Medical Device Daily Washington Editor

WASHINGTON — The third day of the med-tech conference assembled by the Advanced Medical Technology Association (AdvaMed; Washington) included a couple of sessions of interest to device makers looking for financing.

And while predictions of a private equity bubble have been made before, a warning flag that such a bubble could also burst was hoisted in a panel discussion titled “What VCs Are Looking For.”

Panel moderator Anthony Viscogliosi, co-founder of Viscogliosi Bros. (New York) — an aggressive orthopedics sector entrepreneur — pointed out the obvious easy-money motive for all investors and venture capitalists (VCs). They all would like to “invest money with no risk and make a fortune,” he quipped.

Among his classification of investors, he identified the so-called “angel” — “a really big risk-taker,” calling a VC just “a big risk taker.” In contrast, he said that a private equity investor prefers entities at a more advanced stage of development and a corporate investor is usually geared toward investment in a company with a finished product on hand, sometimes with the intent of spinning that company off after market share is established.

The numbers Viscogliosi presented were impressive.

“In 2006, nearly 40% of all angel investment capital was invested in healthcare or biotech” to the tune of $10 billion, he said. “The angel investor market has grown steadily,” rising 11% from 2005 to 2006, and that current market conditions “are pushing angel investors beyond the startup and seed stage into the first or second round” of financing. In 2006 46% of angel money was in post-seed investment.

As for traditional venture capital, “we see that there was a huge bubble investing in 2000,” he said, mostly in IT and Internet stocks, which piled up to almost $95 billion. However, venture funding “has shrunk since that time,” he said, expected to be $29 billion in 2007.

Viscogliosi said that private equity investment has roughly paralleled that of venture funding, with about $50 billion invested in 2004, rising sharply in 2005 to roughly $173 billion. He pegged the private equity investment in med-tech in 2006 at about $252 billion, possibly reaching $274 billion by the end of the current year

Viscogliosi warned device makers: “we may see a private equity bubble” which could burst next year. “It looks like there’s a real bubble that’s developing” because “investors are chasing returns, and maybe the reason so much money has gone into private equity” is that opportunities for fast, high returns seem good.

The problem with this picture, he said, is that “as more capital pours in, returns go down.”

Later-stage investing is growing by $1 billion a year, Viscogliosi said, not due to risk aversion. “They’re putting more capital in later rounds because the companies are staying private longer.” And VC groups may account for as much as $13 billion total for 2007 if one includes existing investments.

“The [VC] investment in healthcare is growing 24% in 2007 from 2006,” for a sum of more than $10 billion, he said, up from a $7 billion jump between 2005 to 2006. The number of VC healthcare deals bottomed out in 2003, but 540 deals closed two years later. The number of deals rose to 647 in 2006, and there may be “close to 700 deals” by the end of 2007. He said most of this new activity has been in the med-tech sector.

“The growth rate in med-tech has grown at twice the rate of pharma,” Viscogliosi said. “While other healthcare industries appear to be flat, devices” are gaining.

In a discussion of how VCs determine a start-up company’s value, Jack Lasersohn of the Vertical Group (Summit, New Jersey) said there is “no magic formula — we value pretty much generically on the basis” of development stage.

“If you look at it from a portfolio point of view,” returns tend to be better for product categories that are earlier in their developmental cycle, Lasersohn said, and that VCs are aware of some of the complaints that entrepreneurs have about FDA’s clinical trial requirements.

He advised entrepreneurs to watch for similar products already coming through the pipeline. “Don’t get behind the curve or you won’t get financed.”

Panelist Noah Kroloff, a partner at NGN Capital (New York), said, “our primary focus is on late-stage ventures” and the skills and experience of their managers. “The people element becomes more important” in early product development, he said. “If you don’t have a team that’s working well together, it’s probably not going to fly.”

Viscogliosi interjected that the factors influencing VC activity have changed, with more consideration of reimbursement opportunities “Years ago, reimbursement wasn’t even talked about,” he said.

“Reimbursement is as important as the FDA regulatory path,” Lasersohn agreed, adding that the evidence-based paradigm adopted by the Centers for Medicare & Medicaid Services has resulted in “notorious non-coverage decisions.” He recommended that device developers talk to CMS as well as to FDA “to make sure that the clinical study design” also will address CMS requirements.

Viscogliosi said he saw it much the same way as Lasersohn. “It is probably going to be three times more expensive to build a start-up, and [will entail] much more risk” in the next few years. “If you are not at CMS at day one, that is a big mistake.”

Middle-stage financing is also becoming more financially demanding, and the panel gave attendees a quick look at how VCs see this trend.

“It is taking more and more capital” to get a device past the middle stages, Kroloff said, and “one trend we’re seeing is the syndication process” involving multiple VCs. “You’re really talking to a syndicate” when talking to the lead VC, adding that “the role of the lead investor is to coalesce” the disparate ideas of the other VC firms. He said that the necessary finances in times to come could run as high as $150 million.

James Thomas, a partner at Thomas, McNerny and Partners (Stamford, Connecticut), said that a C round” can be the “most complicated” because it takes place so close to the product launch. “These are the rounds where you either come together very quickly” or end up with “a Bataan death march” in an effort to keep all the syndicate members moving.

He said that “the proper pricing of this round generates the greatest debate” of all because the target company is usually burning through substantial cash and each of the member VCs has a different idea about how and when the returns should start to flow, and how the company should emerge once the product goes to market.

Lasersohn said that his firm usually has a syndicate put together at the A round that handles the entire life cycle, but this does not always work out. He said his company avoids strategic buyers “because they’re always after something” more than just the device in question, and “it can taint the deal.”

Viscogliosi said that “knowing where investor are in their fund life is important” because a VC that expects an early out can be problematic for other members of the syndicate if the exit scenario calls for a longer timeline.

Thomas said that a strategic buyer, such as a larger device maker, might be the solution to such dilemmas, but that strategic buyers often cannot ask for much information about the device if the startup has a device similar to something in the buyer’s inventory. Any VC manager who offers more info might feed a perception on the part of the strategic investor that the VC is not in a good spot.

Viscogliosi told Medical Device Daily that “we’re going to see some impact” on private equity investing in healthcare, due partly to the sheer volume of recent investment. However, he added that “we see a bubble in orthopedics” because of the proliferation of devices designed to deal with a given condition.

He said he expects “a big disruption,” which will be more of a factor for private equity because such organizations typically seek a shorter turn-around than VCs.

Viscogliosi also said that “private equity regulation is coming,” regardless of which party comes out ahead in the 2008 elections because of the controversy over the low tax burden enjoyed by such organizations compared to other corporate structures, and device investments are nearly certain to suffer as a result.