2009 Medtech Funding and Investment Climate

In the medical device industry, company and investor success go hand in hand.

Capital investment in medical device companies is expected to occur at a healthy pace during 2009. While the number of medical device companies receiving venture capital may not increase significantly, the aggregate dollar amount invested is expected to increase as the average size per round expands to meet the broadening capital requirements of emerging companies.

Investor expectations of enormous growth in healthcare spending—and confidence that exit opportunities will satisfy internal rate-of-return requirements—are together continuing to attract venture capital dollars into the medical device market. Ultimately, the capital invested in medical device companies will contribute to reducing comprehensive healthcare costs and improving patient outcomes in the years to come.

For the purposes of this overview, the medical device industry covers implants and associated instruments intended to affect the structure or any function of the human body in a therapeutic manner. Representative devices included in the analysis are hip and knee replacements, pacemakers, and cochlear implants. Products not included within the data are devices such as diagnostic tools and external bracing devices.

Venture Capital a Bright Spot

Although the credit crisis of the past 18 months and the dismal performance of public equities over the past 12 months have cast a cloud over the broader economy, the outlook for the venture capital market is brilliantly sunny. Since the venture capital market is not directly reliant on the debt and public equity markets (beyond exits), other factors have solidified its growth. In each of the past four years, the number and size of venture capital rounds has steadily increased (see Figure 1). Meanwhile, during the first three quarters of 2008, macroeconomic factors have not decelerated VC investing, which is only slightly off pace with the same period in 2007, a record-setting year.

Escalating Capital Demand

Remarkably, from 2004 through 2007 the total venture capital dollars invested in medical device ventures more than doubled to nearly $2.5 billion. While the number of transactions increased by approximately 40% during this period, the more impressive increases in average amount per raise across all stages of investment was an equal driver. From 2004 through the first three quarters of 2008, the average amount raised by round increased significantly. You can see the percentage of increase in average venture capital investment in medical device companies from 2004 through the first three quarters of 2008, by funding round:

Start-up/Speed companies saw a ~ 145% increase.

Early stage companies saw a~ 84% increase.

Expansion companies saw a ~ 15% increase.

Late Stage companies saw a ~ 19% increase.

From a demand perspective, these significant capital increases are a consequence of rising operating expenses for medical device companies. Beyond the initial research and development costs related to medical devices, innovative technologies typically require substantial investment in areas such as clinical trials, administrative infrastructure, and the creation of a distribution network. Further, the slowdown in the initial public offering (IPO) market as a funding alternative is compounding the circumstances with which late- stage medtech companies must contend.

The past five years have seen a minor shift in the mix of stages receiving funding and their respective portion of total funding. Expansion-stage companies—typically those with a commercially available product that have been in business for more than three years—have seen a 7% decline in their proportion of number of capital raises, and a 13% decline in their proportion of capital dollars.

Speculatively, such decreases represent the proportional shift of capital toward follow-on rounds of late-stage portfolio companies (necessary as time horizons to exit have lengthened), and new investments toward early-stage companies with greater home-run potential. The expansion stage is a critical phase when a company needs to prove that its technology and organization can reach revenue milestones and become cash-flow positive. With regulatory hurdles rising higher, achieving these goals is proving increasingly difficult—and therefore less attractive to investors. The relative decline in expansion-stage investing has resulted in increased investing spread evenly across virtually all the other stages.

Sustained Capital Supply

For the past several years, industry pundits have discussed the large 'capital overhang' within private equity, where there are considerably more dollars to invest than companies representing sound investment opportunities. For each of the past five years, venture capital firms with a focus on the broad category of medical equipment and healthcare services (which encompasses medical devices) have raised between $3.5 billion and $5.2 billion annually (see Figure 2). The number of funds raising capital has not increased as quickly as the aggregate dollar amount raised. Thus, the size of the average fund has increased from less than $100 million in 2004 to more than $150 million in 2008.

Industry data and broad anecdotal evidence suggest that venture capital firms are becoming increasingly specialized in the industries they pursue, thereby decreasing the pool of target companies in which they may make an investment. The 10 most active venture capital investors in medical device companies over the past five years have completed 380 investments in 130 companies (see Figure 3). In aggregate, the number of investments have increased each year over that period. As the venture market becomes increasingly crowded, and inherently more competitive, VC firms are further leveraging prior investment experience and directing internal resources toward fund commitments in narrower fields of focus.

Forecast for 2009

During 2009, medical device companies can expect a neutral investing environment for receiving infusions of growth capital. While the broader credit crisis has affected overall liquidity, cash is widely available for growth-capital investment because of the large amounts of capital that have previously been raised. However, with the length of time to exit increasing for medical device companies, venture capital firms are likely to become even more selective and diligent about making investments, further lengthening the capital-raising process. Such cautious attitudes and expanded due diligence will result in tighter institutional fund­ing for medical device companies with merely mediocre technology. For these reasons, the rapid growth in transaction activity experienced from 2004 through 2007 is expected to flatten at 2008 levels.

