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Investors Still Skittish of the Life Sciences Industry

It wasn’t supposed to end this way.

With the economy ostensibly on the mend (the most recent data show that jobless claims are down and productivity is up, growing at the fastest pace since 2002), bigwigs in the life sciences sector finally seemed poised to reconnect with their long-lost capital venture partners as 2010 drew to a close.

That reunion, however, never took place. Still smarting over the billions of dollars in wealth
they lost in the self-implosion of Wall Street, venture capitalists apparently are in no rush to financially tether themselves to their former life sciences (and medical device) holdings. While such dubiety is understandable considering the beating these financiers took during the near-annihilation of the world’s economy, their newfound tightfistedness triggered a significant drop in life sciences and medical device venture funding in the last quarter of 2010.

Life sciences venture funding plummeted 42 percent to $1.1 billion in the fourth quarter of 2010, according to a new report from PricewaterhouseCoopers LLP (PwC).

The decline is the largest annual decrease in life sciences funding since the first quarter of 2009 and represents the lowest level of funding in nearly eight years, research shows. Deal volume also fell in the final months of 2010, with the number of life sciences transactions shrinking 21 percent to 165 (deals) compared with the last quarter of 2009.

PwC’s analysis, which includes statistics from the PricewaterhouseCoopers LLP/National Venture Capital Association Money Tree Report based on data from Thomson Reuters, provides further proof that the venture capital industry is undergoing a significant, if not permanent, metamorphosis to ensure its future success. Analysts contend the industry is transforming itself into a leaner, more selective force that eventually will resemble the landscape from the early to mid-1990s.

“Leading venture investors around the globe foresee an industry with fewer players investing in smaller amounts in companies that will reach profitability faster than they do today,” states a recent venture capital report from global advisory services firm Ernst & Young.

“Long-time industry players look to the industry of the early to mid-1990s—when company capital efficiency and fast revenue growth drove industry returns—as a model for the future. It appears that consolidation may be the best solution for putting the venture capital industry as a whole on stronger footing and providing limited partners with the exits and corresponding returns needed to restore confidence in the venture asset class.”

Indeed, Ernst & Young’s 38-page report, titled “Back to Basics: Global Venture Capital Insights and Trends 2010,” confirmsanalysts’ observations. The company’s research shows a striking decline in the number of “active” investors (venture capital firms that make at least one investment annually) and “very active” investors (venture firms that make four or more investments a year) over the last decade in the United States, Europe and Israel.

The overall number of active venture capital firms investing in U.S. companies fell 34 percent over the last decade, going from 1,338 in 2000 to 885 in 2009, the Ernst & Young report states. The number of very active venture capital firms sustained a more severe loss, sinking 56 percent to 313 in 2009.

Active venture capital investments fell even more steeply in Europe. Between 2000 and 2009, the overall number of active investors dropped 38 percent to 392 while the number of very active (capital) firms plunged 66 percent to 96. Israel fared even worse (if that’s even possible), losing 25 percent of its active investors and 57 percent of its very active financiers only since 2005.

“The continued downsizing of the venture industry has positive implications for investors and entrepreneurs,” said Mark Heesen, president of the National Venture Capital Association, based in Arlington, Va. “An agile venture capital model likely translates into more capital efficient and fewer duplicative deals in the IT arena as well as less capital intensive deals in the life science and clean technology arenas.”

An agile venture capital model also translates into fewer overall deals in the life sciences arena. While capital investments seem to be recovering from the decade-low levels of 2009, there is evidence that venture firms are being more selective in the companies they choose to fund. Industry analysts confirm Heesen’s observation that investment firms increasingly are gravitating toward capital-efficient business models with a short path to profitability—favoring sectors such as social media, consumer services and software over past preferences like life sciences.

PwC’s report also supports this thesis, noting that most first-time financings and first-time deals occurred last year in the software, biotechnology and industrial/energy sectors rather than in the life sciences industry. According to the data, venture firms funneled $194 million into 39 life sciences companies during the fourth quarter of 2010, a 12 percent drop compared with the number of companies that received funding during the same period in 2009 and a 30 percent decrease in the total amount of dollars invested. In addition, the average amount of first-time deals in the sector fell 21.5 percent, going from $6.5 million in the final months of 2009 to $5.1 million in 2010.

