sufficient euro and US dollar reserves to cover its immediate and short-term liabilities in respect of these currencies.

Where a substantial net foreign currency liability exists, Vectura will consider hedging against it to minimise foreign currency expense. However, such hedging is based on estimates of liabilities and future revenues and will not fully eliminate future foreign currency exchange fluctuations.

9. An unexpected tax liability could materially impact the Group's reported results

Trend - 2016: Increased risk

Adverse interpretations or rulings on the tax effect of specific transactions or changes in tax rulings which have been granted could give rise to substantial costs in dealing with the appropriate tax authorities and/or unfavourable tax treatments and tax liabilities not currently envisaged or accrued, resulting in negative effects on the financial condition or prospects of the Vectura Group.

Historically, the Group has been loss making and therefore this risk is increasing in profile as the Group moves towards a tax‑paying position.

Mitigating activities

The Group uses external tax advisors in each of the jurisdictions within which it operates to ensure continued compliance with relevant legislation and to ensure that the impact of potential future changes is fully understood and incorporated within business plans.

Broader risks specific to the pharmaceutical industry

10. Changes to regulations and operational restrictions due to Brexit

Trend - 2016: Increased risk

A referendum will be held in the UK on 23 June 2016 on whether the UK will remain in the EU, and the Group faces a range of risks associated with a vote to exit the EU. For example, as a significant proportion of the regulatory regime applicable to the Vectura Group is derived from EU directives and regulations, a vote in favour of the UK exiting the EU could lead to material changes in the regulatory framework applicable to the Vectura Group's operations. In addition, a UK exit from the EU could result in restrictions on the movement of capital and the mobility of personnel, for instance. Any of these risks could result in higher operating costs and could have a material adverse effect on the Vectura Group's business operations and financial conditions.

Mitigating activities

Due to the nature of this risk, no mitigating activities are in place at the current time.

11. Regulatory approvals

Trend - 2016: No change; 2015 - No change

The international pharmaceutical industry is highly regulated by governmental authorities in the UK, the US and Europe and by regulatory agencies in other countries where Vectura or a collaborator intends to test or market products they may develop.

These regulatory requirements are a major factor in determining whether a substance can be developed into a marketable product and the amount of time and expense associated with such development. There can be no assurance that Vectura's, or a collaborator's, products will receive and maintain regulatory approvals. Even if products are approved, they may still face subsequent regulatory difficulties. Such difficulties may result in financial loss and reputational damage.

Mitigating activities

We work closely with expert regulatory advisors and, when appropriate, seek advice from regulatory authorities on the design of key development plans for pre-clinical and clinical programmes.

In respect of our collaborations and partnerships, we work with a number of blue-chip pharmaceutical partners, such as Novartis, Sandoz, Baxter and GSK, who have significant regulatory expertise.

12. Unforeseen side effects

Trend - 2016: No change; 2015 - No change

All drugs have a risk of adverse reactions and side effects and therefore unforeseen side effects may result from the use of Vectura's, or a collaborator's, products or product candidates. This is an inherent risk which may be identified at any time, even after a product has been approved and sold commercially. Discovery of unforeseen side effects, other than those acceptable to the regulators, may result in a substantial loss of royalty revenues, other liabilities, a significant delay to a development programme or withdrawal or suspension of regulatory approval.

Mitigating activities

Vectura and its collaborators conduct extensive pre-clinical and clinical trials designed to test for and identify any adverse side effects. In addition, there is a significant amount of safety data available regarding existing marketed products to which our generic products relate.

13. Pricing and reimbursement

Trend - 2016: Increased risk; 2015 - No change

Vectura or our collaborators may not be able to sell its products profitably if reimbursement from third-party payors, including government and private health insurers, is unavailable or limited.

A significant portion of Vectura's future revenue is likely to depend on payments by third-party payors, including government health administration authorities and private health insurers. As such, Vectura may be adversely affected by third-party reimbursement and healthcare cost containment initiatives. Vectura may not be able to sell its products profitably if reimbursement from these sources is unavailable or limited. Third-party payors are increasingly attempting to contain healthcare costs through measures that are likely to impact the products Vectura is developing, including:

• challenging the prices charged for healthcare products, limiting both coverage and the amount of reimbursement for new therapeutic products, and denying or limiting coverage for new products that are approved by the regulatory agencies; and

• refusing to provide coverage when an approved drug is used in a way that has not received regulatory marketing approval.

