The “Asset Centric” investing model

In his blog­post David Grainger, calls it “choco­late fla­vored-poi­son”: cre­at­ing biotech com­pa­nies with mul­ti­ple drugs to di­ver­sify risk makes us feel more com­fort­able about the en­deavor ahead, but in the end it does more much more harm than good. Here’s why.

Any mol­e­cule early in de­vel­op­ment is not yet an asset, but it is al­ready a "cash burner". Of course, that mol­e­cule may be­come an asset later on, once util­ity in hu­mans is first demon­strated in an ap­pro­pri­ate clin­i­cal trial) - let’s call it the “proof of con­cept ” mo­ment, or “POC” – that the ugly lit­tle duck­ling will be­come, against the odds, a beau­ti­ful swan. 

Sadly, in our busi­ness only a very small per­cent­age of ugly lit­tle duck­lings be­come beau­ti­ful swans. Un­der­stand­ing this high in­trin­sic risk of early stage mol­e­cules the knee-jerk re­ac­tion is to start sev­eral pro­grams in par­al­lel. Risk re­duc­tion the­ory tells us that the "as­sets" must be di­ver­si­fied, so that, at any point, one asset can be re­placed by an­other whose chance of suc­cess is un­re­lated. That's the key word: un­re­lated, un­cor­re­lated, di­ver­si­fied, dif­fer­ent. Tak­ing the same risk over and over is not di­ver­si­fi­ca­tion – quite the op­po­site: its gear­ing your re­turns.

Worse still, at­tempt­ing risk mit­i­ga­tion through di­ver­si­fi­ca­tion within each early-stage com­pany may have some per­verse ef­fects that end up en­hanc­ing risk, in­stead of re­duc­ing it. Hav­ing a full early stage pipeline de­mands real in­fra­struc­ture, like a big man­age­ment team, with human re­sources and G&A sup­port and a host of other ex­pen­sive func­tions in­side the com­pany (as op­posed to being out­sourced). And that means they need large and reg­u­lar in­fu­sions of cash.

This has two con­se­quences: it means the cap­i­tal at risk is high be­fore you even begin along the path to de-risk the asset and it means the team will focus on rais­ing larger chunks of cash, cov­er­ing mul­ti­ple mile­stones on dif­fer­ent as­sets. Which, in turn, means that if one (or more) of those as­sets fail the money is in the com­pany any­way, where it might be used for any ac­tiv­ity the man­age­ment can think of, ir­re­spec­tive of qual­ity. Both these fac­tors re­duce the cap­i­tal pro­duc­tiv­ity.

Things are very dif­fer­ent in a com­pany with a sin­gle prod­uct can­di­date. Fi­nanc­ing of the pro­ject is tightly, and ex­clu­sively, linked to achiev­ing the very next mile­stone: only the amount strictly nec­es­sary to pass the next value in­flec­tion point is put at risk. The risk: re­ward pro­file for each in­vest­ment is eas­ier to cal­cu­late, with a gra­da­tion from small amounts of cap­i­tal at risk in the early days when the risk of fail­ure is sky high through to higher amounts of cap­i­tal as the tech­nol­ogy is de-risked, and the mag­i­cal POC mo­ment is ap­proached. Best of all, cap­i­tal ef­fi­ciency is max­i­mized be­cause noth­ing was spent on any­thing other than achiev­ing the next step-up in value.

We don't sug­gest that its never right to build a com­pany, with all the nec­es­sary in­fra­struc­ture. But we see a ten­dency in the in­dus­try to build in­fra­struc­ture way too early. And many of these “early build-out” com­pa­nies end up as “sil­ver medal­ists” (as David Grainger calls them in his post, see link….): above-av­er­age com­pa­nies, that have sur­vived long enough to find rea­sons to sur­vive a bit longer, and grow a bit more, and that may even end up de­liv­er­ing some re­turns to the stake­hold­ers. But those re­turns are sel­dom good enough to make the in­dus­try as a whole ex­cit­ing for in­vestors. And be­cause these fully-formed com­pa­nies are so cap­i­tal-hun­gry, they lock up a dis­pro­por­tion­ately large frac­tion of the cap­i­tal in­vested in biotech, and be­fore long their dis­ap­point­ing re­turns be­come the de facto re­turns of the sec­tor as a whole.

One area where this doesn't apply are com­pa­nies that are formed to ex­plore major new bi­ol­ogy areas re­vealed by sud­den break­throughs at the fron­tier of unmet med­ical needs: it is dif­fi­cult to imag­ine how these com­pa­nies can be de­vel­oped with­out major up­front in­vest­ments and long terms com­mit­ments by in­vestors and man­age­ment teams. We cer­tainly be­lieve that re­turns from un­rav­el­ing the se­crets of major new areas of med­i­cine (like mon­o­clonal an­ti­bod­ies in the past, and stem cells or gene ther­apy or small RNA ther­a­peu­tics in the fu­ture) will be im­por­tant value dri­vers for in­vestors and all stake­hold­ers. These com­pa­nies would never sur­vive in the ethe­real, vir­tual world of the “as­set-cen­tric” com­pany.

