Europe’s biotech venture market seems to have recovered from its low point in 2002, but the wall of money targeted at this space appears to be moving later in stage year-on-year. Most biotech venture funds, under pressure from their LPs to generate returns so they can raise their next fund, are looking to expansion stage because it’s a quicker and more profitable route to exit. Angela Sormani takes a look at where biotech venture spend is ending up.
There are some 1,800 private biotech companies in Europe so a source of deals is not an issue for venture funds. What has changed is the level of risk biotech venture funds are prepared to take, which appears to have shifted over the years so that angel investors and high net worth individuals, where they can, are assuming the role of seed investing, which was traditionally venture capitalists’ mainstay. There’s also recognition that most early stage biotech investments require significant amounts of capital in order to get them to a meaningful phase of development, something many VCs in the space are unable to commit to due to lack of sufficient funds.
Paul Claydon of law firm Mofo says: “It’s at a pretty low ebb at the moment in terms of new company start-ups. In my experience over the last two years, I can’t think that we’ve had more than one new company formation. The last 12 months we’ve been doing lots of exits including AIM floats and a bunch of M&A disposals acting for the selling VCs. Most deals have been internal follow-on rounds. Some VC’s in the sector, including 3i and Apax, are looking for larger healthcare investments in the buyout space rather than pure development capital deals.”
According to data from Thomson Financial, of the 528 VC rounds of investment in the biotech sector in Europe in 2005, 231 were expansion, which also accounted for the largest sum of investment at €879.74m (45%) out of a total of €1.877.23bn invested in 2005. Appetite for start-up and seed funding did witness something of a revival in 2005 with 91 rounds amounting to €157.54m. This was followed by 85 early stage rounds at €304.23m and 70 buyout deals worth €369.70m. Later stage, however, took the smallest slice of the pie with €122.4m in 24 deals. For the last two years later stage has taken a consistently smaller share of investments, an obvious shift taking into account the supply and demand of the sector with fewer seed and early stage deals having been funded in the earlier years and so diminishing the number of later stage deals for the VCs to fund. Most of the deal flow is now coming from spin-outs of larger corporations, which are seeking expansion capital and already have established business models and therefore lower risk.
Another reason for the shift in investment focus is that many of the specialist biotech funds are at the stage in their lifecycle where they’re fully allocated and just about have enough capital to cover their follow-on investments. Many of these funds are also concentrating on making realisations from their portfolios, as they are about to embark on a much-needed fund raising trail. Funds in, and rumoured to be in, capital raising mode include Abingworth, Advent Venture Partners, Global Life Science Ventures, HealthCap and Ventizz Capital Partners, see fund raising feature, page 16.
Claydon of Mofo says: “Part of the reason we’re seeing more exits is that most of the 10-year funds are reaching the end of their life cycle and would like to raise more money, so inevitably there is a lack of funds available for seed stage investments. In a 10-year fund, there will probably be no more new investments after years five or six and this is reflected in the figures. The last two years have been the leanest in terms of new company formation. I guess the question is whether this is just a timing issue or is it something more fundamental. Are we not going to see the same number of new company formations that we have in the past?”
Examples of a company that has attracted seed funding and managed to keep investors on board to achieve a successful exit are hard to find. Claydon cites KuDOS, a developer of drugs based on targets involved in DNA repair mechanisms backed by Advent Venture Partners, BankInvest Biomedical Venture, Euclid SR Partners, Johnson & Johnson Development Corporation, Life Science Partners (LSP), 3i, and SV Life Sciences, as an example where investors made a significant return on what they invested. The company had done three rounds of fund raising and was sold by way of an auction to AstraZeneca in December 2005 as an alternative to more VC funding or an IPO.
Claydon says: “It’s a long, hard slog with biotech. Whether we’ll see a whole wave of new company formation once new VC funds have been raised remains to be seen. But the funding gap is always shifting and it is just at another part of the cycle. It’s likely to shift again once certain stages have been satisfied and dependent on the VC fund life cycle.”
