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Test Tube Alchemy: Venture capitalists hope to concoct portfolio winners out of life-sciences stocks that have taken their lumps

James Cavanaugh, a general partner at HealthCare Ventures L.P., has no intention of becoming a mutual fund manager, but he and his colleagues are spending a good deal of their time looking at public companies.

Focused on biopharmaceuticals, the New Jersey and Massachusetts-based venture firm hopes to take advantage of the drubbing micro-cap life-sciences stocks have endured by investing in public equities for the first time.

HealthCare Ventures is far from the only bio/medical-oriented VC outfit trawling the public waters for small fish. Stock prices of micro-cap medical and biotechnology companies are sinking below the valuations of their private company counterparts, VCs observe, making these stocks hard to resist.

Prospect Venture Partners General Partner Alex Barkas says every VC he knows is exploring the public market with the expectation of reaping venture-level returns.

Venture investors scanning the public horizons look for fallen angels – companies whose stock prices have plummeted but whose promise and fundamental soundness remain intact. Sometimes these companies are paying for the sins of others. Their stocks, for example, can become innocent bystanders when another company in the sector suffers a well-publicized problem or outright failure and investors flee.

Fallen angels also can be victims of larger trading trends. When markets are volatile, as they were in late 1998, investors flock to the relative safety – and liquidity – of large-cap stocks, leaving small-cap companies hungry for capital. Right now, coincidentally, venture capitalists have a lot of money to invest.

Investing in cheap public stocks is hardly a new strategy for venture firms. Institutional Venture Partners, for example, entered the public markets more than 20 years ago by investing 20% to 25% of its mid-1970s vehicles in public equity, recalls Partner Reid Dennis. After October 1987’s crash, the firm plowed every dollar it could find into the public market, Mr. Dennis recalls.

While the stock market’s fast recovery from its summer swoon has put aside any thoughts, at least for now, of broad-based venture investing in public stocks, some sectors have not rebounded, leaving plenty of attractive opportunities.

It is difficult to pinpoint exactly how severely and for how long the smallest biotechnology and medical device stocks have been ailing because industry-specific stock indices tend to be heavily weighted toward large-cap stocks. Archie Smith, senior medical-device analyst at Piper Jaffray, says the value of small-cap medical device stocks has been declining for two years.

Hambrecht & Quist biotech analyst Richard van den Broek notes that the light market for small-cap biotechnology companies results, in part, from their small size. Institutional buyers do not want to be bothered with “miniscule” investments and do not want to own more than 10% of any given company, so they shy away from life sciences companies with market capitalizations of $100 million or less. Additionally, they worry about liquidity, given the tiny appetite for micro-cap life science stocks. “So people say Forget it, call me when you’re grown up’,” Mr. van den Broek says.

Venture capitalists, by contrast, are much more willing to hold a company for several years and much better situated to make investments of “just” several million dollars.

Like HealthCare Ventures, Asset Management Associates Inc. is considering life sciences companies in the public market. Previously, the Palo Alto, Calif., firm had made public investments in only a few companies it had supported when they were private, says General Partner Craig Taylor. But Asset Management is looking beyond its portfolio now, scouting for public companies with valuations of less than $50 million that have $10 million to $15 million in cash and products in various stages of clinical trials or beyond. The venture firm would like to make investments of about $5 million in diagnostics, device or therapeutics companies.

Asset Management Associates 1998, the firm’s latest fund, closed on $115 million in August 1998 (VCJ, October 1998, page 20). About 35% of Asset Management’s capital is slated for medical investments.

Mr. Taylor and other venture capitalists targeting public companies hope to use their VC skills to help the businesses they back with such tasks as hiring managers and deciding which projects to pursue and which to kill. Many public-investing VCs want board seats, which they acknowledge could be a jolt to public-company managers more accustomed to passive stockholders than active investors.

The vast majority of venture firms considering public stocks are doing so cautiously. Most plan to limit their involvement to 10% of their capital, and some establish that ceiling in partnership agreements, according to Prospect’s Mr. Barkas. A notable exception, however, is Alta Partners’ Alta Biopharma Partners (VCJ, May 1998, page 16).

The $170 million vehicle, which wrapped last spring, was created to back clinical-stage biopharmaceutical companies, and many of those are public, explains Managing General Partner Dan Janney.

The fund was designed to support product development, making four- to seven-year bets on investments. Alta plunks down $10 million to $15 million chunks in companies with market caps of $50 million to $150 million, Mr. Janney says.

The firm told limited partners it expected to put half of Alta Biopharma in the public market. By press time, the fund had backed two private companies and one public company: Connetics, a San Mateo, Calif. developer of therapeutics for the rheumatology and dermatology markets. Of the six deals Alta was working on in mid-November, four were in the public market and two were private.

Despite some venture capitalists’ enthusiasm for the public market, it has not attracted everyone. Of course, IT specialists haven’t spent much time considering public stocks in their sector; they are too expensive.

The public market is not appealing to small venture funds, either. Stan Fleming, a general partner at San Diego’s Forward Ventures, is considering underpriced public companies, in part with an eye to a roll-up with some of his smaller private companies. But were he investing from Forward Ventures II, a $12.5 million vehicle closed in 1993, he would bypass the public market, not wanting to drain his early-stage investing resources to manage stock deals, he says. Forward closed its latest vehicle, the $42 million Forward Ventures III Institutional Partners, in November 1997.

Ironically, very large venture funds also tend to shy away from public market investments. Institutional Venture Partners, for example, is not looking at the public markets now. It would take some truly fantastic stock wins for public investments to make a dent in the firm’s latest mammoth fund’s returns, Mr. Dennis notes, and it simply is not worth the effort. “It’s more of a distraction,” he says.

Public company investing comes with different risks, drawbacks and expenses than traditional venture capital investing, Asset Management Associates’ Mr. Taylor cautions. Public companies typically attract a different level of publicity than private businesses; they need to make frequent public announcements and Securities and Exchange Commission filings; and their management often is fully vested, creating motivational issues.

Venture firms also have to be sensitive to their limited partners’ attitudes toward the firms’ investing in public companies. Some L.P.s are dead-set against it, but most will at least tolerate modest public market investing.

Mike Borrelli, assistant vice president for investments at the University of Chicago, does not seek public market prohibitions in venture fund charters, but he pushes for 10% limits. “To me, that’s almost always a deal killer if I don’t get that,” he says. After all, he reasons, he could hire his own micro-cap manager who will specialize in biotechnology companies and who will charge 50 basis points and no carry. Meanwhile, he is paying his venture firms 2% to 2.5% and giving up 20% of the carry for private-market work.

Randy Crawford reviews venture fund investments for Boston University as venture capital director of the school’s Community Technology Fund (VCJ, November 1998, page 33). In light of market conditions, he thinks it makes sense for VCs to make modest investments in public companies or even to undertake a merger that ultimately returns a public company to the private side.

“I’m looking to receive venture capital returns, and I think in my mind, venture capital returns can be made with such a strategy … on a limited basis,” he says.