The work that stands out the most is a detailed study in 2010 by the folks at Silicon Valley Bank -in which they found that sub-$250M funds signifigantly outperform their larger brethren.  This piece is a must-read.

They looked at 850 funds and found that only 5% of funds over $250M have ever distributed greater than >2.0x capital  (so-called DPI) to their Limited Partners. That is a pathetic statistic for the venture industry.

The brain-trust at HBS (Felda & Josh Lerner) came up with similar data that shows that the optimal fund size is $200M or so (credit to Todd Hixon of New Atlantic for the graphic):

There is alot of wisdom in these data sets gathered over 30 years of venture returns.

…which is why it is so odd that 2011 was the year of the return of mega-fund.

Mega is Back – But Is This Time Different?

According to the NVCA, $18B was raised by VC funds in 2011 – a seemingly great headline number – up 32% over 2010.

But what belies that number is a jaw-dropping number of firms raising mega-funds in the past year or so:

1) Bessemer $1.6 billion

2) Accel (growth + early): $1.35 billion

3) Sequoia  $1.3 billion

4) J.P. Morgan Digital Growth $1.2 billion

5) Khosla (growth + early) $1.05 billion

6) Greylock (growth + early) $1 billion

7) Kleiner Digital Growth $1 billion

Only three things can explain this:

1) LP’s have gone mad

2) Returns of large funds have fundamentally changed since the SVB and HBS data sets

3) We are in the midst of another period / trend in VC that might again end badly

Part of this rush to mega-funds is clearly driven by the strong later stage (but still largely paper) returns that many of these funds have and will realize from investments in Groupon, Facebook, Twitter, Zynga, and other recent digital media IPOs.

My full spreadsheet of IRRs and multiples from these later round investments is here.  The returns in these late rounds are much better than you might think – except for that last round in Zynga which doesnt look so good right now.

So these firms did what any good investor would do – they leveraged (largely unrealized) momentum to raise mega funds when the wind was at their backs.  Yet another grand venture experiment in progress – one for which we won’t know the outcome for another 10 years.

Back to Fund Size – New Numbers

Now back to fund size – the existing analyses mentioned above all look at funds across the history of venture capital. The problem with this approach is that in the 1980s and 1990s, almost all funds were sub-$250M  - certainly all of the good ones.

That also means that the record breaking 20-30x (!) funds that Matrix, Sequoia, Benchmark, and Kleiner had in the mid-90s are part of this data above and probably move it quite a bit.

So what is the optimal fund size when focusing on funds from 2001-2011 vintages – looking solely at IRR – since some of these funds are still in the J-curve to look at DPI?

The results actually don’t change much – small is still beautiful – with a caveat that requires explaining.

Two fund size ranges emerge as the optimal based on this data set of several hundred funds.

$400-$450M AND $100-$150M – across all quartiles and the top quartile funds.

Bruce Booth wisely pointed out to me the following caution when looking at this data:

Since there are only 8 to 50 funds per sub-group in this data set, the outperformance (or underperformance) of one or two funds can move the needle for the group quite sigifigantly – and in the case of the $400-$450M range, Accel’s 2004 $400M fund that is currently rumored to be valued at 12.5x – largely due to Facebook’s 95% contribution to the TVPI of this fund – probably is moving the IRR needle quite a bit as well.

So with that caveat – I still stand by the rule that small is beautiful in venture – the recent mega-funds and the imperfect data above not withstanding.

Navin Chaddha from Mayfield put it best in a reccent interview in the WSJ:

“I believe that the VC asset class will continue to attract investment, but there will be a flight to quality, with both teams as well as track record playing significant roles. There will be the haves and the have-nots. Further, in the haves category, there will be a divergence between firms that opt to raise and deploy sub-$400 million funds into classic, early-stage companies and a few firms that will raise billion dollar-plus funds to continue a multi-stage, multi-sector (IT, digital media and health care) and multi-geography strategies all in one fund. “

But will the latter strategy actually pan out?

The historical data implies that it won’t.

What came as a surprise to many in the industry, including many LPs I have spoken to, was that healthcare venture investments have produced better realized returns for LPs over the past decade than IT investments have.

Let me say that again for those of you who didn’t see the paper: Healthcare investments outperformed IT investments over the past decade.

But the news wasn’t all good. In the accompanying blog post, Bruce and I touched on the fact that the data showed that the unrealized portfolio of active investments across all of healthcare venture is basically being carried at no mark-up whatsoever vs. a nice mark-up for IT investments that are still unrealized.

In that post, we explained the following:

 As we outline in our paper, significant mark-ups from round to round tend not to occur in LS companies. Instead, even well performing LS companies tend to be held at or near cost until an exit occurs leading to punitively low unrealized LS IRRs.  Tech companies that perform well, however, can get large round-to-round mark-ups – which helps significantly in driving the value of an unrealized Tech portfolio.

