Bringing the bounce back to biotech

Healthcare and life sciences companies have been as hard hit as any other sector by the slump in the public markets. The late 1990s boom market is best remembered for its Internet bubble, but alongside that IT hype the biotechnology sector, in particular, was also overheating. Venture firms eager to ride the rapid-exit IPO train invested huge amounts of capital. Now, with that route a non-starter, firms looking for exits are busy displaying their healthcare wares for the benefit of the big pharmaceutical companies. And by a happy coincidence, big pharma just happens to be on the acquisition path right now.

The life sciences sector was one of the few bright spots for venture capital investors in 2002. For the year, life sciences investment totaled $4.7 billion in the US, accounting for 22 per cent of all venture capital, up from 13 per cent in 2001, and the highest proportion of total venture capital investment in seven years, according to the annual PricewaterhouseCoopers/Venture Economics/NVCA MoneyTree Survey. Biotechnology was the dominant component within the life sciences sector, attracting $2.8 billion in 2002, compared to $1.9 billion for medical devices. In Europe the sector is showing signs of rebounding from a 2001 dip (EVCA reported investment of €2.47bn for investment in the medical, health-related and biotechnology sectors in 2001 as opposed to a total of €3.78bn in 2000) with first reports suggesting that around €3bn was invested in these sectors across Europe in 2002.

Statistics also indicate the miniboom in life sciences investing still has some momentum to it ? in the US for example, life sciences investment increased by 15 per cent to $960 million in the fourth quarter of last year over the third quarter.

Moreover, US data reveals that life sciences is expanding its share of the first-time funding pool. While software as a stand-alone industry accounted for the most deals and dollars in 2002, with 209 companies receiving $880 million, or 21 per cent of all first-time financings, unchanged from 2001, 158 companies in the life sciences sector (biotechnology and medical devices combined) secured $943 million, or 22 per cent of all first-time financings, in 2002, up from 14 per cent in 2001.

However, for all the activity on the investment front, the initial public offering route as an exit strategy has been choked off as effectively for life sciences companies as any other industry. There were only 22 venture-backed IPOs in the US last year, but tellingly two were VC-backed biotechnology companies, four in medical devices, and three in healthcare services (40 per cent of the total in other words).

?I would say we've been in a bear market here in biotech that roughly mirrors the decline in NASDAQ, so it's been three years almost of pretty tough times, with very limited exits through the IPO market,? says Dennis Purcell, a senior managing partner at biotechnology investment specialist Perseus-Soros.

?Today, in this environment, the chances of an IPO for a biotechnology company are essentially zero,? says James Barrett, a general partner at New Enterprise Associates. ?Even a later stage biotech IPO play is probably not fundable in our judgment for the next 18 months at least, maybe even longer.?

Enter big pharma
So what exit opportunities are available for healthcare investors with a maturing portfolio? The good news is, big pharmaceutical companies are on the acquisition trail, and trade sale opportunities abound for healthcare companies with promising new products.

?There's a lot of acquisition activity going on right now with big pharmaceutical companies,? John Klein, chairman at New York-based life sciences investment specialist True North Capital, says. ?They're in reload mode.?

Big pharma ? giant international corporations like Pfizer, Johnson & Johnson, Merck, GlaxoSmithKline and Eli Lilly ? are feeling acquisitive for two reasons. First, many drugs are coming off patent over the next few years, forcing these companies to spend time cultivating the biotech industry in order to find replacements. More importantly, these companies have not been able to generate new products in-house as quickly as they hoped.

?For reasons that are a mystery to me – because there's certainly been enough money put into it – the ability of big pharma to regenerate its own pipelines has clearly been a serious disappointment,? Barrett says. ?That's the opportunity we have, provided we can put enough muscle behind a given project.?

?Large pharma, as they get squeezed on top-line growth, are really focusing more of their partnering efforts on product acquisition, as opposed to the past, where they were focusing more on platform opportunities,? Dr. Dennis Henner, a general partner at healthcare sector investment specialist MPM Capital, says.

?Virtually every pharmaceutical company now is spending a significant amount of its capital helping to fund the biotech industry because of the need for new products,? Purcell adds.

