Big ego VC says Pharma needs more big ego VCs

Read it here:

http://www.xconomy.com/san-diego/2012/09/27/kinsella-redux-charting-a-way-back-for-life-sciences-startups/?single_page=true

I'm not convinced that venture returns are meaningfully impacted by the venture partner involved. In the article above, a big ego VC wistfully urges that his sector return to the glory days. One of his funds from 15+ years ago is offered as evidence that he's brilliant and Big Pharma is stoopid.

Not that Big Pharma is blameless, but there are better explanations for declining returns even as drug discovery has gotten more capital efficient. Here's a few that occurred to me:

1) VC's own movement away from investing in early technologies to later stage deals. VCs basically don't do old-fashioned $500,000 seed stage deals anymore. They're now all about financing companies graduating to Phase II. Gee, Mr. Kinsella, I wonder why there aren't as many early-stage companies.

2) the hangover from VC over investment in the early genomics era. Remember the year 2000 hype behind genomics companies like HGSI, Millennium, and others? Yeah, I can't imagine why Pharma stopped trusting VC.

3) the rotation in investing strategy from FIDDCo (fully integrated drug discovery companies) and platform technologies to target driven companies each based on a small amount of closely-related leads. 

4) a lack of public market liquidity for small cap biotech, partly influenced by structural changes (like increased financial regulation reducing the attractiveness of IPOs), but more driven by increasing VC fund sizes. VCs are paid based on assets under management (size of fund = size of paycheck), and with larger fund, it is less economical to make smaller, earlier investments, which also require longer holding times, so VCs moved their money towards PIPES - investments in already-public companies.

There's four reasons generated in about 10 minutes. I'm sure I could come up with 10 more if I spent another hour on the idea, but I'd hate to accidentally give any credence to VC vanity.

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Biotech’s Capital Intensity Challenge: A Post-Mortem on 2007’s Biggest Deals

Truth from Booth: there is no correlation between the amount of venture capital raised by a biotech and it's ultimate outcome. 

I suspect that huge VC rounds just incent management to take on more risks beyond their control.

Read Bruce's full article here: http://pocket.co/s8kDC

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This just in: biotechs with pharma VC $$ are more likely to IPO or be acquired

OK, this news from Burrill & Co isn't exactly revolutionary, but it is interesting to see numbers applied to common sense.

Burrill analysts looked at ~2,900 companies that received venture funding. ~10% of those companies received financing from the VC arm of a Big Pharma company (such as Lilly Ventures, SR One, etc.)

Burrill sees the Big Pharma VC $$$ as a differentiator in outcomes. Consider these outcomes from Burrill's study:

Venture WITH big pharma VC                                  Venture WITHOUT big pharma VC
           ~25%                 % companies ultimately acquired                  ~15%
           ~50%              % companies w/pharma partnership                ~30%
           ~12%                     % companies that IPO'd                             ~8%

Combining acquisition and IPO outcomes to say "who got liquidity," you'd see that ~37% of biotechs with Big Pharma VC got liquid, while only 23% of biotechs without Big Pharma achieved liquidity.

(I'm surprised the figures are that high, and ultimately likely higher, as additional companies from the studies IPO or are acquired. Given another year or two, I wouldn't be surprised if the respective liquidity figures reach 50% and 33% respectively. Who thought that 50% of all pharma $$ backed drug discovery biotechs achieve liquidity? I'd naively guess that these figures are higher than what is experienced in internet/IT/software investing.)

So, based on Burrills analysis, attracting big pharma VC boosts by 50% or more your odds of partnering, IPOing, or being acquired. 

The big question is: does Big Pharma investment make a company better, or is big pharma better at picking winners?

I'd argue strongly the latter - that Big Pharma picks winners - for the simple reason that for every biotech, the ultimate customer is Big Pharma, not patients or attending clinicians. In that respect, biotechs attracting Big Pharma VC are by definition doing a better job of understanding the customer (Big Pharma) and are 'pre-selling' Big Pharma during investment discussions.

What I found surprising was that the Big Pharma VC investment IS NOT predictive of acquisition by the Big Pharma that made the investment.

