“We Have Met the Enemy… And He is Us” is the very fitting title of a recent report on the state of the VC market with a focus on the GP-LP relationship.  This thoughtful and thankfully analytical report highlights a series of lessons from 20-years of venture investing by the Kauffman Foundation.

Its received lots of coverage in the media (here, here) and blogosphere, including an excellent pair of posts from my partner Fred Destin (here, here), and should be required reading for those interested in the venture ecosystem.

It’s fair to say, though, that many of the themes highlighted by the report are not “new” news, but they’ve put quality analytics behind a number of these points.  Insiders have long known about most of these issues, and I’ve discussed many here in this blog.  Some reflections on a few key points:

• The “venture capital math problem” places real constraints on the returns achievable by large funds.  The simple math, and the unimpressive data for >$500M funds, have been covered elsewhere (here, here).  More funds in the $250M range have delivered handsome returns than any other size.  It’s particularly relevant in biotech where Facebook-sized exits aren’t even a remote possibility, as I covered in a recent post looking at the assumptions required to deliver “venture-like” 3x gross returns.  At Atlas, we’re true believers in the “small is beautiful” mantra: our most recent fund is ~$280M and anticipate similar sizes going forward.  We know the consequences of big funds because we’ve made those mistakes at Atlas.  In the bubble, Atlas raised far too much, far too fast, and invested like drunken sailors (much like everyone else).  For the past decade, we’ve been working hard to get LPs their capital and then some.  As most in the industry know, the bubble vintage funds of 1999-2001 will probably go down as the worst years in the history of venture capital.  Lots of lessons learned, but its clear to us that in the long run smaller funds are better for LPs, GPs, and entrepreneurs.
• Partnerships are complex and often blackbox, and understanding what being a “partner” really means should be important to LPs.  Partner titles can mean lots of things: GPs, key men, junior partners, managing directors, operating partners, venture partners – the industry uses a bunch of terms for different roles and there is no consistent definition.  And the economic fund flows within partnerships often require armies of accountants.  These oddities certainly create confusion.  I can’t speak for other partnerships, but I think we’ve got this right (finally): Atlas has undergone an evolution since I joined in 2005, and is a much healthy, leaner partnership today.  We’re now a flat, equal partnership with six GPs and are exclusively focused on early stage innovation in life sciences and technology.  The cohesion of the team and clarity of the strategy is part of why I love coming to work in the morning.
• The median venture fund underperformed the public markets in the Kauffman portfolio.  This is certainly true, and affirms what insiders have long known about returns.  And no LP invests in venture hoping for a median performer.  What’s also true is that the median managed mutual funds underperform the passive equity markets (e.g., according to Vanguard, 84% of actively-managed U.S. large blend funds underperformed their index for the decade prior to 2007).  Actively managed asset classes aren’t about the median performer: they appeal because top quartile performers can vastly outperform.

So in general, I’m in complete agreement with the big themes in the report.

That said, there are a few nuances worth mentioning:

• The “vaunted J-curve” was challenged as a myth in venture.  The J-curve has been described elsewhere, but in summary its that value of a VC fund may post negative IRRs in the early years as money is spent on deals and expenses, but no exits or upticks in value have been achieved.  The Kauffman report does a good job of showing that many VC funds (Tech-biased) didn’t actually have a J-curve: that is, they achieved rapid paper write-ups in the value of their portfolio (and then use those write-ups to raise their next fund).  But I don’t think it’s a myth in the life sciences: biotech deals don’t typically achieve big write-ups early in their lives.  Bijan Salehizadeh has written on the “unrealized” problem in biotech, which is the product of the lack of these write-ups.  Many remain flat for 4-5 years and then, if successful, hockey stick upward with a favorable M&A exit, like Avila Therapeutics prior to its deal with Celgene, for instance.  The reason VCs like Atlas like to get into startups early that are likely to be held at flat valuations for years is to shape the DNA and direction of a company while securing out-sized ownership stakes.  Many great deals, like Plexxikon, didn’t raise money for the 8 years prior to their exit – so getting in early was the only way to get into those deals.  So, at least from my experience, biotech venture portfolios more often than not exhibit a J-curve early in the life of fund.
• There’s a reference to liquidation preferences and how VCs apply them to their portfolio but not themselves.  Before the bubble of 2000-2001, it was more common to pay carried interest on a deal-by-deal basis (which led to the clawback problems when the funds were underwater), but these terms are not common at all today.  The “market rate” terms for a venture fund’s LPA today effectively have a liquidation preference in place: VCs are only paid a share of the profits when all the committed capital and fees have been paid back.  This is the equivalent of a 1x liquidation preference feature in a typical startup, except that its over the entire fund.
• Kauffman recommends that LPs invest directly into a portfolio of startups.  I’m generally supportive of LPs investing directly, but making sure it’s alongside “trusted” investors is key.  I’m a firm believer that startups benefit a great deal from having value-add, high quality venture capitalists involved on their boards.  Good VCs also bring the best of their entire firm to bear on a portfolio company’s issues across a spectrum of company-building activities: corporate strategy, business development, resource allocation, etc…  So if LPs are going to “go direct” to avoid the fees and profit-sharing of a VC investment, its definitely worth teaming up with some trusted co-investors.

As I’ve said before, the venture model is clearly in flux – hopefully better returns from some of the experiments we’ve been doing in biotech venture capital will bring back some of the enthusiasm for the asset class.

Twenty years ago the biotech world was in the midst of one of the best IPO windows in its history.  Nearly a hundred biotech companies went public from 1991-1994, including a number of the great companies that have become household biotech names: Alkermes, Amylin, Cephalon, Gilead, Human Genome Sciences, Imclone, Isis, MedImmune, PDL, Sepracor, and Vertex.  Of course there were also a lot of names lost to the annals of history, or bankruptcy, but this window certainly helped launch a solid set of fully integrated, “built-to-last” biotechs.

Reflecting on today’s very different environment, I think it’s instructive to look back at that window to understand some of the drivers for why the early stage biotech arena is undergoing dynamic change and experimentation today.  Two key observations jump out at me.

1. Many of these IPOs brought windfall returns to their venture backers.  These are the IPOs that helped reinforce the mythical status of the biotech IPO.  The average step-up in valuation over the private invested capital was ~4x, highlighting the very low cost-of-capital provided by public equity investors in that period.

Lets explore two examples, Isis and Amylin, since both are still with us today and the subject of much discussion.  Both raised their “1^st rounds” in 1989 and went public only a few years later in 1991-1992 after raising roughly $20M in venture capital each.  The chart below with implied stock price says it all.  Not only the impressive valuation step-ups, but the short time from first institutional funding to IPO.  Wish I had been in venture capital back then.

Today’s capital markets are obviously very different: most companies raise capital privately at relatively flat rounds over long timeframes and if they go public at all their IPOs are valued at or near their aggregate invested capital.

Take a couple recent examples: AVEO got public in Feb 2010 at $9.00 per share, yet had an average private investor share price of $8.97 over the past 10 years (see related post).  Merrimack just IPO’d in Mar 2012 at $7.00, essentially flat with the last private round in 2011, and only a 1.8x over the average price of the past 11 years.  And these are great biotech companies.  For most of the past decade, step-ups on total invested capital have typically been only 1.5x or so.  Sadly, high capital intensity has been the signature of many of the past decade’s IPO stories.

As everyone knows, the biotech IPO model just isn’t what it used to be, and nor has it for a decade.  It’s also not likely to change anytime soon.  Why is this?  In large part because of the second key observation.

2. Only a subset of the 1991-1994 IPO window have accrued real value over time.  There were certainly a few big winners in there – Gilead probably being the biggest, up over 100x since its IPO in 1992.  MedImmune also fared quite well with its $16B acquisition (though AZ is not thrilled about it now), and Vertex is up 10x.

