The Case for Healthcare Venture Capital
HEALTHCARE HAS BEEN NEGLECTED BY EARLY-STAGE VENTURE CAPITAL FIRMS
For LPs interested in true diversification and outperformance, we believe the majority of venture capital allocations should emphasize contrarian firms that will deliver a basket of non-consensus investments in areas that are typically overlooked.
These days, the majority of venture capital dollars flow into a small number of cities where there are high concentrations of venture capital firms. Many of these firms focus primarily on tech investing and find themselves fiercely competing amongst themselves to invest in companies that are working on similar problems, leading to higher valuations and a lower likelihood of meaningful multiples on invested capital for LPs.
Despite venture capital returns in healthcare outperforming tech returns substantially from 2012 to 2016 (see below), there are half as many firms investing in healthcare than in technology. As a result, we see an exceptional opportunity for LPs in venture capital opportunities outside of traditional tech investing. While many early-stage tech VCs invest in healthcare technology, very few invest in biopharmaceuticals, healthcare services/delivery, and medical technology – massive industries where only a small number of firms consistently invest at the earliest stages.
“NEGLECTEDNESS” SHOULD BE A CORE CRITERIA FOR ANY CONTRARIAN INVESTOR
When we invest at FundRx, we of course consider the usual criteria many health and life sciences venture capitalists use. For Example:
The scale of the unmet medical need a company is tackling,
How feasible their approach is based on their team’s capabilities and where modern science is today, and
Whether market dynamics indicate their solution will ultimately make economic sense (or not).
Critically, we also consider a fourth criteria that is uncommon in the fear-of-missing-out driven venture capital business: “neglectedness”. That is, is the prospective company working on a problem or method that is not presently well-funded and resourced, despite clear unmet need?
Many VCs believe their job is to get into “hot” deals (e.g., scooters, blockchain, CRISPR.). Our view is that this strategy will only work for a very small number of incumbent firms who are the first port-of-call for entrepreneurs. Instead, we actively work to invest in areas that most investors would view as not "hot" at all.
For example, we were one of the first investors in Meissa Vaccines, which is developing a vaccine for RSV, a life-threatening virus that hospitalizes over 3mm children under the age of five each year. As a result of a long string of failed attempts to develop a vaccine starting in the 1960s, many investors have entirely ignored the space, despite recent advances in our understanding of the virus and of vaccine development.
Many of the entrepreneurs we’ve backed are working on similarly high-neglect problems. They run the gamut from Contraline, which is developing a male contraceptive (a space ignored by the industry for decades), to Atlas Health, which helps low-income patients reduce their medical debt by algorithmically matching them to aid programs they are eligible for. These companies are solving problems many investors see as intractable. Yet if they succeed, they will capture the vast majority of their potential addressable markets, not to mention the good they will do.
INVESTING IN NEGLECTED AREAS LEADS TO MORE MEANINGFUL RETURNS ON CAPITAL
From a purely financial point-of-view, we believe neglect-investing leads to outperformance within the venture capital asset class. This is in part because in a world flush with venture capital dollars, competition between VCs within trendy investment areas leads to sky-high valuations that make it very challenging to generate meaningful returns on capital.
Firms in neglected areas, on the other hand, have more rational valuations that allow investors to minimize their downside (because they can purchase a more reasonable percentage of the company for fewer dollars), while maximizing their upside (because successful companies in historically neglected areas often have low-to-no competition themselves).
Though this neglected-firm effect has been studied academically, few VC investors have explicitly tested it in practice. As early as the 1980s, Cornell faculty demonstrated the existence of this effect and showed that neglected firms (in their cohort) delivered over double the monthly returns than those that were widely covered by analysts. The below chart highlights this effect in the public markets (Credit: Dr. Riccardo Colacito, New York University).
Of course, not all neglected companies make great investments. Venture capital firms must have the infrastructure to identify why the timing is right for a previously high-neglect area, and the resources to support those companies through their early development. Firms that have these qualities, however, will likely have the kind of proprietary access to companies that will enable them to generate the outsized outcomes – both financially and socially – that should be expected from the venture capital business.
Special Thanks to Our Contributors:
At FundRx, we have a global community of over 1,500 venture partners - all healthcare domain experts - that we collaborate with to understand what's feasible and what's not, and to catalyze the companies that we ultimately partner with. If you're interested in learning more about how we invest, please reach out.
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Gurdane Bhutani is a cofounder of FundRx, a health and life sciences venture capital firm. He can be reached at firstname.lastname@example.org.