Venture Round: Now where's that panic button?

Private equity investors, reeling from a weekend of news that ranged from bad to really bad to really, really bad, met for a group hug this week at the Private Equity Analyst’s annual conference in New York. But there wasn’t a lot of love to go around.

The typical bravado of the private equity world seemed to be in short supply at the conference. IN VIVO Blog was particularly shaken as we wound through the revolving door on the Park Ave side of the Waldorf Astoria. A young, private equity professional—the kind of person who typically reeks of overconfidence—declared simply to his cohorts. “I’m terrified.”

Thus the tone was set.

To be fair, we did hear a bit of “this is good for the industry” talk, and there’s some truth to that. Richard Caputo, managing principal of The Jordan Company, a PE shop, says many of the debt structures that fueled the rise in private equity are as shaky as any of the sub-prime mortgages that are sinking the US economy. Private equity investors will have to go back to doing smaller deals requiring little or no debt, which will require honest and thorough due diligence to assure the acquired companies are worth the dough. “The world has changed and we’re going to have to work harder,” Caputo says. “There is going to be a lot of carnage before it gets better,” adding that in six months we’ll be looking at the “good old days of Sept. 2008.”

But here’s the good news. Health care is a safe haven again.

Terrence Mullen, managing director of Arsenal Capital, says health care companies still are a strong bet. He didn’t elaborate much during the session, but after the meeting, Mullen said the fundamentals of the business aren’t going away. People will get sick. They’ll need to get better, and companies will get paid to provide the products and care. These facts are irrefutable. They’re also word-for-word what we were hearing when the technology industries collapsed eight years ago, forcing venture investors and private equity folks to rediscover health care.

Arsenal Capital isn’t one of those come lately types. But don’t be surprised if interest in health care deals get a little frothy, particularly in those companies (or divisions within larger companies as you can read here) that generate solid revenues.

Given the interest private equity firms have shown in pharma, it will be interesting to hear the feedback at our Pharmaceutical Strategic Alliances conference next week in New York.

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Attendees at the last session on Tuesday had the opportunity to vote on several questions regarding the state of the industry. The polling showed that 79% of the attendees don’t think the credit crunch will break for private equity investors until later next year; 50% say the IPO window won’t open until 2010; and 62% say that venture firms will need to change their investment models in order to find faster routes to liquidity.

While You Were Sipping Mint Juleps

We're not sure it's the 'most exciting two minutes in sports' as the Kentucky Derby bills itself (there were a few minutes in Saturday night's Flyers/Canadiens game that may have qualified though) but it's hard to argue with any sport associated with such a delicious beverage. We've traded our mint juleps for some cava out here in Barcelona, where a few of your IN VIVO Bloggers are attending Windhover's Euro Biotech Forum. We'll try to bring you some updates later this week. Meanwhile, over a quiet weekend in industryland ...

• BMS continues to part with anything that isn't core to its biopharmaceutical efforts. Late on Friday the company said it was offloading its wound care and ostomy care business to a private equity duo for $4.1 billion. Analysts like the price that Nordic Capital Fund VII and Avista Capital Partners paid for the group, and the deal comes on the heels of the announced spin-out of nutritionals group Mead Johnson. We're just eager to see what Bristol's going to do with all that cash. Reuters and the FT have the story.


• Forbes' Science Business blog recaps the state of the Merck/Schering-Plough relationship, and why SGP has a bit of a raw deal. (h/t Pharmagossip)

image from flickr user rcrowley used under a creative commons license

Private Equity Goes Public

One of the simplest metrics we have to measure interest in a company or industry is just how jammed the rooms are at the JP Morgan conference. It's there people can literally vote with their feet...and their elbows and shoulders and briefcases and pepper spray (well, not yet) to find a few square feet to take in a company presentation.

So if an SRO presentation reflects strong interest, then this year will be a big one for private equity and health care. (The entire discussion is available here, btw.)

Last week's Private Equity Panel discussion literally could not have been more crowded with every seat, storage container, alcove and appropriate patch of carpet filled by people eager to hear what four sages from the Private Equity World had to say about their own industry and health care.

The conversation was lively and informative, and since no one left early to hit the cocktail parties (the session started at 5 p.m.) we’re guessing those many in attendance found it useful.

