“The last year and a bit, for later stage, has been a good time to invest. The absence of the public markets has meant more mature, later stage companies at attractive valuations,” says Denise Pollard-Wright of Nomura, which invests off its balance sheet as it has done for the last five years since Pollard-Wright set up the private equity biotech team.
Stephen Bunting of Abingworth concurs: “Some companies that would normally be going public have remained private and are getting financed on attractive terms, so it is a good time if you have got a new fund.” Abingworth not only has a new fund but one that was oversubscribed to the extent that its cap was increased from $275m to $350m, although this reportedly fell well short of the total subscriptions it received. This fund, which closed in the summer, was the firm’s fourth and a $125m increase on its previous fund, which closed at the end of 2001 on $225m.
The absence of an IPO market on both sides of the Atlantic has proved fortuitous for those interested in later stage venture capital, no matter which side of the Atlantic they hail from, given the way the venture capital market for biotech works. Edward Brittan, a partner at Covington & Burling, who recently transferred from the US to the firm’s London office, says: “Most of the companies that we work with have interest from both sides of the Atlantic. A lot of American companies are almost primarily funded by European money. Part of it is the connections the management team starts out with. And we have worked with European VC investee companies relying to a substantial extent on US money. There is also fair amount of Asian money that shows up, but they rarely take a lead position.”
Francesco Robertis of Index Ventures believes that interest in biotech began to emerge in the spring. “Five to six months ago there was a three to four-fold step up in interest from institutional investors. In the second half of 2004 you should be able to get one or two IPOs in Europe,” he says. But the same problems that have always plagued the biotech companies that list in Europe exist. Namely the size of initial public fund raisings has tended to be small and is unlikely to increase dramatically when markets do reopen. As such this can mean poor liquidity in a stock and a significant overhang of venture capital investment, which gets locked in, typically for a six-month period. The VC is then faced with having to stage manage a full exit from an investment so that it does not collapse the share price in the process. Sometimes this is done on a pre-agreed basis among all the venture capital backers and other times it’s pretty ad hoc.
Shahzad Malik at Advent Venture Partners has concerns about the companies that may eventually seek a listing when IPO markets in Europe reopen. “Our role is to make sure we only present the best of the crop to go public. We should not allow second rate companies to go public because people will lose money and they will not be happy,” he says.
While concerns about Europe’s appetite for biotech IPOs and their subsequent fortunes on the stock market exist the very fact that people are openly talking about such events has had a noticeable effect on VC investors. “It has been a difficult two or three years. There are a couple of things that have happened over the last four or five months that have made a difference. An up tick in stock markets means this really changes people’s perceptions, whether it should do or not, that a new window for those seeking capital has been created,” says Brittan.
This period of uncertainty saw some, generally the survivors of today, step back from the market. “There were not any suitable investments available which met our criteria, which is not just a function of science, development stage, and potential exit, it is also the pricing level and I think we were right in refraining from doing any investments because our portfolio valuations, so far, are not suffering any great write downs,” says Hanns Peter Weise of Global Life Sciences. Pollard-Wright is another who stepped out of the market for a time. “We did not do a single investment for a nine month period during 2000 and into 2001,” she says.
This is especially interesting by virtue of the way in which Nomura sources its deals. “The deals that we actually do are bought by our fellow VCs. We spend a lot of time building relationships with other VCs, especially early stage ones so we can get to know the companies before they do a formal fund raising. It gives us a head start and the company a head start,” says Pollard-Wright.
Some of the newer entrants to biotech investing stayed in when pricing was unjustifiable to the experienced investors, principally during 2000 and 2001, and have either crashed and burned or are barely hanging in there. The clearout in the German market is a good example. Even those that with hindsight made sensible choices were not immune from the impact of the harsher economic climate that followed the bubble years. Many investee companies were reorganised and downsized to cope with a new economic reality, which was in part characterised by a limited prospect of raising follow-on funds.
