Monday, June 25, 2007

Venture Debt in Europe: Opportunity Missed?

European biotechs may bemoan their funding disadvantages relative to US counterparts—the lack of specialist investors, fragmented public markets, poor liquidity and meagre or non-existent PIPEs—but some of the trouble is of their own making.

They’re simply not seizing the alternative funding options available to them—such as venture debt, for instance. At least, that was the message from a panel of—you guessed--venture debt providers, speaking at the UK’s BioIndustry Association's BioFinance Europe 2007 meeting last week.

Venture debt has been going strong in the US for at least 20 years; it offers VC-backed companies the opportunity to leverage their equity capital by borrowing quickly, non-dilutively, without affecting valuation, and usually without relinquishing any board seats or voting rights. Last year the US life sciences sector borrowed about $1 billion of this kind of money, according to executives at venture debt providers ETV Capital and GE Financial Services. In Europe, the equivalent figure was less than $50 million.

So what’s going on? That's what the debt providers wanted to find out.

Emotions and ignorance were the top two answers from the panel discussion. The emotional barrier is that these debt providers need to secure their loan—naturally enough—and typically do that against a company’s IP. At a minimum, borrowers may have to sign a “negative pledge” promising not to use their IP to raise debt elsewhere during the course of the loan. But since IP is what the CEO-founders have often spent several decades creating, they’re not, in general, keen to mortgage it, the panellists suggested.

Lack of confidence is another way of putting it: European biotech management and VCs see venture debt as too risky, was the suggestion, because they don’t think they will be able to create sufficient value to pay back the loan—and thus fear that their assets will be seized.

And indeed, venture debt isn’t a lifeline for struggling companies. It’s intended for firms that expect to create value in the near to mid-term and need tiding over—for “high return” situations, as one debt-provider explained in his presentation. If the borrower isn’t in a (relatively) strong position, the deal gets too risky for the lenders. “Companies must have VC support and more than 12 months’ cash” to qualify for venture debt, noted the panellists.

They’ll need enough cash to pay back the loan, too—plus up to 14% interest, and the legal fees associated with the loan. As in any business sector, creditors take priority over the shareholders if things go pear-shaped, which is why management does need to be pretty sure the next round is an up-round, or that the exit they’re after comes at a nice premium. The debt providers require that confidence, too: none will lend without taking share warrants so that they can participate in the hoped-for value creation and meet their return criteria.

Still, for any company not on its knees, venture debt offers “an option to use someone else’s money to create equity value,” the debt providers argued, at least if you think you can create more value than the cost of the loan, and do so before you need to pay it back.

But on to the other reason venture debt hasn't caught on in Europe: management and VCs in Europe just don’t get debt, according to Peter Keen, a partner at VC firm Esprit Capital Partners, chairing the panel. “When you start talking about debt, their eyes glaze over,” he says. Apparently your average European biotech board meeting doesn’t often include a discussion of cost-of-capital, either—and if it does, “that goes right over their heads,” Keen continues.

Here’s the thing: equity is more expensive than debt in many situations. Equity investors expect a 20-30% return (or they used to). Even expensive debt may not cost half that—provided, of course, you can pay it back. So sometimes it’s cheaper, and therefore makes sense, to use debt rather than equity to fund capital expenditure and working capital.

A few European firms have cottoned on. Arrow Therapeutics took a £4 million venture loan to help tide it over while considering its exit options—it was in the end acquired by AstraZeneca for $150 million, so had no trouble with repayments. UK firms Vectura (now public) and Domantis (now part of GlaxoSmithKline) have also used venture debt in the past, according to the panelists, both in order to buy time during financing negotiations.

But these are exceptions. So far, the rest of the UK and European biotech sector either doesn’t like debt, doesn’t get debt, or doesn't feel confident enough in future value creation to take it on.

This may soon change. Public investors, the conference heard, are exiting biotech, not entering. The few specialist funds that exist in the UK and Europe by and large haven't made great returns on that portion of their holdings. US and foreign investors are blocked by pre-emption rights, granting existing shareholders the right to maintain their ownership share in any capital increase. PIPEs are frowned upon (and not easy to do, also because of pre-emption rights).

So soon enough UK and European biotechs may have no choice but to look more pro-actively at alternative financing sources, including venture debt. Especially as M&A continues to offer the prospect of future value-creation.

Meanwhile the inexorable rise of private equity, across all sectors, may help change attitudes too. If anyone knows how to do debt, private equity does. And they’re all getting rich, so eventually perhaps the love-debt message will trickle down to biotech.

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