How To Invest in Cardiac Surgical Devices –

The medical device market has come back with a vengeance. VCs pumped $437 million into 52 medical device startups in the second quarter, a 54% increase from the prior quarter and the largest increase of any major industry segment. Devices to treat cardiovascular disease show particular promise for high returns.

Let’s take a look at the cardiac surgery market and get perspective from a surgical and investment point of view to ensure that venture capitalists get the biggest bang for their buck – and avoid making costly mistakes.

The cardiovascular device market earned about $12 billion last year, or 7.2% of the $165 billion market for medical devices as a whole. The cardiovascular segment is set to get even bigger. Standard & Poors projects that the global cardiovascular device market will expand by about 13% annually though 2005, outpacing the overall medical device market. This market is segmented by products used by cardiologists (most commonly defibrillators, pacemakers, angioplasty devices and stents) and products used by cardiac surgeons (most commonly devices used to perform coronary artery bypass surgery and repair or replacement of heart valves). For a number of reasons, venture investing in the cardiovascular device area represents one of the best opportunities for risk-controlled return of capital.

* Each of these segments is poised for growth.

* Cardiovascular services still account for 40% or greater of revenue at many hospitals.

* Despite better medical management with drug therapies, the number of people being treated for heart disease will increase dramatically because of both an aging and expanding population.

* There have been several significant paradigm shifts in the approach to cardiac diseases based on mandates for less invasive procedures.

* Cardiologists and cardiac surgeons generally tend to more open and accepting of new technology than other physicians.

* There is intense competition between a handful of large public medical device companies that are constantly looking for new devices to expand market share and product lines though acquisition.

A recent example of a successful exit in this space is Guidant Corp.’s third quarter acquisition of privately held X-Technologies Inc. for $160 million. X-Technologies, based in Israel, had recently received U.S. Food and Drug Administration (FDA) approval of its FX miniRAIL balloon catheter, a unique device for the treatment of coronary artery disease. The company was founded in 1999, and closed two rounds of financing in early 2002 with a post-money valuation of about $52 million. It had a total of $17 million in backing from ABS Ventures, Alex Brown & Sons, Etgar LP, Giza Venture Capital, Trefoil Capital Investors and Yozma Venture Capital.

Interest in companies like X-Technologies remains strong because of continued demand for cardiac surgery devices. Over 700,000 coronary artery bypass procedures are performed worldwide every year. As a specialty, cardiac surgery has historically been very device driven. It remains the largest surgical specialty that uses highly invasive procedures. The public is demanding less-invasive procedures, and such surgeries are only possible with the use of an assortment of new, commercialized medical devices. Aided by new device technologies, many heart operations can now be safely performed without the heart lung machine (so called off-pump or beating-heart surgery) and through smaller incisions.

One could make the argument that the recent introduction of drug-coated stents to open up blocked heart arteries will negatively impact the number of patients referred for surgery. These stents are placed without surgery by cardiologists. However, a fundamental law of imperfect markets dictates that competition drives markets, and this in turn spurs innovation. Thus, rather than drive down the number of heart surgeries, drug-coated stents will stimulate a golden age for cardiac surgical device development and commercialization. This in turn, creates a huge opportunity for well-positioned early stage capital.

Even later-stage deals are attracting VC. Cardica Inc., a privately held developer of devices for use in coronary artery bypass surgery, raised a $4 million third round in August. The 6-year-old company, based in Menlo Park, Calif., makes medical devices that are designed to provide surgeons with an easy-to-use, automated method for joining blood vessels without sewing. Its backers include Allen & Co., Sutter Hill Ventures and Guidant Corp.

While I believe the cardiac surgical device market is ripe for investment, I would caution that it’s not for everyone. It requires special expertise. Following is a list of “do’s” that venture capitalists need to follow to avoid mistakes – and find success.

1. Thoroughly understand the disease spectrum and know that the major efforts will center on newer surgical approaches to coronary artery disease, valvular heart disease, and arrhythmias. All too often I talk to venture capitalists who confuse the distinction between which diseases are best treated by the surgeon, the cardiologist and even the generalist.

2. During the due diligence process, use a cardiac surgeon who is well versed in both the technical and business aspects of device development. It does not suffice to consult anyone with a medical degree, as the depth of specialization and issues involved require an expert who has experienced the touch and feel of devices while operating on the human heart. Use a consultant who not only understands current treatment trends but also understands business development in general. Experience-based intuition about true market potential is enormously valuable.

3. Look both at devices that incrementally improve older technology and those that have the potential to be disruptive. Avoid looking for a holy grail for this market.

4. Look at devices that can be used in different types of heart operations. Some devices will make multiple types of procedures more accessible. Devices that can meet multiple needs may render a higher reward.

5. Focus on devices that will be used for doing coronary artery bypass operations, since bypass procedures remain over 80 % of a typical surgeon’s output. The major effort will be on devices that make less invasive approaches possible.

6. Clearly define the target customer. All too often the customer is erroneously defined as the patient or even the device distributor. It must be understood that the target customer is the cardiac surgeon. This means that the venture capitalist must intimately understand the threats that competing technologies, decreased reimbursement and higher-risk patients pose to the customer (i.e., cardiac surgeon).

7. Clearly define the customer’s needs. While it’s true that the goal of a new device is to provide for better patient therapies, the adoption of a new device will not happen if it doesn’t serve the needs of the cardiac surgeon. Needs may vary, but they will largely evolve around a device’s ease of use, safety, time savings, cost savings and improved outcome data with respect to other non-invasive options. All too often cardiac surgeons are presented with techniques and devices that are too complicated or risky to employ, even after a so-called learning curve. In today’s legal and reimbursement environment, such risks are unacceptable. While increased reimbursement may be included as a customer need, a discouraging stance from Medicare and/or Medicaid may make that a moot point.

8. As with any new technology, a new medical device should have a clear competitive advantage or basis of differentiation. Note that the advantages may be difficult to distinguish, as is the case with the plethora of heart valves or stabilizing devices for beating-heart surgery.

9. Study the competition and thoroughly understand competing technologies such as drug-coated stents. For example, forging a closer interaction with competing technologies using hybrid procedures may create one of the great growth areas in cardiac surgery.

10. Understand the business model and look for cardiac surgical devices that have multiple revenue streams, like those used for beating-heart surgery. Remember that market acceptance is critical, since reimbursement remains an important issue.

11. Finally, look at devices that have the potential to lower the overall cost of a heart operation. A potential Achilles’ heel of the use of drug-coated stents in the treatment of blocked coronary arteries may be a prohibitive cost for the deployment of multiple stents. A device or group of cardiac devices that prove to lower the cost of surgical revascularization in comparison to stents (which do not require surgery) will drive cost-conscious hospitals to favor surgical approaches to the disease.

Don’t be put off by the maturity of this market. Yes, there are about 8,000 medical device firms, mostly small and medium-sized. But the demand for innovation remains strong, due to an aging population that has expectations of living longer with new therapies, a more streamlined regulatory approval process for devices and the promise of greater clarification on reimbursement from the Center for Medicare and Medicaid Services. The companies that can meet that demand will be rewarded, whether they are established corporations or venture-backed startups. Investing in surgical device companies promises to be profitable for venture capitalists who are well prepared and well informed.

Dr. Hendren is a cardiac surgeon and an advisor to Catalyst Health and Technology Ventures in Newton, Mass. He consults on health care-related investments. Dr. Hendren is also a student in the Executive MBA Program at the Marshall School of Business at the University of Southern California.