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when VC firms are looking for returns next quarter or next year—not five years from today.
Compounding matters, the life sciences IPO market has rewarded those brave enough to take the plunge with pretty anemic valuations. There have been a few lucrative acquisitions lately—BioVex, Calistoga Pharmaceuticals, and Plexxikon to name a few—but most of the time really successful biotech investments generate 5- to 8-fold returns on investment, Hutton says. That means the winners aren’t that huge, and they often don’t hit big enough to offset all the losses that make a fund look bad.
“You might get several 3-to-5x returns in a biotech portfolio,” Hutton says. “You need several of those, because it’s not like what you might see in IT, where one Facebook can wipe away a lot of ills. We don’t have that luxury. We’ve got to drive value throughout the healthcare portfolio.”
That’s why looking at the whole portfolio is important. While encouraging, none of the companies mentioned above has yet matured to generate liquid returns that pensions and endowments want to see.
Here’s basically how the math has to work. In a fund like Canaan’s most recent one, with $650 million, it plans to make about 40 investments in private companies. The usual VC rule of thumb is that at least one out of every 10 should be a hit. So that means Canaan needs to have at least four or five hits in its current portfolio, and, one would hope, an internal rate of return that can stack up favorably against the S&P 500. One of the keys here, Hutton says, is to show that the firm doesn’t strike out very often.
“We think there’s still a great story to tell in venture if you can produce multiple winners in a single fund. That’s a believable story,” Hutton says. “If you have one winner against a bad backdrop, it’s hard for investors to say that’s a model that will work for them. One winner is hard to invest in.”
When I asked Hutton if she thinks there will be four or five winners in the current Canaan fund, she didn’t duck the question
“We think there will be a lot more than that,” she says.