Dana Callow is the Managing Partner of Boston Millennia Partners. Prior to founding Boston Millennia Partners, Dana co-founded Boston Capital Ventures. In addition to working with Fortune 100 companies in strategic planning and implementing M&A strategies, Dana is, or has served as, a director of a number of other public and private companies. He chairs the Investment Committee for Tufts University's endowment and is an executive member of the Advisory Board of the Dartmouth/Tuck Center for Private Equity and Entrepreneurship. He is a graduate of Tufts University and holds an MBA from the Amos Tuck School at Dartmouth College.
Some have recently argued that the venture capital industry is undergoing a substantial reduction in size, in large part due to institutional capital reallocating funds to more conservative investments. Some have even argued that this is a necessary contraction in the industry. Will you share your thoughts on this subject?
Most institutional investors have reassessed their overall tolerance for risk. The poor performance of most asset classes last year and a loss in confidence of traditional correlation effects of multiple asset classes has changed investors' thinking. The venture industry has been inconsistent at best in its recent investment performance and therefore it is a casualty of the recent downturn. However, we believe there will be a reversion to the norm, and we will see the venture asset class outperform relatively significantly over the longer ten year term. Combined with a broader reduction in risk tolerance on the part of many investors the result is a slow consolidation of our industry. This trend will reverse as returns and increased liquidity and exits show up through M&A, limited IPOs and secondary restructuring. Many industry observers suggest that there has been too much money chasing too few good deals, but we believe that the weaker return issues are more centered around a limited pool of great CEOs and inadequate thinking on how and when to exit an investment. It has always been easier to buy than to sell. What results is a healthy realignment of efforts toward the strategic sale on the part of the GPs. The industry consolidation is a necessary condition based on smaller or substantially reduced allocations to alternative assets coupled with liquidity problems in many of the larger institutional investors.
Another contributing factor is the "denominator effect" from a declining public market which inadvertently put many investors into an over-allocated position to alternatives, which includes venture capital. This denominator effect will slowly work its way through the markets and allocation percentages will normalize. Nonetheless, there is still substantial capital available to those venture firms with a clear strategy, strong investment teams and a proven track record. A contraction in the number of firms is beneficial to both investors and entrepreneurs as it is a form of natural selection creating a more efficient marketplace.
While the economic conditions over the past year have created cause for concern for the venture capital industry, will you comment on what you are seeing on the positive side in terms of innovation and advancements from companies in various sectors that excite you from an investor's standpoint?
There remain substantial ongoing opportunities in many sectors for innovative companies which genuinely reduce costs and improve productivity for their customers. Any idea that materially improves the business model for a customer serves as the basis for a growing and vital company. In difficult economic times, it is ironically more important for innovation to create economic growth and new opportunities. In particular, the healthcare information and services sectors continue to offer many interesting investment opportunities due to (1) large dollars flowing through the segment and continued above average growth; (2) the need for immediate and substantial cost reduction; and (3) the critical need for better information to improve the productivity of healthcare providers, better accountability and improved quality of care.
In addition, because capital is very difficult to come by for most small companies, the ones receiving the capital are being subject to a higher level of scrutiny than when capital was easy to obtain, and hence the chance for these current companies to be successful may actually increase as a result.
Specifically, we have been active in the orthopedics space, the healthcare information space including data collection and management sector using new sensor-based approaches, the drug development process and ways to reduce the cost of clinical trials for large pharma and biotech organizations and the agricultural biotech space where we have recently sold one of our portfolio companies. Specialty pharma is also a lower risk area, as are combination therapies which will have an increasingly important role in the future.
Large companies have been our partners in a number of areas and continue to look for acquisitions to supplement their own internal growth rates. Truly differentiated intellectual property is essential as there are so many underfunded opportunities at present that the corporate buyer has a multitude of companies to review and seeks only the best strategic combinations for their long term growth. Recently two of our companies, GlycoFi and Athenix, were such cases that improved the buyers' own strategic programs.
You are to be commended for your prediction two years ago that the IPO market for most venture-based companies was all but over. What is your current outlook for the IPO market?
