Venture-Capital Funding Falls but Shows Some Momentum

Echoing last year's performance trend, biotechnology venture-capital funding dipped during the third quarter of 2011, but it remained on track to outpace 2010 in total dollars invested. US venture capitalists funneled $1.1 billion into 96 deals during the third quarter, a drop of 18% in dollars and 20% in the number of deals from the second quarter of 2011, according to the MoneyTree Report from PricewaterhouseCoopers and the National Venture Capital Association (NVCA) based on data provided by Thomson Reuters.

Despite this loss of momentum during the third quarter, dollars invested in biotechnology companies grew 26% compared with the same quarter of 2010. The number of deals declined 14%, but average deal values continued to trend upward. The third quarter's largest funding, $300 million, went to the biotechnology firm Reata Pharmaceuticals, which is developing oral anti-inflammatory drugs.

Among all industries, biotechnology continued to rank behind software in dollars invested. The software sector captured first place during the third quarter of 2011, attracting $4.8 billion in 742 deals. Software investment, which holds the potential for a much quicker return, appeared to be making a sharper recovery from the economic recession than the biotechnology sector.

In keeping with this trend, one venture-capital firm, Scale Venture Partners, recently announced it was shifting its full focus to technology and will not make additional healthcare investments. Scale mentioned the uncertainty of the regulatory environment and capital requirements as reasons for its move away from healthcare.

This shift comes as no surprise to those who follow investment trends. A recent survey by NVCA's Medical Innovation and Competitiveness Coalition, a partnership of NVCA member venture-capital firms and their early-stage companies, found that US venture capitalists are decreasing their investments in biopharmaceutical companies. Firms cited the cost, time, and unpredictability of the US approval process as reasons for the funding slowdown.

FDA has countered reports critical of its approval process by pointing to its recently launched innovation initiatives and an uptick in the number of drug approvals for fiscal year 2011. Drugs targeting cancer or paired with a diagnostic are gaining quicker review and approval from FDA. Despite these positive signs, until investors see concrete evidence of a more consistent, predictable, and transparent approval process across a broader spectrum of products, they will remain cautious about funding early-stage biotechnology companies.

For the third quarter of 2011, early-stage funding for the biotechnology sector did manage a small gain of 7% year over year to a total of $481 million. Late-stage funding fared better, jumping 48% to $598 million. Both categories dropped from the second quarter of 2011, echoing a similar fall from the second to the third quarter of 2010.

Biotechnology funding by stage

Early-stage funding will remain tough in the current regulatory and economic environment. Venture capitalists, however, will continue to seek out companies with experienced talent and breakthrough products that have the potential to measurably improve health outcomes.

As in years past, follow-on funding outpaced first-time funding during 2011. Those companies with enough cash on hand to carry them through a milestone, such as proof of concept or FDA approval, stand a better chance of attracting follow-on funding.

One factor holding investment levels down is that venture capitalists are hard-pressed to find an exit in the market for initial public offerings (IPOs). Venture-backed IPOs during the third quarter of 2011 had their weakest showing since the fourth quarter of 2009. Only one venture-backed IPO during the period represented biotechnology. Low venture-backed merger and acquisition activity for the third quarter also contributed to investors' lack of confidence.

One bright spot for biotechnology financing that bodes well for 2012 is a growing willingness on the part of Big Pharma's venture arms to invest in early-stage companies. Corporate venture funds were involved in 25% of early-stage US biotechnology financing deals during the first half of 2011, compared with 15% for all of 2010.

In the near and long term, innovative companies developing game-changing products that target cancer and rare diseases or that significantly improve outcomes and lengthen patient life-spans will continue to attract private and corporate investors.

Tracy T. Lefteroff is a partner in the life sciences practice of PwC US, tracy.t.lefteroff@us.pwc.com.