Drugbaron Blog

February 28, 2013 comments

Venture Capital 2.0

Innovation is the life-blood of venture capital.  Whether the innovation is in marketing, business model or the product itself, the principle of venture funding is to identify that novel spark that disrupts markets and delivers supra-normal returns – albeit accompanied by abnormally high risk.

But for an industry focused on innovation, the business model of a typical venture fund has remained remarkably consistent for more than a generation.  The majority of funds today, and for the last several decades, raised a fixed term fund, charge a management fee off the top, and then find exciting portfolio companies to invest in and earn a percentage of the upside that they generate.

Asset-centric investing is only the first step on a road to improved returns for life science investors

Not only is the model pervasive, but the “2 and 20” formula, referring to the 2% management fee and 20% carried interest, has also stood the test of time.  For a limited partner seeking to invest in another venture fund, there is plenty of competition in terms of track record of the fund management but remarkably little in terms of the basic business model behind the funds.

Given the performance of the sector as a whole – across life sciences and tech the median funds scarcely return the money invested after accounting for the management fee – one is forced to ask if there is a better solution.

DrugBaron asks whether the shift to asset-centric investing pioneered at Index Ventures might actually be the foundation for yet more innovation in the venture capital business model, yielding a step-change in returns for all concerned.  Looking into the crystal ball reveals VC funds that look very different to many alive today.

The typical model for a life sciences venture fund has looked much the same since the 1980s: the fund managers raise money from limited partners to invest in a portfolio of opportunities.  Typically, the money is invested over a five year period, followed by five years harvesting those investments as they reach maturity with a 2 year “safety valve”, leading to a 12-year horizon for returns.

To pay for the fund managers to source the investments, do the due diligence, monitor their performance and manage the exits, a percentage of the fund is top-sliced – typically 2% of the total – as the “management fee”.  As well as the opportunity cost to do something better with the money, if the investments don’t perform this is money down the drain (as far as the investor is concerned; those whose salary is paid from these fees are probably happy enough).

At the other end of the process, once all the portfolio companies have been disposed off, the managers get a bonus, in the form of 20% carried interest – provided, of course, there is any upside to share in.  Sadly, for most fund managers, the proportion of the upside they get to keep is irrelevant, since the majority of funds fail to generate good enough returns to generate any carried interest at all for the managers.  No wonder they needed the management fee to pay them for their efforts.

Fund investors seek to align their interests with those of the managers by insisting the general partners invest their own money alongside them.  But the size of the management fee on a large fund dilutes this alignment by reducing the importance of carried interest as a proportion of total compensation.  Indeed, the principal concern for many venture capitalists is not the carried interest itself but securing a sufficient return on investment compared to his peers that he can raise another fund – and earn another management fee.  No wonder then, that over the past few years, a growing band of these managers have been forced to leave the industry.

Ultimately, the cause of the disappointing returns, excepting only the top percentile of funds, seems to be inherent in the asset class in which the funds are invested: life science companies don’t succeed often enough or big enough to generate a durable return – at least not for a 12 year fund with a top-sliced management fee.

Of course, the big wins are still out there – companies returning 10 times their invested capital crop up with reasonable frequency.  Many more – some 40% according to Bruce Booth’s recent analysis of the Adams Street Partners dataset – lose all, or virtual all, the money invested in them.  Venture investing in the life sciences, then, is about backing outsiders to win.

As any horse-racing pundit will tell you, backing outsiders is no way to earn a living.  Unless, that is, you know something about the horse that everyone else missed

And that is the special sauce all fund managers sell.

Judging by the median returns across the sector, they just aren’t good enough at predicting the winners.  And as Nassim Nicholas Taleb pointed out in his bestseller “Black Swan”, it’s worryingly easy to mistake the lucky for the gifted.

The industry has not stood idly by as returns continue to disappoint.  There has been a rash of “new investing models” each promising to avert the crisis in venture capital.  Some of these, such as the “asset-centric” investing model we have pioneered at Index Ventures, seem to be gaining real traction – and with good reason.  The focus of asset-centric investing is cutting costs.  If you can turn more cards with the same money, the returns should automatically increase.

Asset-centric investors – or at least the good ones – should beat the average, and offer highly competitive returns to their limited partners, earning their management fee in the process.  But does the innovation have to stop there?  If VCs are rushing to offer “new models” for their own investing, why not go further and offer limited partners who invest in them a new model?  Today, new funds being raised look like the old funds – but with the weaklings weeded out.

