Monday, October 26, 2015

Uncertain Health in an Insecure World – 62

“Saving Private Equity”

In Steven Spielberg’s Saving Private Ryan, Tom Hanks leads a band of eight G.I. (government issue) soldiers into post D-Day France in search of the surviving 25% of Mrs. Ryan’s sons. The movie was based on the true WWII story of the Niland brothers. As the embattled G.I.’s search for Private Ryan, they frequently utter the term "FUBAR", reflecting frustration with the absurdity of the personal risk they bear for returning one mother’s last son.

Indeed, "F***ed Up Beyond All Recognition" describes many government issues.

For example, money from the very banks rescued by the U.S. government in 2008 (see post #61) now heavily impacts the private equity venture capital (VC) marketplace. Bank-backed VC's financial return point-of-view now counterbalances the more strategic approach of non-banking corporate VC’s. At a recent University of California Berkeley meeting, one corporate VC director from General Electric called his firm “a bank”. The irony of public sector reversal of private sector misfortune was not lost on those in the room.

In the private equity sector, fund illiquidity is the most common investment outcome.

In the Wall Street Journal (Sept. 20, 2012), Deborah Gage reported on the big secret of VC – 3 out of 4 start-ups fail. The U.S. National Venture Capital Association confirms that 95% of private equity funded start-ups return no cash to investors, or miss important business hurdles. Such outcomes are even harder on the entrepreneurs who have maxed out credit cards and borrowed from friends & family to get a VC deal rolling.

In the Harvard Business Review (August 5, 2014), Diane Mulcahy cynically (?) posited that VC general partners (GP’s) get very well paid to lose limited partners’ (LP’s) money. VC investors take on the very real risk of losing big as a way to outperform public equity markets, which is rarely accomplished by the majority of private equity funds.

Mulcahy concluded that most VC’s can serially underperform and not only survive, but thrive!

Remember, a typical 20% carry to the GP’s on a $1 billion VC fund is $20 million annually. Given that, one wonders, “What’s the hurry for these big funds?” Is an early exit financially better for GP’s than running the course? Of course not! And the market standard deal is for GP’s to personally invest only 1% of the fund size while LP’s contribute the remaining 99%.

Talk about playing with house money!

Global stock markets tank when economists discover that The Fundamentals are off. But VC has been resilient, surviving the 2008 depression, and weathering the 2015 China market meltdown. However, annual industry performance data shows that VC’s routinely underperform the S&P, NASDAQ and other public equity market indices. Riding this wave of VC underperformance in a $1 billion fund is still profitable to the GP’s, while more typical $100 million funds cannot coast on such choppy surf.

Investors seeking returns on capital freely pivot to the best opportunities. If the VC sector does not reward risk by outperforming the public markets by 300-500 basis points, the VC industry sector contracts. But serious investors require investment vehicles – viable choices – including both the public equity markets and private equity funds.

Only the bigger better VC funds that consistent generate venture level returns survive to fight another day.

With the current average time from start-up to Newco launch of 11-14 years exceeding the desired VC fund 10-year liquidity goal, time is clearly money for all involved. The 460 highest performing VC start-up companies (the “0.3% Club”) grow the fastest, leaving more money in private equity partnerships for the founding managers and investors on exit.

For example, LinkedIn founder Reid Hoffman (above) retained 20% of the company’s original start-up funding, as compared to the typical 3% figure in most new tech evolutions. Fifty percent of the 0.3% Club’s exiting tech companies (the ‘Alpha’) is found in California, and 50% of that Alpha is located in the Silicon Valley.

Top Newcos outstrip their start-up contemporaries by growing faster and using cash more efficiently.

While the big banks that were bailed out by the U.S. government in 2008 are now major corporate VC investors, that same government is not a player in the high risk early round private equity market. The Fed will never directly bail out failing big VC firms or save this important financial sector. It is just not in the public interest to rescue underperforming high-risk private equity.

There’s no bailout mission coming for private equity!

Given this reality, is a fundamental restructuring of the classic VC fund fee & carry deal and the typical entrepreneur investment model needed?

Does the pro-entrepreneur VC sector need to innovate itself?

AngelList is an emerging group of investment syndicates that forgo VC management fees in favor of carry, such that the GP’s and LP’s share in the investment upside and downside. This absence of fees puts VC’s and angels on similar financial footing.

And as always, China is paying close attention.

On October 12, 2015, AngelList CEO Naval Ravikant (above, right) announced that his 30 person syndicate will be getting US$400M from a Chinese VC fund, CSC Upshot. As late stage investing in startups lags in the wake of the recent market correction, he says “You don’t want to be a company that is burning tens of millions of dollars a year and hoping you are about to raise another $200 million around the corner.

