Biotech VCs, Stung by Startup Returns, Elbow into Royalty Financing

By Steve Dickman, CEO, CBT Advisors

Aug. 21, 2013

(Originally published on Xconomy)

The new landscape for venture capital investing does not seem to leave much room for classic company formation. Investor after investor has shut down or moved beyond startups into what seem like greener pastures.

So it should come as no surprise that at least a few VC firms are now expanding into the royalty space, as shown by a deal announced this week. Aisling Capital and Clarus Ventures, two top-tier VC firms, acquired 20 percent of the royalty stream created by sales of ibrutinib, a novel tyrosine kinase inhibitor developed by Pharmacyclics (NASDAQ: PCYC) and partnered with Johnson & Johnson (NYSE: JNJ) for use in B-cell malignancies such as chronic lymphocytic leukemia (CLL).

According to the press release, Aisling and Clarus each invested $48.5 million for matching 10 percent shares of a $485 million royalty-financing deal that Royalty Pharma struck last month with Quest Diagnostics Inc. (NASDAQ: DGX). Ibrutinib recently was designated by FDA as a “breakthrough” therapy. Analysts cited by FierceBiotech expect the drug to hit $5 billion in revenues in a short time, making the royalty stream very valuable. Under a deal structured like this, Aisling and Clarus are essentially wagering that the drug will be a blockbuster, and will provide them much more than $48.5 million in steady royalties over the lifetime of the product’s patent – if they or their limited partners do not choose to take profits first. It would not surprise me to see some of the royalties later bought back at higher prices by Royalty Pharma or acquired by third parties.

There is no doubt in my mind that the choice to invest in royalties had to be explicitly approved by the funds’ limited partners (LPs), either in the fund charter or, more likely, in an ad hoc fashion before this deal was done. I can’t imagine there was much resistance when the Aisling and Clarus general partners described the risk-reward in the ibrutinib deal. The LPs probably asked them to do more of this type of investing, given the product’s high-reward/low-risk profile.

The announcement answered two questions in my mind: first, what will VC funds do now that the returns make it harder to justify raising more money to support traditional models? Second, what will royalty funds do to make money now that they are facing a more efficient (read: barbarously competitive) market for the royalties of approved drugs?

Royalty deals as likely winners

In some ways this deal looks like a one-off: maturing VC funds that need to deploy large amounts of capital setting themselves up for near-term (if more modest) returns in lieu of typical home-run, long-term bets on early-stage biotech. Once they get a few of these out of their system, the VCs will swing back to their true nature as swashbuckling, entrepreneurial investors, right?

I am not so sure. In fact, I would argue that actually the royalty play illustrates the “new normal” in life sciences VC investing: a search for investments with short time horizons; a lack of faith in preclinical or even phase I molecules and the teams developing them; and an irresistible pull to “sure-fire” deals of a more financial nature.[1]

These are the same trends that have led to the rise of the asset-based strategies deployed by life science VC funds like Atlas Venture and Index Ventures. Those strategies build portfolios of assets, rather than management teams, and flexibly deploy those teams in ways that can be changed depending on the success of the molecules.

The trends have also led to a much more active market in secondary positions of VC funds. In secondary investing, funds buy up positions in VC-backed companies. They buy them either from general partners who are exiting the business or choosing not to manage older funds all the way to exit; or from limited partners who prefer up-front cash to hoping for later exits from their illiquid VC investments. Sales in the secondary market of overall private equity investments, including those in venture capital, were reported to hit a record $26 billion in 2012.

Some long-time VCs have told me recently that their firms are promising limited partners to do secondary investing as part of their core business, just as secondary funds such as Omega Funds have branched out into direct investing. Whereas royalty investing is more of a numbers game, secondary investing to me feels like a true hybrid of VC skills (assessing value in early-stage or mid-stage companies and managing portfolios of such investments skillfully) and financial engineering skills (pricing the portfolios well enough to stave off competition and still leave room for an arbitrage).

Late last year, a client approached my firm CBT Advisors and asked us to make a case for investing in life sciences venture capital. The client, a family office with a private equity bent, was preparing to deploy some capital in life sciences and wanted to know what strategy made the most sense for a potential limited partner.

CBT Advisors teamed up with Fred Meyer, another Boston-area consultant, and the team carried out some strategic and financial analysis based on our knowledge of the industry and on the limited available data. The upshot of our work: there are several alternatives, including secondary investments, that can provide what look like better returns than VC (especially when considering the 10-year historical figures) at what looks like considerably less risk.

One of the approaches on our list was royalty investing. We concluded that, strictly from a risk/return perspective, royalty firms were a very attractive way to participate in pharmaceutical finance. Royalty Pharma, in particular, has built a stellar track record investing in the royalties on marketed drugs such as sitagliptin (Januvia), a diabetes drug from Merck that accounted for $5.7 billion in revenue in 2012 and adalimumab (Humira), a treatment from AbbVie for autoimmune diseases that recently hit  $9.3 billion in annual revenue, making it one of the best-selling drugs of all time.

But Royalty is at some risk of becoming a victim of its own success. The fund, which had little competition when it was founded in 1996, has grown to over $10 billion in assets, and it is facing a much more competitive market for royalty streams of approved drugs.

So the announcement of what is, according to VentureWire (paywall), one of Royalty’s first three investments in a not-yet-approved drug was not a total surprise. Today’s press release completes the picture. Royalty Pharma got an assist on the due diligence on ibrutinib from Aisling and Clarus and the VC funds got a piece of the action.

The end of VC? Hardly

Where does this all end? To me, it does not spell the end of VC as we know it. To the contrary. Even those investors (like Aisling and Clarus) making headlines for investing in royalties are still actively looking at direct investments into startups and (especially) later-stage companies. At the end of the day, most venture capitalists like these funds who have made it to 2013 with any dry powder at all are in a position to make the case that early-stage, high-risk investing will continue to play out well for selected investors. The recent wide-open biotech IPO window has certainly bolstered their case.

Part of my argument has to do with both the skill sets and the personal wishes of VCs, who are usually more adept at (and more interested in) the messy reality of picking management teams, intellectual property and assets that will make companies work instead of primarily crunching the numbers. Many VCs would rather find other jobs if all that was left in VC was financial analysis.

But more of it has to do with the returns. When I look at the stellar track records of folks who have recently raised funds (Jean George, Mike Carusi, Jim Broderick, Chris Christofferson and Hank Plain of Lightstone Ventures; Martin Murphy of Syncona), I am encouraged in thinking that royalty investing is just one of many ways that VCs are finding to raise new funds that they hope will make money for investors. First, the ibrutinib deal has to go well, along with others like it that are undoubtedly in the works. At least in this case, the likelihood of ibrutinib becoming a commercial success is high and the timeline is short. If the drug and deal do, in fact, succeed, then the benefits will accrue to the entire ecosystem.

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