Private equity boom (and bust?): Implications for the Life Sciences
Earlier in April, I wrote about the $29 billion KKR deal with First Data as a springboard for a discussion life sciences innovation, the relative shift of capital from early-stage (equity) deals to later-stage (debt-based) deals and pharmaceutical research pipelines in general.
In that article, I wrote:
“There is also another price to be paid for an economy that is tilted in favor of debt rather than equity. Roughly speaking, debt is a conservative financing instrument. While not inimical to innovation, it is not the currency that lubricates revolutions.”
There have been rumors that the private equity boom which until now has been catalyzed by low interest rates and cheap debt capital, may have peaked. Indeed the lead article in the Economist earlier this month entitled “The trouble with private equity” points exactly to that.
“… 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, I will refer to some quantitative research and would like to acknowledge my gratitude to 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 the KKR-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.
Venture capital booms when interest rates increase
Below is a graph of 10-year U.S. Treasury yields (from the U.S. Federal Reserve) from 1962 to 2006. The graph is annotated with several comments relative to venture capital and private equity "booms."
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
Implications for Life Sciences
So 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.
Ogan Gurel, MD
gurel@aesisgroup.com
http://blog.aesisgroup.com
Private equity venture capital biotechnology medical devices U.S. Treasury interest rates investment capital allocation Aesis Research Group Ogan Gurel MD
I posed this question in response to Ogan's comment over at VB Life Sciences, but I thought I'd reprise it here. I'm curious as to whether the tax code still favors debt over equity and whether that's also fueled the private-equity boom. I recall that issue getting a lot of attention during the LBO boom in the 1980s, but I don't know if the many tax-law changes since then -- particularly cuts in capital-gains taxes -- have altered the equation much.
In any case, although this is an intriguing thesis, doesn't the VC boom during the bubble (both tech and biotech) kind of blow a hole in it? Sure, the Fed may have nudged up the discount rate in 1999 and 2000, but it held steady or fell from 1995-1998 (see here , for instance), yet VC funding remained strong and there was no private-equity boom. Yes, VC funding jumped dramatically in the boomiest of those years (from $26B in 1998 to $57B in 1999 and $83B in 2000), but surely you're not arguing that a move of less than 50 basis points in the 10-year Treasury rate was responsible. Because if so, then you have to explain why a similar move from 2005 to 2006 from 4.29% to 4.8%) didn't have similarly dramatic consequences :-).
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Thanks David. I appreciated the discussion on on VB Life Sciences and, of course, your comments here.
Economics certainly shares with biology the characteristic of complexity so that just as we in medicine see diseases of multifactorial origin, the same can be said for what drives economies and investments.
To this extent then, it would be impossible to "prove" that there is a one-to-one relationship between interest rates and VC funding - there are just too many complexities and, in particular, the unique circumstances around the dot-com boom blew alot of assumptions (as well as wallets) out of the water.
On the other hand, economics tends to be simpler than biology to the extent that questions (and decisions) can often be distilled down to one number - e.g. a stock price, an interest rate and so forth. I think it is generally accepted that in high-interest / high inflationary times (which are not necessarily correlated), investors will try to seek even greater absolute returns on their capital which may entail seeking higher risk, earlier stage projects. This is the fundamental crux of my argument and while there are certainly bound to situations that may cloud that basic equation, I do think that it is hard to refute that basic premise.
Now with all the "fog of war" out there, this would imply then that as interest rates go up, the cost of debt capital goes up and as the economists like to say - all other things being equal - one would predict then a RELATIVE increase in the proportion of capital that goes towards venture funding.
You do point out, of course, a huge potential complication to all this and that is, indeed, the tax issue that is now front and center in the private equity debate. The one thing that certainly distorts markets (whether for good or bad is not the issue here at least) is government intervention - typically through taxes. That certainly can also blow a hole in any economic argument that seeks correlations at the basic, fundamental level. We shall see how this debate unfolds as it certainly will have a big impact on things.
To this end, if we see the favorable tax status for private equity (and hedge funds) being reduced, then this may also very well accelerate capital movements towards venture funding projects..
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