Biopharma Venture Capital Update: Down Cycle of Inflection Phase?

With 2011 at the halfway mark, checking in on the state of biopharma venture capital (VC) investing seems appropriate. The data from the first quarter of 2011 indicate a still-struggling biopharma VC market, showing some minor signs of recovery from the recent bottoms of the past couple of years. There was a decline in the number of deals, and a slight increase in total dollars invested, though not for all subsectors.

Biopharma VC first financings were sharply down, as most deals and money went toward later-stage ventures. Not surprisingly, the nature of both 2010 and 2011 biopharma investments signals greater risk aversion. However, some aspects of recent investment approaches run contrary to what studies indicate are the key factors to high returns.

The longer-term trends point to a model that is changing by necessity. Pharmaceutical companies are becoming a more important player throughout the process—as investors, partners, and exits. Strategies to minimize capital and resource utilization also are successful.

California biotech company Plexxikon, which recently was acquired by Daiichi Sankyo, exemplifies one new prototype for a successful biotech venture model.

Putting this snapshot into a broader context, it appears that rather than representing a cyclical downtrend, biotech venture investing is undergoing fundamental, structural modifications that will involve new players and models.

Still Languishing

Biopharma venture investing has been in the doldrums for a few years now. First attributed to the financial and economic crises of 2008-09, these dynamics no longer can be fully explained by macro factors. Ernst & Young’s (E&Y) analysis of biotech investing in 2010 found a 20 percent decline in “innovation capital,” leading E&Y’s Glen Giovannetti to call that year another challenging one for the biotech industry.¹John Carroll, “E&Y dissects biotech’s toughest challenges,” FierceBiotech, June 14, 2011.

PricewaterhouseCoopers’ (PwC) report on first quarter 2011 biotech venture investing found a slight 5 percent increase in total dollars invested ($784 million), but a significant 21 percent drop in deals (total of 85) compared with the 2010 first quarter.²“A case for cautious optimism,” PricewaterhouseCoopers, May 2011. PwC writes, “This marks the fewest number of deals in a single quarter for the Biotechnology sector since the second quarter of 2003.”³“MoneyTree Report,” PricewaterhouseCoopers National Venture Capital Association, Q1 2011, Data provided by Thomson Reuters.

The biopharma and therapeutics area is being particularly hard hit. There was a 45 percent decline in venture capital investment for the pharmaceutical biotechnology subsegment in Q1 2011 versus Q1 2010.⁴“A case for cautious optimism,” PricewaterhouseCoopers, May 2011.

Another clear biopharma VC trend is a move away from first financings toward later-stage deals. PwC reports that during Q1 2011, there were 35 life science first-time venture financings totaling $129 million, representing a steep 40 percent drop in the number of companies and a 46 percent decline in funding compared with the first quarter of 2010.⁵“MoneyTree Report Q1 2011,” PricewaterhouseCoopers and National Venture Capital Association, Q1 2011.

Tracy T. Lefteroff, global managing partner of the venture capital practice at PwC, remarked, “First-time funding is expected to remain challenging for the sector, with fewer deals and smaller deal size for fledgling companies. Lengthy and costly R&D and uncertainty in the regulatory approval process continue to drive more investors toward follow-on and later-stage deals with companies that are closer to successful product launches or the exit market.”⁶“Life Sciences Venture Capital Investment Level Rebounds in Q1 2011 but Deal Volume Declines, According to the MoneyTree Report,” PricewaterhouseCoopers press release, May 4, 2011.

An analysis of U.S. VC financings of biopharma therapeutics companies in Q1 2011 identified 28 deals comprising $534 million in funding (See Table 1 for the results).⁷Primary data source was OnBioVC.com; additional information came from Xconomy.com. Here’s how they broke out by dimension of interest:

• *  Series by number of deals:

• ▸  Series A deals = 29 percent (8)

• ▸  Series B deals = 39 percent (11)

• ▸  Series C deals = 18 percent (5)

• ▸  Series D deals = 7 percent (2)

• ▸  Series E = 3.5 percent (1)

• ▸  Series F = 3.5 percent (1)

• *  Series by funding dollars:

• ▸  Series A = $68 million (note: $20 million was for funding Alkermes spinoff Civitas)

• ▸  Series B = $237 million

• ▸  Series C = $124 million

• ▸  Series D = $40 million

• ▸  Series E = $20 million

• ▸  Series F = $45 million

• *  Therapeutic area:

• ▸  Oncology—25 percent of deals

• ▸  Infectious—18 percent of deals

• ▸  Central nervous system—18 percent of deals

• *  Specialty, formulation, or drug delivery products—32 percent of deals

Interpreting the Numbers

Biopharma VC investing apparently has become less financially attractive, if deal and funding activity can be taken as reliable indicators. Given that other areas of venture capital investing have rebounded from the financial crisis, with some areas such as social networking booming, this downturn cannot be completely ascribed to dissatisfaction with venture capital.

