Traditional Venture Model is “Broken” for Biotech, Companies Need to Adapt, Says VC Alan Frazier

12/4/08Follow @xconomy

Alan Frazier controls one of the world’s biggest life sciences venture capital funds, so it would only be natural that he’d like to hide under a rock these days. But he was still willing to sit down with me at his 32nd floor office in downtown Seattle this week for a wide-ranging talk about the shellacking his industry is taking in the financial markets, and how biotech companies can adapt.

Frazier, for those who don’t know, is the founder and managing partner of Seattle-based Frazier Healthcare Ventures. The company, founded in 1991, has raised seven venture funds with a total of $1.8 billion for emerging biotech, medical devices, and healthcare services companies. Before that, he was one of the early executives at Seattle-based Immunex during its fast-growing 1980s heyday.

To hear Frazier talk now, the days when VCs could gamble on a promising technology and a driven management team, with the idea of creating the next Amgen, Genentech, or Immunex, are history. “The traditional venture capital model is broken,” he says.

Here’s what he had to say, edited for length and clarity. (Despite some grim observations, you won’t need to take a selective serotonin reuptake inhibitor like Prozac after reading this.)

Xconomy: You’ve been through a lot of downturns in your career before in biotech, like 1994 and 2001-2002 being the most recent. What’s different about this one?

Alan Frazier: The downturn is not just over the last two months. It really began two and a half years ago, when IPOs started to represent only a liquidity event, not a profit event. I think it’s challenging the traditional biopharma venture model. It’s more significant than we’ve ever seen in the past. That doesn’t mean biopharma venture is dead, it’s just different.

X: How’s it different?

AF: The venture capitalists will be making two very different types of investments than they have traditionally made. One is that VCs will be investing in public companies as a private security, a PIPE, or sometimes known as a VIPE, a venture investment in a public equity. They’ll also do companies like Calistoga Pharmaceuticals, with more targeted types of enterprises whose ultimate exit is a sale, not an IPO.

X: Is the traditional venture-backed biotech model broken?

AF: Yes. It’s broken, or at least severely compromised. The upside doesn’t justify the downside. In the old days, VCs could make eight or 10 times their money when things went well. Now, by the time you can take something public, it requires a lot more capital. The sheer amount of capital that has to go in has resulted in a lower multiple. You couple that with the rather dynamic nature of the stock market, with hedge funds hanging on every little piece of data, and sometimes overreacting both up and down, it results in a highly challenging public environment for biotech.

On the positive side, never has there been a better time for companies to be acquired. Not just by Big Pharma, but if you look at the statistics, it will tell you that over half of the mergers and acquisitions now are not coming from Big Pharma. That’s pretty exciting. Biotech companies have to follow up their first product with another product. Gilead Sciences has made a franchise out of doing this, as has Cephalon and others. If you look at the statistics on Japanese and European mid-market pharma companies, they are acquiring a lot too. The universe of people to acquire companies has gone up dramatically.

X: What advice are you giving to your portfolio companies to get through this?

AF: This will be a long-winded answer, I’m not sure I can be pithy about it. First, you have to focus on a business model that is realistic, i.e., that your exit is a sale. That demands a very different kind of business entity and all kinds of plans. The other thing I tell people is that in starting a company, they need to demand of themselves what we demand of ourselves. Frankly, we have to bring in expertise on regulatory affairs at a level we never had before. They have to have better understanding of what large payers think about their products. They need to know what Europe is going to do regulatory-wise. They need expertise in the manufacturing side. They have to have more answers to more questions than they did in the old days. It’s challenging.

X: It sounds like they need to raise their game.

AF: That’s what I say. I sound like this old grandfather, lecturing the children about how you have to raise your game. It’s challenging as hell. I don’t want people who read this or hear my speeches coming away too depressed. Our little Calistoga has an excellent future to it, just like it would four years ago, it’s just in a different market. We’re working with them to raise their game.

X: What two or three companies are you most excited about, and if they’re in your portfolio, you have to disclose that. Who do you think is still doing well?

