By Danielle Silva, Director of Research, LSN

For life science firms, choosing the right kind of private equity fund to partner with can be a difficult task, especially if the business owner does not wish to give up a great amount of their firm’s equity. This issue can be exacerbated if the firm needs further capital in order to grow the business, or possibly finance an acquisition. Last week, we looked at one source of expansion financing, which were private equity groups that use a “growth capital” strategy. This week, we will explore another source of growth financing – mezzanine debt funds.

Mezzanine debt is usually considered a kind of hybrid financing – financing which lays somewhere between debt and equity in a firm’s capital structure. Therefore, mezzanine debt has some characteristics of equity, and some characteristics of debt, falling between senior debt and equity. Some forms of mezzanine debt are convertible debt (meaning the debt issuer has the right to convert the debt into equity), and senior subordinated debt; mezzanine debt is accordingly more junior debt, which means that mezzanine debt issuers are paid back after senior debt holders. Mezzanine debt, however, is senior to equity.

Mezzanine debt is an attractive form of financing for life science firms because it allows business owners the opportunity to access more debt, and thus finance growth or expansion activities without having to give up a good amount of equity. In many cases, business owners will not have to relinquish any equity at all.

Because mezzanine debt is subordinated, however, it has a higher interest rate than senior debt. This is because it is perceived as riskier than senior debt; mezzanine lenders are paid back after senior debt holders. Senior debt holders are essentially the first group to get repaid in the case of liquidation, followed by senior subordinated debt holders (mezzanine lenders), then preferred stock holders, and finally the remainder of the equity stakeholders. Because mezzanine lenders are thus essentially second in line for repayment; there is a higher default risk for mezzanine debt.

One important fact about mezzanine debt is that it is only issued to firms that are cash-flow positive – meaning that mezzanine private equity groups would not issue debt to a pre-revenue company, such as a biotech therapeutics company in pre-clinical development. Mezzanine firms would, however, issue debt to a therapeutics company that, for example, has a couple of products on the market and was seeking to acquire a smaller biotech therapeutics company in order to grow market share.

There are many advantages to using mezzanine debt over other forms of financing; the first, as aforementioned, is that firms have less equity dilution with mezzanine financing than with other forms of private equity – even less so than with growth equity groups who typically do not take a controlling equity stake. Generally, mezzanine lenders will take an observer position (non-voting) on the firm’s board of directors, whereas growth equity funds typically are more operationally focused, and will take an active board seat.

Another advantage is that mezzanine loans are typically longer-term than other forms of debt, and require interest-only payments until their maturity date. Some of the downsides of mezzanine funding are that it is a lot more expensive than other forms of debt, with higher interest rates than other forms of financing.

Furthermore, mezzanine funds may sometimes require firms to give up a portion of their equity upside in order for the fund to achieve their desired rate of return on the debt instrument. Thus for life science firms who are seeking an alternative form of debt to senior debt, and are looking for a form of funding that requires little to no equity dilution, a mezzanine lender may be the solution.

By Max Klietmann, VP of Research, LSN

Recently, two major trends have surfaced in early stage life sciences investment; the concept of the virtual pharma and private equity aggregation of early stage portfolios. According to several conversations I’ve had with these two categories of investors over recent months, these entities are beginning to employ a new strategy to take advantage of the plethora of promising early stage assets available. The basic idea is to grow a synergistic portfolio around a specific silo (indication, technology, etc.) over time. These portfolios of complimentary assets can then be brought directly to market (via third party distribution) or sold into large pharmaceutical companies, whose pipelines are increasingly suffering from a myopia leaving significant market opportunities unaddressed.

The concept is quite simple and intuitive: In the case of a virtual pharma, a group of highly seasoned life sciences and pharma experts raise capital to buy a portfolio of promising early stage academic assets, vet them, and shepherd them through clinical trials via a very lean model relying heavily on CROs and outsourced development. By focusing on only fast-moving, highly promising assets (and strategically divesting those that aren’t), a very lean pipeline is maintained. This keeps capital allocated exclusively on getting product to market as quickly as possible. Then, either through licensing or third party distribution via a rent-a-salesforce, the products are sold into the marketplace.

Similarly, highly strategic mid-market PE investors (who typically invest in large scale opportunities closer to phase II or III) are making very small $1-5 million investments spread across a very broad range of very early stage assets, including academic laboratory research. The assumption is that by maintaining a hands-on approach and scrupulous focus on performance, a fund is capable of maintaining a portfolio of companies that not only have a promise of success on an individual basis, but as a collective whereby the whole is more valuable than the sum of its parts.

This approach allows investors to follow big pharma and provide solutions to upcoming pipeline gaps. It is also a more attractive opportunity for buyers down the line, because it is a fully integrated and curated portfolio with a strategic orientation towards marketability. The end result is a more efficient flow of capital through the industry, stronger drug development pacing, and an improved return profile for equity holders in life sciences companies that constitute the portfolio constituents.

By Brian Gajewski, VP of Sales, LSN

Many firms that are looking to raise capital in the life sciences arena have the difficult problem of finding a place to start – that is, figuring out how to gather a list of potential investor candidates to reach out to. As with most firms, the first pass at raising capital is with friends, family, and industry colleagues. This is a great category for the first couple million, but moving past this stage becomes a difficult task for many firms because of their lack of experience in raising capital.

Once a firm has exhausted the investments from that first stage of capital raising, the next step is to create a complete list of qualified investor leads that they can then begin reaching out to. LSN refers to this as a Global Target List (GTL). The fact that the life science arena is a global marketplace justifies getting past the regional mentality for fund raising efforts.

One of the first ways to start collecting investors is to target those that have invested in companies similar to yours over the past 5-10 years of financing rounds (another reason for the global approach). For that reason, it is very important to take the appropriate amount of time in performing research.  One best practice is to start by finding firms that are look-alikes, which are firms that have similar profiles to yours. This allows you to identify major investors in the space that have invested in similar firms based on therapeutic or device indication. For example, within the LSN platform, our clients are able to search through the past 12 years of financing in the life science industry by filtering the series & type of financing, as well as the date, sector, and phase of the product.

The next step in creating your Global Target List of investors is to create a list of foundations that might have an interest in your area of development. Foundations are a key investor in the life science industry because it fills two of their investment mandates – one being capital preservation, and the other, their philanthropic portfolio of investments. What is more interesting is that the donor lists to these foundations are in the public domain. The astute marketer can peruse this list and hopefully parse the high dollar donors and find a few nuggets that would be worth researching for an introductory call or meeting. The premise of this exercise is to remember that donors to foundations have a desire to move the science along for treatments and cures. Foundations are great vehicles to help move science along, despite being held back by process and bureaucracy. However, for some donors investing directly, companies that are moving the science along may be just as compelling.

It is important to remember that when your firm is raising capital, you are not just selling to people, but you are also selling to them a way to potentially affect the world. The most powerful reason for investors to allocate capital is that you are developing a cure for a disease that has affected them, their family or their people in their orbit.

Not only do you want to target foundations that might have an interest in your target indication, but also the major contributors to those same foundations. We are finding that more and more families are becoming interested in investing directly with a life science company.

Finally, you have to think globally, and create a Global Target List, but you must act locally – meaning, draw that two-hour road trip circuit, and figure out how many investors on your GTL are a short trip away. This is an excellent way to start to learn who your good targets are, and to give you the practice you need to make your presentations more compelling.

Now that you have a list of investors that have a specific interest in your type of company, it’s time to make sure you have the bandwidth to begin reaching out to them and tracking your success.