Charles Waddell of law firm Dechert says: “The mantra of the bigger venture capital funds still active in the biotech sector remains ‘management, management, management’. If management has a track record of making VC investors money in the past, they will find it easier to raise funding for a new project.”
He adds: “It remains difficult for early stage companies to get series A funding, especially where the management does not have a track record. Five to 10 years ago funds such as Apax were making early stage investments. By way of example, RiboTargets was an Apax-backed start-up. RiboTargets is now part of Vernalis. The bigger funds are now focusing most of their investments on expansion investments.”
Even with a significant decrease in seed and start-up investment, the source of deal flow for venture funds wanting to invest in this space doesn’t look likely to dry up. Rainer Strohmenger of German VC investor Wellington Partners says: “Deal flow is very good currently in Europe. This is because we have 1,800 private biotech companies and what is typical for a biotech company, the more it develops, the more capital it needs, especially in a clinical development stage. More and more biotech companies in Europe are reaching that stage and deal flow has never been better.”
Andrew Fraser of 3i adds: “We see many exciting opportunities within the healthcare venture market to invest. It’s not really an issue of there being insufficient early stage companies to fund, even in a sector where we believe that consolidation will continue. For funds of our scale and track record, we can afford to take an international, value-based outlook.”
3i has been moving its healthcare portfolio away from early stage drug discovery towards medical devices. “Over the last three years we have adopted a bias towards medical devices, which does tend to be different to the majority of the European venture market. We invest in companies with global ambition, that are in a stage of technology development or commercialisation and require more capital. Typically we can invest between €10m and €40m in a company over its lifetime.”
He cites Endosense as a model investment for 3i. The emerging cardiovascular device company was the largest medical device start-up in Europe last year in terms of financial commitment, closing a CHF26m (€16.53m) financing with 3i and NeoMed. Endosense, set up in 2003, is developing a Force Sensor ablation catheter for use in the field of cardiac arrhythmia. More than five million patients globally suffer from a trial fibrillation, the most prevalent cardiac arrhythmia that impairs patients’ quality of life and ultimately causes stroke and heart failure. Percutaneous catheter ablation is an emerging curative therapy that allows patients to resume a normal life and reduces healthcare costs. In 2005, around 1% of patients were treated by percutaneous catheter ablation. Endosense’s Force Sensor ablation catheter has the potential to increase the uptake of this treatment by improving the safety and efficacy of the procedure.
IPOs
Because the IPO market has been tough in the last couple of years, the larger private equity funds have not been getting the exits they were expecting. Consequently, they have had to hold back some of their funds to support portfolio companies for longer than they originally anticipated. This has meant they have less cash (and management resources) to devote to early stage companies.
This has had a knock-on effect for the smaller funds that aim to provide early stage finance and whose business model was based upon the premise that the early stage fund would provide seed money and lead a series A round before handing over to one of the bigger funds to lead the series B round. But these larger funds have been driving down valuations such that early stage investors cannot really justify supporting early stage companies. Angel investors who provide seed money are being squeezed in the same way.
But recently the European IPO market for biotech has been going from strength to strength and so a more benign IPO environment may lead to the bigger funds starting to sniff around for series B opportunities again.
Rainer Strohmenger of Wellington Partners says: “There have been more biotech IPOs in Europe than in the US according to Biocentury. So you have at least an equally liquid exit market, and in addition data clearly shows that you buy cheaper in Europe.”
But the stock market is not only being used as a route to exit. Andrew Fraser says: “Realistically now, we can view the IPO market
as a fund raising tool for our portfolio companies and not just look at it as a means to exit. We tend to look at the IPO as another funding round and can be fairly flexible as to how long we stay in.” He cites portfolio company Paion as an example. Paion was the first company to list on the Prime Standard (after the Neuer Markt’s revival in 2005), achieving a capitalisation of €126m. Paion is developing innovative drugs for the treatment of stroke and other thrombotic diseases. 3i was one of the early investors in Paion 2000, backing the company with €8m in its first round. Fraser says: “3i still holds a stake in the business because Desmoteplase could be a really significant drug in stroke.”