In addition, in many European countries there has been an increasing trend towards reference pricing, where the amount of reimbursement is determined in light of reimbursement levels for comparable drugs in other European countries. This is likely to severely restrict the potential per unit price for many new drugs unless such drugs can be significantly differentiated from existing products. If products developed by Vectura or its partners are not covered by government or other third-party reimbursement schemes, are reimbursed at prices lower than those expected by Vectura, or become subject to legislation controlling treatments or pricing, Vectura and/or its partners may not be able to generate significant revenue or attain profitability for any product candidates which are approved for marketing.

Mitigating activities

Where appropriate, products may be out-licensed to partners who have the expertise to commercialise products and negotiate pricing structures with third-party payors, especially in disease indications that require large sales forces. Should Vectura self-commercialise, this would be targeted commercialisation for niche products with significant unmet need, which requires a small sales force to target specialist physicians.

Our business model includes bringing highly innovative products to address unmet needs and we are also involved in a number of generics programmes which support government initiatives to reduce costs. This adds balance to our business model in an era of increasing cost containment.

14. Competition

Trend - 2016: No change; 2015 - No change

Our business faces intense competition from a range of pharmaceutical and biotechnology companies. Technological changes could overtake the products being developed by Vectura or by its collaborators.

Our competitors in the biotechnology and pharmaceutical industries may have superior research and development capabilities, products, manufacturing capability or sales and marketing expertise. Many of our competitors have significantly greater financial and human resources and may have more experience in research, development and commercialisation. As a result, our competitors may develop safer or more effective products, implement more effective sales and marketing programmes or be able to establish superior proprietary positions. In addition, we anticipate that we will face increased competition in the future as new companies enter Vectura's markets and alternative products and technologies become available.

Mitigating activities

Vectura performs detailed reviews of the development process and progress of projects through trials. For programmes managed in house, Vectura has an established project management framework. The potential commercial opportunities for each project are assessed at the end of each stage of the project. Projects are assessed using widely accepted valuation metrics based upon discounted cash flows. These cash flows are discounted using a hurdle rate that is in line with industry standards and the expected return of each project is further risk adjusted by its phase of development. Vectura has experienced development and commercial teams who all contribute to this assessment. This in-house review is supplemented by well regarded disease area reports and, where appropriate, bespoke market research.

Under this framework, research and development programmes will only be approved by the Board if it can be shown that the expected benefits outweigh the expected costs. All programmes are subject to a stage-gate approval process and, in the event that it was no longer considered that future revenues would be higher than future costs, the Board would consider terminating or redefining the programme.

Where appropriate, the Group looks to mitigate the development and commercial risk of its product pipeline by partnering drug candidates at an appropriate stage. The partnering event crystallises part of the programme's value, with the goal of retaining an attractive proportion of the commercial upside through future milestones and an ongoing royalty interest from commercial sales.

Vectura's current royalty-generating products are expected to continue to provide royalties until patent expiry or until Vectura is no longer entitled to receive royalties in accordance with a licence agreement.

Vectura works closely with its advisors and obtains, where necessary, opinions on the intellectual property landscape relevant to the Group's product development programmes and manufacturing activities and processes. In addition,

Vectura works with a number of key licensing partners who have significant expertise in the research, development and commercialisation of pharmaceuticals. These licensing partners have access to significant financial and human resources.

15. Product liability

Trend - 2016: No change; 2015 - No change

In carrying out its activities Vectura will potentially face contractual and statutory claims, or other types of claims from customers, suppliers and/or investors. Vectura is exposed to potential product liability risks that are inherent in the research, the pre-clinical and clinical evaluation, pre-clinical study, clinical trials, manufacturing, marketing and use of pharmaceutical products. Consumers, healthcare producers or persons selling products based on Vectura's and its collaborators' technology may be able to bring claims against Vectura based on the use of such products in clinical trials and the sale of products based on Vectura's technology.

Mitigating activities

Vectura maintains an appropriate level of product liability insurance and operates quality systems relating to the manufacture of products. Vectura has a pharmacovigilance system to monitor safety events arising with respect to products sold. Vectura's insurance portfolio also includes other third-party liability insurances which would provide cover in the event of certain other contractual or statutory claims.