Unfortunately, the conversation seemed more focused on the services sectors. This isn’t a knock on the collective wisdom of Madison Dearborn Partners (represented by Tim Sullivan), CCMP Capital (Steve Murray), Welsh, Carson, Anderson & Stowe (Paul Queally) and Bain Capital (John Connaughton). All are well-heeled firms led by brilliant folks. But the firm we really would have liked to hear from was Warburg Pincus.

WP’s sweet spot seems firmly in line with our own: biopharma, devices and everything in between. Of course what moved us to write this is this week’s announcement that Warburg Pincus would spend $239 million to acquire Lifecore Biomedical Inc. The announcement came just after last week’s panelists suggested the criteria for “take private” would be much higher than last year, resulting in a slow down of such deals. “I think the vast majority of the deals done in the last 18 months will have very disappointing returns,” says Queally. “Risk was mispriced throughout the system. So I think it was a great time for public equity investors but not so good for private investors.”

But the panelists drew an important distinction. Murray says transactions aimed at taking a company private “because there was the availability of cheap financing and the other parts we’ll figure out later” will be scarce. But those firms with a plan to turn around or advance companies that have a strategic fit will still happen.

Warburg Pincus generally falls in the latter category. Last year, the firm paid $4.5 billion for Bausch & Lomb and invested $75 million in publicly traded Inspire Pharmaceuticals Inc. In 2006, Warburg Pincus secured a deal with French Orthopedics company Tornier.

IN VIVO Blog expected big things from the private equity industry in 2007 following the Biomet acquisition in 2006. (See our look at the new Biomet here.)


At first, the results were disappointing. Overall private equity dollars being used to acquire device companies dropped from 2006-2007. But the drop seemed far less significant when you realized that 2006 consisted mainly of the Biomet deal while 2007 figures were made of up of several smaller deals, including the Bausch & Lomb acquisition.

What’s going to happen in 2008? The panelists predicted a slow recovery as the private equity industry tries to digest all the companies consumed during the all-you-can-eat-affair of 2007. But we’re a little more bullish on the life sciences front. Warburg Pincus will still find deals. Meanwhile, firms like Avista Capital are identifying spin out opportunities from larger firms like Bristol-Myers Squibb and Boston Scientific. In fact, 2008 is starting with more than $1 billion in private equity acquisitions since Avista’s two deals didn’t close until this month.

Life sciences companies will probably draw much attention from the folks on the panel. “We will not take drug discovery risk,” says Connaughton. “But we love to build companies that help biotech and small and large pharma develop their drugs. But we do not want to take drug discovery risk, we're not smart enough.”

But then again. “We’ve done diagnostics, device and pharma,” says Queally. “It’s almost the nature of the company as opposed to the specific sector. In other words, is a company is going through dislocation? Is it maturing? The device industry over the past few years has matured to the point where they are trying to optimize a portfolio. Pharma is trying to figure out how to focus. All those things are things we bring to the table. If we can get those companies at appropriate valuations we can bring some value and generate some good returns.

“There was a time 10 years ago where every single device or pharma company was trading at 15 times,” he continued. “It’s very difficult given that leverage is a piece of our capital structure to garner that kind of return. But now they have come down and are going through dislocation. I would see a lot of opportunities in upcoming years.”

Well, this would explain why the room was so crowded.

New Year's Resolution 2008: Create Infrastructure Strategy

It’s January 2 and so, in case you haven’t already settled on your New Year’s resolutions, we’d like to suggest one: figure out your infrastructure strategy.
A good place to start is with the number of people you need to do the job you’re in business to do. Since you will always have failures, you need a minimum number of programs to achieve a minimum level of return. Once you’ve figured that out, staff to that number of programs.

The problem is determining when a program achieves its minimum level of success. To answer that question, we’d ask another: for what are you looking to get paid?

As it stands today, companies can get paid -- pretty well, too – for doing a variety of jobs: creating INDs, for example (like Plexxikon); or getting a compound through proof-of-concept (like Exelixis or Vertex); or taking a product from Phase II to approval (like New River). It is by no means always necessary to do all of these jobs -- and therefore no need to staff them.

Think about the drug business like professional sports: the same guys who play in the NBA aren’t ever likely to qualify for Wimbledon; and none of them are likely to end up playing for the New England Patriots or worrying Tiger Woods. The physical requirements are different from sport to sport. And where they’re not, the training and focus required to perform at a high level in any one sport usually precludes excelling simultaneously at another.