AF: Look at Genentech. They’re continuing to do incredibly well. They have embraced great science with very smart clinical trials. They know their population they’re going after, and whether it’s going to work to increase their probability of success.

I think Gilead is another example of a great company embracing this notion that as a bigger company, you don’t have to do it all. You can use wise acquisitions to take up companies that make innovations.

X: What about here in Seattle? Who do you consider the up-and-comers?

AF: ZymoGenetics is perhaps a tough one to bring up because of their stock price, but they are an example of a company that has the technology that can address these specialty products with a high degree of success. Trubion would be another example, although I have to disclose that it’s in our portfolio. Clearly, this is the decade of monoclonal antibodies, and these newer generations of antibodies that are more targeted, and smaller will lead to a new set of amazing products. Obviously Calistoga is another one in our portfolio that’s a great example of this kind of semi-virtual model that we like that takes a product in a later stage, and brings in an incredible amount of experts to make sure it’s developed correctly. Then there’s the excitement about the Institute for Systems Biology and spinoffs there. The challenge for all these companies in Seattle is capital. Are they realistically developing a company that’s going to work in this kind of environment? This environment is not going to change for the next year or two.

X: Do you think Seattle biotech is stronger or weaker than it was five years ago?

AF: Stronger.

X: Really? Why?

AF: We’ve obviously had a few companies go away, so it’s not an obvious answer. Corixa, Icos, and Corus Pharma have gone away. Why? I think we’ve seen some strong companies come along in that period of time, like the ones I’ve mentioned. The Accelerator, the offshoot of the Institute for Systems Biology, has done a fabulous job of getting smart young companies well-financed, and at least in its incubation period, capital-efficient. Good companies can get money here. Bob Overell (a former Frazier partner) just started an RNAi company, PhaseRx. I’m sure it took him longer to raise money than it might have before, but the quality of the syndicate is there. Look at the quality of the syndicate at Calistoga. Good people can get money here. Good people live here and they can start good companies here, and it will attract folks from around the country.

X: What about your strategy? I know you raised a $600 million fund a year ago. How much do you have left, and what’s your strategy in terms of the number of companies and how you want to allocate it?

AF: We have invested about 12 to 14 percent of it. So we still have quite a bit left, as we do from earlier funds. So, our strategy is to do about half in growth equity. These are cash-flow positive companies. We’ve been investing in them for about 13 years, even though it’s something we’re not known for. Unfortunately, it reflects a more conservative view of venture capital. We are investing a little more than half in biotech, and the balance in medical devices. We are, for sure, doing less startups and more later-stage companies. We do a lot of new companies, still, probably one-fourth of our companies are new companies. But a lot of them are like Calistoga where it starts out with a product pretty much ready to go, where we pull it from someone else and try it in a new indication.

X: What do you mean by growth equity? Does that mean highly-liquid stocks?

AF: No, it’s all private securities. It can be services, specialty pharma, medical devices. These are companies that already exist that are cash-flow positive. We buy them, we invest growth capital into them.

X: How is Seattle comparing with other regions you visit? I know you’ve expanded your office in Menlo Park, CA.

AF: As a sustainable place for venture capital, it’s probably fairly consistent with us being around No. 5 or so. We have been continually hurt by all of our companies being taken out, like Icos or Immunex or Corus. We seem to have some bad luck. We haven’t lost, but we haven’t moved up the tables.

X: What trends in healthcare do you see over the next five or 10 years that will endure beyond the downturn?

AF: The trend is toward smart pharmaceuticals that address smaller populations, narrower indications, with better results. It’s based on a better understanding of disease from genomics and proteomics. You’ll see more targeted drug delivery. You’ll have incredibly focused pharmaceuticals, which will take care of some of the safety issues you read about.

X: Any days you just don’t want to get out of bed?

AF: (laughs.) It would have been nice to go on sabbatical the last couple of months. From January 1 to now, the microcap part of biotech has gone down about 60 percent.

It’s all true, but we can go too far sometimes with getting depressed. There’s a lot of innovation out there. The traditional VC model is broken or severely damaged, but that doesn’t mean you just go home and forget about it. You’ve got to get smarter, and innovate new business models.

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