Above The Line Of High Risk

By Wayne Koberstein

If life sciences investment is a balancing act, its gravity has shifted, according to Phyllis Gardner, M.D., partner at Essex Woodlands (a healthcare VC and growth equity firm). “Right now, high risk doesn’t mean high reward, and people are afraid of high risk,” she says. Dr. Gardner has a well-founded perspective on the matter: besides her work with Essex, she is a full-time professor and previous dean of education at Stanford and a former head of research at Alza. She was instrumental in the creation of the technology that led to Alza spin-offs Duros and Zosano, helped found other companies, and continues to serve on several boards. She mentions that her connections to the life sciences industry are even familial; her husband, Andrew J. Perlman, was a developer of Nutropin at Genentech and top executive at Tularik and other start-ups. Gardner coholds patents in molecular diagnostics and did fundamental research in cardiology. She has been in academics and business long enough to see life sciences funding go through more than a few swings of the pendulum.

Gardner speaks with authenticity on the current funding gap for start-ups, the effect of the economy on investors, and the switch to more risk-averse funding strategies as demonstrated at her firm. She also offers some practical advice to company leaders who must somehow finance development of their platforms and products despite an ever-shrinking investment bandwidth.

Innovation Lost?
Although life sciences investing has rebounded from the past years’ doldrums in some sectors, especially agriculture and diagnostics, PwC reports a continuing decline in first-time deals in 2011. Also, recent gains in other forms of investment have occurred mainly among large, established biotechs that have spent most of the money on stock repurchases rather than R&D, according to Ernst & Young.

That means the weakest sector for VC investment is the one Big Pharma is counting on to save it from expiring patents and poor R&D productivity start-ups with new, innovative therapeutics. Even as average deal value goes up, the number of deals falls. Another key source of life sciences funding, the U.S. government, also faces severe cutbacks.

No one knows how many breakthrough opportunities will be lost in the gap between what small companies need to develop their products and the dwindling reserves of nondebt financing. The funding gap is also reflected in state universities, which must turn increasingly to exclusive research arrangements with pharma companies as their public funding falls, a trend that troubles Gardner.

“I believe in investing in education, infrastructure, research, and new technologies, and insomuch as the government pulls back from that, it does so at its peril,” she says. “The state university systems are being squeezed to death, and that is absolutely crazy because they are the source of tremendous long-term growth. Am I worried? Yes, I’m a little bit worried.”

Big Pharma is reacting to the situation by capturing early stage technologies while cutting back on late-stage risk, leaving small companies to carry the burden of clinical trials and NDA (new drug application) filing. Thomson Reuters confirms that large companies are even trimming their own clinical trials and organizations along with late-stage deals as the Phase 3 failure rate continues to climb. Thus, the funding gap is most acute in clinical development.

“A lot of venture firms used to invest in Phase 2, and if you got to Phase 2, the Phase 3 would be snapped up, and nobody is snapping up Phase 3 drugs now,” Gardner says. Nor, she adds, is anyone picking up the slack in the earlier stages. “The firms are also leery of early-stage investing because right now the trend is for some early investments to be down rounds that wash out with the investors, and you lose all your money. When you do an early investment, you look for a quick exit through a merger and acquisition or even a potential IPO.”

Companies that do find investors to fund clinical development often deal with unrealistic expectations about the resources and timelines necessary for NDA-required trials; not all VC analysts have the depth of operational experience of Gardner and her peers at Essex, such as ex-Pfizer exec Karen Katen and former FDA head Frank Young.

Regulation adds another layer of risk beyond economics. “FDA really has its own problem with risk aversion,” says Gardner. “First, that is because of the agency’s tremendous turnover in personnel, so you get an FDA that changes its requirements on you after you’ve done the trials, despite having earlier FDA guidance. They don’t have the tenure to have the experience or memory to deal with this the way they did. So, the only thing predictable about FDA is its unpredictability.”

She puts some stock in future reduction of clinical-development risk through better trial designs, probability modeling, statistical analysis, and drug targeting to reduce safety and efficacy-related failure. A rebound in political support for regulatory resources would also help.

At the heart of the funding gap, however, is the overarching downturn in the global economy, Gardner observes. “With the market having plunged, limited partners having lost lots of money on the market, and the losses of state pension funds and private funds people were spooked. So ventures are highly risk-resistant. When the economy comes back, people start to relax and put more money where it isn’t just safe, but has the potential for high risk and high reward — the traditional venture investment. But right now, high risk doesn’t mean high reward, and people are afraid of high risk.”

