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March 21, 2012 no comments

Five Vital Statistics of a Successful Venture Fund – How does the new Index Ventures Life Science Fund Measure up?

The launch of Index Ventures’ new life sciences fund on March 21st is another big step in the reincarnation of the biotech investment model.  As a smaller, focused fund it will carry even further the “asset-centric” strategy Index have championed.  But the most obvious new feature is the inclusion of two global pharmaceutical giants as strategic investors in the fund.

It is, therefore, a very different beast from most venture capital funds, particularly in the US.  Different doesn’t always mean better, so DrugBaron asks what would be the optimal parameters for a life sciences fund to have in 2012, and measures this new entrant against that yardstick

Predicting the future is a difficult and dangerous game.  But science has gotten quite good at it, at least in some spheres of activity: statistical process control can predict when a production line making computer chips is going to start producing duds long before the first QC-failure rolls of the conveyor belt.  Trading models predict the performance of stocks and other financial instruments with useful reliability (much to the detriment of the market, since all the major players end up behaving the same way leading to unsustainable bubbles and painful crashes).

But predicting the future performance of biotech venture funds is much harder – not because they are more complex, but simply because there are fewer of them.  You can train the models of chip production with billions of real-world observations.  By comparison, there has only ever been a tiny handful of life science investment funds.  This paucity of data causes two quite different problems: firstly, you often have to aggregate data that don’t really belong together to get a large enough sample to analyse; and secondly, performance is heavily dominated by the big outliers – events that only occur once or twice in the dataset, but are so different from everything else that they become the tail that wags the dog.

Consider the first problem – should you include funds that invest in devices and diagnostics as well as (or instead of) therapeutics?  You could argue they are all life science investments, but they differ from each other in their capital intensity and risk profiles as much as they do from retailing or mining.  Should you include funds from a decade ago as well as last year?  The world has changed (at least twice) in the interim, so its questionable how valid ten year old data might be.  Can we combine data from the US and Europe? And Japan? What about emerging markets?

Don’t bother to answer these questions.  It just illustrates the hopeless task of trying to divine useful insight out of past performance data.  People try, but for the most part DrugBaron wont be joining them.

The second problem has been dealt with in depth elsewhere – most notably, the excellent (in content, if a little irritating in style) Black Swan by Nassim Nicholas Taleb.  As Taleb points out, with enough people (or maybe even monkeys) trying their hand as investors, every now and then one will be completely and improbably successful.  They were just lucky – and no amount of analysis can tell find you the secret to success for these outliers.  Some biotech deals are outliers for similar reasons, and can drive returns for funds whose basic strategy was fundamentally flawed.

The team not only invest the hardwork necessary to deliver success but also add the magical “fairy dust” that turns a sensible recipe into a winning formula

So if (as the statutory warning pinned to every investment reminds us) past performance is no guide to future returns, then what yardstick can we use to judge the prospects of new funds, such as the Index Venture life sciences fund?

We have to rely on theoretical arguments.  What seems sensible.  And that, in the end, comes down to opinion.  For what its worth, then, here are DrugBaron’s opinion of the five most important determinants of success for a life science investment fund:

1.         Size

Size matters.  When you have very little cash, then you make what you have go a long way.  You think an extra couple of times before you commit to any expenditure, however small, and you ask if it materially advances you to the next point where you can raise further cash.  As Michele Ollier, partner at Index Ventures, says: “In a small company, capital efficiency is maximized because nothing is spent on anything other than achieving the next step-up in value.”

And if that applies to portfolio companies, it applies doubly to venture funds.  The team has only so much time to keep an eye on how its investment is spent, only so much time to qualify new investments.  If they have too much capital to put to work the inevitable tendency is to dole it out in larger chunks.  Instead of giving people 30% less than they need (because you can always find a way to manage with less, even when you think you have pruned the budget to the hilt), you might give them what they thought they needed, or worse still what they actually asked for.

The eventual value of an asset is usually pretty much fixed (by the immutable properties of the technology and by the marketplace for ‘similar’ assets).  So the more that had to be spent getting from start-up to exit, the lower the multiple.  Its as simple as that.

If Index Ventures have found a way to merge the strengths of the very large and the very small to drive biotech innovation, this may be the model for decades to come

What’s the optimum size for a life science venture fund?  In his excellent analysis from first principles, Bruce Booth at Atlas shows how hard it is to earn a worthwhile return on funds larger than about $200M.  And one of those “analyses of past performance” probably does shed a little light here: Bijan Salehizadeh of NaviMed Capital highlighted several studies that suggested small funds out-perform larger ones on the whole tech sector (not just life sciences).  His conclusion was that $200M was the optimum size to maximize returns.  These analyses can’t be that accurate but small is definitely better than big, and the Index Ventures life sciences fund is close to that optimum.

2.         Strategy

Under the heading ‘strategy’ comes everything that determines the way the fund allocates its resources.  What kind of assets does it invest in, how does it structure its portfolio companies, how actively does it manage those investments?  The sum of these choices define the strategy of the fund.

Over the last five years Index Ventures have come to invest almost exclusively according to their “asset-centric” platform.  In simple terms, that means investing companies with one asset – single molecule companies (or at least single molecules and back-ups).  Francesco De Rubertis, Partner at Index and one of the pioneers of the asset-centric platform, describes the principle advantage of the approach: “There is overbuilt infrastructure in the industry.  The Index asset-centric model focuses investments on asset development, avoiding as much as possible building further infrastructure.  In a classical private biotech company, 30-40% of the gross burn is spent on fixed costs. In an asset centric company, up to 80-90% of the burn is variable and focused on the drug.”