To put a fine point on the issue of the unrealized portfolio, I took a look at the same vintages from our data set (initial investments made by US VC firms into US companies between 2000-2010, updated to 6/30/2011 data) and this time focused on the carrying multiple of the unrealized investment (vs. the unrealized IRR which we studied in the paper and post last summer).

What is unrealized multiple?

Well, quite simply, it’s the value at which a particular investment round of capital is being carried at in a particular company. So if a first round is done where a VC invests $5M – then $5M is the cost basis.  If the company is marked-up by 2x at the second round, then that original $5M of cost will typically be marked-up carried at $10M by the initial VC.

Why is looking at unrealized data important in this context?

Well for one thing, according to VentureSource, there are 2,363 US-based healthcare companies that received venture financing from Jan 1, 2000 to present that are still privately held and in active operation.

Our collective hope as investors and entrepreneurs in healthcare ventures is that these 2,363 companies will perform just as well as the realized returns from the past decade and will continue to lead the pack vs. the benchmarks for venture  capital returns in other industries like IT and Software.

But the doom-and-gloom crowd, often led LPs who unrealistically pine for the once-in-a-lifetime heyday of the late 90s internet boom, clearly think that these 2,363 active healthcare companies will perform far worse than the already exited healthcare companies that have been proven to have returned a strong IRR in the past decade.

Why else would the pressure on healthcare venture be as great as it is these days? If the realized returns since the late-90s bubble have been better in healthcare than in IT, then only the perception of the quality of the unrealized portfolio would drive the fear of healthcare venture capital that is being seen these days.

And a cursory look at the data would reinforce this perception problem that healthcare venture has.

Indeed, almost 40% of medtech and biopharma investment rounds from the past decade are being carried at less than 1x today. And only 2% are being carried at 3x+.

Compare that to the internet sub-sector of IT – which is the sub-sector that LPs and industry watchers mostly focus on.  For internet companies, only 20% of all investment rounds are being carried at less than 1x and a whopping 7% are being carried at 3x+ their original cost.

This disparity between sectors at the two ends of the returns curve is notable. We explored the reasons behind it in the article last summer – and capital efficiency clearly has alot to do with it. It’s harder to have marked up rounds when so much capital has to go into healthcare companies vs. tech companies.

But  there is more to it: interim milestones in healthcare companies just aren’t valued as much by outside firms as revenue or momentum growth is in tech and internet companies.

Making this worse is that as the healthcare venture ecosystem shrinks, there are less and less firms that are even able to lead follow-on rounds for companies – and reduced competition is a bad thing for both entrepreneurs and early stage investors alike who are left holding the bag or taking an “any-pre” round to get a company financed.

So, following Bruce’s lead, here is my glass half-full prediction for healthcare venture for the next decade:

Realized gross IRRs in healthcare will continue to be strong and consistent – as they have been for the past 3 decades. Probably in the 15%-20% range – perhaps even somewhat higher if an IPO market ever returns for venture-backed healthcare companies.

LPs will continue to make money investing in funds with healthcare exposure.  Pharma, medtech, and health insurers – all sitting on growing and massive mountains of cash –  must keep buying new companies to help their flat organic growth rates.

Now here is my glass-half empty prediction:

The unrealized problem will only grow worse.  There will be more ugly down rounds in healthcare. The unrealized IRR will go down further and the number of companies valued <1x will continue to increase.

“Vulture venture” investing will proliferate in healthcare. And it will be the longest buyer’s market we have seen in any sector of venture capital since the creation of the asset class. What we will have is a “name your price” market for many companies in many sub-sectors of healthcare for the next several years.

These flat and down rounds will exacerbate the patently incorrect perception in some circles that healthcare venture is in some way “damaged” – and it will particularly be so in diversified firms where internet partners will be the heroes for the next couple of years as the public markets absorb the high flying consumer internet companies of the past few years at huge gains to the small handful of VCs who invested in those companies.

Of course, there were some excesses in the 2006-2007 vintages in healthcare – too many early stage medtech and biopharma companies were likely funded in those two years – which probably explains why 2007 is only 1 of 2 vintage years since 1981 where investments in healthcare venture companies have a negative realized gross IRR.

But it’s important for everyone to focus on realized returns as the only barometer of the true health of a sector. While unrealized is interesting data – it probably over-estimates IT and Internet returns and under-estimates healthcare returns.

The NVCA and Cambridge Associates actually do LPs and the entire venture industry a dis-service by publishing aggregate realized+unrealized data when they put out their quarterly company level returns data by sector and not breaking out realized returns from unrealized data.

Headed into the 30th Annual JP Morgan Healthcare Conference – my 10th one in attendance, I am very hopeful about the future of healthcare venture.

Those with money and investment fortitude over the next few vintages will see continue to see some exceedingly strong realized returns.