True North's Klein explains that big pharma's own research and development efforts have largely resulted in a generation of ?me-too? drugs, rather than innovative new lines of products. ?They are about to face a tidal wave of generics, and they know that their drug pipelines are questionable,? Klein says. ?Shareholders are demanding more. They realise they can't invent everything, so these guys have ferocious appetites for acquisitions.?

Purcell says his firm's policy of not relying on the IPO market for exits is a smart one. ?We had always thought that half of our exits were going to be trade sales to big pharma, and the other half would be via the IPO market, but we financed them as though there was no IPO market, because we felt we needed to have business models that don't rely on the public markets to make a return.? Indeed, figures from Capital IQ reveal the potency of the exit market in the life sciences sector (see charts).

A textbook case
Perseus-Soros's one exit to date, the sale of Novazyme Pharmaceuticals to Genzmye, provide's a textbook case of a well-structured ? and profitable ? realisation in the biotechnology sector.

William Canfield, a professor at Oklahoma University, formed Princeton, New Jersey-based Novazyme in 1999 to develop a treatment for Pompe disease, a rare genetic disorder that prevents the normal breakdown of lipids and cell building blocks. The disease causes severe physical deformities and often leads to death during childhood. After one year the company had raised only $1.8 million from angel investors and $562,000 from Neose Technologies, a Horsham, Penn.-based researcher of complex carbohydrate chemistry.

But then Canfield recruited an experienced management team led by John Crowley, formerly an executive with New York-based Bristol-Myers Squibb Co., and began aggressively seeking venture financing.

Perseus-Soros, Boston-based Catalyst Health and Technology Partners, and Princeton-based HealthCare Ventures invested $8 million in Novazyme's series A round in September 2000. The three investors were joined by New York-based Morgan Stanley Dean Witter Equity Funding in a $16 million Series B round in April 2001.

By August of that year Genzyme was prepared to put an offer on the table. The transaction was finalised in September 2001, with Novazyme's shareholders relinquishing control for approximately $206 million, and the prospect of receiving two additional payments totaling $87.5 million once Genzyme completes human trials and gets Federal Drug Administration approval to market the first two products in the U.S.

It can be a long road
As the drug-discovery and trial phase process becomes subject to greater and greater scrutiny, private equity firms in the space are focusing on creating companies that are fit for acquisition. This can be expensive and time-consuming.

New Enterprise Associates, for example, is concentrating its efforts on preparing portfolio companies to meet these more stringent standards in the quest for strategic sale opportunities. ?As an investor, what we've been doing over the past 12 to 18 months is to try to invest in projects with a syndicate that is sufficiently large to get a company through an important clinical milestone ? most of the time, at least through a Phase II trial where they have a good indication of efficacy,? Barrett says. ?At that point, we look for a corporate relationship or a corporate buyout.?

?The venture community is going to have to be able to back their companies, to take these products through a longer development cycle than we would in the past,? Henner says.

Henner, a twenty-year industry veteran, says this increasing focus on later stage product development is part of a long-term trend. ?It used to be that when an interesting gene got cloned it could give you a boost on your stock price. Those times are long gone,? he says. ?We're focusing on the ability to get through a Phase II proof of concept, where you have a pretty good idea of the toxicity profile of your drug, and its efficacy in humans as opposed to animals. We think that's one of the most significant value creation points, and we're looking at our portfolio along those lines.?

Barret agrees: ?If the public markets do open up, companies that are attractive to big pharma as partners or buyouts will no doubt be reasonably attractive at some point. But since we can't count on that, we have to be prepared to put a syndicate together with enough dry powder to get these projects across that critical Phase II line.?

Healthcare investment specialists stumbled during the 1990s by focusing on products instead of people. A great patent or idea backed by the wrong people, they found, became a bad business. Interestingly, venture capitalists say that big pharma and venture capitalists view potential acquisitions differently. ?The first thing big pharma looks for is the product itself,? Purcell says. ?That's the gap they're trying to fill.? The focus from the venture capital side is different. ?I think the key thing for us is to back the key people, because science is never a straight line. The right people will be able to figure out a way to make value for you, whereas even if you have a great product, if you don't have the right people you may not recognise the value.? Barrett confirms the significance of the management teams: ?That's the horse we're riding,? he says; in the end, ?That's all we've got.?