VentureBeat

Are venture capitalists really shunning biotechnology, as I wrote a few days ago? A deeper look at the data suggests the answer is still yes, although not exactly for the reasons I first suspected.

First off, the most striking data point I noted in my earlier post — that VC funding accounted for just 62 percent, or $872 million, of the $1.4 billion invested in biotech startups during the third quarter — did indeed turn out to be a statistical anomaly. According to Jessica Canning, director of global research at VentureOne, a single private-equity deal accounts for most of the difference: Blackstone Group’s $500 million investment (PDF) in Stiefel Laboratories, a maker of skin-care products.

Although I didn’t know this until recently, VentureOne counts private-equity startup investments as “venture capital” so long as the investment doesn’t amount to a buyout and at least one traditional VC firm is involved. As a result, VentureOne’s VC-funding numbers don’t actually differentiate between VCs and private equity, as I had mistakenly assumed. Since the Stiefel deal didn’t involve traditional VC, however, VentureOne classified it as a non-VC equity investment, thereby skewing the top-line “equity-finance” numbers. “Skewing,” by the way, is my term, not Canning’s — I find it kind of hard to believe that any investment in a 150-year-old company like Stiefel (it was founded in 1847) should be included in what is ostensibly a measure of startup funding, but Canning said a VentureOne client had specifically requested that the deal be included in the data. Since it was apparently a minority investment, in it went.

Canning also argued that VC backing for biotech remains strong, and sent along the following data to underscore that aggregate biotech funding over the first three quarters of this year remains up compared to last year (click on the image for a larger and more legible version):

I’m not wholly reassured. Those aggregate numbers obscure the fact that biotech funding went gonzo in the first quarter — jumping to a record $1.8 billion that exceeded the previous high by almost 30 percent — but then fell sharply for the subsequent two quarters. Biotech backing in Q3 was lower than any quarter since the first quarter of 2006, and if you want to discount possible seasonal effects, it was also the worst third quarter since the dark, post-bubble days of 2002. In fact, when measured against the prior-year quarter, Q3 marked the first time biotech funding has fallen in two-and-a-half years. The number of deals also dropped to a level not seen since early 2005.

That said, one quarter of data doesn’t make a trend, as a commenter kindly pointed out earlier. Still, I suspect the relatively horribleness of this quarter might have gotten a bit more attention without the confounding effects of the Blackstone/Stiefel deal on the top-line numbers. We’ll be keeping a close eye on this going forward.

(UPDATED: See below.)

At first glance, life-sciences investments seemed largely to hold steady in the third quarter, despite failing to match a 7.6 percent rise in overall funding, according to data from VentureOne and Ernst & Young. A closer look, however, reveals a very different story — namely, the fact that venture capitalists appear to be fleeing the biotech sector with great speed. Private equity and other non-VC funding sources are presumably taking their place, at least for now.

Biotech startups raised $1.4 billion in equity financing during the quarter, according to the top-line data VentureOne/E&Y normally makes available (click on the chart thumbnail at left for more detail). It turns out, however, that only 62 percent of that, or $871 million, originated with VCs, with private equity and other non-VC sources making up the difference.

Overall VC investment in biotech dropped by more than a third — 38 percent — in the quarter compared to a year earlier. That precipitous drop stands in sharp contrast to 2006 and the first half of 2007, when VCs accounted for the vast majority of biotech financings. (According to VentureOne, VCs still account for almost all medical-device investments as well, although now I wonder if that data can still be trusted on that point; see below.)

As you’d expect, many of the top biotech deals in the quarter involved non-VC investors. GlobeImmune, which raised $41.2 million in September in the quarter’s third-largest biotech funding, counts a number of private-equity and hedge funds among its investors, including Wexford Capital. (See a detailed list in our coverage here.) Tengion, which raised $33 million last month, was backed by non-VC financiers such as Deerfield Partners, Bain Capital and Johnson & Johnson.

That said, the reason for the sharp one-quarter drop in VC funding remains kind of a mystery. VentureOne’s quarterly financing data is often pretty “chunky,” in the sense that the numbers can swing wildly based on whether a just a few deals fall on one side or the other of the quarterly cutoff. On the other hand, a few VC firms with interests in life science have recently announced cutbacks or cancellation in new fundraising — see, for instance, news on Enterprise Partners here, while Matt Marshall noted problems at Sequel Venture Partners in Boulder, Colo., here — and while there’s not exactly an avalanche of such issues, these announcements might be trailing indications of bigger problems to come. I’ll be looking into this more closely as soon as I can.

