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June 2006 issue
Venture Capitalists Refine Investment Styles Sign up for a trial subscription and get the current issue! Read more about Healthcare Corporate Finance News Read the past headlines.
Companies Mentioned in this issue:
3i Group p2, p8 |
Venture Capitalists Refine Investment StylesThe biotechnology industry is something like The Little Engine That Could of storybook fame. This train has been carrying investors on an uphill climb of peaks and valleys, rolling up the line as bystanders babble about a bubble. In a sense, the valleys have been very low points for a good number of companies and the peaks have been the high levels of success achieved by a few companies, such as Amgen (NASDAQ: AMGN) and Genentech (NYSE: DNA). But the investors, scientists, business people and other professionals who make the biotech engine run still seem to have the same attitude… I think I can, I think I can. What do they think they can do? Improve the quality of human life. Predict, prevent, treat and manage diseases. Create cures. These are noble and worthy goals, but are not easily achieved and not necessarily profitable. As has often been said, nothing worth doing in life comes easily. So if biotech has been on a rough ride so far, perhaps at the end of the line, investors will get their money’s worth and patients will get effective new therapies. But how are investors coping with the innate risks involved in biotechnology and biopharmaceutical development? The dealmakers we talked with at a few major firms had some similar answers to that question. Allan Ferguson said 3i Group is moving away from early-stage investing, and Nick Galakatos said Clarus Ventures will not invest in a company until it has at least one compound in the clinic. Jeani Delagardelle said NLV Partners is crafting fewer "vanilla" term sheets. Investors are taking action to protect themselves from possible downsides of the development process, a trend that Ms. Delagardelle said is partly driven by the innovation of devices such as percutaneous valves, which are not yet covered by any clear regulatory pathway. Back in the day, Mr. Ferguson remembers that even middle school teachers with a bright idea had a chance at funding. But 3i, like the other investors we talked with recently, is moving away from early-stage investing, and even occasionally setting up milestones in its term sheets. In Mr. Ferguson’s words, "we’ve all gotten more rational," and investors are showing more discipline in seeking out companies with business models that will become profitable as well as excellent management teams. Mr. Galakatos observed that over the years, fund managers have become more adept at balancing the deployment of capital with meeting the expectations of limited partners. There are a few other ways that the investors who spoke with us have seen the industry change over the past several years. Ms. Delagardelle, commenting particularly on the area of medical devices, explained that NLV is now looking much more closely at reimbursement issues than in the past, and weighs regulatory issues much more carefully. Reimbursement, she noted, is almost harder to get than FDA approval, and of course market acceptance and adoption is key to the success of any medical product. In addition, NLV associates a risk profile with the investment candidates it examines to help define how early- or late-stage a company really is, based on clinical activities as well as the regulatory issues inherent in specific therapeutic areas. We also talked with Brian Polzak of Aquilo Partners, a life sciences investment banking firm that advises public and private life science companies in mergers and acquisitions, private placements and general corporate matters. His impression is that venture capital investors are trying to be more efficient with funding in earlier stages, with the goal of keeping young companies as lean as possible until build-out is appropriate. Logically, the idea is to avoid unnecessary spending on product candidates that may or may not pan out. In the course of structuring deals, these days investors are considering portfolio investments in terms of the optimal amount of capital needed for a company to operate at an ideal size to reach value inflection points, such as clearing the clinical hurdles that are prerequisite to gathering human data. Another change equity investors have had to come to terms with is the fact that when they take a stake in a biopharmaceutical, biotechnology or other novel health care technology company, more time and also more capital is required to reach an exit. As a result, Mr. Galakatos says, private equity firms are making moves with larger chunks of capital per deal. However, portfolio companies do not necessarily get all that capital up front. All four dealmakers are seeing more equity commitments that are set up to close in tranches. Ms. Delagardelle pointed out that especially when a firm provides a larger financing, or participates at an earlier stage, it makes sense to structure the deal in tranches if milestones can be clearly distinguished. Lessons have been learned from the past. When technology stocks took a hit, so did biotechnology, but Mr. Polzak, for one, believes that as the population ages and