Has the shift to asset-centric investing laid the foundations for even bigger changes to come?  DrugBaron imagines what this brave new world – Venture Capital 2.0 – might look like.

The most obvious parameter for optimization is the time axis.  If the same returns could be generated in less than half the time then the internal rate of return (IRR) of the investment significantly increases (its about double, in fact).

But life sciences is a slow business – rather than generating returns quicker, the discussion round the water cooler in most VC offices engaged in life science investing relates to the inflexibility of “only” a 12 year fund life.

Examining where a reasonable chunk of the fund life (and for that matter the management fee) goes, however, tells a different story.  It takes time to find the right investments for the fund.  Typically three or four years to fill up the portfolio, and even then the majority of the cash may not be at work – still held in reserve for follow-on rounds.  So the managers have to be paid for an extended period while they seek out, and perform the necessary diligence on, a whole portfolio of assets.

For the imaginative iconoclast (whether a new breed of limited partner or fund manager), Venture Capital 2.0 may be the way to beat the depressing odds of conventional VC funds and win big

Imagine instead being presented with a pre-selected portfolio of assets waiting to be funded – with completed diligence and operational plans ready to implement.

You can’t short-cut the time it takes to develop a successful drug (well, maybe you can – but that’s a different topic altogether), but you can take the time required to assemble a portfolio outside of the investment period.  Since portfolio assembly and maturation take similar lengths of time, such a simple change can dramatically reduce the time from investment to return.

Pre-assembling the portfolio has other potential advantages too: the investors have an opportunity to examine the assets before committing to the investment.  It has to be said that they do not typically relish that prospect, lacking as they do the ability to do any kind of technical due diligence, but the ability to pre-judge the general areas where their investment will be put to work may be attractive (for example, whether its in diagnostics, therapeutics or med tech, in rare diseases or blockbusters).  This is much more flexible than the (now prevalent) alternative – where the fund managers are restricted in the field they can operate in by the investors ahead of the selecting the assets.  Such restrictions unnecessarily limit the ability to freely choose the best assets.

Critically, though, the assets need to be pre-assembled by a group with a track record as conventional venture investors.  We will never reach a situation where generalist investors have sufficient depth of knowledge to invest in an early-stage life sciences company without first trusting that the assets of that company would have met the criteria for a conventional investment by the kind of fund such generalists would typically invest in.

Cutting the time to returns is only one way to improve returns by innovating the venture fund model.

Selecting the assets is not the only job for which the fund investors typically have to pay the managers a salary to perform.  The second job is to oversee the management of the portfolio companies, typically through board seats, and most importantly of all to manage the exits once the assets have been developed according to the operating plans.

Here, though, the fund investors end up paying twice – because they are paying for two layers of managers.  Each portfolio company has its own set of managers paid for from the invested dollars, responsible to the company board (that includes directors representing the funds invested in that company) for implementing the agreed operating plan.  Then the investors pay the fund managers to sit on the boards and manage the managers!

Disintermediation of the fund managers, therefore, would yield an immediate boost to returns

And it is here that the move to asset-centric investing proves to be an essential foundation for the next steps towards Venture Capital 2.0.  Collapsing two layers of management into one is quite possible for an asset-centric fund.  Having selected the portfolio of assets (ideally before raising the fund), the fund managers need to back their decision with their own skin.  They need to take active, operational control of the vehicle that is developing the assets.

Such disintermediation is, of course, only possible if the fund managers have, as is increasingly the case in asset-centric platforms, the battle scars of real operational experience in drug development companies.  Venture Capital 2.0 is no place for the Wall Street type – only those with their sleeves rolled up and ready to dive into the trenches need apply.

And from within the development vehicle, these managers will be ideally placed to choreograph the sale of the individual assets as they mature (or, if it maximizes the value of the portfolio, the sale of the vehicle as a whole).  None of the tensions between company managers and fund managers that dog most biotech exits will be evident here: alignment of interest is guaranteed when operational manager and fund manager is the same person.

New funds being raised look like the old funds – but with the weaklings weeded out

Sharing the upside still requires some care: the managers cannot simply own a percentage of each individual asset (or else they could make a profit when one asset sells and nineteen are under water).  Instead, they need to own a percentage of the vehicle as a whole – but in a different share class to the financial investors, allowing a simple 1x liquidation preference to operate ensuring the investors get all the money back before the managers gain a penny.