On a separate note: What seemed like a nascent revival in innovative, early-stage biotech companies earlier this year may have petered out. Looking only at VC fundings, seed rounds accounted for only 6.9 percent of all deals, compared to 11 percent a year ago. Second and later-stage fundings accounted for 60 percent of all VC biotech fundings, way up from 47 percent last year.

Overall, healthcare-related equity financings rose a meager 3.7 percent in the quarter compared to a year earlier. By contrast, total startup investments rose 7.6 percent. Biotech fundings dipped slightly compared to a year earlier, falling 2.3 percent to $1.4 billion. Medical-device investments continued to rise sharply on that basis, jumping 19 percent to $830.3 million, although funding was down compared to the first and second quarters.

Major deals in medical devices during the quarter included Globus Medical ($110 million), Simplex Diabetic Supply ($50 million) and Satiety ($30 million). Arguably, however, neither Globus nor Simplex really qualifies as a VC deal, as I noted at the time (here and here). Which could, in fact, suggest that VCs may be pulling back from the device sector as well, and that only definitional issues with the data are obscuring that fact for now.

UPDATED: Rewritten to focus on the sharp decline in biotech VC financing.

UPDATE REDUX: I’ve since taken a closer look at the data with the help of VentureOne. Things aren’t exactly what they seemed, although the outlook for biotech still isn’t good: See here.

Over at VentureBeat proper, Matt highlights a theory advanced by venture capitalist Keith Benjamin, who argues that the credit crunch now threatening the private-equity boom may have the unexpected effect of boosting returns in technology investments. (Keith puts this all down in his own words on his personal blog and in this contributed piece at VentureBeat.)

Turns out a few people have also been wondering whether a deflating private-equity bubble might also redirect capital to the life sciences. (That’s a graphic of the redirected blood flow during a heart-bypass operation over to the left.) Last month, for instance, Ogan Gurel — chairman of the life-sciences consulting firm Aesis Group and a prolific blogger in his own right — suggested that because the private-equity juggernaut is fueled by cheap credit (or low interest rates, essentially the same thing), a slowdown implies higher rates that might naturally make high-risk, high-return venture investments more attractive.

That’s because it’s relatively easy to make money from mundane investments with low-to-middling returns when it doesn’t cost you much to get into the game with debt funding, but much harder when the capital itself is more expensive. In turn, that means savvy investors are going to look harder for bigger payoffs, even at the expense of taking on more up-front risk. (Of course, the recent aftershocks rippling out of the subprime mortgage market make clear that there was plenty of risk in the private-equity strategy as well — it’s just that everyone was perfectly happy to pretend it wasn’t there until it couldn’t be denied any more.)

As to the specific implications in the life sciences, Ogan writes:

First of all, life sciences VC funding has – as a proportion of overall VC funding – has been markedly increasing. Life Sciences (Biotech and Medical Devices together) accounted for 36% of total first-quarter 2007 VC dollars. Medical device investing, in particular has skyrocketed to an all-time high of $1.08 billion going into 96 deals representing a 60% increase over fourth-quarter 2006 results. Biotechnology was the largest sector with $1.B actually displacing software investments which has traditionally been the largest sector according to the NVCA and Pipal Research.

Second, if my hypothesis is correct, then higher anticipated interest rates will – ceteris paribus as the economists say – stimulate investors to allocate funds towards higher potential return, higher risk investments which means that venture capital will benefit just as it did during the late 1970s and potentially during the latter part of the 1990s as well.

If we combine the two premises that (1) the life sciences share of VC funding is intrinsically increasing and that (2) venture capital will see growth relative to other investment strategies, then the future is bright for life sciences funding in the foreseeable future.

As you’ll see if you read the comments of his piece, I’m somewhat skeptical that the relationship between interest rates and venture returns is as cut-and-dried as Ogan makes it sound. On the other hand, I don’t have any trouble believing that the relative attractiveness of high-risk, high-return investments should rise as the seemingly easy money available in private equity goes away. Heck, perhaps investors might even show renewed interest in the all-but-moribund biotech-IPO market.

Galen Partners, a Stamford, Conn., private-equity firm that concentrates solely on the healthcare industry, closed a $250 million fund, its fifth. The fund will focus on healthcare IT, medical devices and specialty pharmaceuticals.

Forget the Web 2.0 bubble, which is in the process of bursting.

Start worrying about the private equity bubble instead.

