If there was a theme in the biotech venture capital world in 2011, it was contraction. As the year drew to a close, the industry was abuzz with reports of Prospect Venture Partners' fundraising troubles, Scale Venture Partners' and Highland Capital Partners' decisions to exit the healthcare field, personnel changes at Versant Ventures, and the merging of the life science teams at ATV and Morgenthaler Ventures.

But despite the retrenchment, private biotechs raised $4.5 billion globally in 2011, according to data from BioWorld Insight. That's on par with 2010 and slightly ahead of the $4.3 billion raised in 2009. It's still a far cry from the $6.2 billion raised in 2007, but a decline from 2007 levels might not be a bad thing: Back then, VCs were concerned about an overabundance of money flooding the system, and that overabundance is blamed for today's poor returns.

Now, thanks to the financial crisis of 2008, the "longstanding criticism of too much money chasing too few investments may have fixed itself," said Brent Ahrens, general partner with Canaan Partners.

But amid all the contraction, new funds are still closing. Just last week, Flagship Ventures closed a $270 million fund, and Canaan closed a $600 million fund, one-third of which is for healthcare. The previous week, Vivo Ventures closed a $375 million fund. Burrill and Co. closed a $300 million fund recently, while Sofinnova Ventures closed an oversubscribed $440 million fund.

"The industry is changing," said Bob More, general partner with Frazier Healthcare Ventures. "A lot of VCs have gotten out of healthcare, but that is also providing new opportunity and a new spring for those that are going to make this industry successful going forward. Reshaping always starts by tearing some things down." The question to ask, More said, is "who are the groups who are going to make things happen over the next 10 years?"

Strategy Session

The biotech venture world already looks markedly different than it did just a few years ago. Some of the differences are obvious, and one of the most obvious is that the traditional "Series A – Series B – Series C – IPO" business model, in which each round added a few new investors and stepped up the valuation, appears to have finally faded from prominence.

"A financing won't get done unless the syndicate comes together with enough money to get to an NDA," said Jay Lichter, managing partner at Avalon Ventures. He added that there's no longer an expectation that new investors will join a syndicate in later rounds.

Hence 2011 brought some hefty start-up venture rounds, including $45 million for Ultragenyx Pharmaceutical Inc., $42 million for Cleave Biosciences, $42 million for Dermira Inc. and $40 million for Imagen Biotech Inc. And each of those rounds was likely backed with much more committed capital – Canaan's Ahrens said that for every dollar the firm invests up front, it holds two more dollars in reserve for follow-on rounds.

But even big syndicates committing big money aren't always a match for the high costs of drug development. "The same old model probably won't work going forward – putting $150 million into a company to get to an outcome – the dollars to get there have just crept up," said Bijan Salehizadeh, cofounder and managing director of NaviMed Capital.

Thus the other major theme in the biotech venture capital world in 2011: the rise of alternative venture models.

Asset-centric strategies have long been used by contract research organizations like The Calvert Research Institute and more recently have been adopted by others including Boston Biocom LLC, Flexion Therapeutics and BioPontis Alliance LLC. This year CMEA Capital also got into the game, launching Velocity Pharmaceutical Development, a virtual firm planning to in-license drug candidates, quickly advance them to proof of concept and sell them off again. (See BioWorld Insight, July 5, 2011.)

Other venture firms are collaborating more closely with a future acquirer on the founding, funding and advancement of their portfolio companies. Versant Ventures helped Quanticel Pharmaceuticals Inc. broker a deal with Celgene Corp. that gives Celgene an exclusive option to acquire the start-up. And last week Third Rock Ventures LLC teamed up with Sanofi SA to launch genomics firm Warp Drive Bio, also giving Sanofi an acquisition option. (See BioWorld Insight, Nov. 28, 2011.)

Atlas Ventures also has been exploring new business models, launching Atlas Venture Development Corp. to derisk assets through virtual development, and also teaming up with Shire plc to identify and fund rare disease start-ups and with Monsanto Co. on agricultural biotech investment opportunities.

Salehizadeh said he is encouraged by the fact that not only venture firms, but their limited partners are interested in exploring new models. He said similar approaches are used in the semiconductor industry because the cost of building a new company is too high. The fact that pharma and big biotech are participating in the creative process is encouraging, too, he said – "they know there won't be anything to acquire if they don't get actively involved in funding early stage companies."

Subtle Shifts

Not all venture firms are undertaking such radical experimentation, however. When Flagship closed its recent fund, the firm said it plans to continue investing in early stage life sciences just as it's always done. (See BioWorld Today, Jan. 12, 2012.)

Canaan made similar comments. The firm was able to close its new fund because it has had success investing in early rounds for biotechs in certain therapeutic areas that have leveraged non-dilutive capital to advance their programs – and it's sticking to that strategy. (See BioWorld Today, Jan. 11, 2012.)

Ahrens did say, however, that Canaan is looking at ways to expand its existing strengths, perhaps through more international deals since Canaan has offices in India and Israel, or through more seed-stage deals, which have become an increasingly important part of Canaan's investment strategy on the tech side.

"Everybody's looking to do some things to push the envelope," Ahrens said.

NaviMed, Salehizadeh's new firm, is focused on commercial-stage investments. "We think there is a rich reward curve in healthcare investing, and the optimal point to enter is by investing in later-stage assets," he said. "What LPs want is a low loss ratio and a high probability of success, and they are willing to take that in lieu of a massive moon shot."

Viewed as a whole, it seems venture firms are honing in on what they do best. For some, that's company formation; for others, it's later-stage investments. It might be a therapeutic area, like antibiotics, or a life science sector, like medical IT, or out-of-the-box new business models.

The specialization makes sense, Salehizadeh said, because the venture world has slowly been heading in that direction for a long time. "Small and specialized generally does better than big and diversified," he said. The trick is to be specialized without putting all your eggs in one basket.

Looking forward, opinions are split as to whether or not the worst of the venture contraction is over.

"I hope we have bottomed out and are coming back around again in healthcare," Ahrens said.

Frazier's More, however, said a lot of venture firms still need to raise money, and not all will be successful. He predicted there could be more healthcare venture mergers, along the lines of ATV and Morgenthaler, as well as more people like Salehizadeh, who was previously with Highland before it backed away from healthcare, starting new funds.

"There are a lot of discussions going on behind the scenes about what's going to work, and who are the people who should get together and raise money," More said.

In the near term, that could make things tough for entrepreneurs. More cautioned that the retrenchment process takes a long time to play out. "People are raising smaller funds, but they're still investing from the large funds raised several years ago," he said.

Salehizadeh agreed the "road will get choppier" in the next few years. Less money in the system means investors become more selective, which is good for returns but not so good for companies – at least not until those returns prompt investing interest to pick up and the pendulum swings the other way again.