What this all means:

for investors: the participation of a Big Pharma VC is obviously a stamp of quality, and likely more important than the identity of the non-pharma participating investment funds.

for biotechs: not all VC $$$ is equal. Getting SR One, or Pfizer Ventures, or the Novartis Option Fund to invest is likely much more valuable than taking VC $$$ even from traditional industry VC. Hmmm. Between this news, and other recent analysis about VC outcomes, you wonder if maybe traditional VCs ought ought to return to their roots in incubating companies, not scaling companies.

More damning VC performance data - the model is broken

Two weeks ago I pointed to a study suggesting that there are structural problems with venture capital. A larger, more damning study is now in the news, confirming low industry returns, and diagnosing more problems with VC.  

I highly, highly recommend clicking through to read Felix Salmon's reporting and analysis on the
matter. Money quotes:

"During the twelve-year period from 1997 to 2009, there have been only five vintage years in which median VC funds generated IRRs that returned investor capital, let alone doubled it," and

"the VC industry, as a whole, is being incredibly successful at extracting rents from dumb institutional investors."

In a nutshell, a study by the Kauffmann Foundation concludes that:

-It is debatable whether or not VC is a worthwhile investment. "78% of the funds that Kauffman invested in (i.e. those in the study) have failed." Not only does the mean VC fund destroy capital on a risk-adjusted basis, recently these funds have had negative IRRs on a gross basis!

-Quality matters: "If you can’t get into one of the best funds — and everybody knows which funds those are — then there’s really no point investing in venture capital at all."

-LPs really don't hold VCs accountable enough: "once you strip out the top-performing 29 funds, the rest — more than 500 — collectively invested $160 billion, and managed to return $85 billion to investors." Shakeout, anyone?

-incentives are misaligned: VCs are invented to raise more and larger funds, as that's where the compensation is. This also incents goosing early year returns to help with fund-raising, meaning all of that VC chatter about long term investing is bull.

-smaller, more experienced funds are more likely to have outsized positive returns.

It's time to change the life science VC industry approach. Here's a few humble suggestions from my quick reaction to the Salmon article and Kauffman study:


1. Full disclosure. Between intense VC fund secrecy and discretionary allocations of costs and returns among funds, VC investors (LPs) really can't get definitive, transparent performance accounting. It's time for quality VC firms to be proactive in publicly disclosing deal-by-deal and expense by expense fund accounting. The message from LPs needs to be "if you're not transparent, we'll assume you're hiding something."


2. VCs: Climb the risk curve. The data suggests that VC has a problem finding alpha (return). The most immediate way to goose alpha is to take on more risk by investing in earlier stages. In other words, if a VC firm says that they don't invest until B rounds, they ought to stretch into A rounds. (And likely STOP investing in later ('D') rounds. An earlier investment carries a bit more risk, but it is more or less the same type of risk seen in the later stages. (In other words, if the primary risk for an investment is target biology or lead chemistry, it still takes the same understanding/risk tolerance whether investing in round A or C. Only the size of the risk changes.) I think VCs get paid for their ability to manage risks, so if a firm's core competency is vetting lead chemistry, getting in earlier plays to their strengths, and might in fact "train" the firm to better assess and handle those risks.


3. Less therapeutics, more enabling tools and platforms. Investing in therapeutics has a more or less binary outcome - success or failure, with not much in between. One way to minimize the downside for VCs is to invest in operating companies - their ceilings aren't as high as a winning therapeutics investment, but their terminal value is, well, >$0.


4. Create smaller funds, with VC compensation tied even more to performance. Typical compensation for a VC is 2% of the amount invested every year, plus 20% of the downstream gains. If it were up to me, I'd get rid of the 2% annual fee - make the funds invest their own $$$ in annual expenses.


5. More specialized funds. The old investing true-ism is that 80% of investing returns are generated through asset (sector) allocation, not through the selection of individual securities. The suggestion then would be to hyper-specialize. A large fund that invested in "therapeutics" is less likely to deviate from traditional poor returns than a fund specializing in "oncology," though I'd postulate that a fund that hyper-specialized in "kinase inhibition in cancer" would have crushed both, and wasn't that difficult to predict 10 years ago. (Easy for me to say.)


