Wednesday, April 11, 2012

biotech VC economics illustrated

HIG announced that they've raised another $268M fund to support drug development investments. (Congrats to them - the squeeze is on in VC, and most believe that VC limited partners are likely to concentrate their investments in 'survivor' VC funds. In other words, it's survival of the fittest, and having a number of LPs in follow-on funds means HIG is fit.)

Separate, Amgen announced the acquisition of KAI Pharma for $315M. (Congrats to them, as well.)

Seeing these two unrelated transactions, I wondered how many KAIs does HIG have to create to provide a worthwhile return to their LPs. (This is intended as general analysis, unrelated to HIG or KAI's specific performance or history, except that I'm using their numbers & press releases as representative of their industries.)

First, a bit about HIG's fund: according to the press release, the fund will support HIG's investment in 12-15 companies, with each investment to receive up to $20M, and liquidity targeted 4-6 years post-investment.

KAI, meanwhile, was launched in 2002, and has received $63M in venture funding over 10 years. So, using really simple terms, KAI generated a 5X return, or (on average) a 17% annual return. (This very simple analysis ignores the fact that the $63M invested in KAI was made a different times and valuations, and that some of the KAI equity is held by employees, not investors. You could assume that employee ownership was ~10% of the shares, but these are certainly common shares, vs. preferred for investors, meaning only that all of my figures could vary if you knew specifics of the KAI story.)

Any biotech that creates liquidity in excess of invested capital is automatically in the top half of all bioventure investments, but unfortunately, the 17% annual return is likely no better than half of the investors' expectations. There's some debate about what the discount rate should be for an early stage biotech - I've always used 40% at a minimum, so would argue this could be lower, particularly for later stage private investments. LP expectations for a biotech fund is for fund returns somewhere in the 20-30% (annual) range overall, which is the net of some positive returns and unfortunately some number of absolute failures.

Using 40% as the target IRR, and six years as HIG's average time to liquidity, the average new HIG investment would need to generate a 7.5X return in 6 years (40% annual IRR.) Overall, HIG needs to turn $268M into ~$2B in 6 years, though more and sooner would always be appreciated by the LPs.

So let's say that HIG funds 13 investments from this fund, and results are distributed as such:

4 x complete duds x $13M avg investment, zero return
4 x small return on original capital x $18M investment, 2X return
4 x modest return x $18M investment, 5X return (roughly equal to KAI's outcome.)
3 x big wins x $23M investment, 20X ROI

Here's what the total fund value becomes with these assumptions:

You can argue with my distribution of investments and ROIs (every VC would), but I've played with the numbers, and can't make it work - I can't come up with a plausible macro scenario for a drug development investor to turn $268M into ~$2B.

(One other observation: this analysis confirms the notion that VC fund success or failure is determined by the amount and magnitude of the big winners. One more or less 'big wins' makes the VC fund either a screaming success or honking failure.)

I tried one other approach to validate the VC drug development model: it is widely stated by Windhover that an anti-cancer compound in Phase 1 trials is worth ~ $100M. Assuming a cost of $5M per program from discovery to Phase 1, HIG would need to generate 20 of these programs, and they'd have enough capital to support ~40 targeted tries (after accounting for the friction of fund salaries, overhead at portfolio companies, etc.) Is there any reason to believe that HIG (or any other VC firm) could bat .500 in their attempts to generate phase 1 programs?

I'd disagree with any program IND success rate expectation of >25%, so my answer is no, though you could convince me that through the use of outsourcing maybe you could get the cost/program down from $5M, thus, reducing the required success rate.

In short, I can't see how the traditional biotech VC model could work, without abnormal success in portfolio companies or sooner or greater liquidity for portfolio companies. I'd say that KAI and other bioventures that have reached liquidity like Plexxikon - while representing above average success relative to the industry, show that the VC model is busted. (In biotech at least.)

I don't think this is a product of macro trends (Sarbox, competition from generics, medicare price cuts, etc.) but rather a by-product of the inefficiency of early stage drug discovery. For example, much of the earliest stage lead discovery is best described as a shotgun approach rather than rifle shots. Part of this is driven by how hard and imprecise drug discovery is, and partially by asset investment (if you spend millions on an HTS lab, you're biased towards quantity over quality).

postscript: just a reminder that this analysis isn't intended as a critique of HIG or KAI. I'm just using their #'s to illustrate.

No comments:

Post a Comment