Biotechnology, considered the darling investment sector of the high rollers in the early 1990s, seems to have fallen by the wayside, and investors are now wondering what kind of future this sector holds.
Returns in biomedical portfolios in recent years have lagged behind those in information technology to the extent that large diversified venture firms such as Accel Partners and Oak Investment Partners have either recently exited the field or have plans to do so. Except for a slight respite for medical device and service deals in 1996, the last time biotech showed significant returns was between 1991 to 1993 (see Figure 1).
The remaining advocates for life science investing, however, point out that a number of biomedical companies have continued to achieve commercial success in the current down cycle, with many of these companies entering Phase III clinical studies, launching successful products and receiving approval from the Food and Drug Administration (FDA). The current trend simply reflects a consolidation of the biomedical equity markets, which have pushed out unqualified companies. Once consolidation is complete, the markets will again accept new companies, and higher IRRs will follow.
Meanwhile, information technology has surpassed biotechnology since 1994 as the prime investment sector and has become the driving force behind the VC community’s high rates of return in areas such as software, semiconductors, networking and e-commerce.
Figure 1 illustrates the last consolidation phase of the technology sector, which took place between 1984 and 1992. Beginning with a grand bull market “blow off” in 1983, a consolidation was started in 1984 and continued through 1993. During this period of weak returns, many technology-focused venture firms moved aggressively into the biotech arena. The buoyant market for biotech stocks allowed companies to file for Investigational New Drug (IND) applications with the FDA and to hold public offerings a year after being formed. The fast pace of those times was a clear indication of an ensuing bear market and a period of consolidation.
The biomedical sector, however, has built several good companies in the last 10 years, and solid businesses in this sector continue to develop.
The Allure of Biotech
Despite the difficulty during the last several years of holding biomedical IPOs, there are many reasons why this sector remains attractive. For example, companies that make significant progress experience share price appreciation in the public markets. Figure 2 depicts the appreciation of several companies that were able to execute their plans, demonstrate the clinical effectiveness of their products and initiate sales.
While this group is heterogeneous, some companies are just completing clinical trials and others have product sales. The net effect is that the market rewards companies successfully moving through the development process. But even if successful product development results in enhanced shareholder value, is biomedical investing worthwhile given its long time horizons and hefty cash requirements?
In the past few years, interest in secondary biotechnology stocks has been in a sideways consolidation phase, with many public investors indicating a desire to invest in more successful large-cap biotech stocks. Less than 10 years ago however, these large-cap biotech companies were viewed with the same suspicion as secondaries are today. As some of these companies made their way through clinical trials, they also have moved into the large-cap arena. Hence, the successful large-cap biotech stocks of tomorrow are the early-stage companies of today. The current biomedical market is a simple consolidation, working through a bull market over the past five years. As new companies pass through FDA regulatory hurdles, they are able to move to the commercialization phase.
One can ask whether valuations are ever consistent within the biomedical sector or if there is a goal post that says successful work will be rewarded. In comparing the valuations of biotech companies in Phase I, II and III of clinical trials during the difficult markets of 1989, 1994 and 1998 (Figure 3), one sees striking similarities suggesting the recognition of an underlying economic force.
While exceptions abound, companies with convincing Phase II data and ongoing Phase III trials were granted substantial valuations. The difficulty for many companies, however, lies in a long product-development period, the large amounts of capital required and the public investor’s lack of interest. How can the biomedical venture investor build value in portfolio companies and generate above average rates of return with such long time horizons?
It is true that the development of therapeutic products takes a long time. Some industry players believe that venture capital returns require a buoyant equity market and quick turn around. Data indicate, however, that if one seeds the companies with small amounts of capital and then injects capital judiciously as the companies’ progress, it is possible routinely to make the 35%-plus portfolio returns required of the venture community. Spending too much money and building too large an infrastructure are common demons for the biomedical investor. The time value of money can be a major drawback if time lines are not met or if technology takes a transient turn for the worse. The timing of spending is critical to returns.
It is crucial to keep the amount of capital small at the outset of seeding a company so that it can make progress. With the knowledge that a liquidity event is likely to be several years away, larger amounts of capital should be provided much later in the development cycle when the time horizon allows for a higher rate of return.
As an example, Figure 4 illustrates the total cash consumption of Discovery Therapeutics Inc. Discovery has succeeded in developing two compounds to late-stage clinical status, and a third compound is expected to enter Phase III trials in the second half of this year. Sanderling’s ability to assist with many of the corporate functions for Discovery and the cash- sparing efforts of our co-investors have enabled the company to consume only $12 million through 1998. The increase in the value of the investment by Sanderling is shown in Figure 5. While there is a small increase in the value of the investment status, it is not until late in the development cycle that the dedicated effort will pay off. In the end, it appears that the investment’s returns – although it might take seven years to harvest – will be satisfactory because the amount of early capital is modest, and it was only in the latter stages of corporate development that larger investments were made. Hence, the time cost of too much capital invested in the earlier stages of development will not have a negative impact on the IRR.
The ongoing trend in the venture community is specialization, particularly in technology and health-care funds. Following are three issues affected by specialization as technological complexities in start-ups and early-stage companies continue to spiral:
* The sheer complexity of each area of technology, whether it be electronics or biology.
* The unique background required for business development in these sectors.
* The natural conflicts that occur within partnerships when one sector is out of favor and the other excites Wall Street.
Venture firms naturally gravitate to certain technology sectors based on the knowledge of their partners. For example, those who understand semiconductor technology and how to exploit opportunities in the field are not necessarily the same partners who will understand the latest moves in e-commerce or advances in telecommunications. Meanwhile, those in the health-care sector that do well in service companies are not necessarily those who find opportunities in genomics.
This argument is made more complex when the actual start-ups are seeded. In the early stages of corporate development, a partner’s business background in developing a new entity can be crucial. This is especially true when an early-stage company is funded by technical founders. In the case of health-care companies in the therapeutics sector, the ability of a partner to have an in-depth appreciation of the clinical development plan, for example, could make a difference in accepting the proffered strategy of the founders. In this case, the ability to follow a plan that resulted in the timely approval of a drug can be a major factor in the partnership – realizing a good rate of return or a poor one. That partner is not likely to be the one who understands the complexity of reimbursements in the nursing home industry, which is in the midst of consolidation and is dominated by factors quite different from that of the drug development sector.
Some venture partners have had difficulty understanding electronics – software, hardware, telecom, etc. Technologists who are not well versed in the area often are misled by technical arguments that overstep wide bounds of undetermined facts. If a partner is a director of a biomedical company and is not versed in the field, he may be easily misguided by management or starry-eyed scientists. When information technology investing is en vogue and the turnaround times are short because of buoyant equity markets, information technology partners have little time for health-care investments, which have longer time horizons to commercialization. These are understandable complexities but lead to internal conflicts within diversified funds, which probably is an unhealthy dynamic within the partnerships and has led to difficulties and withdrawals.
The logical conclusion of these observations is that the health-care industry is likely to find itself in the current consolidation for a while longer. As successful companies rise to the surface, however, the biomedical markets will again emerge. Such is the history of the markets, and, as such, history will likely repeat itself. Yet, the players might end up being different. The era of the generalist venture capitalist is over. Specialized funds are a logical extension of the continued evolution of both health-care and information technology investing. Not everyone can be an expert in every subject. When health- care markets rise again one might predict that the specialized partnerships will be the ones to benefit first and to the greatest degree. For firms that have left the sector, too much water may be under the bridge to play catch up.