In today’s health care finance environment, early financing rounds are harder to fund and the market for initial public financings is dead, with no revival expected anytime soon.


This was the consensus of a Wharton Health Care Business Conference panel that looked at the “brave new world” of health care financing in 2003 and 2004. The conference, held last month in Philadelphia, focused on changing dynamics within the pharmaceutical, biotechnology and medical devices industries.


The downturn in biotech financing since the boom of 1999 and 2000 is a necessary and healthy correction, said panelist Katherine Wolf, managing director, health care banking, at Bear Stearns. “It is a bit of a bitter pill, but will bode well for all of healthcare going forward, particularly biotech and medical technology.”


On the positive side, the panel noted that while early round financing is difficult for start-ups to get, those that do receive backing are starting at higher levels. In addition, secondary offerings are beginning to pick up. And while overall venture investment fell 44% in 2002, healthcare took an increasing share, accounting for 27% of 2002’s investment compared to 17% in 2001, according to Ernst & Young’s Venture Capital Survey.


Total healthcare venture investment declined from $6 billion in 2001 to $5.2 billion in 2002 – a 13% decrease – although Ernst & Young said that was “negligible” compared with declines of 48% in the information technology sector and 60% in products and services. In the fourth quarter, healthcare investment was up 4% to $1 billion, with gains in medical information systems and devices offsetting a drop in biopharmaceutical funding.


Sense of Paralysis

The health care industry, already concerned about the economy, has grown increasingly hesitant with the prospect of war in Iraq, the panelists also suggested. “There’s a certain sense of paralysis taking place,” said Fred Frank, vice chairman of Lehman Brothers. “Decision-makers are becoming more risk-averse.”


“Let’s face it, we can’t make a lot of money in venture capital without robust public markets,” added Jesse Treu, a general partner in Princeton, N.J.-based Domain Associates. “We keep building companies,” but when it comes time to cash out in a public offering, “there’s a log-jam in the river.”


Yet healthcare investors still have money available, choosing to invest it in larger initial financing rounds of up to $50 or $60 million. According to Jonathan Leff, managing director of Warburg Pincus, one force driving larger early rounds is a change in the business model for many biotech start-ups. In the boom years, companies centered their model on providing a technology platform for other companies, often based on genomics. That tactic failed when a glut of companies sprang up and prices for their products and services fell. Those companies are now trying to become full-scale product-oriented companies, like Amgen (the largest biotechnology firm, known for its promising drug pipeline and marketing alliances with a number of pharmaceuticals). Such an approach, however, requires funding for expensive clinical trials.


“That is the model that has led to the billion-dollar successes,” Leff said, “but it is an extremely capital-intensive model.”


Terry McGuire, managing partner of Polaris Ventures, a private-equity firm based in Waltham, Mass., pointed out that while today’s larger first rounds benefit entrepreneurs, he does not see the upside for investors. Look at the numbers, he said: To earn 30% to 40% percent on an investment of $50 to $60 million in seven to eight years, a company would need to reach a valuation of $500 million. “That’s a huge challenge,” he said. “I think it is torturing a company to over fund it and raise unrealistic expectations.”


During the feverish period of biotech investment in 1999 and 2000, executives refused $50 million rounds in favor of lower financings because they didn’t want to dilute their stock, Frank said. “That used to raise the hair on my neck. I’m sure many of those companies now wish they had taken the $50 million.”


With today’s weak public markets, Frank added, healthcare startups need to keep their investors on board for subsequent rounds, because they are unable to access the cheaper public markets as early as they did a few years ago. At the same time, investors are now more likely to stick with investments they already have, rather than invest in as many early-stage companies. “The money is different than it was a couple years ago. There’s a lot of capital out there, but not as much is available for early stage percentage-wise as [before].”


The Biotech/Pharmaceutical Partnerships

Financing for biotech and medical device firms remains intertwined with large pharmaceutical companies, but those relationships are changing too, panelists said.


Frank stressed that the nation’s 1,400 public and private biotech companies need vast amounts of capital. If all of them were to push a product through the clinical development pipeline they would need the equivalent of Germany’s GDP. Investors, he said, are not willing to allocate that much.


So biotechs turn to big drug firms, which have a need for new drugs to fill their vast marketing channels, particularly now that many face a dearth of new products coming out of their own labs. As Frank noted, “The pharmaceutical industry is capital long and opportunity short, and biotech is opportunity long and capital short.”


According to Leff, the pace of biotech-pharmaceutical licensing deals is slowing because many of the most promising projects already have been snapped up. Some products will continue to become available as large drug makers merge and spin out compounds that do not fit with their larger strategies, Frank said, adding that biotech firms can use a partnership with a large drug company as validation that their science is important.


