[NOTE: This is a life-sciences perspective piece by Robin Bellas, a partner at Morgenthaler Ventures. For previous perspective pieces, see here. --D.P.H.]By ROBIN BELLAS
Does an ebb tide lower all boats? Not when the ship you’re sailing was christened “Medical Devices.” Since the beginning of the year, the Dow Jones Medical Equipment Index of public medtech companies has registered a 13 percent increase in value compared to just a 1.6 percent increase for the Standard & Poor 500 Index. Earlier in the year those two indexes marched upwards in tandem, but began diverging with the onset of general stock market volatility in July.
The continued buoyancy of medical device stocks in the face of broader market storms represents one more victory for this recently enlarged category. Until just a few years ago, public medical device stocks consisted mainly of a handful of large battleships led by Johnson & Johnson, Boston Scientific, Guidant, Medtronic, and St Jude Medical. Since then, they’ve been joined by a flotilla of several dozen smaller companies like Kyphon, Conor MedSystems, Fox Hollow, Insulet, and Masimo. While the former have churned steadily forward, the latter have either gotten acquired at post-IPO multiples of sometimes 4X or more or are speeding ahead independently with annual share growth over 50 percent. No matter what the state of the broader economy, doctors are unlikely to curtail adoption of the more effective treatment of spines, coronary and peripheral arteries, diabetes or neonatal illnesses.
Aside from rapid growth, one of the common characteristics of these smaller medical device companies is that they usually began life backed by venture capital. Their post-IPO performance, unsurprisingly, has attracted even more venture capital — just under $1 billion per quarter in 2007, or 25 percent above last year’s pace. New VC entrants are also flocking to the business; I count a dozen or so new ones in the last year.
Such an investment wave raises the question of sustainability. My guess is that the higher level of investment is here to stay and will even continue to rise. In fact, we may be on the verge of seeing the disappearance of an old venture capital truism — namely, that life-science investment cycles up whenever IT investment cycles down, and vice versa.
Why? Largely because the whole medical device industry has matured. Compare for a moment the performance of medical device stocks during their previous upswelling back in 1996. That rise proved brief and, in retrospect, highly frothy. A few companies with revenues (e.g., Perclose, a Morgenthaler vascular closure company that was ultimately acquired by Abbott for $650 million) did well. Others, however, representing the majority of IPOs at that time, were concept companies like Heartport and CardioThoracic Systems (another Morgenthaler company). Most such companies ultimately failed to live up to expectations.
Investors underestimated the difficulty that concept companies would have in opening new markets. It was a case of not-always-straightforward products aimed at slow-to-adopt physicians. With each unexciting outcome, public investing enthusiasm sank that much lower. Throughout the late 1990s and early 2000s, medical device venture capitalists could only exit by selling companies to the large medtechs. VCs would first identify a product gap in the portfolio of a given medtech, invest in the company developing the new product through proof of concept, then sell. Solid, but nothing worthy of a 21-gun salute!
Look, however, at medical device investing today:
- We’ve got experienced CEOs on their third and fourth startup and more experienced VCs to support them. In short, we’ve got more people who know how to build successful medical device companies.
- We’ve got large, proven device markets like stents and joint replacements. We know that if our companies develop a significantly better product in such markets, physicians are on the lookout for improved patient outcomes.
- Even where our companies are opening new device markets — for instance, fresh approaches to chronic obstructive pulmonary disease such as emphysema — improved technology and the increasingly less invasive nature of the products lead to much faster physician acceptance. It’s common today for a simple, insertable device requiring a one-hour procedure to replace a highly complex, expensive and lengthy surgical procedure. It’s harder to resist change that is easy to implement and improves outcomes while lowering health care costs.
- A number of new devices—e.g. for treatment of obesity, heart disease, glaucoma, etc.– have the potential to achieve the “blockbuster” billion-dollar-revenue status previously attained mainly by Big Pharma.
- Finally, we’ve got far more experienced bankers, analysts and investors who know much better how to evaluate companies and markets. As a result, we have remarkably un-frothy markets which reward companies commensurate to performance, either up or down.
Such facts all add up to a rising tide that can support two distinct VC investing strategies. The most common is late stage device investing, the approach favored by most new VC entrants, but also many established device investors, as well. The rationale is to finance largely proven technology to market and then exit relatively quickly—say, two to three years.
The less common is early stage investing, the one we and a few other VCs prefer and one that capitalizes on our experience at early identification of winning technologies. We think such an approach offers higher returns, albeit within a longer time frame. As our portfolio companies mature, we prefer to use other people’s money for higher-priced later rounds.
We think the rising tide of medical device investing is strong enough to support both strategies. Indeed, as we scan the horizon we only see three small clouds. One is the more recent reluctance of large medtechs to buy young medical device companies early in their development. Instead, they will often wait until the company demonstrates growing revenues and profits. This puts VCs more than ever on their mettle to develop real, fully-staffed companies rather than merely effective technologies.
The second is the increasingly short attention spans of public investors—which, of late, includes many hedge funds. As Thom Gunderson, the able medical device analyst at Piper, Jaffray likes to put it, “it used to be that a long-term investor would check his portfolio every quarter. Now it’s every five minutes.” This fact of investment life has led to increased volatility for device company stocks, especially those that are still pre-revenue. Such volatility can threaten to put further financing for such costly activities as U.S. clinical trials, at least temporarily, under water.
Finally and third, some areas of medical device investing like obesity, artificial spinal disks and neural stimulation seem to be attracting the kind of over-investment that leads to widespread company failures. We think such situations can be avoided by investing early in large markets capable of supporting several winners and by picking projects that offer faster clinical endpoints.
Overall, however, these clouds seem unlikely to expand into storms that bring unmanageable turbulence. The quality of and demand for better medical devices is just too strong. For the foreseeable future in medical device investing, we expect “fair winds and following seas.”
Robin Bellas, a former nuclear submariner, continually scans the horizon for new medical device deals. He is a partner at Morgenthaler Ventures in Menlo Park, Calif.