Cover Story: Life Sciences – The Cure for What Ails VC? –

Having been largely ignored for the latter part of the 1990s, life sciences has recently emerged as the hottest drug in venture capital. The potent combination of new, exciting opportunities like genomics and proteomics, coupled with limited partners’ need to diversify their portfolios, has created a significant increase in life sciences investments. In fact, during the second quarter of this year 13.8% of all VC investments went to the medical/health/life sciences sector, a marked rise from a year ago, when just 3.95% of disbursements went to such companies, according to Venture Economics.

Just how red hot is the space? In a venture marketplace where investing, fund raising and returns have all dropped considerably, life sciences-focused funds are raising large amounts of capital. Frazier & Co. recently closed on a $400 million fund, of which half will be devoted to biopharma companies, while Prospect Venture Partners, a strict backer of life sciences, closed on a $500 million vehicle earlier this summer. Meanwhile, VC firms such as MPM Capital, Sanderling Ventures and Schroder Ventures International Life Sciences are either raising new funds or busy preparing to launch new life sciences vehicles targeted for a few hundred million dollars each. Simply preparing to launch a fund is no achievement, of course, but the fact these firms are optimistic about doing so in the current environment is noteworthy by itself.

Equally important, this surge isn’t being fueled by a few cash-rich, niche investors-most of the industry’s top dogs are on board, as well. Gargantuan limited partner California Public Employees’ Retirement System (CalPERS) has been busy bulking up its health-care portfolio to nearly $1 billion from just over $100 million in the last 15 months. CalPERS has also established CalPERS Healthcare Side Fund, a $24 million to $30 million fund to co-invest in biotech deals with ARCH Venture Partners. And on the GP side, heavy hitters like New Enterprise Associates are boosting their presence in this space. While NEA doesn’t set hard allocation figures for certain sectors, it’s likely that as much as 30% of NEA X, a $2 billion vehicle that closed in 2000, will go toward health-care deals, says Chuck Newhall, a co-founder and general partner at NEA.

The nagging question, of course, is whether this ebullience will be short-lived. Life sciences has had its ups and downs over the years, and VCs point out that areas like health-care and biotech are generally viewed as a defensive investment in a down market. Others note that with Internet-related investments previously representing such a huge portion of venture portfolios, it’s only natural for other sectors to enjoy an increase.

“I would say that about half the people [doing health care and life sciences] are chasing the sector and the other half see it as a risk balance/risk arbitrage approach to venture investing,” says Dana Callow, a managing general partner at Boston Millennia Partners.

That said, the enthusiasm feels a little different this time. The completion of the human genome project in June 2000 was viewed by some as the biggest achievement yet in life sciences, and more recently the area of proteotomics-an offshoot of genomics that looks at how cellular proteins work-has VCs salivating over the potential profits of these companies. Moreover, some of the technological development that took place over the last few years has benefited life sciences as well, putting the sector in position for what could be a long upward climb.

“The applications of technology are allowing life sciences to speed up and to become more predictable, so people are saying to themselves, Gee, this space is for real,” says Jim Tullis, co-founder of health-care investor Tullis-Dickerson & Co.

Return to Tradition

Much has been made of the fact that life sciences companies generally take much longer to exit than many of the technology companies funded over the last few years. For companies that produce disease-attacking drugs, for example, it can take years to conduct the clinical trials and obtain the government approval needed to start selling a product. However, VCs say the renewed interest in these deals does not represent a fundamental change in the nature of venture capital. Instead, they see it as a return to the industry’s traditional way of doing business, following a period of time that was anything but normal. “Most of the investors out there understand that the quick returns of the dotcom era were not the way this business works,” says Jim Garvey, chief executive officer and managing general partner of Schroder Ventures International Life Sciences Fund. “Funds that were raised, invested and generated a return in two years were the anomaly.” Indeed, in the early 90s, before the technology markets took off, the time it took to exit from life sciences deals was only marginally longer than the time it took to exit tech deals, adds Steve Lazarus, a managing director at ARCH.

“Some people forgot about the five-year investment cycle and the fact that it usually takes companies four to six years to develop and generate a return after the initial investment,” adds Schroder’s Garvey. “But nothing has changed. Are investors ready to tie up their money in an illiquid venture capital fund for five to seven years now? Yes, and they always have been willing to do this.”

In addition to longer exit horizons, investors in life sciences also have to get comfortable with a more capital-intensive process, often requiring somewhere between $30 million to $60 million in funding to get a company to a position where it can go public, says Ansbert Gdicke, a general partner at MPM. EyeTech Pharmaceuticals Inc., for example, raised a $108.5 million expansion round in August at a $200 million valuation, while Myogen Inc. raised $52.4 million in its fifth round during the same month. “I have never worried that there is too much capital available for life sciences companies, but I have worried, at times, that there is not enough,” says Alex Barkas, a managing principal at Prospect, adding that his firm syndicates every deal it does.