Our capitalist system has a habit of swinging between fear and greed (see Stu Phillips’ column today), and right now we’re seeing it lean toward greed • at least in private equity. Wealth has accrued, and investors — many of them public pension plans — are searching for places to put their excess capital. So they’re parking it with the huge private equity firms and hedge funds promising to put large dollars to work profitably. PE firms firms raised a whopping $198 billion in 2006, a record, and almost five times the amount raised in 2004. And they pumped $725.3 billion into companies, to take public companies private, and buying divisions from public companies that are trying to restructure. That’s another record, more than twice the level in 2004. The trend is expected to continue this year. One firm, Apollo Management, alone participated in $37 billion of transactions in just three days

Things are getting out of control. With PE firms buying up all these companies, they will need to sell or take those companies public again, in order to cash out of them. But no one knows how they will do that. If you try to sell these companies on the public market at the same time, the resulting downward pressure will kill the stock market (Stu Phillips says firms will have to hold their stakes, thus lowering returns, and causing a shakeout). Meantime, the excess cash is pushing up stock values artificially, because if a company doesn’t like its stock price, it knows it can get a premium price by selling to a private equity investor. Alternatively, if a company’s stock price dips too low, it becomes an acquisition target. So, of course the market has gone up! The Dow is at record highs.

We recently corresponded with Roger McNamee (pictured below), who two years ago raised a technology-focused private equity firm, Elevation Partners. He tells VentureBeat, in an email:

Private equity has been a turbocharger for the market. Every time private equity takes a company private, they pay a big premium and investors mark up the rest of group in the hope that another PE firm will come along. This has forced private equity to pay ever higher prices for the deals they do. As long as rates remain low and the economy is strong, private equity can pay up.

That’s the problem. Most economists say 2007 is likely to herald an economic slowdown. If it slows too much, we could be in for a choppy ride. It takes a long time to unload stock, even in the best of markets. McNamee helped buy disk drive maker Seagate in 2000 while he was at Silver Lake Partners. Though Seagate’s value rose within a year or two, and is now near an all-time high — creating handsome profits for Silver Lake on paper — the firm has been unable to sell Seagate shares very quickly. It still owns a large portion of Seagate shares — six years later. And that’s a near-ideal case. Continues McNamee:

For the past couple of years, private equity has been a safety net under the public market. Stocks go down less than you would expect on bad news because private equity is there….So many companies went private in such a short period of time, that you have to wonder what happens in three years when they all want to go public again. What happens if the market says no?

Another example is the purchase of Warner Music Group for $1.25 billion in 2003, by a group of investors led by Thomas H. Lee Partners. Within two years, Warner Music made dividend and other payments to those investors of $1.43 billion, in other words paying off the Thomas Lee and other investors the entire cost of the acquisition. Like Seagate, the investment represents a fortuitous case. However, even in these best of conditions, Thomas Lee has been unable to knock it all home with a sale. It is stuck holding to the company, with a declining stock price. Warner can’t merge with EMI, as originally envisioned, because European anti-trust regulators have said no.

The bubble might continue to grow for a while, because there’s so much cash still looking for a place to go. But its time for investors — and here we mean state employees and others whose pension fund money is being pumped into these PE funds — to start asking questions. It’d be too bad if joe public investor is left holding the bag again, just like in 2000.

Dan Primack, the guy who holds court at PE Week each morning and rants about the world of private equity, is launching a blog site Monday. It is called PEHub.

He’ll be blogging, there will be columns from buyout and VC guys, and other ways for folks to participate. Dan, based in Boston, is the most entertaining blogger out there on private equity, but he’s been stuck in an email format thus far. Congrats, Dan. It’s about time! This should be fun.

“It scares the hell out of me, but I’m looking forward to doing it, nonetheless,” Dan tells Podtech’s John Furrier in a podcast. Here is the podcast. Here’s John’s story.

U.S. private equity firms have raised a record $177.89 billion, according to Dow Jones VentureOne.

Private equity firms have an unprecedented amount of cash sitting in their treasure chests. Since they are typically mandated to invest it within a certain time frame, this signals that an unprecedented of money is now sloshing around looking or a home within the next year or two.

This has all kinds of complex implications, but one obvious result is that money is easier and cheaper to raise, whether for the young entrepreneur or for the developed business unit looking for help to restructure.

The previous record was 2000, which was $177.75 billion, but we’ve still got two months before the year is over — so 2006’s lead will be significant by the time were done. The total could reach $225 billion, according to VentureOne.

“Private equity,” as defined by VentureOne, includes buyout and corporate finance funds, venture capital, mezzanine funds and funds of funds.

Much of this money is being raised by firms that invest in mature or very large businesses, but venture firms are raising more money than they have in several years too.

The buyout industry has led the boom, representing $118.05 billion of the total raised so far this year, or about two-thirds of all funds, the group said. In 2000, venture capital firms were a more significant driver of that record-breaking year.