How badly do we need alternative financing for healthcare innovation?

By Said Francis

For decades, the Pharma industry relied on VC-backed biotech firms to fuel its pipelines with innovative drug candidates. Licensing and acquisition transactions offered attractive exit opportunities to VC-backed companies and thus institutional investors increased their investments as limited partners for life-science focused venture capital firms.

Nevertheless, in the past few years, many factors destabilized the traditional VC model for funding early stage ventures and led typical limited partners to shy away from partnering with life science VCs. In fact:

·         Between 2007 and 2010, healthcare VC fundraising declined by 16% annually.

·         Healthcare share of total VC investments declined from being 30% in 2009 to 20% in 2012.

·         Biopharma represented only 37% of healthcare investments in 2012 compared to 50% in 2009.

o   HC IT investments increased from 4% to 17% in the same period.

·         Well known healthcare VCs have lately raised smaller funds.

A review of the pressures on the industry helps us understand whether the current negative outlook on healthcare VC is temporary or persistent:

A)   Pharma breaks up with early-stage Biotech: In the past five years, Big Pharma sought margins improvement ahead of the daunting patent cliff and a series of mega-mergers consumed much of the industry’s acquisition dry powder[1]. Additionally, the patent cliff exerted tremendous pressure on R&D budgets[2]. Pharma became reluctant to consolidate the cash burn of VC-backed early-stage biotechs: a funding gap emerged.

B)   Goodbye to the IPO markets: the financial crisis essentially shut off the equity markets for VC-backed life science firms, pre-commercialization.

C)   The facebook phenomena

Can we blame the institutional investors for allocating their capital elsewhere? There are structural problems with today’s life science VC such as long development cycles beyond fund’s life and Biotech bets becoming increasingly risky and very expensive.

These contextual and structural problems facing the industry beg for alternative business models for early stage investment in the healthcare industry[3].

Some VCs have taken bold steps in the right direction to tackle the structural problems mentioned above:

A)     ThirdRock Ventures: focus on disruptive platforms as opposed to single assets and placement of its own professionals in management roles until a certain milestone is achieved

B)      Flagship Ventures: creation of Flagship Labs as an innovation engine

C)      Symphony Capital: establishes “Symphony Collaborations with biotechs to invest in their strategically important clinical development programs”

D)     Big Pharma as anchor investors: Merck/Flagship Ventures (2012), MPM Capital/Novartis, GSK and J&J/Index (2012), etc

One common aspect to all these funds: they all support biotech firms through equity investments.

Professor Andrew Lo et. al. (MIT Sloan) proposed the most radical model to-date: the industry needs to rely on sources of capital other than equity injections. He suggests the use of portfolio theory to diversify away the risk of any single compound and fund numerous molecules by raising debt. His paper was published in Nature in 2012 and resonated across the industry. The secret sauce of his proposal is the size of the fund (an equity tranche of $5 billion and the rest to be raised via structured products for a total fund size of $30 billion) nevertheless it is quasi impossible to launch an experimental fund that large.

Which brings me to the question that I have been trying to answer: what opportunities exist for MBAs (not PhD or MD) in today’s VC reality and the new disruptive models?

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[1] Merck/Schering Plough, Pfizer/Wyeth, Roche/Genentech, Novartis/Alcon, and Sanofi-Aventis/Gilead

[2] Assuming R&D to be 20% of sales and sales decrease by $5bn due to generic entry, R&D budget is cut by $1bn

[3]  Prof. Pisano of HBS advocated for change in the industry in his book “Science Business” published in 2006.