Who Needs Biotech VCs, Anyway?
Welcome to In Translation, and thanks for reading. As a companion to Xconomy’s regular life sciences coverage, this new column provides me with a chance to dive a little more deeply into strategic, cultural, and scientific topics around the biotech world, and bring more of my own point of view to bear. I welcome and encourage your feedback, of course. With summer vacations and schedules in full swing, we’ll publish the column every other week to start, then reach for a higher gear when we’re all back in our offices, labs, and schools after Labor Day. Enjoy.
“The model is broken.”
I used to hear that chant from biotech VCs all the time, often accompanied by the thwack of self-flagellation. The model was supposed to work like this: put money into highly risky science, nurture it, and wait a long time—sometimes five years, usually a lot longer—for that risk to become an unlikely reward. Most efforts would fail, but a few home runs would propel the investors to the next fund. That model built Genentech, Amgen (NASDAQ: AMGN), Gilead Sciences (NASDAQ: GILD), Regeneron Pharmaceuticals (NASDAQ: REGN), and so many others.
But those ambitions, to build companies with the muscle to make a medical difference, have largely fizzled, and at least 10 well-known venture firms have exited health care or called it quits in the past few years. At a time when the world’s health crises—Alzheimer’s disease, obesity, drug-resistant pathogens, and more—require all hands on deck, can biotech VCs be a major force behind the next 50 years of cures?
You could argue venture’s job is not to cure the world; it’s to provide superior returns. But as Big Pharma increasingly looks to biotech as its “farm system,” the uncertainty puts pressure on the entire pharma industry.
“This era has made us all step back and say what the heck is going on,” says Brad Vale, who runs Johnson & Johnson Development Corp., the health care giant’s 41-year-old venture group whose fortunes, despite different strategic goals, are intertwined with those of traditional VCs. “What are the fundamental principles of success in venture, and what do we have to do to be successful?”
Is the model still broken? I haven’t heard the complaint as often lately. Some interesting things have happened in the past few years. Some biotech VCs, facing limited partners skeptical of the traditional model, began tinkering with new ways to build valuable products and services faster. The genomics revolution that produced a bubble and a ton of disappointment more than ten years ago began to deliver insights, and a few products. And public markets roared back from the recession (even though jobs haven’t), pulling nearly 100 U.S. healthcare firms, most of them biopharma-related, through the IPO window since the start of 2013, according to Renaissance Capital.
But all those exits, plus the ascending fund sizes of a few prominent firms—Third Rock Ventures, OrbiMed Advisors, Sofinnova Ventures (which just filed notice of its intent to raise a new $500 million fund)—mask a different reality. If you prefer, call it the 2014 version of “the model is broken.” In biotech innovation, VCs have lost their appetite for risk, and thus are losing relevance.
To express his disdain for the lack of courage, Bob Nelsen of ARCH Venture Partners described biotech VCs with a crude word for female anatomy—and generously invited us to print it. (We declined the offer.) Even without the locker-room language his point stands: Only a handful of life science VCs are bravely pursuing the old model, risking big dollars to build big companies, and that pursuit, Nelsen argues, is ultimately what leads to real medical progress.
He counts himself among the few and the brave. On my recent visit to his tower office with a view of Seattle’s skyscrapers, Nelsen ticked down a list of “billion-dollar companies” he’s helped build, including Alnylam Pharmaceuticals (NASDAQ: ALNY), Illumina (NASDAQ: ILMN), Agios Pharmaceuticals (NASDAQ: AGIO), and Ikaria. These days, he is the co-founder, director, and lead investor of Juno Therapeutics, a Seattle company pushing forward two different, cutting-edge kinds of cancer immunotherapy, licensed from three major research institutions, and backed by $176 million in Series A cash; ARCH contributed a big chunk of the money, the biggest bet it’s ever made on one company.
Nelsen is dismissive of small-bore risk-management strategies, and he’s contemptuous of scientific incrementalism. “No one wants a VC as an asset manager,” he says. “Make a drug curative and you’ll get paid. Anyone who invests in a drug that promises seven weeks of life extension should be shot. Too many VCs are chasing risk reduction for two-, three-, or five-x returns. As an asset class, we don’t take enough risk.”
By “asset managers,” he means the growing number of VCs building virtual companies around single products or programs, with a shorter R&D timeline in mind, and ideally, a buyer waiting on the other end of that timeline. Versant Ventures, Atlas Venture, Index Ventures, TVM Capital, VenBio, CMEA Capital, and Avalon Ventures are all systematically trying versions of this model (often while still making more traditional investments, it should be noted).