There is an­other ad­van­tage to the “as­set-cen­tric” com­pany model: it lever­ages the power of op­por­tu­nity cost to hone the per­for­mance of the de­ci­sion mak­ers. With­out other pro­jects to hide be­hind, man­age­ment is forced to face up to new data show­ing their prod­uct op­por­tu­nity is fail­ing. And in­stead of vainly hop­ing to pro­long the gravy train, they can see their up­side has dis­ap­peared com­pletely. Its time to move on to the next thing, ben­e­fit­ing man­age­ment and in­vestors alike by forc­ing early “killer ex­per­i­ments” and re­al­is­tic as­sess­ments of the data as they emerge.

Quite sim­ply, a sin­gle asset en­vi­ron­ment coun­ters the nor­mal human ten­dency of de­lay­ing tough de­ci­sions: in a pipeline play, the cash needed to keep try­ing the fa­mous “last few ex­per­i­ments” in a bid to save a dying asset is al­ready in the com­pany bank ac­count - and hence more eas­ily ac­ces­si­ble with­out hav­ing to do too much con­vinc­ing on in­vestors and di­rec­tors. The sin­gle asset model shifts the em­pha­sis from the "ab­sence of red flags" to the "pres­ence of green flags" to jus­tify keep­ing any pro­gram alive.

A sin­gle mol­e­cule com­pany is al­to­gether a health­ier en­vi­ron­ment for early stage R&D. But how do you run these in­vest­ments in prac­tice? Over the years, start­ing with our first such ex­per­i­ment, Pan­Genet­ics, sold to Abbot in No­vem­ber 2009, (see the blog­post by KJ) we have as­sem­bled a plat­form of trusted and suc­cess­ful sci­en­tific en­tre­pre­neurs with ex­ten­sive in­dus­try ex­pe­ri­ence that, for sim­plic­ity, we refer to as "Index Drug De­vel­op­ers (IDD)". The IDDs iden­tify at­trac­tive-look­ing pro­jects in aca­d­e­mic labs, in cen­ters of trans­la­tional med­i­cine, in in­dus­trial re­search cen­ters, in­clud­ing biotech­nol­ogy and phar­ma­ceu­ti­cal com­pa­nies, These IDDs use their ex­pe­ri­ence and knowl­edge of what makes a good “as­set-cen­tric” play to sniff our the best op­por­tu­ni­ties, know­ing that each of them can han­dle only one or two – its not like ad­vis­ing an in­vestor (when you might “like” a lot of what you see); here it’s about them find­ing the best, not merely the good, be­cause they will live with that pro­ject.

Some­times we will pass on po­ten­tially good op­por­tu­ni­ties or maybe stop cer­tain pro­jects too quickly, be­fore they are given the chance to bloom, but on a fund level we must be more ro­bust against false pos­i­tives than false neg­a­tives. Fail­ing early (even if it was a ‘false’ neg­a­tive) is cheap, and we can have many such early op­por­tu­ni­ties in play. Fail­ing late (on a ‘false’ pos­i­tive) is ex­pen­sive.

The per­fect IDD is clearly a hy­brid fig­ure be­tween a pure en­tre­pre­neur and a ven­ture cap­i­tal­ist: over the last 5 years pur­su­ing this strat­egy, we have seen this model di­rectly ben­e­fit­ing the sci­en­tists and in­no­va­tors that are the ori­gins of the mol­e­cules: their in­ven­tion or dis­cov­ery will re­main the only focus of the In­dex-backed com­pany, till the pro­ject stops. And the man­i­fold ben­e­fits should trans­late into su­pe­rior re­turns for the in­vestors, too.

The biotech in­dus­try does not have the same lux­ury as in the tech­nol­ogy sec­tor: in­dulging in the plea­sure of cre­at­ing com­pa­nies, start­ing large with a vi­sion to take over the world has no place in early-stage drug de­vel­op­ment. The path is too long, and the process far too cap­i­tal-in­ten­sive. Given the mas­sive unmet needs that clearly per­sist into the 21st Cen­tury, there is a strong ra­tio­nale for in­vest­ing in early stage R&D. But de­liv­er­ing re­turns that match, or ex­ceed, other sec­tors re­quires us to adapt the in­vest­ment model in our in­dus­try.

The so­lu­tion is not, in our opin­ion, just drift­ing away and in­vest­ing in late stage drug can­di­dates in­stead, as many have done, but to be brave enough to forgo the com­fort­ing choco­late-taste that masks the poi­son of di­ver­si­fi­ca­tion within each com­pany, and in­stead focus on focus – and leave the di­ver­si­fi­ca­tion where it prop­erly be­longs: at the level of the VC’s port­fo­lio. Only that way can we cure the ail­ing in­vest­ment re­turns of early-stage biotech – one asset at a time.