As biotech venture capital warms up, the pandemic strikes suddenly

Amir Nashat has been deeply involved in the biotechnology field for nearly two decades. He co-founded Alnylam Pharmaceuticals, which pioneered new approaches to genetic medicines. Since then, he has helped incubate and mentor at least 16 startups, several of which were acquired for hundreds of millions of dollars. Despite these achievements, this partner at Polaris Partners admits that most of his venture capital career was spent in an "extremely unfavorable environment," making investments in young pharmaceutical companies quite challenging. It wasn't until about the last five years that things truly began to improve.

It was during this period that public markets showed great favor toward young biotech companies, with record stock offerings becoming common. Large pharmaceutical companies, facing a lack of innovation, also turned to these startups for next-generation drugs. Nashat described this as creating a "highly compressed, high-pressure environment," where the paths for venture capital firms to achieve returns became clearer and faster. For venture capitalists, there had never been such a good opportunity to invest in drug startups, and as 2020 began, many expected another bumper year ahead.

However, the spread of the novel coronavirus quickly shattered these expectations. The virus has infected millions of people and brought the global economy to a standstill. In the past, economic recessions have shaped how venture capital firms fund and incubate drug companies; now, a pandemic could have a similar impact.

BioPharma Dive interviewed six venture capitalists who nurture drug companies, as well as legal and financial advisors serving healthcare venture capital firms. Nearly all said that the spread of the novel coronavirus has, to some extent, affected how they manage existing investments or consider new ones.

"In the past, we faced a lot of chaos, but the rest of the world was predictable. Now, we face chaos, and the rest of the world also faces chaos, so some adjustments are needed," said Noubar Afeyan, CEO of Flagship Pioneering. Flagship is the incubator behind COVID-19 vaccine developer Moderna and more than 25 other companies.

As venture capitalists assess the damage caused by the pandemic, they appear to be proceeding cautiously—financial data provider PitchBook found that biopharmaceutical venture capital deal volume has fallen about 16% compared to last year. Some companies told BioPharma Dive that, in the current environment, they are cautious about investing in certain types of drug companies.

Given the critical role of venture capital firms in the drug industry, even minor adjustments could have lasting impacts. Many biotech companies would not exist without venture capital support, and these investors have significant influence over which drugs may come to market in the future.

Is funding harder to obtain?

After the recession in the early 2000s, scientific breakthroughs triggered a surge in biotech investment, but many investments ultimately disappointed. When the 2008 financial crisis hit, healthcare-focused venture capital firms found it extremely difficult to raise funds from investors, who viewed biotech as a high-risk bet.

It wasn't until around 2013 that their attitudes began to shift. By then, the recession had ended, and progress in drug research made biotech more attractive to a broader range of investors and potential buyers. Biopharmaceutical mergers and acquisitions and initial public offerings (IPOs)—typically the two main ways venture capital firms achieve returns—hit record highs in the following years, boosting confidence among these firms and their backers.

In fact, since 2013, the number of financing deals conducted by venture capital firms has risen year over year, according to PitchBook data, with nearly 70 more deals each year than the previous one. By 2019, the number of deals reached 941.

The total value of these deals (from angel investments to larger subsequent funding rounds) has also grown. In four of the past five years, the total value exceeded $10 billion.

Recent surge in deal volume and value

Favorable conditions have also enabled venture capital firms to seek more funds from investors. Firms such as Polaris Partners, 5AM Ventures, Third Rock Ventures, and Versant Ventures each secured hundreds of millions of dollars in 2018 and 2019, while Flagship, Arch Venture Partners, and venBio completed new funds totaling nearly $3 billion this spring.

Deerfield, an institution known as a "crossover investor" because it invests in both private and public companies, also just completed an $840 million healthcare venture fund.

Despite ample capital, the economic disruption caused by the novel coronavirus has raised questions about whether this situation can be sustained.

Bob Nelsen, managing director at Arch, said he would be surprised if any new first-time fund could raise capital this year. He added that firms with existing investor relationships might be able to close follow-on funds, but it could take longer.

If the slowdown persists, younger biotech companies may find it difficult to complete their next funding rounds. PitchBook counted 228 biopharmaceutical venture capital deals between early February and mid-May this year, compared to 271 in the same period in 2019, indicating the pace of deals has already slowed.

A major concern is that crossover investors (who typically step in at later stages and provide substantial capital to support companies until they go public) may shy away from biotech startups. Without these investors, early-stage venture backers might have to dig deeper into their pockets to move their portfolio companies forward.

"Bringing a drug to market can cost $1 billion. Few venture capitalists can afford that," said Kristopher Brown, a partner in the life sciences practice at Goodwin law firm.

Nelsen predicts that some crossover investors will temporarily step back from biotech startups, instead focusing on public stocks that have become cheaper due to market turmoil. But Jon Norris, managing director of healthcare venture capital deals at Silicon Valley Bank, is not so sure.

Norris noted that biotech stocks have performed relatively better than the rest of the market this year, which bodes well for continued interest in crossover investing. Additionally, as of May 26, 14 biotech companies had gone public this year, only a slight decline from the 17 IPOs in the same period in 2019.

"To me, that suggests people continue to view this industry as a worthwhile area for investment. If you see good returns, people won't rush to exit the market," Norris said.

Nevertheless, there remain many unknowns about how the pandemic will further evolve.

For pharmaceutical companies, social distancing and its ripple effects on the economy are expected to have a more significant impact in the second and third quarters. Industry leaders Merck and Johnson & Johnson have already lowered their full-year revenue forecasts by billions of dollars, which could be an ominous sign.