However, there are a few things that weren’t discussed openly in the hours of case studies and classes I took on entrepreneurship and venture capital.  Today I will tackle one of them: career planning in venture capital.

Rob Go of NextView Ventures perfectly captures this in a post today over at his blog discussing what it’s really like to be a VC – one of the few very realistic and pragmatic perspectives I have read on the topic. As Rob states:

 VC is a risky career path. It’s a lot of fun for a couple years.  But after two years, even if you were an operator before, your skills become stale and you are realistically not going to be as good at your former craft as you were before joining venture.  Your hire-ability is still pretty high at that point, but in years 4-6, you start running out of options.  It’s also on those years that you face the pressure of establishing yourself as a partner in the firm and hope to get meaningful economics in the fund.  As as I’ve blogged about before, the deck is kind of stacked against you.  Here’s why: a typical VC will do about 2 investments per year.  A principal or junior partner might be on a slightly slower pace.  So in years 4-6, you are realistically responsible for ~3 investments.  This is also the time when your partners (or other firms) are making the decision to make you a meaningful partner in the fund. So, in a way, your prospects as an investor are largely linked to these 3 investments.  Those odds aren’t great, in a world where most startup companies fail and only about 20%-10% drive a meaningful return to the fund. Do you really want to be evaluated on those 3 shots on goal, when a) it may be way too early to tell if any of them are winners but losers are usually identified more quickly, b) broad market fluctuations have a huge impact on the success of these companies, and c) most VC’s will agree that there is a huge amount of luck involved in this business?  Tough odds.

This is critical – as a young partner or principal in your firm, you will be judged on the outcome of your first 3 to 5 deals.  Indeed, I will sharpen that and say that in this era of shrinking firms and a shrinking VC industry as a whole, you will likely be judged on the outcome of your first exit.

As the data shows, somewhere between 57% (healthcare) and 76% (IT/Internet) of investments return less than 1x invested capital according to Cambridge Associates numbers which I analyzed in a paper last summer with Bruce Booth from Atlas.  The data also shows that median time from first investment to exit is between 6 and 9 years.

Sorry to say it, the deck is stacked against you.  But it doesn’t have to be if you think through it carefully from the outset.

If you are a young partner at a firm, how do you put points on the board early in your career and in a timely fashion?

Of course you do all of the obvious stuff: source great companies, network constantly, make yourself valuable to other partners and portfolio CEOs, and be first in and last out every single day. In short, earn their trust.

But the best to prove your value is with mark-ups or early winners. Inside the hallways of venture firms, money talks.

You do this most easily by investing in “momentum stage” companies – define momentum as you wish – but typically it’s companies having revenues or in a market that is frothy enough that a 12-24 month mark-up from a new investors is possible.

This is of course easier said than done. But it probably excludes filling your bench of 3 to 5 deals with early stage, science-heavy investments or academic spinouts that are years from market or will necessarily take inside-only capital for several years to come.

In healthcare it might mean leaner early stage, asset-light biotech with near term milestones or revenue stage HCIT, medtech, or services. In internet and IT, it probably means either finding a category defining game-changer (high risk) or more likely by investing in a company with revenue or traffic traction of some sort.

It’s much harder to prove your value as a partner after 5 years at a firm by going back to them and showing an unrealized portfolio full of companies that have done tranched insider financings or flat rounds. Even if those companies are largely going according to plan, that’s probably not good enough to get you promoted or to build your track-record such that you can take it to another firm.

If you are 3 to 5 years in and don’t have some of these momentum stage companies in your portfolio and you still haven’t had an exit, then stop reading this post and go find a great company with momentum now.

Career planning in VC is about portfolio planning from the outset. You can never time markets, but you can enrich your odds by thinking through.

Thanks Rob for inspiring me to finally post this.

And what an incredible 16 months it has been for the company.

Today’s exciting news that BÂRRX is being acquired by Covidien has me beaming from ear to ear for lots of reasons.

Not only am I proud to have been associated with such a stellar and professional management team, led by the incredible duo of Greg Barrett and David Utley, but I am also thrilled to know that almost 100,000 patients were treated and cured successfully with BÂRRX devices over the past several years.

Rarely do the stars align in an investment like they did here:

1. Tireless, hungry, and inspiring management team

2. Incredible clinical data – including a randomized double blinded New England Journal of Medicine study

3. Dramatic published cost-effectiveness data

4. Positive recent medical society guidelines

5. Strong reimbursement rates despite the current backdrop of cuts

6. Rapidly growing global presence, revenues, and clinical acceptance

I could not be more thrilled for the 100 or so men and women who have made BÂRRX such a great company since its first round of capital in 2003.

I’ve learned a lot from this company and its management team. Namely – if you do things right clinically, for doctors, for patients, for your employees, for your shareholders, and the healthcare system, good things will happen.

I also learned that investing in category defining and leading companies really matters.

So to all who think healthcare VC investing has been left for dead, please think again.

We’re not going anywhere.  

The recent pullback is of course temporary.  When the inevitable bubble bursts in other sectors of venture capital investing, does anyone doubt that healthcare venture will again be in favor, as it was just a decade ago after the carnage of 2000 and 2001?  After all, history may not repeat itself but it sure does rhyme (to quote George Zachary from CRV).

Fact Check:

• People are still getting old.
• People are still getting sick.
• Healthcare still is the only net area of employment growth in the economy.
• Whether we like it or not, healthcare is nearly one-fifth of our economy.
• Large-cap healthcare companies still need to acquire innovative and growing private companies to boost their growth rates.

Thank you BÂRRX for restoring my faith that the good guys do actually finish first sometimes.

I have my own theory about why decline happens at companies like IBM or Microsoft. The company does a great job, innovates and becomes a monopoly or close to it in some field, and then the quality of the product becomes less important. The company starts valuing the great salesmen, because they’re the ones who can move the needle on revenues, not the product engineers and designers. So the salespeople end up running the company. John Akers at IBM was a smart, eloquent, fantastic salesperson, but he didn’t know anything about product. The same thing happened at Xerox. When the sales guys run the company, the product guys don’t matter so much, and a lot of them just turn off. It happened at Apple when Sculley came in, which was my fault, and it happened when Ballmer took over at Microsoft. Apple was lucky and it rebounded, but I don’t think anything will change at Microsoft as long as Ballmer is running it.

I hate it when people call themselves “entrepreneurs” when what they’re really trying to do is launch a startup and then sell or go public, so they can cash in and move on. They’re unwilling to do the work it takes to build a real company, which is the hardest work in business. That’s how you really make a contribution and add to the legacy of those who went before. You build a company that will still stand for something a generation or two from now. That’s what Walt Disney did, and Hewlett and Packard, and the people who built Intel. They created a company to last, not just to make money. That’s what I want Apple to be.

–Steve Jobs (Kindle Locations 9752-9764). 

Jobs makes two critically important points here:

1. Product matters. Founders understand this better than anyone else.  Companies that lose their founders often lose their way. This is not an indictment of sales people – many of whom are wonderful people as much as it is an admission that founder-led businesses do best. That’s been shown time and time again – and I really believe it to be true. The best companies I have the pleasure of being involved with or observing have been the ones where the founders played a critical role from inception through product launch and growth.

2. Too many companies are being “built to flip” these days.  VCs have figured out this game as well.  There are very few VCs backing truly innovative big ideas these days – whether it’s in healthcare or tech.  With 10 year fund lives and a real paucity of returns for the past 10 years from most of tech venture as a whole, the sandbox that most VCs play in has become smaller and smaller.  The entrepreneurs get this too – why try to build a lasting company from some foundational science or cutting edge new technology when the challenges are so great and the VCs wont even bother investing?  It makes me wonder whether the Apples of tomorrow are actually getting started today or not?  This is why I am so excited about Peter Thiel’s Breakout Labs and some of the great companies that big thinking VC firms are backing these days.

Of course, this got me to thinking about growth in healthcare. Whose got it and where is it?

Here is the quick and dirty analysis – without any of the pretty pictures that Glenn  got from the bankers at Cowen in his post.

• Total publicly traded healthcare companies globally: 3983
• Those with LTM (last 12 months) revenue growth of 30% or more: 462
• Of the 462, those with LTM EBITDA margin of 30% or more: 59

Looking at the location of these companies shows us that unlike the internet, the US retains leadership in profitable and growing healthcare companies (at least by these metrics) – BUT it would be clearly foolish to discount China – which probably would not have made much of a showing on this list had I done the analysis just 5 or 7 years ago.

• US – 21
• China – 13
• Canada – 4
• India – 3
• Australia – 3
• Sweden – 3

The Top 20 in order of market cap (large to small) are:

1. Celgene
2. Alexion
3. Valeant (Canada)
4. Illumina
5. Endo
6. OJSC (Russia)
7. United Therapeutics
8. Guangxi Wuzhou (China)
9. Questcor
10. Sihuan Pharma (China)
11. DIVI Labs (India)
12. DiaSorin (Italy)
13. Jazz Pharma
14. Jiling Zixin (China)
15. Intermume
16. Viropharma
17. Biosensors (Singapore)
18. Zhonghong Holdings (China)
19. Momenta
20. AVEO

The best US healthcare companies (both public and private) have management teams who can commercialize products developed here in the US into fast growing markets like China, India.

Meanwhile, all of us as investors, operators, and managers in healthcare companies should be mindful of the fact that some of the fastest growth in the world is occurring outside of our shores – where it is unencumbered by our complex regulatory and reimbursement schemes and where access to graduates with degrees in biological sciences and medicine is growing dramatically through stated government policies.

A thriving set of healthcare companies is a major national strategic asset for the United States for many reasons – including most importantly high value job creation and an engine to drive and soak up graduates of PhD and advanced degree programs from our universities.

We should do everything as a nation to grow these companies while smartly reducing regulatory barriers that challenge this growth – always with patients and our domestic economic engine in mind.

(Note: I did not include a forward year revenue and EBITDA growth projection in this analysis like Glenn did in his post)

Most venture capitalists think that Tech investing has been what makes the best returns – which is why they’re pouring money into Facebook, LinkedIn,  Twitter, and the like.  They may be right now and in the future, but at least over the past decade, they’ve been wrong: in the 2000′s, venture investing in the Life Sciences has outperformed venture investing in Tech.

The venture business is now 12 years into a slump in returns that has discouraged even the most enthusiastic investors and limited partners in the space.  Yet over the past 18 months, hope has sprung eternal amongst IT and Internet venture investors driven largely by a daily barrage of blog and news headlines covering the exponential growth and dramatic returns prospects of a small handful of social networking and gaming companies.

Left behind by this good news is the Life Sciences and Healthcare Venture Capital industry which according to PWCMoneyTree / NVCA data accounted for nearly 30% of the $21 billion invested in venture-backed companies in 2010.

A widely held notion amongst GPs, LPs, and entrepreneurs is that Life Sciences/ Healthcare (LS) venture investing is too challenging and has underperformed IT and Internet (Tech) investing over the past decade and will only continue to do so.

Nothing could be further from the truth – it seems that like Rodney Dangerfield, LS gets no respect. 

As we outline in our paper in the July issue of Nature Biotechnology, LS venture investing dramatically outperformed Tech venture investing over the past decade.

We believe our study is the first widely published, peer-reviewed look at the actual venture returns data for the 2000s comparing Tech and Life Science performance – which we took from the NVCA Benchmarking Database powered by Cambridge Associates. This is the most robust database of its kind – covering returns from nearly 1300 firms over the past 30 years of venture capital. To focus our analysis on actual returns, we looked primarily at companies that achieved first investment and realized an exit in the past decade.  Importantly, we looked at the aggregate of individual investments themselves rather than funds since sector-specific and diversified venture funds exist.

Our analysis yielded thousands of data points and unearthed two critically important trends that we think are widely misunderstood or unknown by the VC ecosystem, the limited partners in the asset class, and the media that covers it.

Life Sciences Realized Returns (IRR) Dramatically Outperformed IT

Overall Life Sciences/Healthcare venture realized gross pooled mean IRR was 15.0% for the past decade.  This is in contrast to 5.5% for all of venture capital, 3.0% for IT and 4.1% for Software.

In fact, every single sub-category of Life Sciences venture showed at least 2x to 3x better realized IRR than IT counterparts.   Including unrealized exits (value of currently active deals) makes the difference less profound, but the outperformance of LS still persists.

(For definitions: “realized” deals are exits, “pooled” data is the aggregate of the full decade  into one dataset, “means” are arithmetic means, and “gross” returns are not net of the fees or incentive compensation).

Life Sciences Had A Lower Loss Rate and Higher Frequency of 5x+ Returns

There’s a perception that lots of Life Sciences deals lose money.  It’s true.  58% returned less than their invested capital.  But surprisingly the failure rate in IT companies is much higher: almost 75% of IT-related investments realized a return of 1x or less in the past decade.  Furthermore, the frequency of 5x or greater returns are higher in Life Sciences – 8% vs. 4% for IT.  We’re sure the Tech distribution curve extends much further out at the top end, but the dataset didn’t allow for that analysis (e.g.,. top 1% of Tech deals almost certainly have higher multiples than LS).

We would bet that only a small percentage of GPs and LPs in venture capital actually are aware of this outperformance of Life Sciences in the past decade, and think that more transparency around the actual returns data in the venture industry is a good thing.

But, as one would expect, not all of the news for Life Sciences is rosy:

Life Sciences IPO Performance Is Poor Compared to IT

Nearly 60% of Life Sciences IPOs from the past 4 years are trading below their issue price versus ~30% of tech IPOs..  And, post-IPO performance has been dramatically better in IT than it has been in Life Sciences.  IT companies that get public tend to be more mature business with revenues and often significant earnings; in biotech, most companies remain cash-burning for the foreseeable future.

This difference in IPO results is important and is a big part of the negative perception of the sector.  IPOs are media darlings, and help create buzz about sectors.  In LS, we aren’t likely to have that type of buzz anytime soon.

Our data and analysis of course has some short-comings. First, it is a look backwards over the past decade and does not include returns from the recent 2011 class of tech IPOs which will surely improve IT returns, perhaps significantly.  However, it has been shown by others that the recent web high flyers are mostly concentrated in the portfolios of a small group of venture firms, so it may have a less profound impact on the overall tech landscape.

Some of you who follow venture returns data may be asking some questions:

Would the data differ if we excluded dot-com bubble vintage?  As you can see in the table below, excluding year 2000 (the year the bubble popped) from our analysis does not change the results with respect to realized exits – which is the best measure of performance. LS continues to show a sizable lead over IT and Software.  And unrealized returns are equivalent.  If one excludes 2001 as well, while realized returns continue to favor LS, the inclusion of unrealized investments gives a slight edge to Tech due to the fact that unrealized healthcare holdings (i.e. current active portfolio companies) are not valued as highly as unrealized Tech holdings.   As we outline in our paper, significant mark-ups from round to round tend not to occur in LS companies. Instead, even well performing LS companies tend to be held at or near cost until an exit occurs leading to punitively low unrealized LS IRRs.  Tech companies that perform well, however, can get large round-to-round mark-ups – which helps significantly in driving the value of an unrealized Tech portfolio

Why this data different than the quarterly benchmark data by sector that Cambridge Associates publishes?

A few reasons for this.  First, the quarterly published Cambridge Associates data combines realized and unrealized returns; the biggest differences noted in our analysis are in the realized exits.  Second, our analysis is for US VCs’ investments into US companies.  We believe that Cambridge includes US VC firm investments into all companies (including companies housed outside the US). Adding international investments by US firms, especially recently from China, does improve the unrealized and realized venture returns in all sectors but particularly Tech. Third, and most importantly, we pooled 2000-2010 together to eliminate vintage year anomalies that the quarterly Cambridge data can show when looking at individual vintage years.  This pooling clearly weights the analysis towards years with more financings higher than those years with fewer financings.

So with these realized returns relative to Technology venture capital, why has such a negative perception of Life Sciences VC emerged in the past few years? We think that there are a few reasons:

1. Complexity – Healthcare and biotech in particular is inherently complex and investing in venture stage companies in this space requires a blend of deep science and medical understanding, plus a strong stomach to withstand the ups and downs of product development.  It’s not revenues and margins, but long term value creation.  And it’s getting more complex – headlines around tightening regulations at the FDA, the impact of health reform, and reimbursement cuts at Medicare can be scary if not put in proper context.
2. It’s the cycle, stupid – 10 to 12 years ago during a prior IT bubble period, there was lots of talk about how lackluster an investment area healthcare was relative to IT.  In fact several high profile firms ditched their healthcare practices during that time.  A lot of that talk seems to have made a comeback in recent months driven by perception that healthcare is a laggard.  Déjà vu.
3. No 100x’ers -  Unlike IT where 100x returns are possible and have driven great outcomes in companies like Skype and Google, and will most likely in Zynga and Facebook, Life Sciences never will have these wild “Black Swan” outliers.. These 100x’ers are the companies that draw press attention, new talent, and more capital into the IT space.
4. It takes money to get to an answer – healthcare companies usually require more money to get to an answer than IT (particularly internet) companies. The dogma in IT VC these days is that funding lean start-ups is the right way to go. Despite exciting new efforts at Atlas and a few other firms to build asset-light bio-pharma companies, it will never be as capital efficient to develop a drug, a diagnostic, or a new medical device as it is to build a mobile app or a web service.
5. Poor marketing – Our IT brethren are much savvier marketers, promoting their new investments, and getting glowing pieces about their latest and greatest new investments into mainstream media. Not so in healthcare where only a small handful of VCs and even a smaller group of CEOs use social media or leverage the press effectively. And, of course, most Life Sciences companies don’t translate well to widely read press outlets from Forbes to TechCrunch.

In conclusion, we think that IT and Life Sciences venture investing are fundamentally different businesses.  But these sectors actually complement each other quite well within a single venture portfolio providing much needed diversification within the asset class.

Tech venture investing is all about the hunt for the Black Swan: it’s about getting a high market-share of top quality deal flow, working with only the best syndicates.   Placing many small seed-stage bets creates optionality, and allows firms to double-down on those achieving real scalability and market traction.  Step-ups in valuation between rounds occur with regular frequency in winning companies and the tantalizing possibility of a 100x in a short period of time is always there when you invest in an early stage company.

Life Sciences on the other hand has been a steadier business, with a lower failure rate and a higher frequency of 5x+ returns.  Because of the nature of the LS venture market and the capital intensity in biotech, differential venture performance is not really about market share of new deal flow, as most syndicate formation isn’t competitive.  It’s about thoughtful scientific and clinical risk assessment, coupled with disciplined titration of capital and active governance, and can lead to very attractive investments over time.

We hope that by publishing this article, we will dispel some of the negative perceptions about Life Sciences venture investing and help to solve the fact that our sector gets “No Respect.”