Another example of using the stock market as a source of capital was ProStrakan’s float on the London Stock Exchange in June last year. Fraser says: “ProStrakan is a totally different animal to the typical life sciences business. It has a growing revenue base and a commercial focus. We’re quite happy to watch the share price at the moment.” The company raised around £40m at its float. Warburg Pincus, LMS Capital and 3i invested in a £30.5m funding round in the company in mid-2001, and followed that on with two further funding rounds in 2002 and 2004. At the time, the funding represented one of the largest healthcare private equity funding deals in Europe.
Paul Claydon of Mofo says: “The funding gap in this sector used to be pre-IPO. Now AIM is becoming your D round. Companies listing on AIM are still cash burning.” He adds: “The funding gap now has become the seed round. There are a lot of business angel-type organisations who want to back these businesses, but the difficulty is they don’t have enough money to support these companies”.
Returns
With certain biotech-focused funds on or about to embark on the fund raising trail, the focus at the moment is on exit opportunities. Most players agree the lack of appetite for seed is mainly due to the fact that most VCs in this space are focusing on exiting portfolio companies and having to put in more rounds than would be the case normally.
Iain Wilcock at Quester says: “The onus in many funds is still on capital preservation. In general more capital than expected has had to be deployed to support promising companies and the average investment period has increased, which has depressed returns in funds that were raised around 2000. Many LPs are keen to see evidence that fund managers are effectively managing these earlier funds.”
He adds that the shift in investment focus towards expansion stage investments is because European biotech is a maturing sector and investors wish to see earlier evidence of success. “It is a sign of the changing attitudes of LPs that early stage fund managers are focusing more now on product rather than platform in an attempt to improve investor returns.”
Quester has had a good run of exits in the space in the last few years. Wilcock says: “Over the last three years, we’ve not been immune to the lack of attractive healthcare exit opportunities that have presented themselves. However, we recently had a very good exit in Glycart, which was a very significant cash exit, which has obviously helped our LPs’ confidence and is proof that it is possible in Europe to create a valuable business and successfully exit. We need now to focus on repeating this with other companies in our portfolio.”
Glycart, which won EVCJ’s Venture Realisation of the Year: Life Sciences award in 2005, is headquartered in Zurich, Switzerland and was founded in 2000 when it spun out of the Swiss Federal Institute (ETH Zurich). Novartis Venture Fund provided €2m seed funding in 2001, with a series A round taking place in November 2003, which raised CHF18m led by Global Life Science Ventures and co-led by Gilde Investment Management. Novartis also returned to this round and new investors included ABN AMRO Ventures, BioMedinvest, DVC Deustche Venture Capital and Quester. The business was sold in July 2005 in a €152m deal to Roche, the Swiss drugs company. At the time of the sale, Glycart had three biotech cancer drug candidates in pre-clinical trials and had developed technology to enhance the efficacy of antibodies. Not all shareholders disclosed their returns, but Novartis generated a 7.5 x multiple, Quester a 5x multiple and Gilde a 6.9x return.
Quester is continuing to support developing companies such as Oxford Immunotec, an international clinical diagnostics company that develops and sells clinical diagnostic products, and Xention, a drug discovery company focusing on ion channels to develop effective drug candidates for underserved disorders. Wilcock said: “We are very pleased with the way our portfolio companies are developing. Xention, for example, raised third party money at the end of last year, a good series B round to back up our series A.” Xention closed an £11m series B financing from new investors ABN AMRO Capital, which led the financing and Crédit Agricole Private Equity (CAPE), and existing investors Albany Ventures, BTG International, Enterprise VCT plc, Isis Equity Partners, MVM and Quester all participated in the round alongside the new investors.
Seed
Quester is probably more active than most in the seed sector for biotech through its involvement with various university seed funds. Quester manages seed funds for nine universities, representing approximately 20% of the UK academic sector, by research expenditure. Among these are the ISIS College Fund, SULIS Seedcorn Fund and Lachesis Fund.