The real question is to figure out what game you’re playing – and which team you need to play it. Presumably, you’ll need different players for the IND game than if you play the Phase III game. And you’ll need different numbers of players for each game.

Most Big Pharmas, thanks to tradition, feel they need to play all the games and therefore staff themselves to compete in each. But in fact they have traditionally played only one game – the commercial game. The only way a Big Pharma wins is by launching a product successfully (remember: what you get paid for doing determines which game you’re playing).

In terms of infrastructure, therefore, Big Pharma is playing at a huge disadvantage. The math goes something like this: to get one discovery compound to Phase I, you need to start with about eleven programs – and by the time you’ve gotten your one successful compound into Phase I, you’ll have spent $23 million in cash, without adding any capital or opportunity costs. (See a more in-depth analysis here). Infrastructure: 50-75 people.

On the other hand, to be relatively sure that you’ll get one discovery program all the way to market, you probably need to start with more than 100 programs – or a discovery cash outlay of more than $200 million. Rough estimate: 500 – 750 people. That math works, incidentally, only if discovery infrastructure is scaleable – that is, if ten times the people can actually do ten times the work. Given discovery’s requirements for rapid feedback and a certain anti-bureaucratic creativity, it seems more likely that at some point, the larger the discovery organization, the less productive it is.

In any event, in the worst case, if you’re making your money at Phase I, you need just one-tenth the discovery infrastructure you need if you’re not getting paid until a product reaches the market.

Same logic with development. If you’re getting well paid by a licensee or acquirer for moving a compound from Phase I to Phase III – not from Phase I to the market – you need fewer compounds to succeed because you don’t have any FDA or launch risk in your business. Fewer compounds, fewer employees. Nor do you need the same kind of infrastructure our discovery-focused player required. You need a different kind of infrastructure for finding new compounds to develop.

For this logic to work, you need to get paid, on a relative basis, about as well for doing a more focused job as for doing the traditional soup-to-nuts work of the traditional Big Pharma. And in fact you can. Phase II compounds now generate upfront licensing fees of $70 million and up – with royalties in the high teens or higher (and there is an increasingly competitive marketplace of companies willing to buy out those royalties, in case you want your returns right away). Domain Associates has done well for itself in-licensing a Phase I compound or two, wrapping a company around it, and hiring no more than a dozen people to manage the compounds’ development, largely through a network of CROs – then selling off the result at huge profits to J&J (Peninsula), or Forest Laboratories (Cerexa), or Merck (NovaCardia).

You can argue how repeatable those models are and therefore how much additional infrastructure you might ultimately need. Celtic Therapeutics – the new follow-on private equity fund building on PE predecessor Celtic Pharma (see here and here, for more) – figures that Domain’s math of onesies and twosies won’t work consistently. Given standard clinical failure rates, Celtic is thus amassing a larger portfolio of projects for which they’ll need a larger number of managers. But because Celtic is focusing only on later-stage development, it will still only need a relative handful of workers (20 projects = about 65 people, says Celtic managing director Stephen Evans-Freke).

We admit that we are oversimplifying the infrastructure debate to make a point. There will be companies who do multiple jobs and will require multiple infrastructures. A Big Pharma might be able to get paid for Phase I to Phase II primary-care development (e.g., Bristol-Myers Squibb’s deals with AstraZeneca and Pfizer) and simultaneously get paid for launching new specialty medicines… or vice-versa. There will be Big Pharmas who can create INDs and get paid – in cash or kind – for distributing them to development partners (Lilly is doing something like this with its Nicholas Piramal relationship).

But the key will be figuring out which jobs you can consistently get paid for. And then to stop doing the jobs – and thus hanging on to the related infrastructures –you’re not getting paid for.

Another Look at Asia

As a small follow up to our post last week on Sofinnova Partners' hiring an Asia-focused professional, VentureWire Lifescience reported this week that Canaan Partners added a principal whose partial duties include finding deal flow from Asia.

Mickey Kim will from Canaan's Westport, Conn. office. He joined the firm in July according to his bio.

