The Odd Juxtaposition In Biotech Venture Capital: Delivering Returns Amidst Sliding Market Share

Posted August 1st, 2016 in Exits IPOs M&As, General Venture Capital, VC-backed Biotech Returns | Leave a comment

Biotech has been one of the hottest sectors in the venture capital asset class over the past few years. Strong IPO and M&A markets have put wind in the sails of the space since 2012, and robust investment activity has enabled a wave of well-funded biotechs to mature with a lower cost of capital than a decade ago.

In addition to helping advance new medicines to patients, this accommodative environment has supported the welcome recycling of capital in the venture world – critical to continued interest of Limited Partners (LPs) in the space. A recent Silicon Valley Bank report from Jon Norris and his colleagues highlights a staggering level of potential venture capital distributions in the life sciences: they estimate returns of $79B since start of 2012 from both IPOs and M&A events. This far exceeds the capital deployed during that period (~$38B), and far more than the funds raised by life science venture firms.

To further explore the specific returns in biotech versus other venture sectors, a recent commentary from industry-leading analysts at Cambridge Associates is a good place to start: it highlighted the outperformance of healthcare in 2015 even with the downdraft in the 2nd half (here). A deeper look at company-level return data, shared “as is” from their Venture Capital Index and Benchmark Statistics report for March 31, 2016, is worth presenting: the chart below reflects the IRRs by vintage year for company initial investments in different sectors and overall in venture. These data represent March 31, 2016 valuations, so are inclusive of the market correction from July 2015 through February 2016 that brought down the valuations of many VC-backed public biotechs. The acceleration of returns from investments made during 2012-2014 is striking.

Deal Specific Returns_CA 3-31-2016

In light of this, and the strength of the sector overall in the past five years, one would think that biotech and more generally life science investing would be increasing its “market share” within the venture asset class. Simple economics would predict that VCs would want to deploy more capital into the space, and that LPs would like to channel more fund-level capital towards managers in the sector.

But the opposite is in fact the case.

Life science investing, including biotech and medtech, as a share of venture capital hit a 15-year low in the second quarter of 2016, coming in below 15%. Biotech investing is hovering near its 15-year lows at just 11% of all the venture capital deployed in 2Q.  The chart below captures the downward trends for the past 5-10 years.

LS as share of VC investing

I’ve written on this paradoxical trend before – that biotech is booming on an absolute basis, but shrinking within the venture asset class (here).

Further, despite the strong returns, the relative flow of funds into biotech isn’t likely to change over the coming quarters. While venture firms in the life sciences have been successfully fundraising, with new funds from Longitude, Orbimed, Deerfield, Sofinnova, MPM, Foresite, 5AM, and Atlas, among others, in the past two years, non-LS technology sectors are also raising large amounts of venture capital (with recent $2B+ funds raised by Tiger, Lightspeed, and Accel, for instance).

My estimation of the life science “allocation” of the venture capital industry’s recent funds is roughly 17%.  This analysis included all VC funds closed over the last 8 quarters July 2014 through June 2016 according to Thomson Reuters. This allocation is identical to the share of disbursements that into the life science deals, implying the capital on today’s sidelines will be just enough to keep up with future deployments at this level.

Recent Market Share

So why the disconnect: strong relative returns for years, yet modest “relative” interest from LP’s? I’m sure part of this is that biotech’s reputation lags its performance and suffers from the “ugly stepchild” mythology among potential LPs that I’ve previously dispelled (here, here). Some of it is probably due to the esoteric nature of biotech investing as well. While understanding what a revenue growth rate means about a tech-enabled business is reasonably straightforward, the details of what a robust human PoC study in neuroscience should look like isn’t very simple to appreciate.

But this juxtaposition – outsized returns on one hand, and “minimized” market share in the venture asset class on the other – also raises a couple of other questions.

Is the deployment of capital into different venture sectors at the LP level efficient?  Almost certainly not – it’s very hard to forecast where sectors will be in 3-5 years, let alone the 10-years-plus cycle of venture capital. Figuring out relative allocations into different asset classes and different sectors within those is always challenging. The current sector allocations, though, do seem out of line with relative returns. Further, the massive expansion of tech venture capital (driving the shrinking share of biotech) is likely going to lead to more inefficient deployment. As Benchmark’s Bill Gurley has opined multiple times (here), “Excessive amounts of capital lead to a lower average fitness.” In many ways, the silver lining for biotech is that the more modest deployment of LP dollars into the life sciences in recent years is a good thing for the sector’s current and future return profile.