There have been a few exits, too. Most notably, VenBio has turned its narrower strategy into big returns, topped recently by Genentech’s purchase of Seragon Pharmaceuticals.
VenBio is an important example of another shift in the life-science VC world, to a different source of funding. The firm closed its first fund in 2011 with $180 million in commitments from three drug-industry companies—Amgen (NASDAQ: AMGN), Baxter International (NYSE: BAX), and PPD (NASDAQ: PPDI)—and pointedly not from traditional institutional investors such as pension funds or endowments.
Other VCs mentioned above are also turning to Big Pharma for help, either as limited partners or as the potential buyers of their virtual companies. (Versant’s new fund, as we reported here, leans heavily on what it calls its “build to buy” model.) GlaxoSmithKline has been particularly aggressive as both a backer of venture funds and potential buyer of venture-sourced startups, as I’ve written about before.
There’s another way Big Pharma has come to the rescue. Their venture groups, usually using a different pot of money from the LP and acquisition funds, are increasingly involved in early-stage syndicates. According to Silicon Valley Bank, the number of biopharma Series A rounds that included at least one corporate investor jumped to 30 percent in 2012 and 35 percent in 2013, the highest since SVB began tracking the data in 2005. (The previous high was 22 percent, in 2008.) More of that participation is significant, too. In 2012, for example, Novartis Venture Funds made six Series A investments, all as the lead or co-lead.
“Corporate VC has been the savior of early stage biotech innovation,” says Silicon Valley Bank managing director Jon Norris. “Without them getting involved early and forming syndicates, biotech could have fallen down like device venture did.”
Other non-traditional financial sources are playing prominent roles. Back to Juno for a moment: ARCH and Venrock are two familiar VC names, but much of the massive round was supplied by the State of Alaska’s Permanent Fund and Amazon CEO Jeff Bezos’s personal investment company. Elsewhere in biotech, angel investors, either alone or in networks of growing sophistication, provide seed capital and occasionally go deeper.
Nonprofit disease foundations want to use their cash to help move products into pipelines, not just fund basic research. And crowdfunders like Poliwogg have touted the disruption their platforms, once fully operational, could bring to venture.
If all these alternative sources suddenly disappeared, there would still be biotech startups. But in five years would that no longer be the case? Or will traditional investors turn back to early stage biotech once it’s obvious how the handful of VCs such as Third Rock and Flagship Ventures building companies from scratch are faring?
There are some signs. Venture as a business took major body blows during the recession, topped by savage punches in 2012 from the Kauffman Foundation and CALPERS. Kauffman, surveying a decade of crummy venture returns in its own portfolio, issued a damning report about venture capital. “Our research suggests that investors like us succumb time and again to narrative fallacies,” the report read. “To fix what’s broken in the LP investment model, institutional investors will need to become more selective and more disciplined investors in venture capital funds.”
The same year, CalPERS—the largest public pension fund in the U.S. with $290 billion in assets—chopped its venture allocation from 7 percent to less than 1 percent.
Yet U.S. venture firms of all stripes raised 134 funds in the first half of 2014, a pace that would make this year the best of the past ten years, according to Thomson Reuters and the National Venture Capital Association. Total dollars committed so far this year, $17 billion, are also on pace to hit ten-year highs. Even if that pace falls off, it’s been a good year for venture fundraising.
But these days, venture is driven by high tech. How much of the fundraising is ticketed toward health care and life sciences? Using healthcare venture plus healthcare allocations from diversified funds as a measure, Silicon Valley Bank’s Norris estimates annual fundraising levels settled into the $3 billion to $4 billion range the past three years. Looking at a ten-year window, that’s up from the nadir of 2010 but about half of the peak of 2007. Norris sees the current level remaining stable the next five years. And that means traditional venture dollars going into healthcare and life science, no longer buoyed by the pre-recession fundraising peaks, have to decline, he says.
If that’s true, then the fruit of the next decade of biomedical innovation—from genomic secrets put to practice to the integration of Big Data and consumer health technology—could be left under-harvested, unless corporate support continues to rise and the U.S. National Institutes of Health’s translational medicine ambitions are realized.
No doubt we’ll hear arguments that these fears are overblown, that great science will always find funding, or that the thousands of Pharma layoffs in the past decade have freed up all kinds of talent to lead next-generation biotechs. But you won’t convince me until the field sees the emergence of new venture firms—like Third Rock seven years ago—dedicated to turning thrilling science into much-needed treatments.