Can’t Get No Respect? Bio-venture Issues Are Deeper Than Paper Gains

6/25/13

In one of his recent blogs at Life Sci VC, Atlas Venture’s Bruce Booth makes the optimists’ case for venture capital investments in the life sciences. Booth’s message is that life sciences venture capital is healthy but misunderstood, but he misses the forest for the trees in important ways.

Based on my 27 years in the venture industry, I would argue that another ten years like the last decade would put life sciences venture capital in serious jeopardy. I’ve seen estimates from the National Venture Capital Association (NVCA) that predict the number of U.S. venture firms will be one-third of the pre-2007 level by the time the post-meltdown shakeout has run its course—and the number of VC partners will be a quarter of what it was. My guess is that life sciences as a subset will fare even worse.

Bruce reviews statistics from a number of sources to make several points, foremost of which is that “Healthcare venture capital actually out-performed all other venture sectors in the past decade. …This outperformance exists at the median, top quartile, and even top decile return thresholds for the last decade.”

Based on his analysis, Bruce concludes that the industry’s primary problem is one of public relations—a Rodney Dangerfield image—rather than performance. If Bruce is right and life-sciences venture is alive and well, but just under-appreciated, then business-as-usual should suffice to see the industry back to health, if we are not already there. But if venture has serious systemic problems, then characterizing them as “cosmetic” is a misdiagnosis that leaves venture and pharma at risk of a deeper, life-threatening situation.

So, if statistics show that biotech is best-of-breed in the venture world, why is it under-appreciated? Pension fund managers generally know little about curing cancer (In reality who does?), but they do know how to count. It seems strange that for ten years they would overlook a good investment when their jobs depend on showing skeptical investment committees and trustees that they can make money.

Bruce’s statistics may be right, but they miss the most important point: Being somewhat better than your venture brethren is not good enough to sustain this industry.

For the institutional investor, venture capital falls into the “alternative investments” bucket that includes everything from natural resources to private equity. At the turn of the century, large pension funds generally had an allocation for venture and some even had buckets for bio-venture. Each year that sector received an allocation of capital. A fund manager had only to outperform his peers to receive a commitment.

Those allocations no longer exist. Bio-venture now has to compete with LBOs, private equity, distressed debt, and a whole raft of other choices. The decision is purely financial. Bio brings a twelve-year track-record of single-digit-to-negative returns and 10-15 years of illiquidity in an industry that is (properly) perceived to be among the riskiest on the planet. Under those circumstances is it any wonder that pension-fund managers are skeptical? Going head-to-head with other venture groups is tough; competing with LBOs is virtually impossible with a conventional early stage life-sciences fund.

The aversion is not to biotech itself. Financially driven late-stage funds like Capital Royalty, which recently announced of the closing of a new $805 million partnership, are raising record amounts of money. Unfortunately, few firms specializing in pharma, biotech, or bio-venture have been able to consistently provide returns to investors sufficient to compensate them for the risk and illiquidity. If bio-venture is to prosper, it must meet that challenge before it worries about its public relations image.

The argument that in the future things will be different may turn out to be true, though no one, including Bruce, has provided convincing evidence why “different” should be better. In fact, I can think of a number of reasons why life for bio-venture is more difficult now than it was ten years ago.

Pharma is the industry’s principal customer and source of liquidity for venture fund investors. A fundamental change in the biotech-phama relationship occurred as a result of the melt-down. Prior to 2008, for example, pharma’s average up-front payment was roughly 80 percent of a buyout, based on data I pulled from the HBM Pharma/Biotech M&A Report 2012. Since 2009, the proportions have reversed such that up-front payments now account for less than half the purchase price.

The gold-standard measure of performance in the venture world is cash-on-cash returns; paper profits in private companies and BioWorld-dollar deals mean nothing to an institutional investor. The shift to back-end loaded payouts delays payment and shifts risk to biotech, in some cases tying the bulk of the purchase price to approval of the drug. According to Bruce’s data, the average time to buyout is roughly 7-8 years, similar for both IT and pharma ventures. However, the bio investors may have to wait another 3-5 years or more for their money. Add to that the usual late-stage failure rates, and venture funds would be lucky to collect half the promised BioWorld dollars. Milestone payouts threaten to make the current venture model untenable.