Equity Rebalance
Gardner says that surviving investment firms—those that did not wash out in the economic plunge—have reduced their risk burden by shifting their portfolios toward so-called above-the-line or “growth equity” deals. Although her firm, for example, still maintains a large venture fund of more than $300M for pure start-ups, it now aims to make two-thirds of its total investment in growth-equity companies, defined by Gardner as “a company that has revenues and is profitable or would be profitable if they weren’t plunging its equity into growth.” That change would essentially reverse the former proportion of venture versus above-the-line investments in the firm’s portfolio.

Gardner says her firm looks for companies “where there is a lot of growth, either organically within the company or inorganically through acquisitions. We put the money in to help them with that growth. And, we seek a value inflection to the growth in the near term, such as an acquisition, in a couple of years.”

A growth-equity company must be profitable already, so “if you put in some money, it will grow,” either through organic or inorganic growth. “Organic growth is to add a sales force or increase product distribution, and of course inorganic is through acquisitions.” Essex looks for a 1.5 to 2 times return “in a reasonably short time.”

A historic case of growth-equity in the life sciences industry is Cetus, which sold traditional chemotherapeutics while it developed biotech drugs such as interferons. “Let’s say you are developing a novel drug but at the same time, you are creating a profit or an income stream through selling some generics, and you use that to bootstrap the development of your novel drug, which hopefully once it’s approved, will take your valuation a huge step up.”

Gardner gives an example of a growth-equity investment. “We have invested in a tools company, CellBiosciences, and the company is growing internally, expanding the product line, and it is acquiring other small tools companies. Its current revenues are in the sub-$100M range. Tools companies, often when they get to $100M, are acquired by the larger ones. So, the company does both organic and inorganic growth until its revenues get to an acquisition point.”

Strict Selection
Start-ups pure research companies with no commercial or licensing income face huge implications as the leading firms like Essex tilt toward growth equity: One, far fewer of them will secure venture funding. Two, the selection criteria for venture recipients will grow much stricter. Some ventures may want to consider going “above the line” by acquiring a product line.

A growth-equity company must be closer to fully integrated than the usual start-up, venture candidate, at least if its profits come from recurring rather than nonrecurring revenues, according to Gardner. “One way you can make a profit is by doing licensing deals that are continuing. There is always more than one way to skin that cat, but the easiest way of course is sales.”

Gardner and her firm have even more specific criteria in mind for venture candidates. “We are very leery of one-shot-on-goal products or technology. We tend to look for platform technology that has broad potential with very clear-cut applications, and obviously at least one of those applications is moving forward.” She points to an Essex investment in Molecular Partners, which also recently received funding from Allergan for its initial product, an anti-VEGF (vascular endothelial growth factor) agent for AMD (age-related macular degeneration). The company’s platform technology is a unique way of targeting biological molecules based around ankyrin repeat proteins. “It’s novel; it’s very terrific science from a European company, and it has clear-cut possibilities for products that will meet major unmet medical needs.”

Gardner also lists the quality of a prospective company’s management as a key criterion for investment. “We want to get to know management, to get the sense that they are experienced and very honest and realistic. We see some management teams that don’t understand the incredible difficulties of working your way through the development maze, and we want a management team that can sail a steady course and not change directions so often it’s like riding the rapids. Will they be able to do it, or will they crash quickly? That is extremely important — as well as their ability to use funds wisely.”

A third key criteria is the company’s IP capability, Gardner says. She allows, however, that along with the need to have solid IP is the necessity to avoid squandering resources on endless patent litigation, especially internationally in countries unlikely to become important markets. Again, she says, finding the right balance comes back to a matter of management.

“There are so many pitfalls, and in the end, that’s what makes a good management versus a bad management — the ability to feint and dodge the bullets. That is why people invest in people, because they can quickly change their strategy if things start to go wrong. It’s really about somebody in charge saying, ‘Oh, oh, we have to switch strategies quickly,’ and making the sell quickly to investors. How many companies have you ever seen absolutely end up doing exactly what they said they were going to do the first time? Most of the time they don’t. That’s all about what management does, and once again, if it were easy, everybody would be a CEO!”

Stopgap Models
Gardner is practical-minded enough to accept the shift to growth equity as necessary and valid in today’s economy. But, she continues to be concerned for the future of innovation if the funding gap for start-ups lingers too long. Meanwhile, she expects that such companies will turn increasingly to nondiluted financing through foundations such as Bill Gates or non-NIH government funding. She cites Iomai and EluSys as two companies that have been mainly financed through large government contracts.

“Necessity breeds invention. It used to be easy if you had a great idea to just go get money from a venture; now it’s not. The hardest part right now for early-stage companies is to get either venture funding or angel funding, because the so-called angels have learned that through subsequent financing rounds, they’ll get washed out. Ninety percent of the time, you’re going to lose all value in an early- stage investment, even if it’s a wonderful investment.”

SOURCE: Essex Woodlands