Smart investors and wise objects in these syndicates (above) learn from their mistakes.
And sometimes you have to make big mistakes… FUBAR’s…. to make a real and necessary change.

Perhaps, these new age investors, in the words of Captain Miller, are “the angels on our shoulders…”

We in the Square understand the risks and rewards. But Miller's rules of war are that combatants should not freely sacrifice the innocents.

Monday, October 12, 2015

Uncertain Health in an Insecure World - 61

“Foundational Myths”

Social policy change and innovation are frequently conflated, but they are concepts with very different drivers and  masters. The foundational myths of America are gun ownership (for personal safety), capitalism (for societal wealth), and world-leading healthcare (via technology).

Let's explore an interface between the latter two myths.

The 26th U.S. President Theodore Roosevelt once exclaimed, “Oh, for a one-handed economist!” The 33rd U.S. President Harry Truman pleaded, “Give me a one-handed economist! All my economists say, ‘On the one hand, and on the other hand…’ ”.

The implication?... Economists are indecisive.

On Friday September 12, 2008, the Iraq war-weary post-9/11 and -Katrina administration of the 43rd U.S. President George Bush was limping through its eighth and final year in office. In the pre-Uber era dusk, a line of black cars delivered the most world’s powerful financial minds to the New York Federal Reserve Bank in lower Manhattan.

The final straw in a fragile global credit market had snapped.

These current and former private sector professionals, not elected officials, were put in charge of The Problem. Career financiers all, they understood that the global upside and downside of a big U.S. bank bailout would eventually become clear, long after they and their elected counterparts had moved on.

So they made a damn decision!

By October 2008, former Goldman Sachs investment banker and CEO, Secretary of the Treasury Hank Paulson (above), was orchestrating the U.S. government bailout of big banks like Goldman Sachs, JP Morgan Chase, Citigroup, Bank of America, and Wells Fargo. Back then, people wondered why the U.S. government rescued these financial institutions.

In 2015, the answer to why the big banks were saved appears more obvious. In fact, Ben Bernanke (above), U.S. Federal Reserve chairman at the time, clearly rationalized this decision in his new book, “The Courage to Act”. On the basis of the best information available, Paulson, Bernanke and others acted.

Let’s review a little of the situational complexity.

The March 2008 acquisition of failing Bear Stearns by JP Morgan Chase was made possible by US$29B in government financing. By early September, the government-backed private mortgage agencies, Fannie Mae and Freddie Mac, received US$200B in capital to assure their liquidity.

But Lehman Brothers’ assets were too troubled for the government to sell or infuse. Its US$32B commercial real estate portfolio was particularly suspect. The gaping “hole” in Lehman’s balance sheet was too big. As someone noted, “The air kind of went out of the room” through that hole.

The British Office of the Exchequer and the U.S. Department of the Treasury contemplated the risk to taxpayers of backstopping a Lehman bailout through national banks (i.e. Barclays, Credit Suisse). With Warren Buffett lurking in the shadows, and with the fate of global insurer A.I.G. also hanging in the balance, they eventually pulled the plug on Lehman Bros.

As one Treasury Department adviser later put it, “We lost the patient.”

Also in 2008, money market funds (the first, the Primary Fund, est. in 1970) were a US$3.5T market. Many corporations relied upon MMF’s to meet their day-to-day cash needs, including payroll. While MMF’s were not covered by federal deposit insurance, these AAA-rated investments were deemed “ultra-safe”, while producing higher annual yields than bank deposits (4-8%/year). Their share values were never less than US$1 (a “buck”). But with the failure of Lehman (its Primary Fund holdings = 1.2% or US$785M), “breaking the buck” was becoming a real risk to this entire financial sector.

At 4:00 PM on Tuesday September 16, 2008 the Primary Fund share value fell to US$0.97. The "ultra-safe" global money market fund sector was now also teetering on the brink.

That week, General Electric (GE) could not secure its daily float of cash flow needs. GE Capital was suffering from these financial sector pressures, putting the entire global conglomerate at risk, and drawing down its profits (below).

Lame duck politicians from both parties in the U.S. Congress, charged with protecting the public’s interests, raised concerns about the authority by which the Fed’s rescue actions made the U.S. government an 80% equity holder in A.I.G..

They were largely ignored.

On November 4, 2008 Barack Obama was elected the 44th U.S. President.

 By March 2009, President Obama said, “I have more than enough to do without having to worry about the financial system.” Obama's administration inherited the ‘mortgage-backed securities’ crisis, and would breathe its toxic financial fumes for the next two terms. Their political decision, beyond the troubled asset rescue (TARP) and economic stimulus (ARRA) programs, was to double down on healthcare reform via the Affordable Care Act (ACA).

