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Thinking about Life Sciences

http://blog.aesisgroup.com

Monday, July 23, 2007

Private equity boom (and bust?): Implications for the Life Sciences

Earlier in April, I wrote about the $29 billion KKR deal with First Data as a springboard for a discussion life
sciences innovation, the relative shift of capital from early-stage (equity) deals to later-stage (debt-based) deals
and pharmaceutical research pipelines in general.
In that article, I wrote:
“There is also another price to be paid for an economy that is tilted in favor of debt rather than equity. Roughly speaking,
debt is a conservative financing instrument. While not inimical to innovation, it is not the currency that lubricates
revolutions.”
There have been rumors that the private equity boom which until now has been catalyzed by low interest rates
and cheap debt capital, may have peaked. Indeed the lead article in the Economist earlier this month entitled
“The trouble with private equity” points exactly to that.
“… it is also possible that the weather is turning and the debt that powers private equity's siege engines is starting o
become harder to scrape together. It may not happen this month, perhaps not even this year, but sooner or later the
private-equity boom will come to an end.”
This phenomenon – the inverse relationship between private equity volume and interest rates – has also been
the subject of other financial commentators as well. See for example “Fallout from end of low-interest rates
likely to be widespread in U.S.” in the International Herald Tribune, “The Money Binge” in the New York Times
DealBook blog and “The End of Easy Money” in Time magazine.
Although this is a brief posting, I will refer to some quantitative research and would like to acknowledge my
gratitude to Manoj Jain – of Pipal Research – who leads that Chicago-based business intelligence and research
outsourcing firm.
What happens when interest rates rise?
To the extent that the private equity boom has potentially crowded out earlier-stage investments, one
could also argue that higher interest rates and a slowing of the private equity train could potentially allow
capital to flow towards earlier-stage, riskier venture types of projects as investors seek to maximize their
return on capital. Because of the importance of this to the life sciences, and indeed to the global economy
more broadly, this deserves a closer (albeit simplified) view.
At a high level, inexpensive debt capital (e.g. low interest rates) means that very high returns on capital (e.g.
high risk) is not necessary to obtain a relatively good return. Lower risk investments such as established
companies with sustained historical revenues are sufficient targets for investment and likewise the positive
cash flow enables debt-leveraged capital.
As outlined in the KKR-First Data article, this means that investors are more likely to allocate their capital
towards more efficient credit card processing (e.g. First Data) than to a risky, no revenue, albeit high
potential return biotech or medical device startup.
Of course interest rates are not the only factor as there are other structural issues involved, such as:
· the increasing size of deals,

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· the cost of due diligence (that helps to drive up that size) and
· the preferential tax treatment of private equity investments
that also play into the equation. However, the underlying logic of that low interest rates = high private
equity volume remains a viable hypothesis.
Venture capital booms when interest rates increase
Below is a graph of 10-year U.S. Treasury yields (from the U.S. Federal Reserve) from 1962 to 2006. The
graph is annotated with several comments relative to venture capital and private equity "booms."

Several items to note.

1. 1978 (when interest rates were rising to 8.41%) was the first big year for venture capital.
2. As interest rates peaked to nearly 14% during the late 70s and early 80s, venture capital
experienced a relative boom. Investors had to take the risks in order to get at least some hope for
return on capital during the nefarious stagflation years.
3. As interest rates declined to a relatively low level (though still not as low as present times),
investors switched to private equity which during the late 1980s was the well-known leveraged
buy-out (LBO) boom.
4. The growth in venture capital (with the rise of dot-coms) was somewhat anomalous but it should
be noted that as the Fed began to raise interest in the late 1990s (in response to Alan Greenspan’s
“irrational exuberance” speech in 1996) this may have fueled even more riskier, early-stage
investments as the dot-com boom continued its advance.
5. The low-interest rates following the dot-com bust and the 9-11 attacks have sparked the private
equity boom that we are all aware of. The slight up-tick in interest rates (4.80 in 2006) should be
noted.
During the last private equity boom, statistics bear out the dichotomy between venture capital funding and
private equity investment. From 2005 – 2006, VC funding in the U.S. increased 12% from $23.5 billion to
$26.4 billion. During the comparable period, private equity investment increased 220% from ~ $130
billion to $415 billion, according to Thomson Financial and Pipal Research.
Implications for Life Sciences
So what are the implications for life sciences?
First of all, life sciences VC funding has – as a proportion of overall VC funding – has been markedly
increasing. Life Sciences (Biotech and Medical Devices together) accounted for 36% of total first-quarter
2007 VC dollars. Medical device investing, in particular has skyrocketed to an all-time high of $1.08 billion

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Thinking about Life Sciences: Private equity boom (and bust?): Implication... http://blog.aesisgroup.com//2007/07/23/private-equity-boom-and-bust-im...

going into 96 deals representing a 60% increase over fourth-quarter 2006 results. Biotechnology was the
largest sector with $1.B actually displacing software investments which has traditionally been the largest
sector according to the NVCA and Pipal Research.
Second, if my hypothesis is correct, then higher anticipated interest rates will – ceteris paribus as the
economists say – stimulate investors to allocate funds towards higher potential return, higher risk
investments which means that venture capital will benefit just as it did during the late 1970s and
potentially during the latter part of the 1990s as well.
If we combine the two premises that (1) the life sciences share of VC funding is intrinsically increasing and
that (2) venture capital will see growth relative to other investment strategies, then the future is bright for life
sciences funding in the foreseeable future.

Ogan Gurel, MD
gurel@aesisgroup.com
http://blog.aesisgroup.com

Private equity venture capital biotechnology medical devices U.S. Treasury interest rates investment capital allocation Aesis Research Group Ogan Gurel
MD

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