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As Atlas Splits, Is There A Case To Make In Venture For Specialists?

Xconomy National — 

Readers of this column who are of a certain age might remember Chrissie Hynde of the Pretenders in black eyeliner, dressed as a diner waitress singing, “I’m special, so special, and I gotta have some of your attention.”

Swap “money” for “attention,” and it could be a refrain that venture capitalists are singing these days to their wealthy backers. Cash is flowing into venture funds at a post-recession high, and with that brass in pocket, more VCs are investing with a narrower focus, say industry observers. How to quantify these specialists is a moving target, but the trend has been ongoing for a few years: old diversified firms have split into tightly focused ones, and new ones have launched from scratch.

Chrissie Hynde

Hynde: Special.

“Five or 10 years ago you had a lot of $500 million-plus funds that included a healthcare or biotech practice, but now there’s a real bifurcation,” says Theresa Sorrentino Hajer, managing director of venture capital research at Cambridge Associates, an advisory firm for institutional investors—pension funds, school endowments and other limited partners that put money into venture funds.

Some data also suggest it pays to be a specialist, sticking either to IT or healthcare, although that suggestion is more of a hint on the healthcare side, as we’ll see in a moment.

Atlas Venture of Cambridge, MA, is the most recent example of what Hajer calls a “bifurcation,” announcing this month its tech and life science teams would part ways and raise their own funds.

Another example is Lightstone Ventures, formed in 2012 by the healthcare investors from Morgenthaler Ventures and Advanced Technology Ventures. A generation ago, says Lightstone general partner Mike Carusi, VCs tended to be generalists. But now “the science has gotten harder,” he says, which means “the need for operating partners with specialized technical know-how—folks with PhDs after their name—becomes more and more important. These resources are only applicable to one side of the house or the other, healthcare or IT, and thus the skill sets of the teams continue to diverge.”

To be sure, the venture world is never static. Firms change direction, partners come and go. But every cycle has its own unique properties. The Great Recession dealt a blow to venture capital returns and began a shakeout that many felt was overdue. Some LPs gave up on venture entirely, but the momentum has shifted, according to the National Venture Capital Association and Thomson Reuters. With three months to go, U.S. venture fundraising in 2014 is up to $23.8 billion, the first time in five years it has surpassed $20 billion, and it could threaten the $31.1 billion mark reached in 2006.

Carusi: Specialist.

Carusi: Specialist.

So VCs have more money to invest. And more of those firms are specializing in tech or healthcare (or in even deeper specialties within those sectors). But are they doing better because of it? Here are two ways to slice it, using data from Cambridge Associates:

—For new investments made between 2001 and 2010 into IT companies, the gross internal rate of return made by diversified funds was only 8 percent. In contrast, the return for the specialist IT funds was 20.5 percent (or 2.7x gross multiple of invested capital vs. only 1.5x for the more general funds).

—For new investments made between 2001 and 2010 into healthcare companies, it’s more complicated. From 2001 to 2005, the diversified funds have a better track record than the specialists (11 percent vs 7.2 percent gross IRR; 1.6x vs. 1.3x multiple). As recently as 2012, Atlas Venture partner and blogger Bruce Booth used Cambridge data to underscore the better performance of diversified funds.

But since then, just like with Atlas itself, the story has changed a bit. Cambridge data now show that from 2006 to 2010, the healthcare specialists hold a slight advantage (13.1 percent vs. 11.3 percent gross IRR; 1.6x vs 1.5x multiple).
Perhaps that shift is simply a blip; it’s not wise to draw grand conclusions from such short time periods. But it’s also fair to note that the better performance by the healthcare specialists, boosted by two more years of return data, coincides with two years of unprecedented return activity in the healthcare sector.

Healthcare companies have accounted for 35 percent of the IPOs in the last 12 months. That’s more than double the contribution from the technology sector, according to the website IPOScoop.com.

There’s an argument to be made that the 2012 JOBS Act might help keep the IPO window open—or at least less boom-and-bust volatile as in the past, which in turn could bring more stability to assuage risk takers. Could there, in turn, be more motivation for healthcare investors, whose ranks until a couple years ago were thinning, now to go their own way? That, of course, depends upon LPs’ willingness to back healthcare specialty funds.