They say, "Never waste a good crisis!"

One year later in March 2010, Obamacare became the law of the land.

As evidenced by its negative initial reaction to Obamacare, the U.S. medical establishment is a well-entrenched trade organization largely dedicated to gradual incremental innovation. Their codependent healthcare delivery and insurance partners are fundamental to this mass market, and are deeply embedded in the economies of every major developed country in the world.

Led by avowed Obamacare opponent Rep. Fred Upton [right, below], and joined by Rep. Diana DeGette [left, below], on July 10, 2015 the U.S. House of Representatives passed the bipartisan 21st Century Cures Act to increase NIH funding while loosening FDA new drug approval criteria (like no clinical trials!).

This act is a quirky good-for-bad policy trade-off.

This act is why politicians cannot be solely entrusted with solving a good crisis.

 U.S. Medicare (est. 1965) is correctly characterized as a socialistic benefit program that is too big to fail. Medicare's trustees still project that ceteris paribus, the program will be insolvent by 2030. It's too early to know whether Obamacare is too big to fail.

The wages of big bailouts - societal and financial - are telling. Big banks have gone from controlling 15% of U.S. GDP to controlling 60%. Since 2008, Wall Street money managers have gone from controlling 45% of U.S. wealth to controlling 55%.

In 2015, America has universal healthcare coverage, but wealth inequity is at its greatest ever. For example, less than 10% of Black Americans own public equities. 

Politicians and economists are not The Problem. But nor are they are really part of The Solution.

The search for the one handed leadership continues... It's called the American Experience!

One one hand, we in the Square understand and applaud American Exceptionalism, But on the other hand, undisciplined and ungoverned action has perverse outcomes that institutionalize inequities.

Uncertain Health in an Insecure World – 60

“Precise Vectors”

The term precision medicine was first coined in a 1979 paper by Ling Wei of the University of Waterloo in Canada, in reference to acupuncture.

Since 2012, precision medicine (PM) has largely replaced the term personalized medicine, after an influential National Research Council report by University of California San Francisco’s Susan Desmond-Hellmann and Memorial Sloan-Kettering’s Charles Sawyers recommended using cancer science precision in oncology medical practice.

PM is a new vector in the innovation ecosystem. A vector moves things in a new direction, with some yet-to-be-defined certainty of future success. Vectors are influencers…

PM’s promise is the capacity to direct healthcare at a personal level, more precisely than the current population-based “shotgun” approach. PM combines a new enabling scientific innovation (better, more affordable gene sequencing) with leveraging of an existing system investment (in lower cost, more sustainable healthcare delivery).

Vertex Pharmaceuticals' "Most Important Drug of the Year", Kalydeco (ivacaftor), was one of 40 drugs approved by the U.S. Food and Drug Administration in 2012. Kalydeco improves the function of a chloride ion pump in a small percentage (4-5%) of the world's 70,000 cystic fibrosis (CF) patients (i.e., CF is a "rare disease"). Vertex has admitted that the drug would not have been developed without the investment of the Cystic Fibrosis Foundation, in return for a somewhat conflicting US$3 billion royalty deal from drug sales. The drug improves CF (see X-rays below).

The annual cost of Kalydeco therapy is US$294,000!

Who pays for these miracles of PM?

Over time, venture capital (VC) aims to reduce the risk of new ideas from infinity to zero in a vector’s domain. VC funds typically have 11-14 year liquidity pathway – the year 2026 is a deal cycle shorter than PM’s likely timeline for successful adoption.

Elon Musk (above) demonstrated a true entrepreneur's vision to found SpaceX in 2002. SpaceX showed the “better, faster, cheaper” business skills to outperform NASA, and Musk made a commitment of $6B in personal wealth from Tesla’s VC funding and exit success.

Using the Dragon lander (below), Musk promises a human Mars outpost by 2026.

Is there an Elon Musk-style visionary out there promising to land PM on Earth? 

Just as Martin Eberhard and Marc Tarpening fueled Tesla until its Series ‘A’ VC funding and Musk’s entry as CEO, wise objects must continuously energize private equity “deals”, attracting resources beyond their personal control (see post #59). This is hard, particularly when people, technology and money are all highly mobile. Beyond geographic mobility, key innovation factors move dynamically in and out of the deal.

The “magic” of this VC process is the pattern recognition capacity of key participants in the value creation channel. Such individuals and teams connect the new technology to the right market, or participate in the creation of a de novo market.