Challenging those that suggested the IPO market would become very active and a source of liquidity was not actually that difficult. Based on long term statistics IPOs have had a relatively limited percentage of all exit values. High profile IPOs get attention, but by far the M&A route has been more robust. After 25 years in the venture business I have watched the fundamental changes that have compromised the IPO marketplace. The very large amounts of capital in the alternative markets may have actually made the smaller IPO less significant for institutional investors. Multiples on investors' capital have proven more important than pure IRR numbers. Legislation such as Sarbanes-Oxley and new valuation rules as well as the potentially damaging tax changes that may be forthcoming from Washington do not alter our thinking and therefore future IPOs may be limited to larger buyout and private equity type companies restructuring their balance sheets. Venture investors will need to work harder and smarter to gain liquidity for their investments. This is not necessarily a bad result for many firms who are lead investors understand the Fortune 200 buyer groups and in effect control the exit process and timing for their positions. An IPO market is needed at some minimum activity level to provide a "second buyer" and keep the M&A market from becoming a distress exit scenario. The exit is more than ever a process not an event that can require a year or more from first sale conversations to cash proceeds. While the market may have opened a little bit with the A123 offering (of which we were a small part) and a handful of other IPOs, for the most part it remains closed to most venture backed companies, as there is little appetite on the part of institutional portfolio managers to buy and hold large positions in smaller companies. I would suggest that all constituents who benefit from an active IPO market help educate our legislators on the need for increased public capital flows for smaller companies as the innovation economy requires it for growth.
Your firm assists its portfolio companies in raising additional capital. What is your assessment of the current lending environment?
While we don't encourage our companies to borrow substantially as part of their capital structure, we are continuing to see very tight lending standards from either banks or finance companies for companies that are not yet solidly cash flowing or do not have substantial positive earnings streams. In past growth cycles, venture investors stretched the balance sheets of their portfolio companies too far and when a revenue plan was missed many companies shut down due to the debt exposures. What we have observed recently is pressure on the LBO business that has been adversely affected due to the limited availability of leverage. In general we have felt that debt can often be seen as "full ratchet equity." In other words, it can strongly compromise flexibility at a high growth portfolio company.
What advice can you give to entrepreneurs seeking capital in this environment?
Come to any potential capital source with a well thought out business plan addressing key "got to have" features in the product or service offering, seeking a reasonable amount of capital for a highly capital efficient model and participating in a sector characterized not only by high growth but most importantly by the prospect of a real and profitable exit within a reasonable period of time, perhaps 5 or 6 years. We expect our entrepreneurs to be investors in their businesses, so align yourself with the investor with a capital gain focus, not operate as a current income centered employee.
Be prepared for a realistic valuation to be placed on the business and demonstrate a willingness and experience of working with professional investors. Further, put as much time into understanding your investor candidates as you do preparing your business plan as they will be your partner for several years and much of the success or failure of your company will be due to that partnering relationship.
Your firm seeks to make investments in the healthcare/life sciences industry. Although the healthcare/life science industry has been affected by the downturn in the economy, has it not seen as many negative effects as other industries?
The US healthcare sector which arguably can be measured as large as the entire Chinese economy and growing equally fast, is comprised of many subsectors and each subsector has its own characteristics and requirements for success. We believe that there will be huge rewards offered to companies which can reduce costs while maintaining or increasing the quality of care.
It is unrealistic to think that opening up healthcare access to more people in the US will do anything but increase total costs. This will mean that efficiency is a must and a win-win for all parties involved. Any time a company can improve interaction of the payer, patient and provider triangle there will be rewards. The lack of simple information technology at many of the nation's healthcare providers is astounding to us, and we are aggressively pursuing improving information flow for many hospitals and physician groups around the country at our portfolio companies. One company alone, MedAptus, guarantees return paybacks for its systems at a number of its hospital clients thereby freeing up cash flow and reducing risk of implementation. The electronic medical record also offers significant payback. Those providers with effective EMR systems have a strong competitive advantage over other local providers without such systems.
Areas where we are quite cautious include drug discovery and development, a sector which requires a large amount of capital, time and more detailed expertise than ever before. Our firm would rather service those research intensive sectors than directly fund early stage molecules. Our company, Parexel, now public, is a case in point that "providing picks and shovels" can be as lucrative as doing the actual "mining."
Innovation has been a hallmark of the healthcare device industry. New ideas that reduce costs directly or reduce the need for in-hospital care or provide better information for more timely decision making and thereby improve productivity and the quality of care can be the basis for a successful business. Finally, large players in this sector have traditionally made many acquisitions of smaller companies thereby creating an exit for the venture backed company, and we expect that M&A activity to increase in the future.
Dana, thank you for your time and insight.
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