Private Equity and Biotech: Yet Another Data Point for Convergence

So I write about KKR booking less risk, and now I read about private equity going high-risk by wading into the quagmire of biotech? I have written extensively about convergence in the past, but what gives?

Here is the punch line from my perspective:

• PE, to use the baseball analogy, is trying to “hit ‘em where they ain’t,” e.g., identify the areas that are under-invested from a risk/reward perspective and deploy capital before others do;

• Biotech investing, just like the PIPE deal KKR did with Sun, is well-suited to PE. Why? Long time-horizon; illiquid; potentially volatile mark-to-market over its life; layers on well to PE’s existing porfolio of very different risks;




• Smart investing in any domain tries to identify cheap optionality, i.e., in the KKR PIPE deal (via the embedded call) or in PE investment in biotech (building a portfolio of inexpensive call options via investment in the common stock of efficient, research-oriented biotechs. Investment in the common stock of these companies is nothing more than buying a call option on its being sold or becoming profitable);

• PE principals tend to have strong relationships with corporate chieftains, for example, of the large pharma companies, who represent the logical strategic partners, licensors of compounds/technologies or acquirors of these nascent biotechs;

• PE investors are attractive to biotechs in need of capital, as they are principally interested in financial return and less interested in meddling with the science and approach of the scientist-driven biotechs.

To be clear, while this might be revolutionary for PE is certainly isn’t for hedge funds. Hedge funds have invested in several biotechs to date, and already understand the concept of cheap optionality very, very well. But, in fact, PE should have an advantage over hedge funds in these types of investments given their compensation model, i.e., volatile biotech investments can profoundly and adversely impact short-term incentive fee compensation for hedge funds, while PEs longer-term oriented performance-fee-upon-liquidation approach should structurally make it less sensitive to such short-term variations in mark-to-market value. That said, this is dependent upon a fair mark-to-market framework for illiquid hedge fund investments, which may or not be the case (remember autocorrelation?).

This type of investing is already in the sweet spot of the venture capital community, particularly those larger funds that are looking to deploy large amounts of capital. That said, PE firms can potentially offer friendlier terms and possibly better relationships with the corporations who are most strategically important to these biotech firms. Who wouldn’t want a KKR, a Carlyle, a Blackstone or a Bain as an investor? I would.

But do you see what is going on here - this type of investing, which was not that long ago only the provenance of strategic corporate (read: big pharma) and venture capital investors, is now being done by hedge funds and even PE firms. Alternative asset managers are allocating capital in a free-flowing, opportunistic manner, aggressively seeking cheap optionality and identifying areas that are under-invested from a risk/reward perspective. So where does VC end and hedge funds/PE begin? You’ve got me. There is only one guiding mantra these days: make money. Any way you can.