Why LPs may be giving health VC another look

Health VCs: Desperate...

As a tech VC recently told me, refuting the latest flimsy rumor of a huge tech-dominated fund contemplating significant new investment in life science, "Wow, you healthcare guys are really desperate for some good news!" 

It's true; not only are LPs looking ever more critically at VC as an asset class - especially since the publication of the Kauffman report - but the life science sector, in particular, has been devastated, and health VCs have been hurting.

Part of the issue, as Bruce Booth and Bijan Salehizidah have described previously, and as Sarah Lacy summarized nicely this week in PandoDaily, is that the return profile of life science venture investments looks very different than tech in general, and consumer web (the focus of Lacy's article) in particular. 

The sex appeal of tech investing is that a relatively small initial investment can blossom very quickly to yield huge returns; the catch, of course, is that this happens very rarely, and much like at a casino, and the tremendous attention lavished upon these winners can almost make you forget how infrequently they occur.

Life-science investments, by contrast, tend to be very different in nature - it traditionally takes a long time and a lot of money (especially vs consumer web) to reach a value inflection point, and even then (i.e. at early clinical stage of development), you usually only get a fraction of your potential value given (a) the large amount of undischarged risk that remains, and (b) current market dynamics, which generally favor the relatively few, deep-pocketed buyers rather than the comparatively large number of sellers, in large measure attributable to the inordinate time and cost of most late-stage drug development.

Some have suggested that venture funding isn't really suitable for the product development cycle in the life sciences, and that it's really geared towards tech applications where a relatively small amount of venture funding can quickly and adequately propel a concept to the point when you can tell whether it's going to work.  Product development times in biopharmas, by contrast, are far longer.

However, with the evolution of ultra-lean, capital-efficient biopharma startups (and virtual startups) targeting compelling indications of interest to regulators (highlighted in recent PCAST recommendations), an influx of capital available from corporate (generally pharma) VCs, and the legitimate possibility of a (somewhat) early liquidity event of some kind (rarely via IPO, more generally via aquisition by a larger biopharma), a path forward just might be possible.

What are the data suggesting that LPs have decided to give life science another chance?  As far as I can tell, the evidence consists of:

(1) This recent article from Reuters, reverberating on Twitter, pointing out that several healthcare funds are out raising money, and that venture investment in biotech in 2011 was higher than 2010.

(2) A recent report from an accounting firm (press release here, nice summary from FierceBiotech here) reporting an increase biotech R&D spending and hiring in 2011 compared to 2010; most of this is occurring in the large biotechs - the small ones report a slight continued contraction.

In other words: 2011 was less bad than 2010 - and it's always pretty easy to fit a trend line to a pair of data points.

... But Also Serious

While I'm not yet convinced that LPs have really had a change of heart and decided to embrace life-science, and healthcare more generally, I believe that the VCs managing to raise significant funds today have an excellent chance at superior performance, especially if they move beyond life science and embrace digital health - or rather, digital medicine (a distinction I first heard from AliveCor founder Dr. David Albert).

As Lacy - one of the Valley's leading tech journalists (see here for a particularly outstanding example of her work) - astutely (some will say unfairly) observed, much of the activity in "digital health" involves creation of fairly trivial apps or other enterprises that could fairly be characterized as "consumer web."  

While some of these approaches may be impactful, most seem to lack a measure of gravitas and rigor, as I've argued previously - see here, here, here, here, and here, and references therein. 

It's just possible that "Pandora for cats" may ultimately prove less compelling than solutions for patients.

There would seem to be an incredible opportunity for the serious application of emerging technologies to healthcare, in a ways that seek to engage rather than circumvent the healthcare systems and its many stakeholders.

The fundamental issue, to my mind, is that most tech funds, and especially funds focused on consumer web (to continue with Lacy's premise), are scared to death of getting enmeshed in a system with which they are unfamiliar, but which is laden with risks they accurately perceive.  Most tech VCs I know would love "to do something" in health, but in practice find it very difficult to convince themselves it's worth it to pull the trigger - especially for opportunities embedded within the healthcare system and thus outside their traditional comfort zone.

The best digital medicine investors - as I continue to argue - are likely to come not from the tech world but from the healthcare world, and have deep experience in medical products (either drugs or devices).  Such investors are likely to have the best understanding of the complex interactions and needs of the various players, and to best appreciate the current pain points - as well as the emerging problems to be solved, as physicians, patients, payors, and medical products companies struggle to adjust to a rapidly-changing world.

I appreciate the appeal of a mixed health/tech fund (an approach Lacy rejects), and Bruce Booth has presented data suggesting that historically, biotech investments made by diversified funds exceeded those from healthcare-only funds.  If a health-focused VC is contemplating technology-oriented investments, the in-house tech expertise - and education of the health team - would seem helpful.

In practice, however, I can easily imagine the tech expertise coming from other, tech-oriented VCs - in which case the diversification would be achieved at the board level, rather than at the level of the individual investor.  This assumes, of course, that tech VCs would be willing to invest in such health opportunities - though I'm hopeful that energetic participation in digital medicine from a resurgent life science VC investor base could provide useful reassurance.

This is an optimistic picture, to be sure, but one that offers exceptional upside, tremendous reward - for the LPs who embrace this vision, for the VCs who execute upon it, for the entrepreneurs who drive it, and especially for the patients, who ultimately stand to benefit from the offerings of entrepreneurial companies created by a thriving healthcare sector.

 

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David
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