Given the massive fund-raising efforts that occurred in 2000, capital may not be a problem, as many funds still have plenty of unspent cash. What does pose a challenge is time, as most life sciences companies are anything but a quick study. Brook Byers, general partner with Kleiner Perkins Caufield & Byers, says the firm will not increase the number of life sciences deals it does because of the time-intensiveness of working with any start-ups. (Kleiner Perkins has done approximately 20 life sciences deals over the last five years and averages about four to six life sciences start-ups a year, Byers says.)

To better equip themselves to make these investments, a number of venture firms are bringing in new people, some of whom are true specialists in this space. NEA added General Partner Barrett, James M.M. James Barrett in late August to focus on biotech deals, and has plans to hire two more pros for its health-care team in the coming months. The new hires should include a scientist with multiple degrees and an experienced executive out of the pharmaceutical industry, says Newhall.

“You are seeing organizations with maturing partners bringing in new blood to work with the people there in those firms that have a more balanced approach, or you see some guys who went over to IT drifting back into health care,” says James Blair, a general partner at life sciences investor Domain Associates.

A Crowded Field

Despite all the euphoria over life sciences, longtime investors in this sector are skeptical about the commitment level of many VCs entering the space. After all, some are the same ones who have demonstrated a propensity for leaving life sciences in tough times. “I don’t see any reason to believe there will be a lot of commitment to the sector on the part of returning firms, who maybe are just coming back while this space looks good and others look bad,” says MPM’s Gdicke. “For those investors switching back to the space, I don’t know if they really understand how much capital and commitment it takes to fund a life sciences company.” Boston Millennia’s Callow predicts that many firms will last about 18 months or so, until they move onto something else.

Unlike other firms, which left health care and life sciences altogether, NEA never left the space entirely, Newhall notes. Now that the firm thinks there are a number of promising opportunities in the sector, NEA is positioning itself to take advantage of this, he adds.

MPM’s Gdicke is also concerned about inexperienced teams chasing bad deals, “which will ultimately reflect badly on the rest of the sector.” Others fear that new investors competing for deals could inflate valuations for developing life sciences companies, thus threatening to create an IT-like monster where young enterprises have tremendously outsized valuations. However, most insiders say they are not overly worried, noting that valuations for life sciences companies had fallen so far in the last few years that any increase will not be overwhelming.

The conventional wisdom is that those firms most equipped to invest in this sector and, more importantly, succeed in this new environment are established health care and life sciences funds, like Frazier, Domain, Tullis-Dickerson and Oxford Bioscience Partners, or relatively new groups, such as Prospect and Versant Ventures, whose partners have impressive track records at other firms. Theoretically, these VCs will know better how to manage complex life sciences companies and the inherent regulatory hurdles. Blended funds, like ARCH, with an established and committed life sciences practice may also be well positioned for success.

Over the long term, the convergence of life sciences and IT should create chances for broad-based VCs who are able to integrate a lot of knowledge and understanding under one roof, adds Domain’s Blair. “You will eventually see the same sea change in life sciences technology you saw in electronics – bringing life sciences right down to the consumer level….so there will be tremendous opportunity in creating systems and devices associated with that,” he says.

The Road Ahead

Even if investors are more committed than they have been in the past, all the enthusiasm toward life sciences won’t mean much unless the public markets can find room for these companies. VCs note that public market investors have been burned before by biotech stocks, and they may be gun-shy about embracing the newest crop of life sciences IPOs.

But Robert McNeil, a general partner at Sanderling Ventures, says life sciences companies should cater exactly to Wall Street’s needs. After going through the IT bubble, the Street will be looking for companies with real products and real business plans, which should be a perfect fit for product-oriented life sciences businesses, he says. Indeed, before the terrorist attacks the public markets had already demonstrated some appetite for life sciences companies, McNeil notes, pointing to Sanderling portfolio company InterMune Pharmaceuticals Inc., which successfully completed a $287 million secondary offering in July.

“The availability of the public markets for exits is the biggest unknown, especially given the recent events in the world,” says Prospect’s Barkas. “It is hard to know what the appetite is or will be for the return of the public markets.”

Perhaps the one saving grace for life sciences is its societal benefit. Unlike a computer software company or a B2B web site, many of these companies can honestly say that their mission is to help save lives. And given America’s reassessment of priorities in the wake of Sept. 11, there may be more support from the investor community for socially beneficial businesses.

“The marketplace will top out eventually and there may well be some excesses in the market at some point, says Thomas Baruch a general partner at CMEA Ventures, which recently closed on a new $163 million life sciences fund. “But will the world be a better place in five years because of what we are doing?” he asks. “Absolutely.”

Contact Alistair Christopher at: