Medical Device Link.

Originally Published MX March/April 2004

FINANCE

With a rising economy and solid medtech earnings projections, experts foresee a good year for funding growth in the medical device sector.

Moderated by Steve Halasey

If the experts are right, medtech executives who are taking their show on the fund-raising road may have an easier time this year than they have for the past several years.

That's definitely good news for a lot of early-stage medtech companies that are seeking investors. But it could also be good news for growth companies whose development has progressed to the point at which acquisition or an initial public offering (IPO) is the next logical step.

A key driver of the improving environment for medtech funding is the gradually improving economy, both in the United States and around the world. But that's not the only factor that prospective investors see as important in determining whether to loosen their purse strings. According to the experts, investors are especially sensitive to the trends in specific sectors of the medtech industry, and companies themselves can make or break their opportunities for obtaining funding by having—or failing to have—a good business plan.

To find out more about the current climate for medtech funding, MX spoke with five experts in the field for this issue's roundtable conversation (see sidebar).

MX: Conditions in the global economy have changed a great deal in the past year. What has been the most favorable change as far as medical technology manufacturers are concerned?

Mark Butts: What we have seen is that, starting about seven or eight months ago, the money for funding medical technologies seems to have loosened up substantially.

At least the individual investors seem to be more flush with cash. They are starting to have some positive experiences in the market, so they are willing to take a little bit of that cash and invest in some early-stage companies. We also see that some of the venture capital firms are much more active in looking at deals—and actually closing on deals—than they were 12 to 15 months ago.

Lars Enstrom: Mark makes a good point, and that is that the biggest factor here has been the improvement of the capital markets, both for private and public medtech companies. That gives companies the capital to reinvest, develop new products, and also fund acquisitions with either stock or cash.

Don Grilli: It is just night and day between the environment that exists today and the environment we went through last year. That has been confirmed somewhat by our venture capital (VC) investors on the board, as well.

Ilya Nykin: I agree with the comment about capital markets. In particular, I would single out the apparent opening, at last, of the window for initial public offerings (IPOs). I think that it becomes the tide that lifts all boats. Liquidity events become more predictable and take place in more attractive time frames. Valuations begin to go up. Investors' optimism rises accordingly.

The VC Outlook

How has the amount of VC funding going into the medical technology sector changed with our recent economic history? How does the coming year look?

Nykin: My sense is that medical technology began to look more and more attractive after opportunities in other areas began to look more and more uncertain. The medical technology investment sphere had a more predictable, more reliable path toward the exit. You can put your arms around the regulatory process more easily. You could eliminate some of the risk factors from the process earlier on. Not surprisingly, people began to rediscover the attractiveness of this area. A lot of money flowed into it.

Grilli: There certainly seems to be a higher level of interest in the medical device corner of the marketplace. Dot-coms had a big impact on a lot of the investment firms. Now we see activity picking up. I think it will continue to increase.

Hugh McManus: I have to agree. Last year was very challenging. Things certainly have improved, even in the last few months.

Some analysts have said that when the recovery starts, other sectors will look better and investors will pull out of the medtech market. Is that likely?

Enstrom: What has changed there is the complexion of some VC funds. Before, people were playing both tech and healthcare, or tech and biotech. Many of those funds are no longer there. Many of them have switched to either an entirely tech or entirely healthcare focus. So what we have, actually, is a much better environment for people who have raised substantial amounts of money.

Last year was a great year for VC firms raising money from people who invest only in healthcare. By corollary, there will always be a certain percentage of the total investment in life sciences that, for example, will be dedicated to medtech. So I don't think there is going to be as much of a shift as there was before.

Butts: I don't think the shift has happened quickly. VC firms hire guys that have medtech experience, and those guys go to work. They have raised their funds by telling their limited partners what they intend to invest in. So, the funds have a cycle to get through. They will stay on course pretty much for a particular fund, then maybe they will change when they move on to the next fund.

Nykin: The structure of the industry has changed. It is true that some funds are no longer there. It is also true that specialized funds have emerged. Some are new and others are the result of a split in a larger firm that had covered both information technology (IT) and healthcare. Partners went their own ways and established their own firms. But from the standpoint of companies that bought into the premise of healthcare investment, not much changed. They like that field because by and large it consists of companies holding a proprietary position with good intellectual property (IP) and who are solving real problems. I think that they will continue to pursue it.

Toward Exit by Acquisition

Some analysts are also suggesting that the greater specialization of VC firms cuts both ways: a company looking for investment capital does not have to explain the industry to somebody who doesn't know it, but, because the VC firm has more expertise in the field, its expectations are higher than they might have been in the past.

Grilli: Perhaps there are more people in the VC community who are more knowledgeable about, for instance, medical devices. I don't know. Whether they understand it well enough to be more aware of the opportunities, I am not sure I can say. I have seen it both ways, quite frankly.