For a “wedge” innovation like PM to enter and disrupt the healthcare mass market, it must be very compelling indeed! In order to prove its worth against entrenched market forces, the innovation must be de-risked by early VC funding, ideally resulting in a long-term cash out event (M&A) or a company creating exit into the market (IPO).

Who, then, will de-risk PM?

In 2013, General Electric (GE) adopted the PM term in its corporate communications ( GE also hired three Silicon Valley VC firm partners from KPCB (est. 1972) and Mohr Davidow (est. 1983) to seek out business opportunities for molecular diagnostics, imaging and analytics.

But GE’s later stage corporate VC approach is not de-risking activity.

In his 2015 State of the Union speech, President Barack Obama announced a Precision Medicine Initiative (PMI) that was subsequently vouched for in the New England Journal of Medicine by NIH Director Francis Collins and NCI Director Harold Varmus. Ironically, perhaps, it was Francis Collins who originally described the rare chloride ion pump mutation in cystic fibrosis patients 25 years ago.

America's highly-politicized healthcare sector has no business motivation to de-risk PM.

According to Keval Desai, a partner at InterWest Partners on Sand Hill Road (est. 1979), the real test of a business-to-consumer (B2C) Newco’s relevance and market value is when its product or service becomes a “daily habit”. For PM to fundamentally change medical practice, its use must become part of clinical orthopraxy. Will PM become a "daily habit" for healthcare givers? Or is PM a technology that will actually dis-intermediate doctors from their usual patient care and referral pathways?

Many more doctors use Uber cars than practice PM. 

Silicon Valley lore states that Uber founder Travis Kalanick (above) conceived his creation in San Francisco in drunken frustration at being unable to get a “black car”. So-called Uber-fication of home health services is being actively tested by tele-medicine companies like New York City’s Pager dispatches doctors and nurse practitioners via Uber cars for $200 per house call. Similar disruptions are popping up in Los Angeles, San Francisco and Minneapolis. VC invested US$300 million in tele-medicine in 2014, including US$81 million in America Well that uses Uber-like capabilities to match a patient with a doctor in <1 minute.
But I’m not still precisely sure of the PM use-case.

In April 2015, The Economist (now in a strategic partnership with GE) called PM a "revolution". Is PM a suite of technologies that predicts a disease so that doctors can intervene before it becomes an illness? Now that would be a Mars landing!

A SpaceX view (above) of the San Francisco Bay area is dramatic, and infused with creative energy. What appears to be missing with PM is an idea-to-launch (I2L) process that can drive this big concept to market.

PM is modern medicine's Space... a precise vector to The Final Frontier.

The rocketry and satellite are ready, but the rapid and adaptive PM launch platform is missing.

We in the Square are counting on PM. The countdown to 2026 has already begun...   

Monday, October 5, 2015

Uncertain Health in an Insecure World – 59

“Wise Objects”

In the 1933 Marx Brothers’ masterpiece, Duck Soup, Groucho Marx played Rufus T. Firefly, the wise-cracking leader of a fictitious nation, Freedonia. The name Freedonia originated in the American Revolutionary War as a snub to British overlords. Not surprisingly, the small, bankrupt, imaginary country had comedic public policy and no great universities.

The evolution of post-revolutionary America continues.

In a 1988 radio address, President Ronald Reagan said, “Although basic research does not begin with a particular practical goal, when you look at the results over the years, it ends up being one of the most practical things government does.” Since then, as the percentage of U.S. budgets used for healthcare constantly rose, national R&D funding (as a percent of GDP, below) gradually eroded. With this, Reagan’s vision of a shining city on a hill faded from America's national consciousness.

The global economy is constantly evolving.

Also in 1988, China’s overheated economy grew by 11.3%, before the Beijing massacre throttled foreign investment. Twenty-five years later in 2013, the Battelle Memorial Institute estimated that by 2020 China would spend >US$600 billion annually on R&D (up from $284 billion, or 2% of GDP in 2014), as compared to an estimated US$465 billion currently being spent in the U.S. (or 2.8% of GDP in 2014). The recent Great Fall of China's stock market will likely impact this 2020 projection, in both China and the U.S.

The U.S. government has been good to U.S. entrepreneurs.

Over the past four decades, government investment has been the greatest competitive advantage for Silicon Valley high-tech and biotech venture capital (VC). Publicly funded science, largely based at research-intensive universities (from National Institutes of Health [NIH], National Science Foundation [NSF]) and often defense-related (from U.S. Department of Defense & DARPA) created and continues to fuel new information discovery (see post #57).

Big governments remain major innovation ecosystem influencers.

