Next Phase 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.

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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.

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By Danielle Silva, Director of Research, Life Science Nation

Venture capital (VC) and private equity (PE) investments in the life science space differ greatly from the typical private equity and venture capital model in other sectors. Typically, venture capital groups will be earlier stage investors – investors who will consider smaller or even pre-revenue firms – that require a small amount of capital ($750,000-$20 million) in order to get their companies up and running, as well as scale their business. Venture capital funds also tend to focus on firms that have little to no debt.

Private equity groups that invest in areas outside of the life sciences space, on the other hand, usually invest in firms that have a greater amount of debt on their balance sheets, and companies that are more mature and have predictable revenue streams. Typically, private equity groups (PEGs) will make equity investments starting at $2 million to $100 million, and larger groups can write checks that are in the hundreds of millions.

It is also worth noting that VC funds typically invest in a greater number of firms because their typical equity investment is smaller, versus private equity funds, which invest in a smaller number of firms, but write larger checks. VC funds also invest in a larger number of firms for diversification reasons, while private equity groups typically have fewer portfolio companies because they are investing in firms based on their financial statements, which presumably makes an investment less risky.

Recently, venture capital funds have faced a number of challenges; due to lackluster performance, many limited partners (LPs) have pulled their investments from underperforming funds, causing many venture capital groups to collapse. Thus the number of VCs that are operating in the life sciences sector has significantly declined. Accordingly, the percentage of funding the life sciences space has received as a whole from these investors has decreased over the past several years. Additionally, many VC funds have drastically changed their investment strategy in the space. [1]

All this has caused VC funds to have a more risk-averse approach to investing in life sciences firms, generally moving to later stage investing. This in part is due to the firms desiring a shorter-term investment period. And because later-stage investments are more appealing acquisition targets for big pharmaceutical companies, many are also now focusing on drugs that have lower FDA standards in terms of efficacy and safety, such as orphan drugs. Thus, VC funds in the life sciences space are now devising exit strategies prior to the firm even making the initial investment in a company.

Private equity funds take a very different approach in the life sciences space. Some of these funds are now investing in biotech firms as early as the pre-clinical phase of development in order to fill the gap for many life science firms funding needs. One way in which funds have started to invest in life sciences firms earlier is through a process called project financing, in which the private equity group will purchase the rights to one or more lead candidates early on in the development process, and finance the life sciences firm through the end of phase II clinical trials. If the firm has positive data in the clinical II testing, the investor will then have the right to repurchase the candidates. Thus, private equity has adopted more of a growth approach to investing in the life sciences space as of late.

Some private equity funds in the life sciences space are still looking for firms that are generating revenue so that they can eventually sell the firm to larger strategic partners. This is especially true for firms that are investing in CRO’s and medical device companies, as private equity funds will typically acquire these companies when they have around 2-4 products on the market, scale their businesses, and subsequently sell them to the larger strategic partners in the space.

Although venture capital is sometimes categorized as a subsector of the private equity space, these two types of investors could not be more different in terms of their approach to life science investments. Venture capital funds have been forced to become more risk-averse and focused on exit strategy in order to survive as life science investors, while private equity groups are becoming increasingly focused on scaling up these firms, and accordingly, are filling a portion of the void in funding for earlier stage firms.

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[1] Hamilton, Michael D. Trends in Mid-Stage Biotech Financing. Hanover, NH:     Dartmouth, Winter 2011.

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