Or does this constraint simply reflect a people and talent issue?  There are plenty of novel, potentially breakthrough ideas to fund in biomedicine today, and more funding might move the needle on the constrained number of new startups in biotech (see first figure here).  But relatively few diversified venture firms still have biotech teams, and relatively few experienced pure-play life science managers made it through the 2000s as functional teams to support.  This lack of partner-level talent could be constraining the ability of LPs to deploy more into biotech. Fund sizes can’t really go up while maintain any shot at credible returns (the venture capital math problem), so the number of viable well-managed firms becomes a real constraint on the system. There are only a handful of firms that do early stage biotech, for instance. Maybe it’s time for some new first time funds to form, like top quartile players such Third Rock Ventures and Column Group did in the late 2000s.

Final thoughts – venture capital is a long cycle time and illiquid asset class. In principle, outsized returns are meant to compensate investors in venture capital funds (LPs) for the duration and illiquidity they are accepting. Much has been made about the skewed distribution of returns (like other asset classes); only the top quartile firms consistently generate returns that fairly compensate LP’s for those risks. This means that LPs in general have to make long-term forward looking bets as they select managers and sectors to support with their capital. Its hard to get right. For instance, few predicted the last few very bullish years of IPOs and M&As in biotech.

So the big question for both GPs and LPs going forward is whether the macro forces supporting biotech are likely to continue. I certainly believe many of the broader tailwinds driving the sector are likely to remain in place (as described here) – which should continue to support stellar absolute and relative returns, and attractive fund flows back into the sector.

 

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Biotech’s Paradox: A Robustly Valued, Highly Active, And Seemingly Terrible IPO Market

Posted July 14th, 2016 in Capital markets, Exits IPOs M&As | Leave a comment

After five very strong years, biotech as a sector has struggled to catalyze positive investor sentiment so far for the past twelve months. In a disastrous start to the year, the NASDAQ Biotech Index shed 30% in just the first forty days. The carnage of this winter’s market was captured in a Feb 2016 post. Since then, the stock market has bounced around considerably, amplified by macro volatility with #Brexit, security, and other issues, but closed the first-half of 2016 largely sideways since March.

Against this backdrop, overall biotech sentiment is resoundingly negative on IPOs. Analysts, investors, and pundits alike all complain the IPO market is “horrible” and companies are “limping” out with weak offerings. So how bad is it?

Well, surprisingly, it’s not bad at all on at least two important metrics – the number of IPOs and their pre-money valuations.  Context is everything.

According to the National Venture Capital Association (NVCA), there’ve been fourteen VC-backed biotech IPOs (and there are a few more non-VC-backed biotech IPOs too). When you compare that VC-backed number to annual NVCA metrics across over two decades of IPO history, we’re tracking to be on the cusp of a top quartile vintage in terms of IPO activity in 2016.  Even more specifically, only five first-half periods in the last 22 years have seen more IPO activity. The second quarter had nine offerings – on average one every 10 days. By any historic measure, this has been a very prolific year for IPOs, and this period would certainly be considered a fully “open” IPO window.1 - Number of IPOs

Beyond just being active, an even bigger surprise is that the valuations of the offerings have been amazingly strong.  Annette Grimaldi and her colleagues at BMO Capital Markets kindly shared the pre-money valuations of all the biotech IPOs since 2011.  As shown below, this year’s median pre-money IPO valuation is 30% higher than it was during the “booming” 2013-2014 period, when close to 100 biotech companies went public ($194M vs $148M). Valuations were only higher at the median in 2H2015, also surprising given how supposedly “challenged” the IPO markets were after September.

2 - pre money valuations

It’s also interesting to note the stage inversion. Early stage IPOs have had warm receptions this year relative to their Phase 3/commercial counterparts. The median pre-money valuations of the 11 companies with pre-Proof-of-Concept (Phase 2a or earlier) programs was $244M. The average is skewed even higher ($290M) because of offerings like Intellia, Editas, and Beigene. Innovative younger companies, with their promise and deal potential, have captured more interest from buyside investors.

Those are the “positive” metrics – clearly different than sentiment would suggest.

But there are some rather bleak post-IPO performance figures. With the NASDAQ Biotech Index off almost 30% since its peak a year ago, it’s been a hard market to perform well in, even with stellar data.  Here are three key pieces of data around performance for the recent four-year IPO window, by annual cohort.