Treu pointed out that drug firms have also acted as venture capitalists in the biotech sector to varying degrees over the past 20 years. A few companies have been long-term players, while others step in and out of the role of venture backer. “They tend to start off by investing in funds. Then they figure out they know what they’re doing and they start to make their own direct investments,” Treu said. “Then there is a management change and they decide it’s not strategic and they wrap it into their research and development division. It loses steam. Then they get out of the business. Then it repeats itself in 10 years.”


Wolf said the medical device industry does not have a tradition of spinning out or licensing products, though there have been cases where larger companies bought entire firms for their products. “An attractive option for venture capitalists and entrepreneurs is a sale to a large company. Even though the public markets are shaky we are still seeing attractive valuations for companies with significant medical advancements.”


IPOs Still DOA

But the market for initial public offerings remains dead, panelists said, although some companies are beginning to have success in the public markets with secondary offerings. “That’s a good sign,” noted McGuire, “but not proof of vitality.”


Leff noted that “we are counseling our companies to design business models and spending levels such that they are not dependent on a wide-open financing window anytime soon because we don’t see any signals that it’s there.”


According to Frank, the finance markets are ruled by supply and demand cycles. In the early phases of a typical cycle investors buy companies based on an expected premium – not necessarily the merits of the company. “When the market opens up, the backlog starts increasing at dramatic speed and companies receive a larger and larger premium until the thing eventually reaches a peak where supply will always outstrip demand.”


The medical device industry, Wolf noted, went through IPO boom and bust cycles from 1995 to 1996 and from 2000 to 2001. “Most were not companies – they [had] one product [and] probably should not have gone public.” All but a few are now trading well below their offering price.


“Why did a second cycle occur just five years later?” Wolf asked. “People have short memories,” she said. “Intellectually people know one-product wonders don’t work. But emotionally they get caught up in the hype that is happening at the time.”


Leff predicted that a recent trend toward biotech consolidation will continue as larger companies look to enhance their own pipelines and smaller biotechs hope to leverage a partner’s expertise in regulatory procedure and marketing.


Frank, however, suggested the consolidation will only go so far. Historically an initial wave of consolidation ends when larger, healthier companies grow reluctant to take on troubled smaller firms. In past cycles, Treu added, the consolidation process never fully played out because “every time we come close to a wave of consolidation, the financing window opens up and saves all the CEOs the pain of having to merge with someone else. We’ll see how long this downturn lasts.”


In the past, pharmaceutical companies have been interested in acquiring medical device firms, Wolf noted. “We might see the pendulum swing back. I personally think some of the pharmaceutical companies will start to acquire medical technology companies to make them more diverse.”


She also said consumer products companies, such as Kimberly-Clark and 3M, may become interested in healthcare to boost growth. However, they may not have the stomach for the dilution that would come with acquisitions of medical technology and biopharmaceutical companies.


The panelists indicated that they shy away from investment in healthcare service providers, though a few highly specialized firms do fund service companies. Treu said Domain has done some service investments that turned out badly. “That looks like a hot stove and we try not to touch that object again.”


The investment fundamentals are different, with less possibility of hitting a major breakthrough, Frank added. “With biotech and pharma, you’re talking about companies that can transform their areas of healthcare. That doesn’t happen in the service sector.”


As always, the panelists said, the biotech and medical device industries are innovating and they pointed to some technologies that are receiving financing. In the medical device market, cardiovascular devices, including biodegradable stents, are getting attention, according to Wolf. In orthopedics the focus is on minimally invasive procedures in which surgeons operate through ports into the body, particularly for hip and knee operations.


Treu expressed excitement over discoveries involving arterial plaque that could lead to cures for heart disease, and is intrigued by the intersection of biology and other technologies such as computing and nanotechnology. For example, he pointed to the possibility of using tiny computers implanted in the brain that can detect, and prevent, an upcoming epileptic seizure.


Leff suggested that rna interference, in which rna is used as a mechanism to suppress genetic expression leading to disease, is gaining traction and may fall in line with other biological platforms such as monoclonal antibodies and gene therapy as a way to treat disease. Those technologies have met with varying degrees of success he said, “but rna interference has a great deal of enthusiasm.”


Frank pointed to new technologies that can simulate drug testing, speeding costly research. But he lamented that the market bubble aftermath has caused investors to focus almost exclusively on products rather than new technologies. “The great areas of exploration are platform technologies. Will pharmacogenomics be able to find the right drug for the right person? That stuff’s all getting backwashed now and is much harder to fund.”