Health-Care Investors Counter Exit Woes By Adapting To New Reality (Koleman Karleski)

By Brian Gormley

After two rough years, health-care venture capitalists are adapting to deal with what could be more tough times ahead.

While medical companies have produced some of the best exits recently— most notably, Ardian Inc.’s $800 million merger with Medtronic Inc.— the downturn has left many companies gasping.

“The biggest issue in health-care venture capital is that most of the funds are out of money,” said David Collier, managing director of CMEA Capital. As a result, “We’ll continue to see ¬†bankruptcies in both devices and drug-development companies.”

Investors do not expect the public markets to rescue them anytime soon. While some companies are going public, few can do so on their terms. This gives corporations the edge in alliance and merger talks. Since these companies are increasingly worried about regulatory risk, however, they are less willing to pay up for rights to therapies that are far from U.S. approval.

The trend is spurring some firms to search for opportunity to gain leverage by bankrolling biotech companies through Phase III trials. The final stages of human studies are often too costly for venture firms alone, but by teaming up with other types of investors, such as growth-equity, hedge and crossover funds, VCs may be able to fund a drug to regulatory approval in some cases, said Michael Ross, managing partner of SV Life Sciences.

“It’s pretty clear that once you have gotten rid of the regulatory risk of a drug, its value goes up a lot more than it used to,” Ross said. “Funds like ours are looking at this as an investment opportunity.”

Some drugs, for example, have potential in niche and large markets. By funding relatively small Phase III studies to gain approval in a niche indication, a company could secure revenue to pursue a larger one. With an approved product, it also would be better-positioned to bargain with partners or acquirers.

“In the absence of an IPO market, pharma companies realize they’re the endgame for most of our companies,” Ross said. “It will restore an economic equilibrium if we have alternatives.”

Another alternative firms are considering is reverse-merging a biotech with a company that has cash to complete advanced clinical trials. That’s what Transave Inc. backers— which include Bessemer Venture Partners, Prospect Venture Partners and Quaker BioVentures— did in December when they united the business with publicly held Insmed Inc.

The new company— 46.7% owned by VCs, and led by Transave Chief Executive Timothy Whitten— has capital to bring Transave’s drug, Arikace, through Phase III studies in cystic fibrosis patients with pseudomonas lung infections and lung infections due to non-TB Mycobacteria.

As firms scour for ways to keep mature biotechs afloat, they are striving to prevent their youngest holdings from suffering the same funding problems. Increasingly, they are urging start-ups to cut their reliance on venture capital by courting pharmaceutical partners early on.

“The intelligent thing in the coming year is to improve your relations with large strategic partners earlier,” said John H. Friedman, managing partner of Easton Capital. “It’s the most efficient way to go about it.”

The good news is that strategic players will bet big when they find a fresh solution to a serious problem. Medtronic bought Ardian— whose investors included Advanced Technology Ventures, Morgenthaler Ventures and Split Rock Partners— for its medical-device therapy for treatment-resistant high blood pressure, agreeing to pay $800 million cash, plus milestones. One in three adults has hypertension, according to the American Heart Association.

Yet uncertainty about how the Food and Drug Administration will rule on novel devices weighs on the medical-technology industry, making some investors wary of innovative but high-risk technologies.

“The hurdles the FDA has put up in the device sector are real, and scary,” said Koleman Karleski, managing director of Chrysalis Ventures.

Instead of drugs or devices, Chrysalis targets health-care services and medical information technology, industries that are attracting more interest as investors seek to use technology to tame health-care inflation. “Our deal-flow in [these] areas has never been stronger,” Karleski said.

One company Chrysalis has backed recently is Foundation Radiology Group, of Pittsburgh, which aims to save the health system money through the diagnostic- imaging and radiology services it provides to hospitals.

Some observers expect hospitals, insurers and other large organizations to adopt new technologies more readily as they seek to keep pace with mandates from the health-care reform law and other changes in the medical marketplace. Ray Desrochers, chief operating officer of HealthEdge Software Inc., a provider of enterprise software to health insurers, said he is seeing payers make decisions more rapidly because of these looming changes.

Deals are getting done in less than the typical 12- to 18-month sales cycle, Desrochers said. An agreement with one client, Neighborhood Health Plan of Rhode Island, for example, closed in only five-and-a-half months, he said. HealthEdge, based in Burlington, Mass., is backed by Psilos Group.

Investors also see growing opportunity to supply consumers with technologies to help them navigate the medical system.

“More of the cost of health care is going to be shifted to the individual,” said Louis C. Bock, managing director of Scale Venture Partners. Consequently, the “consumer side of health care has interesting possibilities.”

Venture firms are already betting on companies aiming to uncloak the costs of medical procedures, which are unknown to most. As more employers try to trim medical costs through consumer-directed health plans, which place employees in charge of managing their care, that information will be increasingly in demand.

In June, one of these companies, Castlight Health Inc., raked in a $60 million Series C round from investors such as Oak Investment Partners, U.S. Venture Partners and Venrock. Meanwhile, Castlight rival Change:healthcare Inc. drew an undisclosed amount of Series B financing in September, led by return investor Solidus Co.