Life Sciences Funding: Has the Private Equity Boom Peaked?
CHICAGO – In April 2007, I wrote about the $29 billion KKR deal with First Data as a springboard for discussion on life sciences innovation, the relative shift of capital from early stage to later-stage deals and pharmaceutical research pipelines in general.
In that column, I wrote:
There is also another price to be paid for an economy that is tilted in favor of debt rather than equity. Roughly speaking, debt is a conservative financing instrument. While not inimical to innovation, it is not the currency that lubricates revolutions.
As catalyzed by low interest rates and cheap debt capital, there have been rumors that the private equity boom has peaked. The lead article in the Economist earlier in July headlined “The Trouble With Private Equity” points exactly to that:
It is also possible that the weather is turning and the debt that powers private equity’s siege engines is starting to become harder to scrape together. It may not happen this month – perhaps not even this year – but sooner or later, the private-equity boom will come to an end.
This phenomenon – the inverse relationship between private equity volume and interest rates – has also been the subject of other financial commentators as well. See “Fallout From End of Low-Interest Rates Likely to Be Widespread in U.S.” in the International Herald Tribune, “The Money Binge” in the New York Times and “The End of Easy Money” in Time magazine.
Though this is just a brief column, I will refer to some quantitative research. I would like to acknowledge my gratitude to Manoj Jain of Pipal Research. He leads that Chicago-based business intelligence and research outsourcing firm.
What Happens When Interest Rates Rise?
The private equity boom has potentially crowded out earlier-stage investments. One could also argue that higher interest rates and a slowing of the private equity train could potentially allow capital to flow toward earlier-stage, riskier projects as investors seek to maximize their return on capital.
Because of the importance of this to the life sciences and to the global economy more broadly, this deserves a closer (albeit simplified) view.
At a high level, inexpensive debt capital (e.g. low interest rates) means that very high returns on capital (e.g. high risk) is not necessary to obtain a relatively good return. Lower-risk investments (e.g. established companies with sustained revenues) are sufficient targets for investment. Likewise, the positive cash flow enables debt-leveraged capital.
As outlined in the KKR and First Data column, this means in real terms that investors are more likely to allocate their capital toward more efficient credit card processing (e.g. First Data) than to a risky, no-revenue, high-potential return biotech or medical tech start-up. There are other structural issues including:
# the increasing size of deals
# the cost of due diligence
# the preferential tax treatment of private equity investments
VC Booms When Interest Rates Increase
Below is a graph of 10-year U.S. Department of Treasury yields (from the U.S. Federal Reserve) from 1962 to 2006. I’ve annotated the data with several comments.
There are several items to note:
1. 1978 (when interest rates were rising to 8.41 percent) was the first big year for venture capital.
2. As interest rates peaked to nearly 14 percent during the late 1970s and early 1980s, venture capital experienced a relative boom. Investors had to take risks in order to get some return on capital during the nefarious stagflation years.
3. As interest rates went to a relatively low level (though still not as low as present times), investors switched to private equity. During the late 1980s, this caused the well-known leveraged buyout (LBO) boom.
4. With the rise of dot-coms, the growth in venture capital was somewhat anomalous. Still, it should be noted that as the Fed began to raise interest in the late 1990s in response to Alan Greenspan’s “irrational exuberance” speech in 1996.
This may have fueled even more riskier, early stage investments as the dot-com boom continued its advance.
5. The low interest rates following the dot-com bust and the Sept. 11, 2001 attacks have sparked the private equity boom. The slight uptick in interest rates (4.80 percent in 2006) should be noted.
During the last private equity boom, statistics bear out the dichotomy between venture capital funding and private equity investment.
From 2005 to 2006, VC funding in the U.S. increased 12 percent from $23.5 billion to $26.4 billion. During the comparable period, private equity investment increased 220 percent from about $130 billion to $415 billion, according to Thomson Financial and Pipal Research.
Implications For Life Sciences
So what are the implications for life sciences? First of all, life sciences VC funding as a proportion of overall VC funding has been markedly increasing. Life sciences (biotech and medical devices together) accounted for 36 percent of total first-quarter 2007 VC dollars.
Medical device investing skyrocketed to an all-time high with $1.08 billion going into 96 deals. This was a 60 percent increase over fourth-quarter 2006 dollars. Biotech was the largest sector with $1.0 billion actually displacing software, which has traditionally been the largest sector, according to the NVCA and Pipal Research.
I believe higher interest rates will serve to stimulate investors to allocate funds toward higher potential return, higher risk investments. This means venture capital will benefit just like during the late 1970s and potentially the latter part of the 1990s.
If we combine the premise that life sciences funding is intrinsically increasing and venture capital will see a relative influx in investment flows, then the future is bright for life sciences funding in the foreseeable future.
Dr. Ogan Gurel is chairman of the Aesis Research Group, which provides forward-looking information and research services to the health-care and life sciences investment community. Gurel was previously CEO of Duravest, a publicly traded Chicago investment company that initiates and develops next-generation medical technologies. Previous to Duravest, he was a vice president and medical director at Sg2, a health-care intelligence think tank and consultancy serving hospitals and health systems. He can be e-mailed at firstname.lastname@example.org.