Q&A With Healthcare VC Doug Kelly

I’ve heard a lot of people say recently that healthcare is recession-proof, and I suppose that is true. After all, people still get sick, even in a downturn, maybe more so, and they still need to go to the doc and get drugs and use other medical services.

But does that mean healthcare venture capital is also recession-proof? I recently caught up with Alloy Ventures’ Doug Kelly, who helped found with Palo Alto-based firm 13 years ago. Kelly and his partners are currently investing in tech and life sciences from a $368 million fund raised in 2005.

Kelly, who is a trained physician, wanted to talk about what one life sciences company was doing to stimulate hair follicle growth, while I just wanted to know what that company could do for gray hair. That’s another story, however…

Q: How risky is the overall sector right now?

A: While there is a lot of upside if you pick the right deals, there is still considerable risk in healthcare investing. Financing/syndicate risk and lack of a clear liquidity horizon are the largest risks in this market.

With such long timelines to exit, there is no guarantee an early stage investor is going to get paid for taking on early stage risk. Also with President Obama’s administration, there is a great deal of uncertainty about what health care is even going to look like, especially on the regulatory and payer sides.

What does a great health care deal look like today?

It’s no longer enough just to have “neat-o” technology. Health care companies must really be solving a pressing problem for the market. A good example is Fluidigm [backed by Alloy and others]. Their integrated fluidic circuit technology increases test throughput, lowers costs and enhances sensitivity compared to conventional laboratory systems. Similarly, we’re seeing quite a few companies get funded that meet critical research needs in academia and pharma.

What’s your stance on investing in pharmaceutical companies?

We are staying away from biotech therapeutics, at least for the foreseeable future. This market is extremely capital intensive with no guarantee of returns.

Instead of investing directly, we are focused on investing in lab instrumentation and reference lab diagnostics, with companies such as Fluidigm, Artemis, Raindance, Labcyte, and ForteBio. This strategy lets us participate in the pharma/biotech space without having to take on drug development risk.

We’re basically selling picks and shovels to the gold miners… and we all know it was the hardware guys who made all the money in the gold rush!

The path to liquidity has been pretty poor lately for VC-backed companies. Are there any health care companies poised for an exit in the months to come?

Actually, we’ve seen several high-profile M&A exits in the health care space recently, and we expect to see more in the coming months as large medical device and health care companies go shopping for innovations and differentiated technologies to boost growth.

For example, SurgRx, a maker of technology that uses heat and electric current to cut and seal tissue for surgery, was recently acquired by Johnson & Johnson at a great price. Acclarent, an ENT (ear, nose and throat) play, and our GI device company BARRx Medical both have ferocious revenue growth rates, are at or near break-even, and are attractive acquisition targets.

What else makes a health care company an attractive acquisition target?

It’s important to think about the strategic imperatives of potential acquirers. For example, take Adiana, a company we seeded at Alloy that had developed an alternative to tubal ligation for women.

Adiana’s procedure has one very important differentiator. It doesn’t use metal, which means it has a much lower risk of interfering with complementary procedures from other companies. We recognized early on that this approach would put Adiana in a position to be courted by several other large players in the space who might want to combine Adiana’s procedure with their own.

Sure enough, Adiana was acquired in 2007 by Cytyc, developer of a complementary system for endometrial ablation.

Would you or others still invest in potentially groundbreaking health care technologies that have a less clear exit strategy?

There is still room for revolutionary technology and “big science,” as long as the potential payoff is big enough.

For example, we’ve made several investments in the genomics space, including Pacific Biosciences, a cross-disciplinary gene sequencing company run by former tech exec Hugh Martin. Although expensive to develop, if their technology works the way they’ve envisioned, Pacific Biosciences will enable the first $1,000 whole genome sequence and directly threaten the multi-billion dollar businesses of many large sequencing and lab instrumentation companies.