Nykin: It is not necessarily a problem that people have higher expectations. Having higher expectations means that people are perhaps more competent and more focused. It may result in their selecting better companies. Better companies would probably develop more successfully and exit at higher values. This would, in turn, propel that whole investment sector to a different level, making it more attractive, more promising.

The better companies that are making the grade may need a longer cycle of early-stage funding to be ready for acquisition. That seems to be a market- sensitive issue. Are potential acquirers looking for companies further evolved in their life cycle?

Enstrom: It depends on the sector, if it is a technology purchase. We have seen deals in this past year involving spine technology that have been done at incredibly high valuations. Those technologies are certainly several years off. But, by the same token, the purchases were intended to make sure that the acquiring company got access to a particular technology. The situation is not going to be the same necessarily in the cardiology sector or some other sector. So it depends on the sector and on how groundbreaking the technology is.

Butts: I agree with that. We recently did a comparative analysis. We were looking for companies that were acquired prerevenue, and those that caught our eye were the spine companies. They went for huge money without even having their premarket approval (PMA) applications in place. With some medical technologies, the acquirers want the technology proved out by a sales ramp—and they want to see a pretty steep ramp. In other cases, they are willing to make an acquisition prerevenue if they have a hole in their product line. And then there are the spine-type companies.

We have one right now that has a cartilage resurfacing product. The technology is a breakthrough. I think all bets are off on those. Companies will pay huge money for breakthrough technology in large market segments.

Grilli: My perspective as a developer of spine surgery technology might be a little different. The spine market is an unusual one that everybody is interested in. Not too many markets are going to grow 25% over the next four to five years funded partly by the needs of the baby boom population. It is an extremely profitable market, and the technology continues to improve.

The artificial disk is at the center of a lot of excitement. Companies can have a problem, though, with a market that big. They feel that if the artificial disk really takes off, they have to be a part of it, so they make an early play. But the bigger companies want more-proven technology. They want to take less risk. The reason is that they are so big they cannot afford to make small investments in R&D; their infrastructure will not allow them to nurture the project and do what is necessary.

That situation is worsening. Corporations are getting so big, and they need so much volume to maintain that top-level growth. Making a risky acquisition is not something that is really going to help them. So if a company has proven technology—and a sales ramp provides good evidence of that—it is going to be in the mainstream.

Nykin: It is true that there is variability from sector to sector. And at almost any time there is some field that is particularly hot. But it is fair to say generally that start-up companies have been taking a longer time to exit.

There are a number of reasons for that, one just very well articulated. As major corporate players grow even larger, they lose some of their ability to work with smaller, fledgling enterprises. It is just too difficult to absorb, too small to bother with.

But some of the very large firms have been active in establishing their own VC funds or investing in small players. What is the deal there?

Grilli: I think companies have had to do that to pay more attention to the new, evolving technologies in the marketplace. That is because most of the major opportunities that their day-to-day managers are concentrating on are the much larger ones that can return some immediate benefits to the P&L to satisfy Wall Street.

M&A

The companies that have had VC funding for a while are starting to mature. Are the large-company acquirers more selective now than they have been with respect to the companies that are available to them?

Enstrom: A couple of changes have occurred over the past few years. Medtech companies have gotten larger, which means that it is increasingly difficult for them to show growth on an earnings-per-share basis and maintain their historical growth rates, as well as enhance their price-to-earnings ratios. This is very analogous to some of the issues that large pharma is facing. The bigger you get, the more deals you have to do because you cannot grow enough internally.

So my thinking, borne out by the activity we see, is that large companies always have a need for new products. When companies see very large market opportunities, they are going to have to make a play because, on a scale basis, those big opportunities are the only ones that will have a significant impact on their growth. They cannot just pursue a small product here, a niche opportunity there. They really have to go for major expansions.

Butts: One market we are familiar with is the femoral artery closure device market. All the companies that are selling stents or are otherwise in the cath lab are looking for a closure device. Abbott recently bought a California company, IVS. The word on the street is that Abbott put down about $65 million, with perhaps another $50 million or $60 million in back-end payments if milestones are met—and IVS does not have an approved product yet. We hear that the product had been used in fewer than a hundred patients in Europe at the time of the acquisition. But a lot of companies are out there looking for a closure device in order to round out their product line. That way, when they sell their stent or catheter device, they can package a closure device with it.

In the past year, the amount of M&A activity in the sector has been improving. There were a few very, very large deals, however. When those are taken out of the equation, was the activity really as strong as people thought? Is it a good bet now?

Grilli: Speaking for the spine market, it has really heated up tremendously during 2003. Small companies in spine that have some interesting technology have got a two-year window of opportunity. I think M&A is going to continue to grow within the spine market as the bigger companies consolidate. What they are starting to do now is acquire some of the smaller companies that have unique platform technologies which they can leverage through the distribution organizations. It is a great time.