"I do worry about the inherent delays caused by the entire economy shutting down and the healthcare system being overwhelmed. To me, that's the big thing next quarter," Norris said.

"Safer" bets

Meanwhile, venture capital firms need to put the capital they have raised to work.

Early-stage investors interviewed by BioPharma Dive said that despite the pandemic, their core strategies remain effective. Flagship and Arch prefer companies with technology platforms that can theoretically generate multiple drugs. Polaris, as always, maintains close ties with academic institutions to find new startup opportunities. Atlas Venture remains relatively flexible, while San Francisco-based venBio seeks companies expected to achieve important milestones in the next three to five years.

However, the pandemic has indeed influenced their thinking.

To attract new investors, development partners, and potential acquirers, biotech startups need to achieve goals such as advancing drugs into and completing human testing. But they have encountered new obstacles. As of the end of May, nearly 100 pharmaceutical companies of various sizes reported pandemic-related impacts on clinical trials.

For biotech companies about to enter or already in clinical testing, "there could be significant capital losses and notably extended development timelines," said James Flynn, managing partner at Deerfield.

As a result, some firms are being more selective in their investments. Aaron Royston, managing partner at venBio, said his team would be "very cautious" about investing in any pharmaceutical company about to start important trials or launch new products.

Biotech companies built around a single drug program may also find it harder to secure funding, as there is little buffer if that program encounters complications.

Nelsen was blunt: "Companies that rely purely on a single asset and are about to release clinical data are in a tough spot."

In contrast, companies at the earliest stages of research may benefit. Investors believe that by the time these companies reach human trials, some of the challenges and uncertainties surrounding the novel coronavirus may have been resolved.

For example, Royston said he has little concern about investing in biotech companies that will conduct early-stage studies over the next 12 to 18 months.

"Preclinical investment is almost a safe haven, while everyone else is at later stages, trying to deal with clinical trial delays," said SVB's Norris.

For now, venture capital firms say they are communicating more frequently with companies that may face setbacks due to the disruption, and helping to craft cash-preservation plans when necessary.

"At the end of the day, data is the currency by which we evaluate progress. So as long as biotech companies have enough capital to get through these data-generation phases and can shake off some R&D delays, I believe we can navigate through this crisis smoothly," said Bruce Booth, partner at Atlas Venture.

Clues from the past

In dealing with the chaos brought by the pandemic, venture capitalists may revisit the methods honed after the 2008 Great Recession.

At that time, the dried-up IPO market combined with fundraising difficulties led some venture capital firms to exit life sciences investing entirely. Others doubled down on existing strategies or adopted new approaches to building companies.

For example, Versant became known for arranging buyers in advance. Atlas gave some companies, such as Nimbus Therapeutics, limited liability structures that made it easier to sell individual drugs to buyers, though going public was more complex. Booth said these tools "are not as critical now as they were during that difficult period," because biotech companies can still conduct IPOs.

At Polaris, the difficult economic times reinforced the firm's trust in syndicated investments, which can spread risk among companies. On the other hand, Flagship avoided co-founding biotech companies with other investors because the process felt too restrictive.

"We found that when people are traumatized by funding risk and uncertainty, the strength of a syndicate depends on its weakest link. In other words, if five investors are sitting around the boardroom table, the weakest one will determine your actions," Afeyan said.

Flagship has since shifted resources to focus almost entirely on creating startups within its own labs. It is not alone. Firms like Third Rock are known for their highly hands-on approach, incubating companies and holding substantial stakes when these biotech companies go public.

Another popular strategy is staged investment to limit risk. Typically, this means companies provide smaller amounts of funding early on and larger amounts later when startups provide more evidence that their drugs may succeed.

Ranking of U.S. biopharmaceutical Series A venture capital deals

Despite the unprecedented challenges of the pandemic, venBio and other firms seem optimistic that a 2008-style shakeout will not repeat, and that they will not have to rely on unconventional strategies to navigate the future. Royston's view of opportunities in 2020 has not changed; Nelsen does not expect the pandemic to prevent Arch from investing immediately; and Flagship still plans to convert about 10 projects into full companies over the next year and a half, Afeyan said.

Several companies and advisors said there is one key difference this time: capital remains readily available. Cowen Healthcare Investments just completed a nearly $500 million fund last week, joining other firms in recent fundraising efforts.

"We've seen these ups and downs, and frankly, some of our best companies were created during down cycles," Nelsen said.

However, the pandemic is more than just a down cycle.

Past recessions did not threaten the healthcare system the way the novel coronavirus outbreak has. Hundreds of thousands of Americans have fallen ill due to the novel coronavirus. For millions of others with different diseases, the way they seek and receive care changed overnight.

Meanwhile, the widespread closure of businesses across the country has caused economic hardship not seen since the Great Depression, and sporadic reopenings are unlikely to heal these wounds quickly.

"Even in a world as smart as the biotech science community, no one fully understands the trajectory and impact of the current situation," said Amy Schulman, managing partner at Polaris.

Whether the pandemic lasts into next year or longer, venture capitalists acknowledge it will have a profound impact on society and the drug industry.

Nashat envisions that "new types of entrepreneurs" will emerge from the chaos, while others will be "scared off." Nelsen predicts significant changes in how healthcare is delivered, which will "shock" the system and create new opportunities.

This means investors will also need to adapt.

"If people just forget all this and return to the old normal, that would be incredible to me," Afeyan said.