First, at the median, post-IPO performance has been very poor since their offerings, as most observers would expect.  All cohorts are negative at the median as of July 1, 2016. That said, top quartile performers – typically the ones with very solid data (here) – have done quite well in the market. Many of these top performing companies are massively off their peak values but still remain significantly above their IPO offer prices (e.g., bluebird bio is off 75% from its peak, but still 250% above its IPO price; Juno and Portola are both off ~50% from their peaks, but are ~50% above their IPO prices).

3 - post IPO price

Second, in line with the absolute return data above, relative performance has also been poor: by comparing the relative stock appreciation (or depreciation) versus the NASDAQ Biotech Index’s price on the day of a company’s respective IPO, one can examine the relative performance of a stock to the biotech market as a whole. A zero on this chart would mean the stock on July 1, 2016 was identical to the Index’ performance over the period since its IPO. The bars represent quartiles, so 25% of the companies are above the top of each error bar.

4 - relative perf vs NBI

A few observations on this chart: (a) dispersion of performance is largest (as you would expect) the greater the time period, e.g., 2013 has a wider range of performance relative to the Index versus 2015-2016; (b) although the median has underperformed significantly, the top quartile of all these annual cohorts has outperformed the Index, especially for those in 2013; and (c) 2016 IPOs have, to date, performed well against the Index overall.

Third, just looking at an IPO price threshold analysis of the data, a strikingly large percentage of 2015’s IPOs are underwater relative to their initial offering: 83% are below their IPO price. Earlier cohorts (2013-2014) are in line with historic numbers where nearly two-thirds or so of the IPO classes in the 2000s were below their IPO price a few years later.  For example, of the 77 biotech IPOs in the 2003-2008 period, as of June 2009 near the bottom of the market, 79% were below their IPO price (Figure 2b of this paper).  At the market’s peak in October 2007, 59% were below their IPO price.

5 - above water

All these charts reinforce the fact that biotech is an investment class – like most sectors – where the Pareto Principle is in full effect: the top quartile performers drive the vast majority of both the absolute and relative returns. In bull markets this dispersion of returns is harder to distill as a rising tide lifts many boats, but in more challenging and volatile markets the outperformance of the winners becomes quite apparent. And real data begins to trump hype over time (though not always).

Two final thoughts of the IPO markets today.

Strong syndicates of investors are required in these tough markets. Even though on a historical basis the IPO numbers and their pricings have been very respectable, getting companies public today requires strong syndicates and significant insider participation.

According to data shared by Jamie Streator at Cowen & Company, 2016 IPOs have, at the median, had at least 50% of their IPO offerings bought by insiders. This is up from 31% in the second half of 2015. Insider participation has historically been a defining characteristic of IPOs in biotech over the past 10+ years (here), but in the headier days of 2013-2015 it became less of a requirement (here). In some ways, the strong IPOs of 2016 are the residual effect of strong crossover rounds in 2015 (these companies had public investors in their private cap table heading into the IPO); it will be interesting to see how 2017’s IPOs deliver given the tightening of the crossover funding world that has been happening in 2016.

In light of the markets, and in particular the volatility, we’ve also seen a number of public IPO plans withdrawn or postponed this spring (e.g., Viamet, Bavarian Nordic, Apelis, PLx, Basilea).

Compelling companies will continue to get out and price favorably. This is a bit of a prediction, but short of major negative macro news, I continue to believe that compelling, innovative stories will be able to get public during the rest of 2016.  Positive clinical news, like that from Sage Therapeutics this week and ASCO ealier in the summer, will be catalysts for the sector. In the near-term queue for upcoming offerings, we’ve got 8-10 companies like Gemphire (this week), Audentes (next week), Kadmon, Visterra, among others.

Further, as support for strong pricing, M&A in biotech remains strong and provides for the prospect of a future takeout premium (or IPO alternative): multi-billion dollar acquisitions of companies like StemCentryx, Receptos, and Acerta certainly help fuel excitement in the sector.

It’s worth noting, though obvious, that simply getting public isn’t the endgame for a biotech company. IPOs can be important steps in the journey of advancing new medicines, and provide access in good markets to larger pools of capital than the private markets can support. While it’s never easy, and it may seem very “tough” right now for those wrestling with going public, the sector continues to benefit from a historically strong period for innovation in the capital markets.

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