“We’ve seen good liquidity for the life sciences sector during 2010, with some IPOs (initial public offerings) in the fall and a fair amount of merger and acquisition activity during the last six months,” said Tracy T. Lefteroff, global managing partner of the venture capital practice at PwC. “That uptick in exit activity could lead to an increase in earlier-stage investments going forward. As venture capitalists get liquid on some of their later-stage investments, they can recycle that money back into new investments. And an increase in exits also gives them additional time to take on new investments.”

Besides infusing some much-needed growth into the industry, new investments and additional early stage funding would enable the life sciences sector to reverse a dire downward trend that began in 2009. Early-stage deal volume in the life sciences sector fell 23 percent to 89 transactions during the fourth quarter of 2010, and the average deal size shriveled to $5.7 million, according to PwC’s report. Late-stage funding decreased as well by 18 percent to 76 deals, with the average deal size withering to $7.5 million.

The medical device industry didn’t fare much better, sustaining a staggering 63 percent drop in early-stage funding to $147 million in the fourth quarter of 2010, the PwC report states. The descent in late-stage funding was not as severe, though it still reached double digits: a 32 percent decrease to $253 million compared with the same period in 2009.

The industry’s double-digit losses transcended several other categories in PwC’s brief report, including overall funding and subsegment investment. Medical device firms experienced a 48 percent reduction in funding during Q4 2010 compared with the fourth quarter of 2009. The number of deals slipped 24 percent, falling to 71 transactions, according to PwC data; for the full year, capital investments tumbled 9 percent to $2.3 billion, causing the industry to slip in rank behind software, biotechnology and industrial/energy in the total amount of dollars invested.

All three subsegments of the device industry also experienced significant decreases in funding during the last quarter of 2010, with medical diagnostics sustaining the largest loss (63 percent). Investments in medical therapeutics took a 46 percent nose-dive while funding for medical/health products slid 37 percent, PwC’s report noted.

While some of the drop-off in funding can be attributed to the typical holiday seasonal slump, Lefteroff believes that regulatory uncertainty also played a role in investors’ hesitancy during the waning weeks of 2010.

“During the fourth quarter, we saw tremendous uncertainty relating to FDA (U.S. Food & Drug Administration) approvals, including the 510(k) process for medical devices, which is thought to have affected venture capitalists’ outlook,” Lefteroff explained. “Until we get more clarity as to the regulatory pathway not only for medical devices but also for drugs and other biotech products, venture capitalists are expected to be cautious with deals.”

The degree of caution, of course, will be impossible to predict. But judging from last year’s funding levels for biotechnology firms—usually one of the healthiest investment areas in the life sciences industry—that caution will most likely continue well into 2011 (particularly since the FDAstill is mulling changes to its embattled 510(k) process).

Despite capturing a larger share of capital investment during the final quarter of 2010 (63 percent compared with 59 percent during the fourth quarter of 2009), the biotechnology sector still received fewer venture dollars. According to PwC’s report, biotechnology funding fell 38 percent to $685 million, compared with the same period in 2009. The number of deals slipped 19 percent to 94, compared with 116 deals during the fourth quarter of 2009.

Biotechnology funding by stage fared similar to the medical device industry, with early-stage investments falling 38 percent to $364 million compared with Q4 of 2009 and late-stage funding contracting 38 percent to $321 million. Compared with the third quarter of 2010, early-stage biotechnology funding dropped 22 percent, while late-stage investments plummeted 26 percent. The industry, however, performed better on an annual basis: Early-stage deals climbed 6 percent while late-stage transactions remained flat compared with 2009.

Not all areas of the biotechnology industry, however, were shortchanged last year. Research investment soared 177 percent, animal funding skyrocketed 136 percent and industrial funding jumped 35 percent, according to PwC statistics. Those gains though, were offset by losses in four other areas: biotech human (a 49 percent loss in funding); biosensors (a 46 percent decrease in investment); biotech pharmaceutical (a 45 percent funding drop-off) and biotech equipment (a 25 percentinvestment slide).

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