Next Phase Newsletter

Introduction:

Identifying the right kind of investor to partner with can often be an arduous task for many life science firms. Private Equity Groups as of late have emerged as major players in the life science space, filling the funding gap that was created by many Venture Capital funds halting investments in the sector. Private equity funds typically have a long-term investment horizon, and because of their appetite for longer-term investments, they have recently been investing in younger firms in the life science space than they have in the past.

There are a number of different strategies that private equity groups employ; because of this, determining what strategy would be the best fit for your life science firm can be a daunting endeavor.  For this reason, Life Science Nation’s Newsletter will be running a series over the next three weeks written by LSN’s Director of Research Danielle Silva that will give in-depth insight into three of the most common private equity fund strategies, and will provide insight into what types of funds are best for life science firms depending on the firm’s financial situation and management team. The three–part series will run on the following dates:

• Buyout & Recapitalization: 1/15/2013
• Growth Equity: 1/22/2013
• Mezzanine: 1/29/2013

Part 1: Buyout & Recapitalization Funds

For life science companies looking to raise capital, identifying the correct type of private equity (PE) group to partner with can often times be a challenging task. One of the first steps a life science company must take in order to select the right kind of private equity group to partner with is to gain an understanding of the different kind of PE fund strategies. Some of the most common private equity fund strategies include buyout, growth equity, mezzanine, distressed/turnaround, and special situations.

A buyout transaction is the most commonly used strategy amongst private equity funds. Buyout funds will typically purchase a company and hold them for four to six years[1]. Because buyout funds are long-term investors, many funds with this strategy have started to invest in younger companies in the life science sector, which traditionally have longer-term investment horizons. Additionally, there are more opportunities in the space due to many VC funds halting investments in the sector, with the remaining few opting to invest in later stage opportunities. For this reason, buyout funds may be a good fit for earlier-stage firms – for example, pre-revenue therapeutics companies that are seeking additional funding to get the firm’s product through the clinical development process.

Buyout funds usually buy companies through a leveraged buyout, meaning the private equity group will finance a portion of the purchase price using equity, and will use debt to fund the remainder of the transaction. The private equity group will pay back this debt by using the operating cash flow of the firm that was acquired by the fund. The firm will also increase the acquisition’s future valuation by reducing costs, increasing sales, and making strategic acquisitions (which are sometimes referred to as an “add-on” or “tuck-under”).

The term buyout, however, is almost counterintuitive because the fund does not necessarily buyout the firm’s stakeholders entirely. Some funds will entirely buy out a firm’s stakeholders. However, many firms use a technique known as a recapitalization (“recap”), which is a transaction where debt and equity is reallocated in the capital structure of a company. In a recap, a private equity group will take a majority stake in the business by buying out most (50% or more) of the business owner’s stake in their firm. A complete, 100% buyout would best suited for life science business owners who are looking to retire from the business. However, a recapitalization may be a better structure if the life science firm’s owner would like to remain involved.

In a recap, the owner has the chance to have an upfront liquidity event for the equity that is bought, as well as the opportunity to stay involved in the business with their remaining equity stake. This way, they can also have a second liquidity event after the private equity group sells the business. If the investment goes well, this structure should give the owner a larger total payday. This is an attractive option for life science business owners who may not want to retire, but have put up a large amount of personal guarantees to grow the business, or just need additional capital expenditures and management support to take their business to the next level. An example of this would be a business owner in the biotech therapeutics space who has been able to finance the discovery and lead optimization phases for the product they are developing, but needs further capital in order to fund the clinical trial portion of the development process. This structure is often also favorable for private equity groups as it is often the owner who has the technical knowledge or management skills that have been able to develop the product and grow the business to where it stands currently. Having that owner stay with the company with the incentive of growing their equity stake can help the private equity group ensure that the owner will continue to have an interest in growing the business.

Therefore, for life science business owners, a fund that uses a complete majority buyout strategy (i.e. a 100% buyout) may be an attractive option for an owner who wants to retire, or would like to move on to a different venture. A buyout fund that employs a recapitalization strategy, on the other hand, may be a fitting option for a life science firm owner who has taken on a significant amount of personal debt in order to grow the business, and needs further capital to cultivate their firm and their product or service to the next level. A recap thus would be most suitable for owners in the life sciences space who wish to still be involved in the firm’s management but doesn’t have enough capital to grow the company or feels it would be unwise to take on greater financial risk. Thus private equity buyout funds can prove to be an invaluable partner for many different kinds of life sciences firms, whether the owner is looking to retire, start a new venture, or wishes to remain involved in the business that they have built.

Tags: letter, Life Science, news, newsletter

By Max Klietmann, VP of Research, LSN

Medical devices and med-tech have become an increasingly attractive space for investment over the past several years due to the relatively short time to reach the market and diminished regulatory risk vis-à-vis therapeutics. As competition amongst investors for medical device investments and acquisitions have increased, several of the major industry players such as Medtronic and Boston Scientific have begun to make decisive moves towards investing in companies at earlier stages, and often seeding emerging device companies.