Enstrom: Just to put some numbers on this, and looking at all life sciences—devices, biotech, and pharma—essentially during the third quarter of 2003 there were about 102 deals, as we measure them. That is about a 12% increase over the corresponding quarter the previous year. Overall, for the past four quarters ending 3Q03, there were about 480 transactions. That compares with around 365 transactions over the previous 12 months and makes about a 31% increase, a fairly significant one that cuts across all sectors.

Butts: We do a limited number of deals every year, recently in the cardiology and orthopedics markets, so all I can say is that, over the past nine months, we have been having a much easier time getting our deals funded. That just suggests that money is freed up and that people are much more active again.

McManus: Somebody spoke earlier about the baby boomers. I have to imagine that this is all driven primarily by them, by demographics to a large extent.

Are there market areas that are begging for attention, where companies are struggling along? Are they being considered at all as opportunities?

Nykin: Let me throw out another just for the sake of the conversation here. I think there are some indications that things having to do with detecting biohazardous agents and various other biodefense applications are attracting a lot of attention.

Grilli: The cardiovascular and orthopedics markets are huge. They are growing dramatically and are very profitable; they have a tremendous number of things going for them. So those two markets are getting the majority of the attention. Dealing with other sectors is more difficult because the markets are more mature; the profitability is more challenging. Unless those companies have some unique technology that can come on strong and capture the marketplace, they probably are struggling.

Enstrom: I will throw out two other positive sectors. One is the diagnostic sector, with several notable recent deals. The other area with potential is medical imaging. The seminal deal of the year was the GE move to buy Amersham, which is a significantly different business from what GE had before. I think the reagent markets are getting more and more interesting with what Invitrogen has been doing in terms of acquisitions. That area should continue to consolidate.

What should company leaders in the smaller areas do to attract the attention of VC investors or potential acquirers? Is it strictly a matter of having the right technology at the right time?

Nykin: Preparation gets a lot of our attention. To begin with, cover the basics. Articulate well what the product is about, what the technology is about, the strength of the company's proprietary position. Have a good sense of the regulatory path. Show a good understanding of the target market and of competitive factors. Present a well-reasoned business model.

The Coming Year

A year from now what will we be talking about in terms of the current status of the industry? Recent significant growth, good funding opportunities for companies, some new areas being covered, or something else?

Butts: Whenever we take on a new company to represent in raising capital, we tell people that the most problematic things they are going to run into are matters over which they have no control. My partner and I ran a telecommunications company in Russia a while back. In August 1998 the ruble lost 60% of its value overnight, something we had no control over. We were in the middle of a capital raise for a client company on September 11, 2001. Unforeseeable external events like those, with uncertain aftermaths, are the ones that can have the greatest impact upon any company.

Enstrom: Looking out a year, I think we will see continued consolidation in the sector. But even more, I think we will see some unexpected transactions involving very tangential players making big bets in the sector. These would be life sciences companies looking at medical devices for the first time, and also firms from outside healthcare making a play in devices. We saw some of that last year.

Medical devices, despite all of the issues we have talked about, is still a very attractive sector. It still has very good pricing power when compared to, say, telecom. It does also have regulatory issues, certainly. But on the whole, the demographics are pretty significant on the macroscale that is the focus of many companies looking at potential acquisitions.

Grilli: Speaking more specifically to the orthopedic and spine market, I think we are definitely going to see growth. And we are definitely going to see consolidation. Bigger is better. This is a relationship sell: the bigger a corporation is, the more it can carry, and the more impact it is going to have in the marketplace. A lot of the consolidation is going to be driven by new technology that takes advantage of a rapidly growing market. However, it is probably going to take a lot longer for the technology to be accepted than most investors believe, because of the conservative nature of orthopedic surgeons.

McManus: Generally when we, as a start-up company, are presenting things to venture capitalists, we are to some extent trying to manage risk. The company shows that it has a good plan, thought through, that the projections make sense, are aggressive but not outrageous, that the IP position looks fine, that the market risk is handled. After that it is up to the VC firm to take care of the financial risk.

Speaking on behalf of individual investors, I get a sense from conversations with them that uncertainty about the geopolitical environment is what might cause people to hold back somewhat. Every orange alert seems to make people a little bit more nervous.

But looking just at the market we are talking about, medical devices, that seems very, very positive. I agree about increased consolidation. Biotech is poised for good times ahead. The pipelines look wonderful.

Nykin: I, too, am optimistic. This sector will continue to attract investment dollars from venture capitalists. I think we will be able to point to some very successful IPOs of venture-backed companies, many of them not only having had a successful IPO but also doing very well post-IPO. We will also see some good M&A transactions involving venture-backed companies. Overall, the level of interest in this sector, and the optimism, will continue to be strong and growing.

Copyright ©2004 MX