To get all of the numbers and the full commentary, please head over to the Nature website.

For simplicity’s sake, in this post, we use the term Life Sciences to cover all of Healthcare venture capital investing and the term IT to cover all IT/Internet/Software and Hardware related categories.

The tech world doesn’t have an event like this where practically every venture capitalist, public company, start-up, hedge fund, PE fund, mutual fund, and investment banker all show up in the same city for the same 4 days.

The uniting topic in SF this week is healthcare.  The center of the activity is the lobby of the Westin St Francis in Union Square.

Most folks who come here have schedules that are wall-to-wall all week with little if any respite – from 7am meetings to dinners and drinks that go till obscene hours.

This year, official conference registrants are 8700 – up from 7200 last year. Probably at least 5x that many people in SF for the week but not officially registered.

This year, I tried to place limits around my schedule – since in past years the meeting has been just too overwhelming for me.

My guiding principles in 2011 for JP Morgan were:

1. Minimize first time meetings with companies – I will be a better listener to your pitch next week or the week after – I promise.

2. Try not to schedule meetings with Bay Area people or companies – since I can see them any other week

3. Focus on seeing people not new pitches. ie, on spending time with CEOs, founders, board members, VCs, senior folks from larger companies

4. Minimize formal scheduling and maximize “time in the hallways” and by the famous (and now long gone) “Clock” in the lobby of the Westin. The clock can be the best place to see people you want to run into.

(Edit – Jan 7, 2012: The clock is back – and has been back for a couple of years. Thanks to those who pointed it out)

5. Try to get a full night of sleep every night – will be tough.

So with that in mind, a few notes:

1. If you are a new company that happens to have passed muster and are pitching to me this week, please keep it short – like 15-20 minutes max. I will forget anything else you tell me. Enough so we know if there’s a basis for follow-up.  No more than 5-10 slides – really. I don’t need to know who is on your SAB, for instance or the background of your Director of Manufacturing.

2. If I’m late to our meeting by a few minutes, I apologize – not usually my style. I blame it on the craziness of the week.

3. For this week, let’s pretend that psychiatrist billing methods apply. If I schedule a 60 minute meeting, let’s wrap it up at minute 45 so we can each get to our next meeting.

4. Please give me a full week or a bit more to get back to you. There will be lots of following up to do after the meeting.

5. If you see me in the hallway and want to give me the “elevator pitch” – I’d love to hear it. 90 second version is great – especially if you include your brief background in the talk up.

6. Not looking at new biopharma deals now – sorry.

7. Very interested in innovative health services and health IT companies at any stage and medical devices that have US revenues.

That’s it for now – I wish you all good luck and happy networking this week.

There. I said it. And I mean it.

I’m talking about healthcare venture capital – the seemingly ugly step-child of venture capital these days. But beneath that tussled appearance is a beautiful object to behold and worship.

The cold, hard facts that the haters love to deny show that healthcare venture investing has outperformed every single other category of venture investing since 2000.   Looking just at the thousands of realized venture returns in the past decade, it’s easy to see that Healthcare puts IT/Internet, Software, Hardware, Consumer all to shame.

Here is the data is from the largest database of venture returns out there.

-Data as of 3/31/2000

No matter how you look at the data, healthcare outperforms. It’s true by stage at initial investment (healthcare wins at every stage from seed to expansion for the past 10 years).

And it’s true for % of realized exits greater than 3x and 5x in the past 10 years. Healthcare again -  FTW.

% of exits below 1x invested capital – healthcare has the best #s there as well. By far.

You wouldn’t know any of this these days – where the talk in the Valley reminds me of exactly where things were 10 or 12 years ago.

Just as it was back then, I’ve heard many IT investors and VC industry watchers write off healthcare venture as being done and over. Wrong.

I’ve learned never to bet against two things:

1. Demographic trends

First – There are 40M Americans age 65 or older today. That numberwill grow to 80M in the next 30 years. By any measure, that is a huge new market to be served by healthcare services, drugs, and medical technologies.

Second – The fastest growing segment of the US population over the last 10 years and projected to be the fastest growing over the next 30 years is people over the age of 100.  That 100+ group has grown 40% in the last decade and is expected to grow by 650% over the next 30 years.

By comparison, the # of people in their 30s has actually shrunk by 6% in the last decade and is expected to remain flat at best over the next 30 years. If you don’t see it now, you better believe that the next 30 years will be all about caring for these people. (source: US Census)

2. Strategic acquirers who need to fill their product pipelines

The sectors with the best cash flows, best gross and net margins in the world are public pharmaceuticals, large cap biotech, and medical devices. And those are the companies who have the most to lose as patents expire and internal R&D dries up.

No, I’m not a sucker or a promoter. I’m just calling’em as I see’em.

Yes the FDA is tougher now than ever, and yes the costs of drug and device development are daunting.

