Healthcare venture capital fundraising and investment activity is at historical levels. Bolstered by robust IPO, business development and Mergers and Acquisitions (M&A) activity, unprecedented amounts of capital are being raised/deployed into healthcare companies and distributed to General Partners (GPs) generating consistent, positive returns for investors.

While healthcare’s resurgence has been breathtaking, considerable challenges for those seeking to invest in venture still exist including:

  • Access to top-decile performing funds
  • The number of healthcare focused venture capital firms (especially those funding early-stage companies) rapidly declined following the “Great Recession” and have only moderately recovered
  • Healthcare continues to compete for investment capital vis-a-vis sectors with perceived greater upside and lower risks (Technology)

In particular, the biotech and pharmaceutical market sectors dissuade many investors from participating given longer development timelines, and burdensome clinical, regulatory, and commercial hurdles. Though capital flows into the healthcare sector remain robust and forecasted to remain strong throughout 2015-2016, there is risk of a crowded private market without investors if the IPO window closes and non-venture capital (VC) investors pull back funding the sector (Crossover Investors).

Venture capital has oftentimes struggled returning “alpha” to Limited Partners (LPs) leading to constriction of active venture funds in the sector (inability of under-performing funds to raise capital and dissolve). However, recent market out-performance (more IPOs during 2013-2014 period than the cumulative total of the previous decade) has elevated distributions ($20 billion in 2014) and returns to record levels stimulating capital raising activity by leading venture funds. (Flagship Ventures raised $600 million, 3/15; SV Life Sciences, $400 million, 5/15, Clarus Ventures, $500  million, 6/15)

reboot cover 3dIn this market environment, management fees and carry are less of a concern to LPs but could change quickly with a reversal in capital flows and if lower returns ensues. Historically high fees detracted significantly from returns rendering most venture fund profits comparable to public market growth (Source: Kauffman Study). These high fee structures (“2”/“20” model) further incentivize fund managers to raise larger funds making it more difficult to invest in early-stage deals (“can’t put enough capital to work”) which is the primary source of innovation in the healthcare sector (as evidenced by decreases in the number of Series A companies funded year-over-year, 2014-2015).

History has a tendency to repeat itself and venture investing is nor the exception exhibiting cyclical waves of out-performance and under-performance. Periods of out-performance characterized by significant inflows of capital (Crossover Investors) and plentiful exits/liquidity (IPOs) are followed by time periods (“Great Recession”) when investors (capital flows) flee the sector for safe havens. Not surprising then to note prior to recent out-performance, the high risk of venture coupled with meager returns led many to declare the “venture model broken.”  Venture is far from dead, however, consider how answers to the questions below have the potential to smooth out capital flows into the healthcare sector throughout market cycles.

  • When venture fundraising/investment levels do subside, will alternative sources of capital become available to meet the growing capital needs of emerging growth companies in the healthcare sector?
  • Will LPs investing on a “direct” basis (co-investing vs. through traditional GP structures) be “that” source of alternative capital for emerging growth healthcare companies?

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