Bio-venture capital’s challenges are pharma’s as well. Neither can survive without profitable innovation. Venture and pharma have to work together to find new, more efficient business models to develop drugs. Atlas and other venture groups have been active in that area, but pharma must take a leadership role in exploring new approaches. They are the customer, and they have the resources to change the landscape in a major way.

Pharma has been an active sponsor of incubators and research collaborations. If they are to realize the value of those investments, they need to encourage the development of an early stage venture community that can bridge the gap to commercialization. Incremental steps investing with established venture funds are a first step, but the industry needs real change, and that does not come from groups that are prospering under the status quo. Pharma needs to substantially increase the scale of their efforts and pursue a broader range of options in this space.

Our entrepreneurial community is remarkably resourceful and responsive. More than research grants, biotech innovators need a clear path to the rewards that a successful new molecule can provide. Pharma can communicate their strategic needs, provide access to developmental resources and complete the bridge from research to commercialization by working through allied venture fund managers. The concept goes beyond pharma-as-VC in captive corporate funds or pharma-as-LP sharing in deal flow and providing advice to a general partner. Those models have their places, but I am talking about a working partnership of equals—pharma and VC, integrated with the internal R&D, as we have outlined in recent Xconomy discussions of a pharma supply-chain model.

With proper incentives and adequate resources, the life-sciences ecosystem can generate the new medicines that both industry and patients need. If pharma and venture managers focus on cosmetic enhancements to the status quo, neither will fare well.

Bruce is a leader in the next generation of venture capitalists, among the brightest and the best the industry has to offer. His analysis reflects a triumph of reason over experience, the eternal tension between young and old. If this industry is to survive and prosper, we need more than a rationalization for the status quo.

Standish Fleming is a co-founder of San Diego’s Forward Ventures, and a 24-year veteran of early-stage, life sciences investing. He has helped raise and manage six venture funds totaling more than $500 million and served on the boards of 19 venture-backed companies, including Nereus Pharmaceuticals, Ambit Biosciences, Triangle Pharmaceuticals (acquired by Gilead Sciences) and Actigen/Corixa (now part of GSK). Follow @

By posting a comment, you agree to our terms and conditions.

  • LifeSciVC

    Stan,
    A good writeup, and glad my post got your interest. I don’t have an argument with your general thesis: just because biotech venture isn’t as bad as folks think, that doesn’t make it healthy nor a great investment overall. A few specific reactions -

    1. As I’ve mentioned many times in prior blog posts, the status quo of biotech venture capital in the 2000s isn’t viable (e.g., big funds, spec pharma, high burn). We need to do things differently to adjust to the new reality: fund real innovation, lean capital efficiency vs bloated capital intensity, new operating models and corporate structures, structured deals, leveraging the virtual CRO ecosystem, etc… We need to build both big science platform companies and specific product plays differently than in the past, and signs over the past few years are that these new models are working. I’ve been vocal that there are lots of experiments we need to do – so I’m certainly not trying to “rationalize” the way the sector has done ventrue capital in biotech for the past 10-15 years.

    2. Similarly, I couldn’t agree more that venture as an asset class needs to improve. The returns of our business, regardless of sector, at the median and perhaps even top quartile are not sustainable – we will be unable to raise capital if we can’t offer a compelling risk-adjusted return spread over other asset classes. Venture capitalists need to up their game across the board or they won’t be around. The consolidation is already in play…

    3. The perception issue is a real one and distracts the sector from focuses on the important areas to change: the reality is the data don’t match to the perception most LP’s and pundits have, on a relative basis in particular. LS isn’t a lottery ticket business like other parts of venture capital and needs to be better understood. Top tier LS firms can deliver very good returns, and those are the one’s raising funds today. Aligning perception to that reality is in part about sharing the new models that are working. Its just frustrating to see the continued promulgation of myths dressed as facts – makes for an uphill battle even when individual funds are delivering good returns. I’ve heard LP’s say “we don’t do LS”, list out a set of myths, and turn down further discussion. That’s just not grounded in reality and throws a blanket statement over all funds active in LS: strong LS franchises can deliver high quality differentiated returns.

