How to Avoid Irrational Exuberance in Health Care Investing –

The contraction of telecom investing has been health care’s gain. Some $1.5 billion flowed into health care startups in the second quarter of 2001, up 39% from the same period in 2000. New health-only funds are springing up daily, adding to the $4.3 billion raised by these funds last year (double that of the year before). That’s the good news.

Now the bad news: All of this money chasing health care entrepreneurs has created some richly funded companies with marginal business models. The problem is that health care delivery is disjointed and illogical in its execution. It’s not telecom, where a technological advance is likely to be appropriately evaluated by canny purchasers at a private company. Selling medical advances is different from selling fiber optic advances. Great technology is just the first step to success in health care.

Missing from many of the deals I see is the knowledge of how health care works on the ground, what it takes for a company to make money and the problems and opportunities to look for when evaluating products in the development pipeline.

First off, market size is invariably over-estimated – often by enormous multiples. In these presentations, the dollars generated by a new product on a per-treatment basis are multiplied by the number of people suffering from a disease. Voila! A huge market opportunity. But new drugs, services or devices must crowd out established therapies, many of which work quite well. There is no groundswell of demand for the 150th anti-hypertensive drug on the market, so promises that it will achieve 30% market share are likely far-fetched. There are already a lot of calcium channel blockers and beta-blockers crowding that space.

Few new products dominate their markets to the extent that even the science indicates they should. To wit: Sepsis is a blood infection that kills hundreds of thousands of people annually, yet until recently there has been no way to treat it directly. Last year Eli Lilly introduced a drug called Xigris as the first-ever direct sepsis treatment. Should be a category killer, right? But sales have been sluggish, with January and February receipts totaling just $14 million. The company has blamed FDA-imposed restrictions on the drug’s use. Any way you cut it, the sales are a far cry from company predictions of $2 billion in annual sales.

Part of the challenge of making money in health care is the industry’s complex system of buyers. The doctor has to prescribe the treatment. Medicare, or the patient’s private insurance (usually tightly controlled managed care plans), must include the product on its list of covered devices and services. Individual hospitals or clinics must agree to purchase and stock the product. Any new product or service must have a clear strategy for penetrating all layers of this system.

Health-care companies need to master distribution as much as science. Partnerships with established players have to be established earlier than in other industries. For example, two purchasing companies, Premier and Novation, have exclusive distribution contracts with more than half of U.S. non-profit hospitals. Together they control more than $34 billion dollars in annual sales. If you can’t convince these companies to distribute your syringe, stent, or pacemaker, it may go down in history as a medical Betamax.

Marketing efforts must target several consumer groups at once. Doctors must be taken on “educational” golf trips to the Caribbean. Slick marketing materials and creative finance plans must be targeted at hospital purchasing agents. Disease advocacy groups must be organized to place coordinated pressure on managed care plans. Congresspersons must be lobbied. I’m a member of a group that has done this with plastic surgery procedures – congenital defects and breast cancer reconstruction. It meets regularly with managed care executives and members of Congress. The results can be impressive, but they take time, coordination, and money to produce. This sort of lobbying led to laws mandating insurance coverage for breast cancer reconstruction in California.

Complicating matters is the time lag between basic science discoveries and clinical applications – longer in the life sciences than in other technology fields. This large window can be a strength in that it allows for competitive advantages once a product makes it to market. Unfortunately, interesting scientific discoveries often never translate into clinical utility. And even those products that work have to make it through FDA approvals, no small task.

Look, for example, at the ImClone debacle. The company’s Erbitux drug was touted as the silver bullet against cancer. It got a huge vote of support (no less than $2 billion in backing from Bristol-Meyers Squibb), but then in December the FDA refused to even review the drug’s application for regulatory approval.

The temptation is to fund companies with novel and exciting technology. But that looks at the situation backward. Technological advances should solve problems. Technological advances should not be shopped around looking for problems they might solve. Such advances sometimes never find their target problem. In order to make money, even early-stage basic science companies must have a clear understanding of the clinical needs their technologies will eventually address.

Health care also has a town/gown conflict: doctors at universities are not always in sync with those at garden-variety community hospitals. Many new products are initially targeted to academic medical centers. From there, the theory goes, the technology will diffuse to the rest of the medical community. This works sometimes. But it is important to realize that academics have self-selected an environment that is constantly awash in new technology. They are a disproportionately receptive audience.

Health professionals in the “real world,” who comprise the lion’s share of the market, are less captivated by the gee-whiz factor. Any new product must be able to win over the staff at Peoria General Hospital as well as that at Harvard.

VC firms often fall prey to these sorts of problems when they evaluate health care deals. They pack their advisory boards with Nobel laureates. In many ways, evaluating the science behind a new technology is the easy part. Understanding the market is what makes for successful screening of companies.

The key to obtaining this knowledge is a wide net of contacts on the ground. Doctors at academic centers as well as in the community. Nurses who administer treatments. Purchasing agents who stock supply rooms. Pharmacists who determine drug formularies. Even drug sales reps who sponsor dinners for medical staff to push new products.

How do VCs tap these resources? They need a good Rolodex, supplemented with an augmented payroll if necessary. They should go to medical conferences relating to the technology they’re studying, not just VC conferences on the topics. They should read appropriate medical journals to see where the specialties are headed.

I know one VC whose wife is a physician. She helps him with potential investments by talking to the people working in the wards in hospitals and clinics. If there’s no spouse to do the job, VCs should seriously consider cultivating these contacts among the medical staff they encounter during their own health care experiences.

Interviewing the world’s foremost university cardiologist about a new heart device only provides a single data point. VCs should also talk to the nondescript older heart specialist who has seen dozens of these devices come and go, the technologist who assists in the procedure to implant it, and the medical director of the mid-sized HMO that will pay for it. In the medical device industry, it can safely be said, “another day, another stent.” Just because a new stent is coated with anti-clotting radiation instead of anti-clotting proteins doesn’t mean anyone is going to buy it. And if the nurses in procedure rooms don’t want to handle a radioactive stent, don’t expect great market inroads.

As a plastic surgeon, I see many companies touting new wound healing technology. When I’m on the fence about whether to go one way or another, I often ask nurses in the intensive care unit what they think. Once, I passed on a company because its wound dressing had a foul odor. The nurses told me they would jump through hoops to avoid having to apply it to patients.

As the first cycle of this go-go era of health-care deals draws to a close, VCs are looking for new startups to replace the failures of the last round. This time around they should spend less time oohing and aahing over the science and more time in the trenches. Success will come from focusing on the market in which that science must find its customers.

Dr. Lloyd M. Krieger is a plastic surgeon in Los Angeles with an MBA from The University of Chicago. He works as an advisor on health care deals for Mellon Ventures and several other VC firms. He helps evaluate companies, management teams and markets.