Monetising life sciences deals

On paper, it is easy to make the case for life-science investing in the UK: its universities are second only to the US in terms of citations in international journals; large pharma companies are hungry for new products to replace star-performing drugs that are going off patent; two-thirds of new drugs approved last year had emerged from niche drug-discovery companies; and inflation is sending investors away from liquid, low-yield assets in search of growth.

The reality is quite different. According to unquote" data, in the sub-£5m deal space only £223m went into UK life-sciences spinouts in the past five years – clearly insufficient given the calibre of UK science. Part of the issue is the perpetuation of risk perceptions, which are themselves driven by LP-GP structures that are simply inappropriate for this type of investment.

Success in this area requires intensive and senior management interaction, and focus on a small number of assets. Yet when investing sub-£5m per asset, it is difficult for a fund to gain sufficient critical mass to generate the fees to cover fund running costs. The historic response of venture managers has been to invest across a wide portfolio of assets in order to put cash out the door. This has inevitably led to a high failure rate and the need for the successes to be big in order to cover multiple losses – in turn reaffirming the "hit and hope" suspicions about the sector.

Yet emerging investment styles defy historic perceptions that it is significantly high risk, capital-intensive and demands long holding periods. Targeting niche products and using specialist regulatory approval frameworks can generate value in a relatively short space of time. This is because the investment process is narrowly focused on delivering a commercially viable asset with a clearly defined, addressable market, rather than building revenue and staff numbers.

A good example was the sale of Auralis, a developer of niche paediatric drugs, to Viropharma Inc. Auralis received less than £2m of investment and delivered 6x return in a three-year period. Similarly, Third Rock Ventures recently made up to 20x its investment from the sale of Lotus Tissue Repair to Shire plc, having invested less than $3m in an 18-month period.

Such investment models and attractive market dynamics are starting to reignite interest in investing in the UK biotech sector. But it may be a mistake to place investment in emerging science through typical fund structures.

Large funds with wide portfolios could only serve to replicate the "bread-on-water" approach of the past, needing to balance gains against substantial losses. Neither is an increase in grant funding a great answer for the sector: while it is attractive to scientists, it often lacks the commercial value-add necessary for growth. Some commercial investors have opted to replicate the club deals that are increasingly prevailing higher up the private equity market, while others have taken a listed fund approach. There is also an increasing presence from pharmaceutical companies themselves opening corporate venture funds to help identify new products to populate their pipeline.

Yet none of these structures have yet delivered a step change in the availability of both capital and the expertise to convert innovative science into commercial value on any kind of scale. With world-leading IP expiring in universities, patient populations left untreated, a benign approval environment in place and a ready queue of trade partners, something needs to change.

Spinouts are underfunded in the UK - time to rethink fund structures?

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• Early-stage
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