Mickey joined Canaan from Pacific Point Ventures, a venture capital fund investing in healthcare infrastructure companies in Asia. Prior to co-founding Pacific Point Ventures, he invested in biotech and medical device companies at BioVentures Investors, including ActivBiotics, Applied Spine Technologies, Cylene Pharmaceuticals, Hydra Biosciences and Sciona. Mickey also served as a strategy consultant at McKinsey & Company and CSC Healthcare, and co-founded an Asian technology venture capital fund.

Canaan doesn't appear to have any health care portfolio companies in Asia at this point. It does have two IT-oriented deals in India.

No doubt there will be more news like this to come.

While You Were Packing for New York

A few notes from the weekend that was. We hope you had a good one. Several of your resident bloggers will be converging on New York this week for our Pharmaceutical Strategic Alliances conference (remember, UBS isn't the only game in town this week!). Hope to see some of you there. Stay tuned to IN VIVO Blog for a few updates from the conference on Wednesday and Thursday.

• Profit up but care down at many PE-backed nursing homes, says the New York Times in a Sunday feature.


• Pfizer gets maraviroc approval in the EU--here's the early morning release--and Novartis gets an EU OK for its transdermal Exelon mild-to-moderately-severe Alzheimer's disease patch. Both approvals were expected.


• The WSJ is the latest paper to take a gander at GSK's slightly unusual CEO succession contest, while the FT wonders who will replace Jon Symonds as CFO at AZ (hat tip, Pharmagossip).

Why Financiers Like Virtual Companies

Capital hates a vacuum.

In this case, the vacuum is Big Pharma’s late-stage pipeline. As deal prices rise for post-proof-of-concept products, investors and clever packagers of financing are stepping into the financing void which, at least relatively speaking, opens up pre-POC. For more on this, see our analysis here and here.

Take Drug Royalty. It’s made a good business monetizing royalty streams from approved products but now is moving upstream, looking to package still unapproved products on which they’d take a percentage of future revenues.

Or Morgan Stanley. Its PhaRMAs (Pharmaceutical Royalty Monetization Assets) likewise package a set of development-stage products into a debt security. The earlier-stage the assets, or the smaller the portfolio, the higher the interest rate. But for the issuer—the biotech with the products--the return is capped: once it’s paid off the investors, the biotech gets all the upside.

It isn’t just biotechs, like NPS and Alkermes, which are exploiting Morgan’s PharMAs. Morgan also used its security idea to place $150 million in mezzanine debt for private-equity firm Celtic Pharma – essentially an investment management team, funded by a set of limited partners, which has acquired a set of eight projects from various biotechs.

Despite its financial structure, Celtic looks a lot like a virtual biotech, exploiting a network of consultants and CROs to get its products developed. And like other virtual biotechs, it has no intention of creating any sort of sales force. The point is to serve the needs of investors, the supreme anti-infrastructuralists.

Most of these investors, usually hedge funds and insurance companies, want “alpha” from these kinds of investments – in this case, a return uncorrelated with major public markets like equity, debt or real estate. Since Big Pharma buys rights to these products regardless of what the markets are doing, they theoretically should provide plenty of uncorrelated return. But once a product is wrapped in infrastructure—into a real company, with an HR department, office politics and an investor-relations group—then its returns begin to correlate with the equity markets.

And the reality is, says Celtic’s founder Stephen Evans-Freke, products are worth more “without the companies wrapped around them.” Big Pharma, he says, needs “more fixed costs like a hold in the head.” And once there’s infrastructure, companies have social and economic incentives to keep working on programs which should be killed. For investors, the faster a developer kills a drug that’s already fated to die, the better – money, being fungible, can be applied elsewhere. Less easy to do with employees.

“The only reason to wrap all that corporate infrastructure around these projects it to take them public,” says Evans-Freke – who, in his days at PaineWebber or in founding companies like Sugen, found plenty to like about IPOs.

And there are indeed other virtues to owning infrastructure. Discovery doesn’t get done without it, for one thing. Happy accidents—like discovering an alternative use for a drug, for example—would be less frequent. It’s hard to think Genentech could have happened without enough R&D infrastructure to figure out which biologies made a difference.

But the virtual is also now real—and investors like it. The development is another unintended consequence of Big Pharma’s earning-driven appetite for variabilizing its costs, creating a vast and technically expert world of CROs and consultants available for anyone to hire. Whether that’s a good thing or not for Big Pharma (and we think in general it’s a good thing—another way to get products), it certainly has opened up a new way for disenchanted pharmaceutical investors to stick with the industry.