Healthcare VCs still seeing attractive M&A exits, despite lack of IPO window

This article is provided to FT.com readers by BioPharm Insight—a news service focused on providing insight into the most price sensitive issues in the global pharmaceutical market. www.biopharminsight.com

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Healthcare venture capital firms (VC) are still seeing attractive merger and acquisition (M&A) exits for their portfolio companies, despite the lack of an initial public offering (IPO) market in the current economy, according to VC executives interviewed by BioPharm Insight.

Probably the biggest trend in healthcare that investors need to face is that the M&A exit route is much more robust than IPOs, said Doug Jamison, chairman, CEO and managing director at Harris & Harris Group (NASDAQ: TINY), a publicly traded venture firm that invests in nanotechnology. The traditional exit routes for healthcare companies have really changed over the last decade, where companies could previously be fairly “capital inefficient” and still get away with a high exit valuation, said Jamison. This is not the case anymore, he said.

Public market investors are now very smart, which has lowered the valuations of many life science IPOs, said Jamison. The industry is still seeing lots of M&A activity, one recent example being BioVex, a holding of Harris & Harris, which was acquired by Amgen (NASDAQ: AMGN) in March for USD 425m upfront payments, in a deal worth up to USD 1bn. “We sold BioVex to Amgen for much more than we would have seen from an IPO,” he said.

There is no exit strategy via traditional public markets, even for good biotechs, noted Barbara Dalton, vice president and director at Pfizer Ventures.

Current market conditions have imposed a very narrow window for healthcare companies that can successfully go public, said Bruce Booth, a partner at Atlas Ventures. The Cambridge, Massachusetts-based firm focuses specifically on early-stage life science investments. For a biopharmaceutical company to go public now, it typically has a very late-stage asset, or should even have a commercial asset, he said.

There will still be plenty of good exits, but those companies will typically be more mature, said Dr Garheng Kong, a partner at Sofinnova Ventures. The Menlo Park, California-based VC firm specializes in clinical and late-stage pre-clinical investments in the biopharmaceutical sector. The days of prior successful Phase I exits is gone, he noted.

The bar for a successful public offering is no longer positive Phase II results, but solid Phase III data, an NDA submission -- or even an approved candidate, said Kong. Most biotech companies that have gone public in recent years have in-licensed a lead compound externally, or reformulated another company’s molecule, Booth said.

The lack of a real IPO window has put a constraint on available exit options, as VC firms plan a development strategy around a particular company of interest. The current market can no longer generate initial capital in the capacity that initially funded Vertex (NASDAQ: VRTX), Gilead Sciences (NASDAQ: GILD) or Celgene (NASDAQ: CELG), Booth added.

VCs push forward with new investments

Corporate VC funds in particular may be “more shielded” from current market dynamics, as they are not dependent on the market to raise each subsequent venture fund, explained Janis Naeve, PhD, a managing director at Amgen Ventures. The corporate VC arm of Amgen (NASDAQ:AMGN) was created in 2004, and typically invests up to USD 2-3m per company, per round with USD 10m invested over a company’s lifespan.

Lilly Ventures will likely make one-to-two new investments in the next six months, according to Ed Torres, managing director. The venture fund will invest as much as USD 15m per company in a single round, with the first tranche typically between USD 5-10m, he noted. Pfizer Ventures will likely make two new investments by year-end, Dalton added.

Merck (NYSE: MRK) has recently entered the fray, with recent reports citing creation of a USD 250m Merck Research Venture Fund.

In the medical device sector, there really has not been much of an IPO window in the last four to five years, said Rich Lin, a partner at Three Arch Partners. As a result, there is a definite focus with strategic partners when planning an exit strategy, he explained. The Portola Valley, California-based fund specializes in medical devices, diagnostics, and healthcare services. There is an added emphasis on early partnering, or at least engaging in initial dialogues with strategic partners at an earlier stage.

The majority of acquisitions tend to focus on a lead asset or compound, which is usually what drives the primary valuation of a company, said Booth. The lead asset or core technology platform is generally what triggers bidder interest, and the underlying logic is the asset will validate the platform technology, he said. Building a financial model is easier when the value is driven from a single asset, rather than putting an “amorphous value” on what a technology platform may be worth, he added.

Returns from an M&A exit have largely been very attractive, said Booth. He estimated 10% of deals see a five-fold return on investment, 40% provide modest returns, and 50% lose all or some of the initial invested capital. This pyramid has been consistent over the past few decades, though the 1990s probably had better returns, he said.

At the time of initial investment, Atlas Ventures will not conduct a deal unless there is a reasonable scenario where the investment can deliver a five-fold return, said Booth.

M&A is a “stochastic event” that cannot be predicted given a company can be acquired anywhere along the clinical development timeframe, said Kong. As a result, VCs typically do not plan this event into timelines, said Kong. However, a company that already has an approved drug has inherent value, and is in better control of its fate at that point, he said. It then makes sense to finance companies through to further stages of development, which then have more inherent value, he said. “At the end of the day, we try to create a company that can stand alone, and go public. But if a strategic transaction happens, we’ll take it,” said Lin.

After a company anticipates getting certain inflection milestones, Torres advises his portfolio companies to build-in an additional six-to-nine months of financing, which will allow the company to avoid negotiating from a position of weakness.

In the current market economy, companies need to conduct contingency planning, as product development will probably take longer than expected, said Lin.

As a result, companies should probably add-in a capital cushion -- a length that could be two-to-three months, or more than six months -- dependent on the asset’s stage of development, he said.

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