Drugbaron Blog

October 12, 2011 no comments

Prospect of Failure for the “Company Building” Model of Venture Investing

Prospect Venture Partners surprised the sector with its announcement on 5th October that current commitments, at $150M, were insufficient to support a new fund.   That life science VCs might find capital raising challenging in the current economic climate is not in itself all that surprising – as DrugBaron noted last month, the returns of the sector as a whole are disappointing, so with risk appetite in the doldrums, a number of partnerships have struggled to raise new capital.

But if financial stress is supposed to weed out the weak, Prospect would not have been one of the names in the frame.  As a top tier US group with more than £1 billion under management from their previous three funds, and with recent liquidity from impressive exits (including a share of the Amira deal that apparently returned 9x invested capital to Prospect), Prospect were surely one of the best placed groups to secure capital. Their failure (if, indeed, locating ‘only’ $150M in commitments can be considered a failure) must send shivers down the spine of other life science investment groups that need to raise capital.

For sure the current climate makes raising capital a challenge, but neither the financial landscape nor the track record of the group explains what happened.  Instead, it is a verdict on the business model.

The fact that $150M in commitments wasn’t considered sufficient to build a diversified portfolio tells you all you need to know about the Prospect business model.   The initial plan, back in 2008, had been to raise $400M for their fourth fund.  The need for so much capital reflects a strategy about building companies, companies with multiple product candidates, companies with the capability to take their products into Phase III and beyond.

“late preclinical to mid-stage drug development plays are where most of our returns have been generated over the last 10 years.” – Alex Barkas, Prospect Ventures

Their most recent investment, last month, in Kythera Biopharmaceuticals illustrates the point: here is a company that has raised more than $100M in four private rounds, and which has already recruited 700 patients into its European Phase III study for its adipolytic therapy to reduce ‘under chin’ fat deposits for aesthetic purposes.  Having a diversified portfolio of such capital-hungry beasts certainly demands deep pockets.

And it brings with it the risk that, good as they look, these later stage companies are ‘silver medalists’.

Making the stellar returns from the winners that is needed to cover the losses from the losers gets harder and harder as the amount of capital at work increases.  If you are aiming for a 5x return, its easier to cut $1 from the costs than add $5 to the selling price, not least because the eventual valuation of the asset in the marketplace is essentially independent of the sunk cost.

Prospect, and others operating the same “company building” model of biotech investing would probably argue that the risks are lower in a later stage company, so the investment multiple can be lower to offer a good return overall, because the losses across the portfolio will also be lower.  But is that right?  The risk of regulatory failure may be lower, but unless the proof of relevance dataset is strong the risk of commercial failure may still be substantial.  And commercial failure (by which I mean launching a drug product that insufficient people chose to buy) is more damaging than regulatory failure, because it takes longer and costs more to get there.

Asset-centric investing is about to come of age

The alternative, of course, is the lean and mean “asset-centric” investment model, with virtual or semi-virtual companies investing the minimum stake in turning a single high risk card – a card that if turned successfully will guarantee an early and profitable exit.  Its interesting that even Alex Barkas, a partner at Prospect, recognizes the strength of such an approach when he told BioCentury “late preclinical to mid-stage drug development plays are where most of our returns have been generated over the last 10 years.”

Successful asset-centric investing requires its own skillset, quite different from the company-builders.  Keeping a tight grip on expenditure, to drive up the return on investment, but without killing the golden goose, is a fine tightrope to walk.  It needs management teams able to operate in virtual environments, smart out-sourcing strategies and above all a relentless focus on only the tasks that add value.  The key to success is ensuring from the outset that if the chosen card you are going to turn over really is an ace then you will achieve a fantastic exit, and additionally to ensure that the management team really do turn the card properly – and without spending any money on anything else!  Failure because the card, once turned, happened to be a deuce is acceptable in this model but execution failure of any kind really hurts the strategy.

Maybe the failure of Prospect to assemble a new $400M fund reflects the realization out there that the “company building” strategy doesn’t yield high enough returns to be competitive with other sectors.  Maybe its not just your track record but also your investment strategy that will determine whether you can raise funds to invest in life sciences in the current climate.  Maybe if LP’s are rejecting this investment model even in the US, where sufficient capital has always been available for company building, then asset-centric investing is about to come of age.




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