But the pendulum will swing on those items as it always does.

And we will be left with a society where an ever-increasing percentage of our GDP is spent on healthcare and an ever-increasing percentage of our population work at health industry jobs.

I am of the firm belief that the next few decades will be all about novel and innovative health services and technologies that will transform how we age and manage our way through the dizzying healthcare system.

So, I’m officially calling out to my fellow comrades in healthcare VC: Be strong. Stand up. Be proud.

When you fell like hanging your head in shame because you’re at cocktails with a bunch of tech VCs at the Rosewood on Sand Hill Road and you can’t name the Google or Facebook of healthcare, just think of these amazing venture-backed healthcare companies – all exited in the last few years for $500M or greater:

Acclarent, AGA Medical, Ardian, Ascent, athenaHealth, Conor MedSystems, Corevalve, LensX…

I firmly believe that we are in the final chapters of “The Great Medical Arms Race.”  And unlike the Cold War, I don’t think the United States will be the winner of this arms race. We might feel like we are winning, but in fact, we will end up losing due to the perfect storm of three unsustainable realities: healthcare cost growth, a federal budget crisis, and demographics.

Some of the advances we have made in life expectancy and quality of life due to some of these new technologies is amazing.  The US healthcare system has been very good at developing innovative new technologies that improve outcomes and increase costs.  Unfortunately, we are also very good at approving new technologies that just increase costs but have little or no effect on medical outcomes.

Lots of people have written about the the vast amounts that Medicare spends on end of life care. In particular, as a society, we spend too much on technology in the last few months of life and too little on basic access to primary care.  We spend too much building new heart hospitals and spine surgery centers and too little on hospice care or access to preventive care.  In short, we don’t “let go” well as Atul Gawande wrote so eloquently last week in the New Yorker.

I think everyone can agree that despite having the most access to technologically advanced therapies, the US taxpayer is not getting any bang for the buck.  A recent study showed that there is little correlation between reduced mortality and increased spending on several major health conditions.

Despite spending 17% of GDP on healthcare, the outcomes are dismal.  According to the WHO, amongst developed nations, the US is

-37th in overall health

-34th in life expectancy

-28th in infant mortality

-30th in obesity

In the world of medical technology, one of my favorite examples of questionable bang for the buck is colonoscopy.

-There are 4 million colonoscopies per year in the US.  Many adults who need colonoscopies still don’t get them due to fear of the procedure, lack of access to care, etc.

-Yet despite that, there is a growing $1b/yr medical device market for colonoscopes and related equipment in the US alone

-Colonoscopy is the bread-and-butter income for most of the 12,000 GI docs in the US and has aided greatly in the proliferation of GI focused ambulatory surgery centers that doctors often own a financial interest in.

-However, there exists little long term cost-effectiveness data showing that screening average asymptomatic risk populations with colonoscopy every 3 to 5 years is actually cost-effective in the long-run.

-In fact, more and more data shows that colonoscopy is being done way too often on average risk patients. High risk patients should of course be screened with colonoscopy.

-Health Affairs recently published an elegant paper postulating that lower-tech and lower cost screenings (ie, FOBT) for colonoscopy would “would result in more individuals’ getting screened, with more life-years gained”

So how about this crazy idea?

What if an lower-tech therapy or diagnostic had 80% of the effectiveness of a new technology but at 20% of the cost of the new technology?  Would society favor the older technology or the newer one? Would patients and families accept that they aren’t getting the absolute latest and greatest?

A totally rational society should choose the older technology and then invest the dollars saved into other areas with higher societal needs (ie, education) and potential benefits. But I fear that without some financial incentive, most individuals would not choose the cheaper technology if given a choice.

My favorite recent paper on this topic reviewed almost 1000 cost-effectiveness studies and concluded that only 0.4% of the interventions in those papers actually reduced cost significantly while only decreasing quality a small amount.

The authors of that study also concluded that “less-expensive, lower-quality innovations are ubiquitous in other economic sectors but have not been described in health care.”

This should frustrate every one of us as consumers of healthcare.  It certainly frustrates me as a investor in healthcare technology companies.

I think cost-effectiveness studies should be mandatory for US approval of new medical technologies.  If you pitch me a new medical technology company, be prepared to answer what your cost-effectiveness streategy is.

Cost-effectiveness is clearly the holy grail and where healthcare is headed in this country given the two big trends of the next 25 years: massive federal and state budget constraints and inevitable demographics.

Getting this issue right is the only fighting shot the US has at not having rising healthcare costs cripple the economy.  I’m really hoping the new government funded Patient Centered Outcomes Research Institute does the right thing here as well.

So, taking off my policy wonk hat and back to venture capital for a second: where is the investment theme here? Better decision support tools for doctors? Generic drugs or “generic” medical devices? Cost transparency services like Castlight?

If you can think of others, please comment below.