While bank loans and VC investors need to be repaid, the NIH’s Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs do not. This offers entrepreneurs non-dilutive government financing – free government capital – that can positively inflect the business trajectory of Newco growth.

Neal F. Lane (above), former NSF Director (1993-98) and U.S. President Bill Clinton's Director for Science & Technology Policy (1998-2001), testified on July 17, 2014 before the U.S. Senate Committee on Commerce, Science and Transportation. Lane said, “Investments in basic research are just that: Investments.” In fact, many experts agree that the U.S. federal government’s R&D funding programs should be viewed as a strategic capital investment in the country’s world-leading status. 

Universities are the roads and bridges of the U.S. innovation infrastructure.

University leaders are growing concerned about the future of this government-academia relationship. A 2015 report from Massachusetts Institute of Technology (MIT) Committee to Evaluate the Innovation Deficit – The Future Postponed – warned that reduced U.S. government spending on basic research negatively impacts its position as a leading global innovator. The MIT report highlighted multiple missed opportunities from federal under-funding of research on Alzheimer’s disease (affecting >5,000,000 Americans), Ebola virus biology, and antibiotic resistant infectious diseases.

Unlike governments and private equity funds, the academic world is highly transparent.

Universities value the publication of scholarly work in publicly available high-impact journals. Unlike publicly traded shares on Wall Street, the private equity VC space completely lacks financial transparency, other than that required to maintain the trust relationships of general partners with their limited partner investors. While technology transfer offices of leading research-intensive universities are part of the innovation food chain, real “deals” occur when (generally) young entrepreneurs emerge from academic “caves” to lead innovation in the marketplace. And while universities are often sophisticated institutional investors (see University of California [UC] portfolio, below), real VC deals are almost always made outside universities.

Research universities can also be unintentional disruptors in the private equity marketplace.

In 2003, UC Berkeley’s Henry Chesbrough (above) defined “open innovation” as the use of purposeful inflows & outflows of knowledge to accelerate internal innovation, and expand markets for the external use of innovations. Per Professor Chesbrough, this concept “falls directly in that gap in the relationship between business and academe.” Hank has since described five “erosion factors” leading to greater corporate VC investment in the open innovation ecosystem. One such factor is the great R&D capability of research-intensive universities, which generally function in a private equity-free manner.

The relationship between great countries and their great universities is compelling.

The U.S. has 26.8% of the top 500 global universities in the latest U.S. News & World Report rankings, followed distantly by Germany at 8.4%. In every ranking list, UC Berkeley, Stanford, Harvard and MIT are the top 4 in the world! University-generated new information is a constantly refreshing supply of free intellectual fodder for the strategically co-located San Francisco Bay and Boston innovation clusters.

Research activity at major universities is not a sine quo non for innovation.

It is the seasoned start-up managers beyond carved-in-stone university gates, and not the learned professors inside them, who are the keys to entrepreneurial and innovation success. They are the “wise objects” that guide entrepreneurs’ entry into the rocky business development and distribution channel.

These VC guys are smart… really smart.

For example, Dr. Larry Lasky (above) left the Genentech (“there’s no B.S. in biotech”) corporate world as a lead scientist in 2002 to enter the private equity world as a founding investor and general partner. His VC “exit” successes include Proteolix (acquired by Onyx Pharmaceuticals), Oncomed, Cellective Therapeutics (acquired by Medimmune), Tetralogic and BioVerdant.  Larry says, “We are living in an extraordinary era of discovery in molecular medicine and cellular biology.” Dr. Lasky, forever a serious scientist despite evolving into a VC whale, devours articles daily from journals like NatureCell, and Science.

The academic research engine is very different from the entrepreneurial activity density found in industry sectors (especially high-tech) and geographic innovation clusters (like the Silicon Valley). An extreme example is Israel, which has only a fraction of the number of universities found in the U.S. (<10 versus >4,700), but has 3-times the VC density of the U.S.. Israel’s number of billionaire entrepreneurs per one million population exceeds the U.S. (see figure below).

A 2015 Deloitte survey of >200 VC funds managing >$50M each rated Israel #2 in the world (after the U.S.) for startup investing. The Israeli government, through the Office of the Chief Scientist in the Ministry of Economy, doesn’t rely solely on its universities, instead making direct investments in its entrepreneurs and their startups (see Chief Scientist, Avi Hassan @BIO2015 below).

With sound government R&D policy, great nations leverage great science.

With experienced VC’s managing the process, great science becomes real deals.

When this virtuous cycle is intact, true innovation happens.

As the forces buffeting global security and markets grow in strength and complexity, we in the Square say “Hail, Hail, Freedonia!” to the wise objects, and enlist in the continuing VC insurgency.