Today’s post is part two of Nooman Haque’s overview of the findings from Silicon Valley Bank’s ‘Trends in Healthcare Investments and Exits 2014’ report, focussing on trends in new company formation and deal activity. Read the first part here.
In this, my second post discussing the trends in investments and exits in US healthcare, I discuss differences in company formation across the sector and trends in deal flow.
Series A/B investment rounds are critical to ongoing innovation.
The most notable trend of the last three years has been the involvement of corporate venture capital (CVC) at series A/B stage. Between 2005, when we started tracking this data, and 2011 CVC accounted for around 15% of series A investment in the US; it now averages around 32% or $200m. Around half goes into preclinical or phase 1 companies. Large pharma are effectively outsourcing R&D to biotech companies – a trend that we see continuing.
The dark cloud has been device investment.
Whether we look at CVCs or venture firms, device investment lags biopharma significantly. Investment into devices as a proportion of all venture investment is at its lowest level since 2001, or 7%, compared to 15% for biopharma, and down from 9% in 2012.
Investors in the device segment prefer later stage rather than series A/B. This reflects disappointing commercial progress and the subsequent poor exit market as returns are driven down. The complex FDA approval process (now being addressed) has added to long and expensive development timeframes.
In contrast, later stage companies, post approval and with certainty on reimbursement, are faring better. The glimmer of good news for device investment is our observation that angel investors and family offices are stepping in to fill the gap. Interestingly we noticed a similar trend in 2010 in biopharma, whereby corporates fearing being shut out of early stage deals and having to invest later at higher valuations, began investing more heavily. The hope remains that this is repeated in the device field.
Interestingly, compared to the tech sector, the number of VCs, dollars invested and companies started has not returned to 2007 levels. Indeed, there are estimated to be only 25 active and significant venture capital investors*, with only a subset who back drug discovery and early stage. This may surprise those who believe fundraising in the US is significantly easier.
M&A is a ‘truer’ exit in the sector rather than an IPO. In both devices and biopharma, aggregate US deal values fell in 2013 to around $7bn, from almost $9bn in 2012, and deal volumes are down.
The simple fact is the IPO market is currently a better route for continued development and valuation.
Another consequence of increased competition from a strong IPO market has been higher upfront payments in deals – in fact the average upfront in 2013 reached $349m, the highest since the era of the structured deal really took off five years ago. Higher up-fronts of course mean higher direct returns for investors, thus helping recycle capital back into the sector.
M&A activity has also shifted in recent years to later stage companies.
Phase 3 and commercial stage exits have increased whilst phase 1/pre-clinical have declined. This reflects the VC trend in 2008-2011 when VCs invested in later stage companies in the downturn.
These companies and spin-outs are now transacting. So is big pharma ignoring earlier stage M&A opportunities? Far from it. Our observation is that the IPO market is causing earlier stage companies to spurn offers from pharma.
What trends emerge from this?
- Declining but stable investment, down from historic highs, that has not recovered in the same way that tech investment has;
- Cross over funds and specialist lenders support pre-IPO candidates, leaving venture investors to focus on earlier stage companies;
- A surprisingly small number of specialist funds with longevity in the US, whose funds are complemented by debt providers; and
- A robust IPO market with specialist and generalist investors.
In the UK we tend to focus on the last point as symptomatic of a weak investing environment. However, one has to look at the complete landscape.
The most glaring omission for me is the lack of debt and mezzanine providers; the former complement VC funds and ensures companies reach value inflection points. It creates attractive propositions for public investors and corporate buyers. The latter support IPOs, strengthening the public markets. Together they help VCs generate the necessary returns to encourage investors to return to the sector.
And what of the decline in number and size of VC funds?
In Europe this is taken as evidence of lack of interest but I view things more pragmatically. A flood of investment, as witnessed in the pre-crisis years, creates ‘too many’ companies with a lower average quality – bad for returns.
When companies compete for scarce capital they really have to demonstrate capital efficiency – the ability to convert invested capital into value – and this should lead (ceteris paribus) to higher quality companies and thus higher returns, reinforcing investor support.
Fundamentally, whilst there are gaps in the UK financing ecosystem, the US experience demonstrates that with a healthy supply of high quality companies, investors will emerge. And whilst I certainly would encourage moves to make VC attractive for institutional investors, we mustn’t lose sight of the real challenge: creating life science entrepreneurs who know how to build value through capital efficiency.
*Defined as investors putting c. $5m to work annually in life sciences. Estimate from FLAG Capital Management/ThomsonOne/National Venture Capital Association