But let’s take the prior two examples, Isis and Amylin, which represent “successful” 20-year old mid-cap biotechs.  Both have gone from preclinical stage companies around their IPOs to having products launched or filed with the FDA.  But they haven’t really created any shareholder value over 20 years.  Isis today trades at $8 per share, but it went public at $10 per share.  Amylin went out at $14, but closed on the end of its first day of trading in 1992 at $21 per share.  It now trades at $25.  So for 20 years, these companies (and many, many others in the 1991-1994 cohort) have underperformed not only all major equity indices, but also treasury bills, and consumed billions in equity capital.  And recall that many more companies from this window, probably at least half, ended up dying long whimpering deaths like long-forgotten Autoimmune Inc and Alpha-Beta Technology.

Though it may seem surprising, public investors have caught onto the flaw in this biotech investment strategy.  Their diagnosis (and mine) of the problem has at least three parts: insatiably high capital intensity funding large portfolios (funded on the back of the serial public equity flows, there’s been little focus on capital efficiency), an endless cycle of “rinse and repeat” anti-shareholder behaviors (in public market there’s always someone else willing to fund the promise, and expand a new option pool, so its ok to wash out the existing shareholders with dilution), and management teams too focused on “built-to-last” company survival vs shareholder value maximization (like going it alone “to build the next Gilead” even when the best outcome for existing shareholders, and often patients, is to sell now and access the balance sheet resources of a bigger company).  These may be harsh criticisms, and lots of companies don’t exhibit this behavior, but they are indeed real concerns held by biotech investors today.

Public buysiders know these tactics well, and obviously seek to avoid exposure to them.  Activist buyside shareholders have gotten increasingly active in biotech, and on the whole I think it’s a good thing: investors behaving like owners, as they should, in order to push for better value-maximizing strategies.  I have a lot of sympathy for many (not all) of these investors because in many ways VCs are the definition of activist owners/investors.

Twenty-years of these observations have led buysiders to become skittish IPO investors, and they are often blamed for the IPO problem today.  I can certainly argue that the pendulum has swung too far, but their skittishness is an understandable reaction to the past decade’s IPO roster.  If most IPOs trade down after their IPOs, why bother buying at the offering.  Seems rational.

But it’s also clear that buysiders will still support innovative biotechs to go public: in fact, I’ve heard them lament that lots of the best companies are being sold “too early” to Pharma.  That may indeed be true, but in most cases the dilution of “going long” with a high cost-of-capital makes selling a company “early” a far more attractive outcome to existing shareholders.  More IPOs (vs M&A) would certainly happen if the cost-of-capital of public equity was cheaper, and it doesn’t need to drop to the 1991-1994 level to be interesting.

The current reality, shaped by a couple decades of lackluster performance, is that the public markets aren’t open for business in biotech.  While they are much less tolerant of the value-destroying tactics of the past (which is a good thing), they have also set the bar so high as to discourage even great, innovative companies from considering it as a viable option.  In this new world, the old company building models just don’t work: it’s hard to back a startup today with an investment thesis around “we’re building the next Gilead” – the capital markets are just so different.

And beyond the public capital market changes, there’s been plenty of other forces at work to adjust to in the biotech: Pharma R&D productivity issues and their increasingly active M&A interests, emergence of a robust CRO network, more translationally focused academic medicine initiatives, corporate venturing, etc…

These forces have certainly changed our landscape over the past 20 years, and it would be a mistake to continue pushing the “built-to-last” biotech strategies born in a different era in today’s environment.

This is why many venture investors are pushing experiments today around capital efficiency, globally distributed R&D, asset-centric models, tighter linkages with Pharma at company inception to access lower cost-of-capital, alternative routes to liquidity like structured transactions, etc…  And many of these approaches are working – great stories like Avila, Stromedix, Amira, Enobia, etc are being built in this new environment.

Who knows what the future will hold, and the re-emergence of attractive low cost pools of capital in the public markets would certainly change the flavor of companies we’re starting today.  However, for the time being, a twenty-year “Back to the Future” isn’t happening, so we’ll just have to look nostalgically at the 1991-1994 window, celebrate its successes, and continue adapting to the brave new world.