science advances, interesting technologies are being developed that appeal to investors. Enthusiasm for health care sector businesses is still growing, and a lot of money is available to be invested in these companies. Ms. Delagardelle said that NLV Partners has actually done some research indicating there is an even greater demand than there is capital to be invested in the sectors their firm targets. Mr. Galakatos opined that although the size of the typical biotech fund is much larger than it used to be, this does not mean there is too much capital out there. Pharmaceutical, biotechnology and biopharmaceutical companies, he reminds us, are highly capital intensive. Mr. Galakatos believes that the size of venture capital funds formed to invest in product-driven companies has been optimized at around $500 million (coincidentally, the same size as Clarus’ inaugural fund). Interestingly, as venture capital funds get larger, some investors say the lines may be blurring between what separates a venture capital firm from a private equity firm or hedge fund. Investment rounds, he told us, have in general grown about three to four times larger in size over the past decade. For example, the $60 million financing of Aerovance, Inc. that was led by Clarus Ventures exemplifies one type of deal that is becoming increasingly common. Aerovance secured a greater amount of funding than we usually see committed in one round, the capital came from investors with deep pockets and the funding is comprised of two tranches, including $28 million up front and an additional $32 million upon the achievement of certain milestones. Ms. Delagardelle surmises that another way more money is actually flowing into health care is that, especially in lieu of later rounds, partnering deals are replacing venture capital deals. We have all seen that strategic deals with big pharma and biotech players are becoming a more common way for venture-backed life sciences companies to secure funding for discovery, development and commercialization. Mr. Galakatos views these deals as a very attractive option in the market. Also, major pharmaceutical and biotechnology companies have a strong interest in replenishing their dwindling pipelines through the acquisition of new compounds and other intellectual property. Mr. Polzak commented on the value that strategic partnerships with large pharmas and biotechs can have for cutting edge life sciences companies. He said companies that have received premium valuations for strong initial public offerings in the past few years often had relationships with major industry players. He identified Idenix Pharmaceuticals (NASDAQ: IDIX), Theravance, Inc. (NASDAQ: THRX) and Eyetech, which was acquired by OSI Pharmaceuticals (NASDAQ: OSIP), as three biopharmaceutical companies that debuted successfully on the public market. One common characteristic of the three is that when private, these companies had entered into development agreements with Pfizer, Inc. (NYSE: PFE); Novartis (NYSE: NVS); and Astellas Pharma Inc. (PK: ALPM; TSE: 4503) as well as GlaxoSmithKline (NYSE: GSK), respectively. Although we have heard some buzz about the possibility of private equity investors bailing out health care venture capital investors, none of the dealmakers that talked with us substantiated that theory. According to Mr. Polzak, private equity investors are still looking for companies that produce revenue and EBITDA, and it’s not likely PE firms are or will be providing any substantial exit market for private, venture-backed health care companies. Besides, Mr. Galakatos added, most private equity firms do not have the domain expertise required to efficiently operate and grow R&D-based companies, and it is unlikely they will devote much energy to pre-revenue companies. Any slack in the health care venture capital market is more likely to be taken up by well-capitalized funds, such as Clarus, that specialize in this industry. Since clinical development is a difficult business, he feels the industry has responded by producing and emphasizing more specialist investment firms. 3i Group, among the largest international venture capital and private equity firms, invests across all sectors of the economy. Mr. Ferguson said the firm’s venture capital and private equity teams will, in some cases, act as co-investors. In addition, 3i is building a growth equity team based in New York City that will deal with companies that have become profitable, in the health care and other industries, such as retail. Mr. Galakatos remembers as recently as five years ago, investors were willing to fund an early stage enterprise, but the prospects of getting a compound into the clinic during the course of their investment was a rare exception. But VCs were not forking over the same kind of money they do today. In his experience, they used to contribute $3 million to $7 million over the lifetime of an investment, but now they put in $20 million to $40 million. There is no definite recipe for success in the financing of health care companies. But venture capitalists have learned to be more creative, more discriminating and more patient as they structure deals for an evolving industry where business meets science, and uncertainty is definite. |
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