That limit on new funds meant few new companies were able to raise funding because venture capitalists were pouring their energies and scarce capital resource, (for the fund raising market was for most of 2001 and 2002 simply closed) into their existing investee companies in the hope that they would stay the course until the economic environment improved.
Companies in the UK engaged in reorganisations and downsizings and looking for any spare cash they can get their hands on have been more active in seeking R&D tax credits according to John Cooney, director at Smith & Williamson. “If you get a grant towards your R&D you are also restricted on your ability to claim on R&D tax credits. If you can isolate what aspect of your R&D that award is made towards then it only limits that particular expenditure for being an R&D tax credit. It needs thought in advance, how you would award the grant application,” he says. He points out that many R&D tax credit applications are turned down and with reworking can often prove successful.
One thing all venture capitalists seem to agree on is that the quality of management they are seeing today is vastly improved as a result. The calibre has lifted either because the management around today survived the boom/bust cycle or because those coming out of research or big pharma to join fledgling venture capital backed companies have few illusions about what is required of them, unlike some of their predecessors that emerged in 1998-2000. A strong management team is so key to success that without it few investments are attractive: “One of the big issues in Europe is getting good management. We have only gone into one [investment] where we knew we were going to have to bring in management,” says Louis Nesbit of Sitka Partners.
One route out of the cash strapped environment of 2001 and 2002 could have been through M&A activity, but this has been a little trod path. “I’m always surprised by the lack of M&A activity in European biotech. Most deals don’t get done because of price and/or ego and that is certainly true of European biotech,” says Bryan Wood of Alta Berkeley. Price is something on Malik’s mind. “A lot of M&A discussions are going on right now between the best private companies. We are keen not to undersell the assets of our best portfolio companies. From our point of view it’s a timing issue,” he says.
But while M&A didn’t provide many answers pulling together syndicates of carefully chosen venture capitalists occupied the time of many. “The problem over the last couple of years is that as the market has started to turn down a lot of financing has been done with extreme anti-dilution devices. Investors had a complete lock on raising future capital and so it was difficult to do a down round. If old and new investors are on the same footing, in my experience they rarely result in a deal,” says Brittan. In the event most of the financings completed over the last couple of years were down rounds and many describe those that managed to keep pricing flat as lucky.
“A lot of the protections were developed by VCs panicking in face of declining markets, now that they have been discovered you will see them turning up in a lot of deals. It’s a case of once bitten twice shy,” says Brittan. He goes on to say that in the late 1990s series D funding documentation tended to be the same as the series C before it, but with the change in market conditions that has gone out of the window and significant renegotiation of terms and pricing tends to be the form.
Some of the new terms are less palatable than others as Pollard-Wright explains: “Nomura continues to invest where we can get a good management team and ensure downside protection; full ratchet anti-dilution protection or more attractive liquidation rights. If VCs are confident enough that they are not going to do another financing the ratchet is achievable, liquidation is more controversial.”
Another thing that emerged during the downturn, and which has exasperated some VCs, is the insistence of new VCs joining a follow-on funding round on taking a board seat. “It has become more difficult to build the syndicates because the requirements have gone up. Every investor wants a board seat and it does not make sense for a 15 employee company to have six on the board but VCs are fighting more on that front because their investors want to see that they lead deals,” says Hanns Peter Weise.
Partly this move can be explained by a desire among VCs to be more hands on with their investments. But it might also be ascribed to the fact that given the dire institutional fund raising market caused by such poor performance institutional investors were and are becoming much more savvy in the questions they asked of their fund managers. Consequently being able to point to a board seat implies a more active than passive investment role, the former being of more interest to institutional investors than the latter.
“Ninety percent of the time we take a board seat when we are making an investment. Because we are investing in later stage companies we use a group of advisers to put an advisor on the board, typically they would have been an industry person, such as an ex-CEO and somebody with biotech or pharma experience,” says Pollard-Wright. Nomura’s approach is interesting because the investee companies can tend to embrace such outsiders since they can see a value over and above having yet another VC on the board. And from Nomura’s perspective they get a good link into the company. Pollard-Wright notes that many of the advisers that they put in place will stay with the company in a non-executive capacity after an IPO.
