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Private equity boom (and bust?): Implications for the Life Sciences by varsha mishra, technical Manager, rfrac

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

By : varsha mishra, technical Manager, rfrac
Industry : Biotechnology Functional Area : R&D
Keywords :

Private Equity

Life Sciences

Implications

Boom

Bust

Innovations/BIOTECHNALOGY

Activity:  0 comments  114 views  last activity : 07 06 2010 20:18:04 +0000
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“… 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, the content of quantitative research is by mr. 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 -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, ·         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.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 SciencesSo 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 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.(courtesy: venture capital, biotechnology) regardsvarsha
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