IPO Window Closed. In the United States, the window for initial public offerings (IPOs) is effectively closed, and not solely for medical device companies, but across all industries. Remarkably, not a single venture-backed company in any industry went public in the second quarter of 2008. Just as interesting, through the first three quarters of 2008, only eight private-equity-backed firms in any industry raised capital through an IPO—a statistic that has significant implications for the venture capital market.

IPOs on major exchanges provide much-needed capital and a path to exit for private equity groups, assuming that enough liquidity exists in the portfolio company's stock. As exits through IPO become less attractive or, more accurately, unavailable, additional strain will be placed on the M&A market to provide exits. This dynamic is likely to result in a lower return on investment for private-equity-backed firms, because sellers will face increased competition to consummate a suitable M&A transaction.

Concerning medical device companies specifically, only one medical device company went public on a major U.S. exchange during the first three quarters of 2008: Mako Surgical Corp. (Ft. Lauderdale, FL), which raised approximately $51 million (see Figure 4). For perspective, during the prior four years, when activity was considerably healthier, 34 medical device companies raised an aggregate of $2.4 billion through initial public offerings.

Unfortunately, the IPO window will remain shut for the foreseeable future. Throughout 2009, therefore, the IPO market is anticipated to be feeble, albeit slightly better than 2008's anemic performance.

The current status of the IPO window is likely to result in fewer late-stage medical device companies receiving capital in 2009. Venture capital firms with standing investments in late-stage medical device companies will encourage those portfolio companies to stretch their cash balances as far as possible. Beyond current institutional backing, self-supporting late-stage companies may find venture financing more difficult to obtain until the IPO environment improves.

Healthy M&A Activity. Despite enduring the most difficult IPO and credit environment in recent history, medical device M&A activity in 2008 has remained strong, comparable to the impressive performance experienced in 2007 (see Figure 5). While transaction volume through the first three quarters of 2008 was slightly off the pace over the same period in 2007, medical device companies have experienced favorable 'seller valuations' and a resulting increase in the average size of transactions. With the strength of the medical device M&A market thoroughly tested in 2008, M&A activity in 2009 is expected to remain at similar levels, understanding that valuations will become progressively more favorable to buyers.

Credit will remain tight in 2009 as markets struggle to correct themselves and banks attempt to clear nearly $50 billion of debt lingering on their books from the pre-2008 loan overhang of $200 billion. Fund-raising efforts from private equity firms have continued to secure capital to add to the already record amount of existing, undeployed equity available for investment. The accumulation of stale capital should support 2009 M&A transactions in the middle market (with values less than $500 million). Deal volume for larger transactions (values greater than $500 million) is expected to struggle, with limited debt available in the market. However, the noncyclical nature of the medical device market, coupled with recent activity in Washington, DC, should improve this dynamic, and attract credit back for larger transactions, enabling volumes to rebound faster in this segment than in others.

While credit markets are soft, strategic buyers should be able to better compete with private equity groups in terms of valuation, especially when considering their ten­dency for all-cash deals and lower dependence on financing. Corporate balance sheets remain strong, and a number of medical device companies are well positioned with large amounts of cash to execute transactions in the near future. As evidence, the top 10 medical device companies alone are carrying $24 billion in cash ready to be deployed.

Large and midtier medical device players continue to bolster their pipelines through acquisitions. As many segments of the medical device market remain fragmented, companies with strong technology will be targeted for continued consolidation. Relatively low trading multiples compared with recent years suggest that many public companies are undervalued. This factor should set the stage in 2009 for a continued 'outsourcing' of R&D via acquisitions, and a trend toward more buyer-friendly valuations.

As the trends discussed here begin to develop during 2009, medical device M&A activity will maintain support for future venture investment in medical technology, and will continue to be the preferred form of liquidity event for medtech shareholders.

Conclusion

In 2009, the investment climate for medical device companies is anticipated to be temperate. Although the number of companies receiving institutional funding during the year may plateau, the average size of investments—and therefore the total capital invested in the sector—is expected to continue to escalate.

Institutional investors are ultimately interested in their return on investment, and the recent history and future prospects of the medical de­vice industry are both admirable in this respect. While the IPO window is anticipated to be closed for the foreseeable future, the M&A market is expected to pick up the ma­jority of the slack and continue to provide attractive exits for medical device shareholders.

Medical device companies persist in developing novel solutions that reduce comprehensive healthcare costs and improve patient outcomes. Investors will help to ensure the success of such companies by properly quantifying a company's risk, assigning a valuation, and providing sufficient capital to enable companies to move forward.