Valuation and Other Biotech Mysteries – Part 8: The Current State of Healthcare Venture Capital
July 20, 2011
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[Ed. This is the eighth part in Wayne's series. You can access the whole thing by clicking here. Please leave comments or questions on the blog and Wayne will address them in future posts in this series.]
The world of healthcare VCs has changed dramatically in the two decades which I have spent in capital markets. VCs are impacted by changes in the broader capital markets, changes in healthcare capital markets and changes in the industries on which they focus.
The risk profile of the broader capital markets can change dramatically. The movement of the technology-heavy Nasdaq Composite Index has been a reasonable proxy for overall market appetite for risk. During the tech bubble, the appetite for risk was at an all-time high and the index peaked at an intra-day high of 5,132.52 on March 10, 2000 (look at a long term chart of the index to get a good perspective of the movements). This index had been as low as 1,500 within the prior 2 years and was below 1,500 about 2 years later. After a slow climb back, the latest dramatic change in the risk profile was triggered by the financial crisis in late 2008 and the index again dropped below 1,500. Although the index has doubled from the recent lows and despite the high valuations of some recent internet business IPOs, the risk appetite of the broader capital markets is still relatively low.
The risk profile of the broader capital markets impacts healthcare VCs in many ways.
- The risk profile of the broader capital markets reflects the risk profile of the investors who put money into healthcare VC funds. Many Canadian and U.S. VC managers have had difficulty finding large institutional investors for new funds.
- Generalist investors, both institutional and retail, with an overall lower appetite for risk will look at individual sector risk. Generalist investors left the development stage healthcare sector starting in late 2007 and have been slow to return, reducing the amount of capital available for healthcare in the public markets.
- Companies without a track record as a public company are viewed as more risky than companies at a comparable stage of development which have been public for a few years. The last development stage healthcare IPO in Canada was IMRIS in late 2007, although several companies have gone public through RTOs (reverse take-overs) of capital pool companies (CPCs). Healthcare IPOs have been completed in the U.S., initially primarily for companies with approved products and revenues but now for some Phase 2 and 3 companies. For clinical stage IPOs, valuations have been low, many have traded below the IPO valuation and VCs had to be major participants in the IPOs.
The large pharma companies are continuing to undergo structural and operational changes as their major products approach and drop off the patent cliff. Despite the inherent riskiness of drug development, pharma has always been and remains risk averse. They prefer to:
- Wait for more data and pay more when the data is positive;
- License rather than buy; and
- Use an upfront and futures structure when forced to buy.
Healthcare VCs have adjusted their operations in response to these dramatic changes, including:
- No investments in new companies because they needed to keep funds for their current portfolio;
- Investing survival money only, often in the form of convertible debt, while looking for an exit;
- Shutting down companies earlier;
- Investing in public companies where valuations were lower than potential private company investments;
- Investing in companies with products or technologies at a later stage of development; and
- Planning to exit through sale of portfolio companies, with an IPO as a secondary option.
How does all this relate to valuation?
- Risk and reward have to be in balance.
- To induce investors with a lower risk profile to make a high risk investment, you have to offer them a larger reward.
- For the investors to get a larger reward, the pre-investment valuation has to be lower.
- Valuation is established by the fund which is willing to lead the next financing round.