The trend toward declines in first financings versus later-stage deals seems to indicate trouble with biopharma VC investing itself. Life science venture capitalists need to continue funding portfolio companies that still offer potential returns, hence the later-stage financings, but seem reluctant to replenish the pipeline.

Much of the reasoning here comes straight from the numbers. There are data indicating that biopharma venture returns have not been very attractive lately. A new study from Silicon Valley Bank analyzed private merger and acquisition deals of 60 U.S. venture-backed biotech and 58 medical device companies from 2005 to 2010.⁸Daniel S. Levine, “Questioning Assumptions About Biotech Investing,” The Burrill Report, May 20, 2011. The results showed that biotech returns underperformed those of medical device ventures. The report stated, “Overall device exits came at an average multiple of 5.3X versus an average 4.1X multiple for biotech exits. In fact, the device group had three times the number of 7X to 10X multiples and more than double the number of 10X multiple deals.”

One of the major biopharma VC challenges concerns venture exits, or rather the relative lack thereof. The public markets have largely turned away from biopharma public financings. Luke Timmerman of Xconomy writes, “Investors—duh—have been burned by so many biotechs over the years that overpromise and underdeliver that there just isn’t much appetite left on Wall Street even for really good drugs. As Tom Marsico, who runs the $51 billion fund known as Marsico Capital Management, put it in a recent interview in Fortune, he’s bullish on Apple, banks, and a lot of sectors—everything except health care. ⁹Luke Timmerman, “Forget About the IPO Market: It’s Time for Biotechs to Think Differently,” Xconomy, March 7, 2011.

Many believe the initial public offering market for biopharma drug ventures is basically dead these days. One analyst describes recent biotech IPOs as having “to slash their IPO price and often boost the number of shares on offer to bring in the money they need. Those kinds of deals only reinforce the notion that exits are hard to achieve in the drug development world.”¹⁰John Carroll, “VCs: Chill sets in on biotech as social networking gets hot,” FierceBiotech, April 5, 2011. Reflecting this view is Reuters’ recent survey at its Global Mergers and Acquisitions (M&A) Summit, which found “a steady shift away from biotech and toward the go-go world of social media.”¹¹Id.

Frederick Frank, vice chairman at investment banking advisory firm Peter J. Solomon Company, concludes, “The IPO market for biotech companies is close to moribund.” Drew Burch, head of health care mergers and acquisitions at Barclays in New York, explains, “Look at the choice a venture capital fund has: to invest in the next social network that might go public in 12 months, versus a scientific idea where they might get the opportunity to take it to the FDA [Food and Drug Administration] eight years from now, and then maybe get a letter where they have to do additional clinical trials on top of that. A greater percentage of the dollars has moved toward technology investments.”¹²Clare Baldwin, “VCs trade biotech for social networking,” Reuters, April 5, 2011.

Without public financings, the primary exit is an acquisition, typically by a large biotech or pharmaceutical company. Unfortunately, mergers and acquisitions in biotech have been declining the past few years as well. Ernst & Young’s study reports three straight years of downward biotech M&A.¹³John Carroll, “E&Y dissects biotech’s toughest challenges,” FierceBiotech, June 14, 2011.

There are a number of other factors driving the poor biopharma investment situation, including the increasing expense, risk, and complexity of drug development. The result of these challenges seems to be a heightened level of risk aversion on the part of biotech VCs.

Fewer financings across the board, later-stage deals dominating activity, and increased preference for relatively safer ventures all point to a more cautious biopharma VC approach.

For example, almost one-third of the Q1 2011 biopharma deals in my analysis involved a “specialty product”—a new formulation, new delivery device, or other mechanism that primarily affected pharmacokinetics. These are much lower-risk products than novel therapeutics.