Such a structure optimally incentivizes the management team, who like conventional VCs must decide how best to deploy the fixed capital at their disposal to maximize the overall return to the investors (and hence to maximize their own bonus).  Assets whose development goes well can consume more capital from the pot, while less promising assets will be killed before they consume unproductive capital.  In no case is anyone falsely incentivized to keep alive a zombie asset, as can happen when company managers face loss (of reputation or income) if their company is closed.

How much ownership might an enterprising set of Venture Capital 2.0 managers seek?  It’s a market place, so it might depend on the perceived quality of the pre-assembled asset portfolio – a much in demand portfolio might command a higher pre-money valuation.  But more likely, only the best portfolios would attract funding at all.

But even a 10% stake (less, on the face of it, than a 20% carried interest on a conventional fund) is likely to yield a very decent return to the managers.  Consider a portfolio of a dozen assets that require a total of £50M to move each to the next value-inflection point.  If each has the potential to sell for £25M upfront (not an unreasonable goal for an asset with Phase 2 proof of principle in the clinic, for example) then just 3 sales (a 25% success rate) will see the financial investors make 1.5x and the managers walk away with £2.5M (on top of the comfortable salary earned as an executive of the development vehicle).  Sell more than a quarter of the assets, or beat a £25M upfront for at least one of them, or take into account the likely substantial deferred consideration associated with these disposals and the returns to both financial investor and manager start to look very attractive indeed.

Only if eleven of the 12 assets fail completely, and the other manages only a median exit, will the financial investor lose cash (and the manager get no bonus).  And that kind of performance would have led to a catastrophic loss of value in a conventional venture capital fund model as well.  Indeed, the loss will be less in the Venture Capital 2.0 vehicle simply because the cost of assembling the portfolio and maintaining two layers of management have been stripped out of the equation altogether.

Sounds great!  Why are we not seeing Venture Capital 2.0 vehicles springing up all over the place?

For a start, the changes DrugBaron advocates are only an option for those who have already institutionalized the asset-centric investing model.  For those who seek to invest in fully-built companies (with pre-existing investors and a sizable management team of their own) these kind of innovations cannot even be considered.

And there is also a downside: the fund manager has to invest (his time and skills) ahead of the curve.  It takes time, energy and a lot of skill to assemble a portfolio of assets uniformly worthy of investment dollars.  It takes a brave and entrepreneurial type to take that risk if the alternative is the protected world of a conventional VC partnership.  And the opportunity to assemble a Venture Capital 2.0 vehicle will only fall to precisely those individuals who already have the track record that would allow them to raise a conventional fund (and top slice those delicious management fees).

So maybe this isn’t such a downside – for the financial investor.  If such a portfolio, assembled by such a team, were presented to them, they would understand that the managers were prepared to take such a gamble because they really believed the upside potential of the assets exceeded the fees they could earn.

“Its worryingly easy to mistake the lucky for the gifted” – Nassim Nicholas Taleb in ‘The Black Swan’

Assembling such a portfolio isn’t easy, even if you are prepared to take such a gamble.   All the assets need to be held at the starting gate for a simultaneous injection of funds.  In contrast to a conventional fund that finds assets that are ready to invest in gradually over time, the Venture Capital 2.0 model requires a set of assets that are ready for prime time at almost the same time.

Worse still, contributing prime assets to such a portfolio is likely to be less attractive to an inventor (whether an academic or biotech company) than a straightforward VC deal.  After all, the asset may need to sit in the deep freeze for months or even years while the complete portfolio is assembled ready to be financed.

Once again, though, the shift to an asset-centric platform is already diminishing this potential problem: at Index Ventures an increasing proportion of the projects we finance were assembled in-house, combining insight and expertise from across our platform – rather than sourced from any outside institution.

Clearly, Venture Capital 2.0 isnt for everyone.  It wont work for fund managers who prefer management fees to carried interest.  It wont work for fund managers who source their deals as sizable existing pre-formed companies or from highly competitive academic sources.  But for the imaginative iconoclast, with a treasury of technologies waiting to be funded (whether home-grown or licensed from global pharmaceutical companies), Venture Capital 2.0 might be the way to beat the depressing odds of conventional VC funds and win big – for investors and managers alike.

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