Biotech VCs Have a Problem, and it Will Get Worse Before It Gets Better

Xconomy National — 

We’ve heard warnings for a couple of years now that the chickens would come home to roost in the biotech venture capital scene. Quite a few VCs just haven’t delivered the returns to back up all their talk, and you can’t wait around forever for things to improve.

This drama is going to be long and painful, and it’s only just beginning. There were a lot of firms that raised their last funds before the financial crisis of 2008, and after putting much of the cash to work in startups, they are finding it much harder to raise new funds today. While some of what’s happening may be a necessary culling of the weaker members of the VC herd, this trend is going to make it tougher than ever for some worthy entrepreneurs to raise cash for new companies to develop drugs, medical devices, and diagnostics.

Consider the headlines from the past few months. The National Venture Capital Association reported in a survey that four out of every 10 biotech funds have curtailed life sciences investing in the past three years, and the same number expect that to continue the next three years. In June, CMEA Capital said it has no plans to raise another fund, although it did carve out the relatively small sum of $20 million to invest in different biotech models through a vehicle called Velocity Pharma Development. Earlier this month, Prospect Venture Partners, a well-respected name in biotech, told VentureWire it was unable to raise enough cash to execute on its strategy for another healthcare fund.

This past week, I heard rumblings about how another well-regarded biotech venture firm in San Francisco—The Column Group—had fallen on hard times, which was about half-true. And I’m hearing that we’re going to see more fallout from other firms retrenching or restructuring before 2011 is done.

The Column Group, a firm with three Nobel Laureates on its science advisory board and a couple of big-name partners in David Goeddel and Rick Klausner, confirmed to me last week that it is no longer investing in new startups. The firm raised its initial $260 million fund to invest in 10-12 early-stage, big-idea life sciences companies, starting in early 2007. Since then, it has invested about half of its money in 10 companies, and is reserving the other half for follow-on investments in the existing portfolio, says managing partner Peter Svennilson. The firm considered raising a second fund about 18 months ago, he adds, but decided against it. The Column Group hasn’t generated any returns yet, and it is essentially in a holding pattern until it does.

Peter Svennilson of The Column Group

“The partnership has decided we want to have a couple spectacular exits from our first fund before we raise the second fund,” Svennilson says. He adds: “The times are over when you can raise several funds on a concept.”

Biotech has long depended on its “blue-sky” concepts that caused people to look away from the cold reality of spreadsheets, and toward the warm glow of potentially groundbreaking technologies like RNA interference, stem cells, and genomics. If The Column Group can’t raise money with all its scientific expertise, then you can imagine how that sends shivers throughout the venture industry. The Column Group has made a number of high-profile investments, and syndicated with some of the biggest boys of biotech VC—Kleiner Perkins Caufield & Byers, Third Rock Ventures, Venrock Associates, OrbiMed Advisors, New Enterprise Associates, and SV Life Sciences. When I interviewed Mike Ross of SV Life Sciences at the last JP Morgan Healthcare Conference, he said he was concerned about whether there are enough venture capital partners, over the long haul, who will be strong enough to help finance a promising company all the way to the point it can generate liquid returns.

I heard a similar theme this week from Mike Powell of Sofinnova Ventures. Sofinnova was a bright spot on the VC landscape last week when it said it was able to raise a $440 million biotech-only fund, after initially seeking to raise a max of $400 million.

Powell expected to get a lot of congratulatory e-mails, which he did. But he got way more than he expected—“hundreds and hundreds” of e-mails from industry colleagues who expressed how big an achievement it was to raise that cash in such a bad environment. And there were other curious signs in many of these notes. Some junior venture partners sent in resumes, and more senior partners sent more subtle job-hunting notes. Quite a few of the folks at these firms don’t have much to say about their future plans, he says.

“There are many groups out there who if you say to them ‘Hey guys, what’s the plan, what’s the future look like for you?’ and they’ll say something like ‘We’re going to work on our existing companies for a while, a year or two, and once we get some exits, then we’ll fundraise.'” Powell says. He adds: “Some of those groups will fundraise, and some will not fundraise.”

Mike Powell of Sofinnova Ventures

Powell’s estimate is that by the end of the year, we’ll see five to 10 more biotech venture firms do something to adjust or restructure. These deals could come in different forms, like what CMEA did by splitting off $20 million for Velocity, he says, or in some cases, firms will merge. “You won’t see that many people just roll up the carpet and say ‘we’re not raising a new fund,'” Powell says.

