Private equity's ups and downs: What it means for the life sciences

23 Jul Private equity's ups and downs: What it means for the life sciences

Earlier this year, I wrote about the $29 Billion KKR – First Data data deal (see: “KKR Buys First Data: On Private Equity, Pipelines, Development”) as a springboard for 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 (also published on the Life Sciences Business & Investment Daily blog), 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, as catalyzed by low interest rates and cheap debt capital, has peaked and 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 article, I will refer to some quantitative research and I 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, then 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.
Again, at a high level, inexpensive debt capital means that very high returns on capital are not necessary to obtain a relatively good return. Lower-risk investments – established companies with sustained revenues – are sufficient targets for investment, and the positive cash flow enables debt-leveraged capital. In real terms, this means that investors are more likely to allocate their capital toward more efficient credit card processing (First Data) than to a risky, no revenue, potentially high return biotech or medical technology start up.
There are other structural issues, such as:
• The increasing size of deals.
• The cost of due diligence (that helps to drive up that size).
• Preferential tax treatment of private-equity investments.
These also factor into the equation, yet the underlying logic remains – low interest rates equal high private equity volume.
Venture capital booms when interest rates increase
According to a graph of 10-year U.S. Treasury yields (from the U.S. Federal Reserve) from 1962 to 2006:
• 1978 (when interest rates were rising to 8.41 percent) was the first big year for venture capital.
• As interest rates peaked to nearly 14 percent during the late 1970s and early ’80s, venture capital experienced a relative boom. Investors had to take the risks in order to get some return on capital during the nefarious stagflation years.
• As interest rates went to a relatively low level (though still not as low as present times), investors switched to private equity, which during the late ’80s was the well-known leveraged buy-out (LBO) boom.
• 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.
• 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 percent (from $23.5 billion to $26.4 billion). During the comparable period, private equity investment increased 220 percent (from ~ $130 billion to $415 billion). [Sources for this data are 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 percent of total Q107 VC dollars with medical device investing skyrocketing to an all-time high with $1.08 billion going into 96 deals, which was a 60 precent increase over Q406 dollars. Biotechnology was the largest sector with $1 billion actually displacing software investments, which has traditionally been the largest sector. [Source NVCA and Pipal Research]
Second, if my hypothesis is correct, then higher anticipated interest rates will – ceteris paribus as the economists say – serve to stimulate investors to allocate funds towards higher potential return, higher risk investments, which means that just like during the late 1970s (and potentially the latter part of the 1990s), venture capital will benefit.
Hence, if we combine the premise that the life sciences share of VC funding is intrinsically increasing and that venture capital will see a relative influx in investment flows, then the future is bright for life sciences funding in the foreseeable future.
That’s my prognosis.
Previous articles by Ogan Gurel
• Ogan Gurel: Crazy like a Google? With GE-Abbott deal scrapped, could Google be next buyer?
• Ogan Gurel: Reforming FDA: Focus on safety, let market judge efficacy
• Dr. Ogan Gurel: FDA: Tortoise, hare, or something else?
• Dr. Ogan Gurel: Who is minding the Innovation Gap?
• Barriers will not stop convergence of medical technologies