    Lastly, who knows, but being the optimist that I am, the recent months’ IPO window is intriguing… the first truly open window for innovative early stage companies in a decade. After three decades in venture you’ve seen half-a-dozen of those open and shut, but its still an encouraging sign to see strong public capital flows at reasonable prices.

    • Stan Fleming, Forward Ventures

      Bruce, Thanks for your comments. I believe that the topic at hand is important and welcome the opportunity for a dialog both with a fellow venture capitalist and between generations. Clearly we share an interest in pharmaceutical innovation and the belief that venture has a vital role to play in that enterprise.

      Venture capitalists, who have long sold themselves as the masters of innovation, must now innovate themselves. It is not enough for individual firms to survive. A sustainable bio-venture community requires a critical mass of firms and opinions to constitute a viable
      market. If the industry degenerates into an exclusive gentlemen’s club, it will surely loose its way. True innovation requires a multitude of ideas and a high tolerance for failure, neither of which sit well with clubs and large corporations, where seniority counts and the comfort of the members becomes the guiding principle.

      Fundamental to my thesis is that venture has to change its perspective from one of making great investments in biotech to one of money managers operating at the portfolio level with the goal of realizing value for our investors. We have to build models that are consistent with the underlying business we serve. The blockbuster model may work for IT, but it isn’t working for pharma and is unlikely to work for us.

      Unlike in the classic Schumpeterian model of creative destruction, new ideas for venture funds and biotech businesses are not going
      to arise out the proverbial garage in Silicon Valley. The future of the bio-pharma industry depends on the vested interests to innovate their way out of a corner. With the possible exception of IBM re-inventing itself as a software company, I don’t know of real innovation from
      powers-that-be, any more than I know how to make money for my investors in platform deals, despite having done so in the past.

      In the business world talk is cheap, but it is a place to start. It is critical that we get the attention of pharma at the highest levels.
      Atlas has done an impressive job of building those relationships. In turn, pharma must expand its dialogue with the entrepreneurial community and push beyond the frontiers of the pharma-venture
      establishment. In exploring new territory there will be “failures”–that’s
      why you have to run the experiment–but “failures” ultimately constitute the legacy out of which new models and new firms can emerge. Pharma has to learn to fail. Who better to teach them that than LS venture? Before pharma can go there, managers have to understand WHY they must go there; that is the value of this discussion and others like it.

      I look forward to future posts and the discussions that they
      will provoke. We need more creative people in the conversation.

      On market windows: Even under the best of circumstances the public markets make sense only for revenue or near-revenue companies. That works for late-stage deals but doesn’t meet the need for innovative start-ups; the time horizon to get from there to revenues is measured in decades.

  • http://ginkgobioworks.com/ Jason Kelly

    When the “original” biotech revolution happened in the late 70s / early 80s, it wasn’t just the pharmaceutical industry that was disrupted – major industries were born in industrial enzymes (Novozymes, Genencor, etc) and Agriculture (Monsanto, Syngenta, Mycogen, etc) as well.

    The other way you could change the profile of returns today would be for life science investors to broaden their mandate beyond pharma drug development. The “new” biotech revolution coming now on the back of rapidly improving synthetic biology tools will be just as disruptive as the first one and create as much new value. It just might not happen in pharma first.

    Biotech VCs are in the best position to evaluate the technology (as compared to the web/tech VCs), but it’s not clear they’ll come around to a different market than drugs. Too bad since these new markets will escape some (not all) of the issues you raise: 10-15 years of illiquidity being the first to go.