In many cases, these single molecule companies remain virtual throughout their life.  At the BioEurope Spring panel on biotech business models, Kevin Johnson, also Partner at Index, suggested that such virtual companies might have as few as two people.  That only raises the challenge of delivering a high value exit as a solo entrepreneur!

“Numbers and facts show that many important innovations have come from small companies: at this specific moment, small biotech companies play as an important role as they have ever played.” Francesco De Rubertis, Index Ventures

The Index asset-centric platform is maturing, as the first examples (such as PanGenetics) are sold completing the first cycle.  Lessons have been learned, and the model has been honed.  The new life sciences fund will demonstrate, beyond doubt, whether the “asset-centric” platform really can boost the returns for investors in early stage biotech.

3.         Financial Model

If ‘strategy’ is the label for processes governing the money leaving the fund, then ‘financial model’ is the label for the structure of the fund itself and the way it raises money.

Like medics, investors should be bound by the core of the Hippocratic Oath: “first, do no harm”.  In other words, if investors cannot add value beyond their cash, then the least they constrain the fund manager the better it is for returns.  Arbitrary constraints must limit returns.  For VC funds, the most obvious example of such limits is the classic ‘5+5’ fund structure, with 5 years to invest and 5 years to harvest the returns (perhaps with a further 2 year buffer at the end).  That limits the time for an investment to bear fruit.

In a world where a trouble-free path from screening hit to marketing approval takes eight to ten years (and for most people in the real world, with innumerable hurdles and problems to deal with along the way, it takes even longer than this), the constraints of a conventional fund structure can begin to … constrain.   To see early stage technology through to the market, then, requires an evergreen fund.  But the other solution is to work within that constraint from the beginning and focus on just a part of the whole drug development process – a part that fits comfortably enough into the investment duration available.

This kind of focus isn’t just a detrimental consequence of the constraints on the fund.  It can have positive consequences too: if you pick the step in the value chain from molecule to medicine that offers the best risk:reward profile, it will improve returns compared to the evergreen fund that chooses to invest across the whole process.  In the current landscape, it is moving assets through the first clinical proof-of-concept that adds the most value in the shortest time.

Predicting the future is a difficult and dangerous game. 

But what if the investors in your fund can add more than just money?  What if we aim higher than simply having passive providers of cash who manage not to get in the way?

That’s the trick Index Ventures appear to have pulled off: by garnering significant investment from two global pharmaceutical giants, GSK and Johnson & Johnson, they have the opportunity to gain more than cash from the investors in their fund.  As Francesco De Rubertis succinctly puts it: “A large investment by a strategic investor establishes proximity between the pharma and the VC. This proximity in turn enables cross-fertilization and intersection of diverse perspectives: great tools to drive relevant innovation.”

The key will be unlocking the benefits of being such unlikely bed-fellows without letting tensions develop.  De Rubertis is relaxed about the culture-shock that might come from VCs and senior pharma executives working together: “It is all about people: very clearly, many top executives in pharma come from the biotech entrepreneurial world and are very clear in the benefits and limits of the small company environment. There is a new generation of R&D leaders that is really driven to find the best possible models of innovation, wherever they come from.”

“The asset-centric approach may not be as easily implemented inside large organizations as it can be pursued by a venture firm. The complementarity of the approaches between pharma and VC is a source of richness and the willingness to collaborate is based upon common long term goals.”

If Index Ventures have found a way to merge the strengths of the very large and the very small to drive biotech innovation, this may be the model for decades to come.

4.         Network

High quality implementation is the single most important factor driving returns in early stage biotech investing.  Each asset has an intrinsic chance for success (and many, perhaps two-thirds) are destined to fail for reasons that no-one could have predicted or avoided.  The question is what fraction of the remaining third will you safely shepherd over the line to success, and what fraction will also fail not because of an inherent weakness but because of a mistake from within?

The priority, then, for any VC fund has to be placing their precious assets in the hands of development teams that are most likely to see them reach their potential.  One down-side of the ‘asset-centric’ platform that DrugBaron has previously noted is that the “one molecule per management team” core principle maximizes the number of development teams you need to manage your portfolio.

In this area, too, Index Ventures have come up with an innovative solution.  Taking a leaf from their tech partners, they are ‘growing their own’.  As Kevin Johnson says: “The real rate limiting ingredient, particularly in Europe, is the supply of serial entrepreneurs. I concluded that what European biotech needs was a ‘machine’ for making serial entrepreneurs. The Index ‘Asset-centric Platform’ is that machine.”  The key is taking experienced drug developers – Johnson calls them Index Drug Developers (IDDs) – and backing these individuals over time in one project after another.

“For the last 30 years my motto has been ‘do good, have fun, make money’ and I can think of no better place to execute on that than in an asset centric company.”  Kevin Johnson, Index Ventures

Proximity is again the key.  Proximity between large pharma strategic investors and the VCs offers synergies; proximity between the VCs and the IDDs in the company management offers similar benefits.  “Everyone is aligned, top to bottom”, says Johnson. “That’s what makes it fun to be in an Index company.”

5.         Team

If you have the other four ingredients (a small, focused fund, a great strategy and financial model and a network of top-tier developers), it would still likely not be enough to guarantee a healthy return for your investors.  The missing glue that pulls the whole thing together is the team of people.

The team not only invest the hardwork necessary to deliver success (and if you have ever looked at the travel schedule of a typical VC, you know how much hard work it involves), but also add the magical “fairy dust” that turns a sensible recipe into a winning formula.

Having been fortunate enough to work alongside Francesco, Michele and Kevin and the rest of the Index team as Chief Scientific Officer of Funxional Therapeutics, an Index portfolio company, DrugBaron is in the fortunate position to be able to offer an opinion on this fifth parameter as well: the new Index Ventures life sciences fund scores top marks on all five of the vital statistics.  And just maybe the team are the highest score of all.

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