The LP and The Biotech VC

08.03.23

In Secrets of Sand Hill Road: Venture Capital and How to Get it, Scott Kupor writes, “If you invested in the median return VC firm, you would have tied up your money for a long time and have generated worse investment results than if you had just stuck your money in a Nasdaq or S&P 500 index fund”. The natural follow-up question to this then is “why should I invest in a VC firm?” Taking that question further, allow us to make the case for why someone would want to invest in a biotechnology VC fund, a sector that has been historically perceived as high-risk.

Power Law and Portfolio Performance

The answer to the first question lies in understanding that investment returns for VCs do not function like a normal bell-curve distribution as they might for a typical investment portfolio. Instead, they follow a power law curve, wherein a small number of the firm’s investments generate an outsized portion of the VC firm’s ultimate returns. In other words, if a VC firm makes ten investments throughout its fund’s life, it is looking for one or two investments to be hugely successful. Successful VC firms in any industry are effective at identifying investments with the greatest potential of generating the highest multiple on invested capital (MOIC) and actively work with those start-ups to ensure they can achieve that exit multiple.

Risk and Reward

Fundamental to the scientific process is the allowance to be wrong. Biology does not always behave as scientists expect, and figuring out why is integral to enhancing their understanding of biology and how to manipulate it better. A biotechnology start-up is, unfortunately, not exempt from this, and while developing a new therapeutic, the drug could fail (preferably early to gain as much information as possible while reducing capital exposure). Pammoli et al. (2020) found that the probability of a drug filing an NDA from pre-clinical studies is about 0.2%, and those that are able to advance to a phase I clinical trial still only have a 2% chance of filing an NDA, certainly stark numbers.

However, because of the high risks associated with investing in these biotechnology start-ups, the rewards are suitably matched. For example, in 2020 ACELYRIN’s series A raised $8M for 8M shares of the company; with the successful completion of their IPO three years later that stake was worth $144M, giving an MOIC of 18x.[i] While a level of success such as ACELYRIN is what every VC wants for all the start-ups in its portfolio, ACELYRIN is an outlier. That said, looking at returns across the industry shows that biotech investors made between 1.5-2x cash-on-cash over the past 3-5 years (admittedly, these were great years for biotech), giving an internal rate of return of 25-35%.[ii] To put that in perspective, the average VC and the S&P 500 have an internal rate of return of 19% and 11% respectively.[iii] While it is unlikely that biotech VCs continue to outperform the average VC to this degree, it certainly makes a compelling argument for the soundness of the investment relative to the sector’s risk.

Innovations and Impacts

Not only are there strong financial incentives for investing in a biotech VC firm, but there is also the greater impact these start-ups have on society. One major lesson to be learned from the COVID-19 pandemic is that there will always be a need for both the innovative ability and agility of small biotech. When the sequence of the virus was first made available on January 11^th, Moderna was able to adapt its technology so fast that the first volunteer was given their vaccine on March 16^th.[iv] They were able to do this because they had been working on the cutting-edge mRNA technology behind the vaccine for years prior.

We are hopeful for the future of our industry. Made possible by recent technological advancements, new and better treatments are actively being developed for various indications. We here at Medical Excellence Capital are proud to be a part of such an exciting time for innovation.

Sources:

Inclusion in this post of any quotes or references to material or opinions published by third parties does not imply or constitute any endorsement by MEC of the views of the authors of such material or opinions.

[i] Numbers sourced directly from Pitchbook

[ii] https://www.baybridgebio.com/blog/biotech-vc-crunch.html

[iii] https://gridline.co/knowledge-base/three-common-misconceptions-about-vc-investing/

[iv] https://www.cnbc.com/2021/07/03/how-moderna-made-its-mrna-covid-vaccine-so-quickly-noubar-afeyan.html

Disclaimer: This post was prepared in good faith by MEC in August 2023 based upon information from sources that are believed to be reliable. The contents herein may contain a description of an investment made by MEC. References to any investment included herein should not be construed as a recommendation of any particular investment or security. Specific investments identified or described as owned by MEC do not represent all of the investments completed by MEC, and the reader should not assume that the transactions discussed were or will be profitable. It should not be assumed that investments made in the future will be comparable in quality or performance to the investment described herein.