Apparently Atlas will soon find out. As its partners part ways, each side aims to raise its own fund: roughly $265 million—the same as the current general fund—for the biotech side, and $125 million for the tech side, according to Fortune. The biotech side will keep the Atlas name, and Booth, who explained the split in public, said the biotech and tech sides were facing “rapidly diverging business models.”

In a follow-up exchange with me, Booth said that the breakup wasn’t about performance; that both sides of the house have had similar returns from recent funds (a claim that’s difficult to verify independently), and that industry returns as outlined by the Cambridge data had no effect on the decision, either. When asked for other reasons, he said “augmenting our footprints in our respective sectors,” “more nimble sector governance,” and “clarity around message and mission” were big factors in the split.

Lightstone’s Carusi echoed some of Booth’s rationale for specialization, and added his own reasons as well.

“I was a big believer in balanced funds,” says Carusi, using another name for diversified funds. But he’s seen the two sides struggle to understand each other’s business models, underlying technology, and culture. The biotech side prefers the experience of “gray haired folks” to run their startups, he says, while the tech side is “often looking for bright young entrepreneurs with unique insights on how to disrupt markets.”

The Lightstone team will continue to manage their old ATV and Morgenthaler investments, but anything new is coming from the $172 million fund Lightstone raised in 2012.

I don’t want to give the impression that diversified funds are an idea of the past. There are still plenty of huge funds investing prolifically and creatively in both information technology and biotechnology. And there are plenty of reasons for firms that house tech and healthcare teams under one roof to keep them that way. First and most obvious: “If it ain’t broke.” New Enterprise Associates, Canaan Partners, Polaris Partners, and Venrock are a few well-known names, and all have raised funds of $450 million or more since 2012. (NEA tops them all with its $2.6 billion fund in 2012.)

I had Canaan’s Wende Hutton (healthcare) and Dan Ciporin (tech) on the phone last week to talk about their new $675 million fund, which, like previous funds, should be roughly two-thirds tech, one-third healthcare. I asked what’s kept the 28-year-old firm together through recent years; Ciporin noted first that “we happen to like each other and get along well.” (Atlas’s Booth wrote something similar about his colleagues in 2012 when explaining why Atlas, in raising its ninth fund, was sticking together: “First and foremost, we like each other.”)

Hutton and Ciporin, who specializes in financial and e-commerce investments, then noted that another reason for staying under one roof is digital health, which in some cases requires expertise from both sides of the house. (Canaan hasn’t participated much yet but looks to do more.) Digital health—or health IT, as some prefer—might indeed be the next hunting ground for big, diversified firms. Investment in the field is taking off, but so far tech-only investors are out in front, with only a couple diversified firms among the ten most active.

Venrock is not on that list, but when I asked people which diversified firms are building a strong digital health practice, Venrock kept coming up. The firm’s partner Bryan Roberts is one of the few life-science veterans to move aggressively into digital health—he’s the chairman of Castlight Health (NYSE: CSLT) and on the board of a few others—but he surprised me with a contrarian view.

Speaking from an airport security line, he told me he thought the tech side of venture would continue to dominate the deal flow in digital health, and diversified firms (like his own) would hold no particular advantage in sourcing deals and building companies. The tech folks, he said, can build software and service companies and look for outside advisors for the requisite healthcare expertise.

Meanwhile, others on the life science side worry about falling behind. Aisling Capital founder Dennis Purcell, whose life-science-only firm mainly invests in later-stage companies and assets, says he sees tech investors like Andreessen Horowitz and Khosla Ventures “making big bets” and wonders if they are “the future of life science.”

“I have to think about what the VC world will look like in five years,” says Purcell. “If it’s toward digital health, who’s ahead of the curve?”

And no matter what strategy is dictated by culture, or fund structures, or degree of difficulty in any particular sector, there’s always that gnawing fear in venture of not being ahead of the curve. Or, as Venrock’s Roberts puts it: “If you go super-specialized, how do you see the next wave of what’s interesting?”