6. Use secondary markets to generate valuations and gain liquidity, lessening short term thinking and attracting Big Pharma investment dollars. New markets like Second Market have made a splash with internet companies for their ability to provide selected liquidity and to unlock equity value for employees. I'd like to see biotech embrace these alternative markets. Earlier pseudo-liquidity would attract more investment capital in general (including from Big Pharma. It would be great to get more of their capital in the game,) provide more transparency, clarify signaling, and likely facilitate consolidation among private companies. There might be some resistance among VCs as alternative markets might disinter mediate them, but they might on net reduce the investing risk for VCs and facilitate earlier liquidity.


7. Begin a 5-year moratorium on pandering to the government to increase funding for young companies and technologies or to reform some regulatory requirement of securities law. If the Kauffman study is representative of the life science industry, then clearly the problem isn't the level of government support, but rather the commercialization efforts that VCs back. VC keeps destroying capital with bad bets, not because there aren't enough ripe, de-risked technologies, or non-equity funds to incubate promising technologies.


8. Fund businesses, not technologies, science projects, or lottery tickets. Sure, the business case for an investment may hinge on Big Pharma buying you out once the leads make it to Phase ___, but if investments aren't businesses first and foremost, you're either ultimately 1) disappointing your Big Pharma customers, and 2) trying to build a skyscraper on a foundation of mud.


Unfortunately, I don't have a lot of confidence in the VC industry adapting. It is way, way more likely that instead of changing the industry's foundation, VC will further squeeze valuations and term sheets for incoming investments in order to try to lift returns.

Structural problems in VC-land

Fascinating blog post and commentary by Noah Smith suggesting that VC returns have lagged the S&P 500 for nearly a decade.

Here's a graphical representation of his point:

Head to Noah's site to get all the details of the study.

(The study seems to be across ALL industries - with biotech/life sciences composing only a fraction of the investing universe for these VCs, but the core lesson probably holds for biotech: VC returns have plummeted.)

The explanation for the plummeting VC returns is an oversupply of risk-capital (and risk-capitalists!), beginning during the dot-com bubble. However, it isn't clear if this is because deal pricing and other investing terms have changed post-bubble, or if the oversupply of capital led to the funding of marginally rewarding portfolio companies, or any of a dozen other explanations. Perhaps it is simply that there had been an artificial constraint on risk capital before the bubble, allowing VCs to earn rich returns by cherry-picking only the best deals.

One commenter at Noah's site provided evidence that VC returns also tend to correlate with the history of the VC team. (In other words, long-term VC groups have done much better than Johnny-come-latelys.)

Whatever the explanations, there are implications for life sciences:

-we're in the midst of a correction in the VC market - many marginal VC players will disappear, and with that, pricing power will begin to return to the survivors.

-if they weren't already, VCs are desperate for returns. Expect them to ALWAYS take the option that cashes them out now at a lower price, than later at a higher price. (If you thought they were short-term thinkers before……..) This is good news for strategic buyers.

-seeing these returns, LPs (those who invest in VC funds) are more likely to "go direct" by investing in PIPES and follow-ons and forego investing with VC funds that 1) don't deliver risk-approproate returns, and 2) charge 2% a year, plus a carry. If this is true, there's more hope for older small cap biotech's, and less hope for early stage companies.

-I'd guess that a side effect will be a decline in risk appetite, which would be a nudge towards tools and tech platform companies, and away from discovery pure-play companies. I'd also guess that target discovery is no longer a viable business - if there's an over supply of VCs, the last thing they'll want to do is add to the oversupply of targets.

-seek quality. All else being equal, the life science VC firm in its' 2nd decade of investing is likely to be a better choice than a firm just beginning in biotech investing.

-as before, there is still a big opportunity for corporate (Big Pharma) VC$.

Hat tip to Tyler Cowen's Marginal Revolution blog for pointing out Noah's post.

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.