Also, 18 percent of Q1 financed ventures developed infectious disease-targeted products. This can be a lower-risk therapeutic area, from the clinical regulatory perspective. A recent study showed that this therapeutic area had the highest clinical trial success rate, at 15 percent for lead indications.¹⁴Sue Sutter and Lisa Lamotta, “Cancer Drugs Have Worst Phase III Track Record,” Internal Medicine News, Feb. 16, 2011.

Morphing the Model

A growing chorus of investors and industry players is calling for a new venture investment model for biopharma companies. Bruce Booth, a partner at Atlas Venture, says, “We’ve got to do something radically different to change the model. … We need to figure out how to do it differently, while improving the odds that winners emerge with more limited capital.”¹⁵Bruce Booth, “Fighting gravity: venture-backed biotech returns,” Forbes blogs, May 2, 2011.

A few different re-engineering approaches are being tried. Two of the more popular approaches involve minimizing capital burn through virtualization, and early pharma partnering for derisking and financial support.

Given that most biotech exit values are in the $200 million to $500 million range, minimizing capital requirements directly boosts returns. Booth looked at data from Cambridge Associates comprising 2,152 biopharma ventures initially funded between 1981 and 2009 and since exited. In analyzing what correlated with high returns, Booth found that “The biggest driver I can tell is the inverse correlation between capital intensity and returns.”¹⁶Id.

In a virtual venture model, only a core team of managers and scientists is employed. Rather than build an enterprise with internal capabilities, management focuses on developing the biopharma product as efficiently as possible, using contracted services and partners. This approach has been successfully deployed by biopharma ventures in recent years.

Another strategy aligned with both lowering capital consumption and a product-centric versus company-centric focus involves pharma partnering. Recently, VC firms and pharmas have been collaborating in new ways. Pharma venture funds are nothing new: “What seems to be changing … is the frequency of and strategies behind partnerships between drug companies and VCs,” said Jean-François Formela of Atlas Ventures. “There has been a very significant change in the amount and quality of interaction between venture groups and large biotech, large pharma, and large life sciences companies. It’s true that today we see far more interactions with large companies in our space than we did certainly 10 years ago or even five years ago.”¹⁷Ryan McBride, “VCs, Big Pharma join forces to tackle market challenges,” FierceBiotech, April 26, 2011.

Biopharma ventures also are turning to pharmas earlier in the development path for support. These agreements can take a range of forms, including straight investments, partnering for clinical trial support, licensing, and combinations of all of these. Given that pharmas are also the primary acquirer, their involvement spans the entire life cycle of the venture.

An interesting, recent success story that involved a virtual, lean capital, intensive partnering approach is Plexxikon. Plexxikon is developing a melanoma therapeutic that targets a genetic mutation it identified with gene sequencing. The drug is thus a personalized therapeutic, with about half of metastatic melanoma patients being candidates. The clinical response rate has been spectacular—about 81 percent of patients showed at least partial tumor shrinkage in one trial.

Plexxikon managed to reach an exit acquisition by Daiichi Sankyo of $805 million upfront, plus $130 million in milestones in 2011 based on only raising $67 million in venture financing, with its last round in 2006. How did it do this? The company ran very lean—few managers and only 43 employees through to the 2011 acquisition. Further, it partnered with pharma companies five times in total to share risk, raise capital, and gain expertise, starting early in the company’s life.¹⁸Luke Timmerman, “Forget About the IPO Market: It’s Time for Biotechs to Think Differently,” Xconomy, March 7, 2011.

Plexxikon Chief Executive Officer Peter Hirth explained, “We’d rather own 20 percent of a given product, not vertically integrate, and license it away at a value inflection point. The industry really needs to rethink itself. Most of the people we know are living 20 years in the past, and they don’t realize they need to change.”¹⁹Id.

Cyclic or Inflection?

Perhaps the most interesting question regarding this biopharma VC “recession” is whether it represents a cyclical investment downturn preceding a return to business as usual or an inflection point preceding a different model of venture development and investment. If better returns cannot be achieved in the next couple of years, capital infusions will move away from biopharma VC funds into other areas. This will force a reboot of the model.

As described above, there already are signs that a true inflection phase has begun. A very likely outcome of the emerging new model is a new set of opportunities for established biopharma companies as they play a more critical and engaged role in the venture process.