The Column Group’s Svennilson said he thinks biotech VC shrinkage could be a good thing, as long as the surviving firms are able to pump a similar amount of overall money into startups. “When we started, we felt there were way too many companies getting started,” Svennilson said. “We felt the best ideas should get funded, not all of them.”

I think there’s some wisdom in that approach, that the pressures VCs are facing today will force them to adapt to the new environment. There are some interesting and healthy experiments going on today in new biotech venture models. But the trend in venture capital today is tilting away from life sciences, and toward IT, in a worrisome way. If biotech VCs don’t really can’t find a way to adapt, then in a few years we can expect thousands of Facebook wannabes crawling all over the U.S. and hardly any Genentech wannabes.

Given how much opportunity there is in biology today, I’ve got to believe that entrepreneurs and investors will find a way to harness it over the next few years to reinvigorate the whole industry. Taxpayers will invest billions in basic research at the National Institutes of Health over the next decade, and somebody needs to figure out how to apply the discoveries that will come out of that work in the business world. It will be a real shame if it’s not the venture capitalists who do that.

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17 responses to “Biotech VCs Have a Problem, and it Will Get Worse Before It Gets Better”

  1. j. Keeney says:

    Luke – As I keep stressing to you, why would venture capital funds, or even the companies themselves, continue to invest in drug R&D when the current regime is so pro-generic by threatening to shorten future marketed-drug exclusivity to seven years from an already intolerably short twelve years? The ongoing curtailment in venture capital into biotech area is simply following that of the older pharmaceutical industry. In reality, there very little difference between the two industries when it comes to marketing their discoveries. All this could be cured if the government would adopt “perma-patents”, as you recently called them. For that, we will have to await hopefully for a change in administrations.

  2. Jonathan says:

    Hi Luke,

    Nice article. I think one of the keys will lie with the FDA and its ability to improve its transparency and give industry guidance that is timely vs on a case by case basis. It is amazing how the FDA relies on or cites “non binding recommendations” for years or even decades, and how some divisions of the FDA have never issued a guidance to industry for major therapeutic areas. This would only help start-ups get their preclinical and clinical package together for a Ph1/2 esp in new therapeutic areas where unmet medical need abounds.

  3. Kevin says:

    Great article — I sure hope this is not a long term trend. Biotech is one of the few areas remaining where we lead the rest of the world, and it sounds like we are putting that unique innovation at risk. Meanwhile, emerging countries (from a technical sense) such as China are pouring money into new biotech ventures and initiatives. Maybe corporate (large pharma) venture funds will have to play more of a leading role moving forward.

  4. Angel investors rock says:

    You get what you pay for: a good, hard look at 2 and 20

    Somewhere along the way, LPs and their investment committees largely abdicated the responsibility for creating and negotiating compensation structures that pay VCs to do what they promise to do: generate returns in excess of public equities. Many LPs state that their minimum target return for venture capital is 300 to 500 basis points above a public benchmark.

    Yet, they don’t structure compensation based on that outcome. Instead, institutional investors allow VCs to “charge” them based on the “market
    standard” 2 and 20. Here is how a typical 2 and 20 compensation model works:

    VC firms earn a 2 percent per year management fee on committed capital during
    the first five years of the fund (the investment period);

    After the investment period, the annual fee usually steps down but continues
    through the fund’s life (e.g., 2 percent on the lower of invested capital or market
    value of the portfolio);

    The VC firm earns 20 percent of all investment profits on a deal-by-deal basis
    when a portfolio company is sold.

    This structure has been the industry standard for so long that it’s difficult to trace its origins or rationale. The same 2 and 20 model remains nearly universal today. One study analyzed compensation from ninety-three VC funds raised from 1993–2006 and found that 90 percent of the funds charged a 2 percent or more fee, and 95 percent of funds charged a 20 percent carry.

    It’s interesting that VCs have positioned themselves as supporters, financers, and even instigators of innovation, yet there has been so little innovation within the VC industry itself. There have been changes—more funds, more money, bigger funds, and bigger deals—but very little ‘creative destruction’ around how funds are structured, capital is raised, or VCs are paid. For more than twenty years, most LPs have accepted the

    following terms:

     A ten-year fund;

     A five-year investment period;

     A 2 percent management fee on committed capital;

     An 80/20 LP/GP split of any profits on investments;

     One percent GP capital commitment invested in their own fund;

     Serial fundraising every twenty-four to thirty-six months.