For large medical device firms sitting on massive stockpiles of cash, investment in younger startups makes a lot of strategic sense, as it affords them an easy way to diversify their R&D portfolio without having to take on the full risk of building out full-scale research operations in house. Deals between emerging medical device companies and large established corporations in this space are typically structured with some form of option or warrant to acquire the company at a given price further down the line. It is precisely this type of deal structure that reflects the mentality driving many large device firms to invest in startups in the space early. It allows them to place multiple bets with a secured option to acquire the most promising technologies further down the road, effectively letting them hedge against their own R&D risk. We have seen similar activity among large pharmaceutical and biotechnology companies, and it is undeniable that the corporate venture arms of large corporations are increasingly becoming a major source for early stage funding.

This is an important trend for CEO’s in the med-tech space who may not have previously realized that their early-stage product was a candidate for investment from a major player at such an early stage. Historically, these firms made tactical M&A moves, targeting companies with either a commercialized product, or one in the late pre-market stages. This has ceased to be the case, and corporate venture is now driving a large portion of early stage investments in devices. These firms are not just secure sources of financing – they also make excellent strategic partners for a variety of reasons, including a willingness and capability to share resources & know-how, as well as their established distribution networks. Moreover, there is a long-term incentive for these firms to acquire quality companies for their portfolios – as these firms are not exit-oriented investors looking for a quick return.

These changes in the medical device and med-tech investing space represent a paradigm shift as well as a resurgence of capital for early-stage companies in the space. This trend will likely continue throughout 2013 and beyond, and CEO’s looking to raise capital should focus on raising capital from these companies due to their multiple advantages as investors and partners.

Tags: letter, Life Science, news, newsletter

By Max Klietmann, VP of Research, Life Science Nation

In the world of big pharmaceutical companies, there exists a void that is the transition phase between promising academic laboratory discovery and the validation of a particular compound’s commercial viability – the so-called “Valley of Death.” This gap exists due to the high amount of risk associated with testing the feasibility of a product so early in the pipeline, which naturally places it far from an exit. This gap has long been an issue for the industry at large, because even though many investors don’t wish to invest so early, avoiding it leads to a diminished pool of strong future investment opportunities, and, on a larger scale, limits how many compounds will successfully make it to market. This is not due to shortcomings in trials, but rather, because of a pure shortage in capital. Most of the large pools of capital, especially venture capital, are no longer making allocations in this area. And despite the fact that large pharmaceutical companies are beginning to invest earlier and earlier in the pipeline, they can’t bridge the whole valley on their own.

Fortunately, a novel funding trend within foundations, nonprofits, and other philanthropic organizations is beginning to address this issue. Worried that potentially valuable treatments will be lost due to a dearth of risk-prone investors, funds are recognizing the vital importance of bringing more technologies over this funding gap. As such, many of these organizations are offering grants for specific indications to help increase the odds of new compounds entering the clinical stage. Keep your eyes open for family offices to begin targeting this space with their high-risk or philanthropic allocations as well, as investment momentum begins to accelerate in this area.

Simultaneously, novel for-profit drug development platforms have started to address this gap by in-licensing emerging technologies, developing them past discovery stages and into early clinical trials, and then promptly exiting these assets into pharmaceutical companies now targeting early-stage products. This is mainly a product of large pharma offering a compelling exit for investors in early stage assets as much as a decade earlier than one would traditionally expect.

These trends have massive repercussions throughout the industry, not only for emerging biotechs and investors, but also for service providers such as CRO’s, who will be presented with a rapidly growing population of potential clients. As the “Valley of Death” is bridged, there is an incredibly powerful gearing effect that will help to accelerate the market faster than ever.

Tags: letter, Life Science, news, newsletter

By Dennis Ford, CEO, Life Science Nation

Historically, single and multi-family offices hired asset managers to help allocate capital adroitly in order to preserve wealth for future generations. The majority of this capital was traditionally placed into the hands of asset managers that focused on conservative holdings. At the same time, however, almost every family office maintains a smaller pool of capital for riskier assets. In the past, this capital was placed into higher-risk vehicles like hedge funds and PE fund with the hope that these investments could offer outsized returns. However, as returns have slowed and, for many funds, turned to heavy losses, it has become unjustifiable for many family offices to keep their capital in an objectively broken asset class. Increasingly, the trend in family offices seems to be heading down the path of direct investment in a variety of industries. These firms are executing this strategy, with the help of trained Wall Street talent, easily plucked from PE and hedge fund firms abound in NYC, London, and Hong Kong.

Arguably, this may make sense for family offices long-term as an investor class, as most family offices are the product of entrepreneurial initiative and investment in what was, at one point, “the next big thing.” This is a documented trend that is picking up traction and may be ready to emerge full force in the near term. Due to the nature of family offices, this is particularly interesting for companies seeking to raise capital; unlike PE firms, family offices can be very quick on their feet and do not have to stick by an investment mandate if they choose not to. Family offices are flexible, and that flexibility can translate to opportunistic investment. Collectively, they are beginning to make waves with large amounts of small investments.

The rate of direct investment is increasing as family offices start to look more and more like PE, VC, and hedge funds. What’s most compelling is that they do not have to pay the “2 & 20” typically garnered by the fund managers who used to manage their money – money managers routinely get a 2% fee of all the assets they manage, and a 20% percent fee of any profit they make. Family offices, then, are doing the math of declining returns – voting with their feet, moving away from the traditional mangers, and taking it all inside (sans fees, of course!) This suggests a trend with momentum and will have some profound effects on the space over the coming years.

Tags: letter, Life Science, news, newsletter