Wilcock says: “On average, we complete a seed investment every two to three months in our university-related funds. Through these seed funds we find some very good opportunities to make early stage investments. A recent example is Haemostatix, a drug design and development company. Quester made a seed investment 12 months ago. That way we were able to do extensive due diligence at the seed stage and so had significantly more confidence when investing at the series A stage earlier this year. Investing in this way significantly improves our decision-making process. It is like an extended due diligence process.”
Another example of a recent Quester seed investment is Lectus Therapeutics, a drug discovery and development company focusing on next-generation ion channel modulators, which spun out of Bristol University. Lectus won seed funding 18 months ago through the SULIS Seedcorn Fund, which is managed by Quester. In February, Sofinnova Partners and Quester co-led the £8.2m series A funding. Unusually, this company has also secured funding from Takeda Pharmaceutical Company and Astellas Pharma, two leading Japanese pharma groups.
Wilcock says: “We have a good flow of deals on the seed side. Resources are precious, however, and making seed investments, then moving to series A is a pretty resource-intensive business and so we have to be selective in what we do.” He adds that the quality of spinouts from universities is improving: “A few years ago very few VCs would have wanted to work with universities in the way we work, but we have seen a significant change in the way the universities handle their IP. Another advantage is we get a good academic network, which gives us a further insight into the businesses.”
Later stage
Venture firms investing in the biotech space are increasingly looking to the US to fund their investments in the later stages and this may be another reason for the drop in European investment at this stage. 3i has been actively promoting its US investments and Quester also mentions the importance of looking Stateside for further funding. Wilcock says: “Internationally, looking further forward, we see the US as a source of capital. We’ve definitely got some companies at the moment in clinical development looking to raise between £20m and £30m to get to phase 2 and for this you really need to look to the US. There just isn’t sufficient capacity in Europe at this stage and it’s doubtful that this type of risk can be financed on AIM.”
Charles Waddell of law firm Dechert agrees: “There is a steady flow of companies over to the US where the funding market is more benign. We recently acted for Xytis Pharmaceuticals Ltd, an Atlas Venture-backed company.” Xytis is a UK company with operations in Switzerland. Xytis is assembling a pipeline of pre-clinical and clinical innovative compounds with novel mechanisms of action addressing major unmet needs in the fields of schizophrenia, depression and traumatic brain injury. In January 2006, it merged with a US company Remergent Inc and raised US$24.5m in a series B private equity round.
Fraser comments on 3i’s investment strategy in terms of its links with the US: “We are typically targeting deals that are a little different and match our own international footprint. We are not just looking at technology, but also the potential to stand alone and for geographical market reach. One of the biggest medical US device deals in 2005, Small Bone Innovations, which was co-led by 3i, has key operations in the US and France. US-based Transmedics, which is developing a breakthrough technology to allow a living organ transplant, has just initiated the first clinical trials of the system in Germany and the UK. The transatlantic nature of the 3i business and expertise means it is possible for 3i to bring an international dimension to its investments, while many life sciences venture firms can be rooted in their local market geography.”
There are 11 members of the 3i healthcare team in total including three in the UK, three in Munich, two in Paris and Stockholm and three in the US. Fraser says: “Over the past three years, half our deals by number have been in the US and half in Europe. We had quite a deliberate shift in strategy to achieve this and made a conscious decision to increase our exposure to the US.”
The main concern in the biotech sector as ever remains at the seed stage and where the funds for start-ups are going to come from to create the companies of tomorrow. Ian Dixon of PricewaterhouseCoopers says: “It’s a very cash-hungry sector and these companies aren’t generating any cash on early
deals. The time lines to get a product to the market can be very long indeed; it could be 10 years easily. There’s a huge demand for cash, but equally for an investor it’s a long time for an investor to be committed. I think early stage companies now are scouting round to get funding wherever they can get it whether it’s angel money or soft money from grants, which means that many of them are very much living hand to mouth.” He concludes: “I worry for that part of the sector. It does worry me how those ideas are going to be financed and where the successful companies of tomorrow will come from.”
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