Not all VCs are looking for IPOs, however, and so what has been happening in the corporate space has been watched with interest. This encompasses activities as diverse as M&A among the pharma community to sizes of R&D budgets. One of the most pressing issues for big pharma companies is their product pipeline, see table titled ‘European public companies – product pipelines’. “Some of the bigger pharma companies say that unless you have a product in Phase III they cannot be bothered. We are seeing that where our companies have products sucessfully in clinic can hold their valuation and companies that have a ‘story’, but nothing in the clinic then people don’t buy the story,” says Wood.
If a compound has entered Phase III the pharma company can see that there is a good likelihood that a product can be brought to market within a reasonable time frame. The product pipeline issue is so pressing because there is a general acknowledgement that a good proportion of the big pharma companies have issues with products soon to be coming off patent. This could see some revenue streams decrease by as much as 70%.
“We have been through various fads including genomics and bioinformatics but now in the private market valuations are down such that the only thing that counts are products in the clinic,” says Wood. The refocus within big pharma on building product pipelines with phase II and phase III offerings was preceded by a dash for platform technologies. That emphasis resulted in far too many product platform companies raising finance, many of them in Germany and most of them expected to disappear. Big pharma has woken up to the fact that it doesn’t need to buy these companies outright, rather for the most part they can achieve the same objectives by buying licences.
Many of Germany’s problems arose from the spurt of soft money schemes run out of government bodies. On that subject Malik echoes the sentiment of many when he says: “The notion that governments can make successful biotech companies is rubbish. The way for governments to foster entrepreneurship and growth of biotech is through taxation of capital gains and options and relief on rent and rates, rather than having a slush fund that can be misdirected.”
Corporate venturing is another area where big pharma has to some extent changed tack, although not across the board. “All the corporate deals are smaller in this risk averse environment and the payments get strung out. Because there is not an alot of activity, at every stage in the approval process the deals get changed,” says Wood.
While corporate venturing might be on the slow down, Brittan points to areas where big pharma has been busy. “We are very active in strategic partnerships and licensing transactions with the big pharmaceutical companies. There has not been a down turn in that level of activity by big pharma,” he says.
If big pharma’s purse strings have tightened the same cannot now be said for biotech funds operating in Europe. Aside from Abingworth’s fund raising mentioned earlier, Schroder Ventures Life Sciences in June closed its third fund with total commitments of $402m and MPM Capital closed its third fund on $900m at the end of last year. And there were a number of fund raisings in 2001 that still have money to spend on European biotech. Index Ventures raised $300m, Advent Venture Partners £300m and HBM BioVentures increased its funds under management by CHF517m.
As always happens when a venture capital group increases its fund size significantly on the one that went before, there is talk about the emergence of an equity gap at the early stage. Given that these funds’ institutional investors have generally signed up on the basis of more of the same, venture capitalists are quick to state it’s business as usual only in greater amounts. “Rather than drip feed companies we are able to capitalise them from the outset and we are able to attract very expensive management teams. Two years ago you could attract people from big pharma with big option packages, now they are more concerned about cash compensation,” says Malik.
But early stage can still matter to these funds, as Karen Wilson at Index Ventures points out: “We often do seed investments but our policy is not to announce them until we do the A round.” Given the fall-out ratio of very early stage and seed investments and attendant negative publicity this seems a prudent strategy. All good intentions aside, the very nature of having more capital to put to work per portfolio company within a fixed investment timescale means VCs will by default find themselves with an element of their investee companies that are further on in their development cycle.
“Despite the current distress and gloom there are signs of a cautious recovery. The underlying fundamentals of healthcare and biotech of an ageing population and uncured diseases are still there and pharma does not know how to fill the R&D pipeline,” says Hanns Peter Weise.
Bunting offers an even more bullish outlook. “Generally we think this is probably the best time to invest that we have seen over the last 20 years, in terms of getting opportunities to put money into private companies,” he says.