Sponsors of life sciences funds have, over the past 5 years, enjoyed a steady but significant run of positive fund raising. Similarly, capital deployed into life sciences companies has increased steadily over this period, with both the absolute amount invested and size per funding round at an all-time high as of the end of Q1 2020. Against this, will the pandemic or other factors negatively impact the steady bull run of the last 5 years? In this article, we explore what trends can be discerned from the recent past and what the pandemic might hold for the industry going forward.
Current State of the Life Sciences Funds Market
First, life sciences focused venture capital funds are sitting on a huge amount of dry power with recent vintage funds adding to that and, perhaps most interestingly, private equity now entering the fray.
Whereas venture capital has traditional focused on early to mid-stage companies, private equity has focused on mature, cash generative companies, not least so that the leverage incurred by such funds when buying out the target company can be serviced. Private equity has therefore largely focused on hospitals, care homes, pharma companies, medical device manufacturers and other healthcare businesses. With intense competition in the buy-out sector and high valuations, private equity has been searching elsewhere for superior returns, such as in the early to mid-stage life sciences sector.
Private equity has thus encroached on venture capital and crossover funds in competing for life sciences investments and that has driven committed but undrawn capital to an all-time high.
Why the Convergence?
- Big Pharma has lost its appeal to many private investors. It is seen as slow, bureaucratic, inefficient and unable to deliver the returns that private equity targets.
- Investor demand has also shifted, with more and more investors attracted to earlier stage biotech, medtech and other innovative healthcare areas.
- Life sciences investing allows managers to present a positive ESG image, particularly as ESG investing is taken more seriously by investors of all sizes and types.
- Competition in the large-cap buy-out space is intense and higher valuations have led to lower returns.
- Private equity has always been on a growth trajectory and managers continue to seek areas where they can grow assets under management.
How is the Convergence Taking Place?
Private equity sponsors have adopted different strategies to try to penetrate the early to mid-stage investment space. Some have developed venture capital skills in-house by hiring specialist portfolio managers. Others have formed joint-ventures and collaborations with niche life sciences managers and pharma companies or have acquired specialist life sciences managers and subsumed them into the broader firm.
Is it All Plain Sailing for Private Equity?
Although private equity undoubtedly wields a great amount of skill, experience and expertise, it is competing with specialist venture capital managers who have been investing in early stage life sciences companies for decades as well as crossover investors who typically invest in later funding rounds, thereby giving life sciences start-ups valuable capital with which to continue growing once venture capital has been exhausted. Aside from venture capital and crossover funds, private equity also faces competition from sovereign wealth funds and pension funds, many of which have long had direct investment allocations to life sciences.
Private equity will also need to re-calibrate its investment time horizons since, for example, drug discovery can take 10+ years which is beyond the lifespan of many private equity funds. Similarly, early stage investments are of a much smaller size than traditional buy-out transactions and growing them requires “buy-and-build” skills more associated with a start-up. It is a very different proposition to buying an existing mature company and instilling management and operational efficiencies which is what private equity excels at.
Challenges Posed by the Covid-19 Pandemic
The disruption caused by the pandemic, especially with regard to raising new funds has not spared the life sciences sector. First-time funds, of whatever strategy, are facing difficulties raising capital due to social distancing measures which prevent meaningful interaction between first-time managers and new investors. Many investors still have not gotten comfortable with virtual due diligence on fund sponsors that they do not have a prior relationship with. Established managers on the other hand, have experienced less of a challenge raising capital from their existing investor base, but even they report the difficulties of raising capital from new investors with whom they have no prior relationship. This brake on fundraising should not, however, affect capital deployment into life sciences companies generally, given the huge amount of dry powder that has been amassed, so it is unlikely that companies will be starved of investment for as long as there is this dry powder overhang. It is hoped that as we approach the end of the overhang in 2 - 3 years, social distancing measures will be relaxed enough to allow investor relations teams to get back on the road and start raising fresh capital.
Social distancing has also had an impact on specific parts of the life sciences industry. For example, companies in the research stage have suffered comparatively less compared to companies in the clinical trials stage, as the latter involves bringing volunteers forward to take part in the trials. Many bio-techs have introduced Covid-safe measures within testing facilities so as to encourage volunteers to take part in the trials. To a greater or lesser degree, social distancing measures have affected drug discovery or medtech trial timelines and this is something existing managers as well as those launching new funds will need to factor in. For existing funds, it may mean extending their lives in the manner provided for in the fund documentation, or it may mean setting up a continuation fund with a mixture of existing and new investors, or possibly a full exit by way of secondary market transaction.
Conclusions – Bleak or Positive Outlook?
The first key factor to note is that the crisis emanating from the pandemic is very different from that of the global financial crisis of 2008. Unlike 2008, there is a huge amount of liquidity in the private markets and a huge amount of dry powder ready to be deployed.
Managers have also learnt important lessons from the crisis of 2008, including developing tools to preserve value and they have been quick to implement these tools to support their portfolio companies. Managers are also more open to forming collaborations with industry and academia as a way to creating or enhancing value rather than operating in silos.
Investors, for their part, have developed a more sophisticated understanding of how investment strategies may need recalibrating to cope with market disruptions or dislocations, including remaining invested for longer if that would result in better returns.
And lastly, for both managers and investors, the secondaries market has come of maturity, providing managers and investors with a liquidity option should other options be unsuitable.
For these and other reasons, despite the chaos caused by the pandemic, the immediate and medium term future for the life sciences industry looks positive because, fundamentally, the asset class is sound and the investor base is solid and committed.