The U.S. health care industry represents a $3.5 trillion market segment, second only to information technology by capitalization (Exhibit 1). The two equity sectors’ similarities are striking. They’re dominated by large, well-capitalized businesses that deliver services to consumers at scale. Health care, like technology, is benefiting from growth in personal consumption. And both feature diverse ecosystems of small private firms that develop innovative solutions and enter the public realm via an initial public offering (IPO) or acquisition.

Key differences do exist, however. Unlike technology, health care has long been considered one of the defensive sectors of the public markets—and with good reason. In 2022, as the broader stock market fell by nearly 18%, the MSCI World Health Care Index ended the year down only 5.4%. And while private venture biotech investing does share some similarities with technology venture capital, including the pressure to seed multiple companies to increase the odds of capturing a few large winners, it involves unique challenges that are not present in many traditional Silicon Valley technology venture investments.

Drug development involves a high failure rate

The corporate development pathway for emerging life science enterprises can be challenging because, unlike startups in other markets, early-stage biopharmaceutical companies are unable to generate any revenue while developing new products and must rely on investors to support the high cost of complex drug development.

One hurdle is financial: Research and development (R&D) requires significant investment capital. Unlike a software company—or even a hardware company that uses relatively common electronic components—biomedical research requires access to costly scientific instruments and laboratory facilities. Human capital is no less a cost, because the skills required are only accessible via employees with extensive (and expensive) advanced degrees. Bottom line: Nobody will be developing the next cancer cure in a dorm room or garage.

A second challenge is regulatory. The extremely rigorous approval process implemented by the U.S. Food and Drug Administration (FDA) leads to a series of binary pass/fail outcomes as drugs progress through the regulatory pipeline. At each step, companies must absorb significant costs to progress to the next stage—with no guarantee of ultimately bringing a treatment to market (Exhibit 2).

Venture investors don’t operate in an environment with a normal distribution of risks. They understand that the majority of their investments will ultimately fail (or deliver only modest returns), but they expect these losses to be offset by a small number of firms that grow at an exponential rate. This dynamic is often referred to as the “power law” in venture capital: A fraction of all investments can drive significantly positive returns for an entire portfolio.

In life sciences, however, higher initial costs make this process somewhat riskier. It’s not as easy to acquire meaningful stakes in a large number of interesting early-stage companies when each one requires a relatively high level of capital to get off the ground. Later on, the regulatory approval process can wipe out a firm’s prospects overnight, with little opportunity for the team to go back to the drawing board. In short, venture capitalists in the life sciences sector are less able to rely on large numbers of investments to produce winners; they must be highly skilled in identifying and selecting firms based on scientific and industry expertise.

In the past, this dynamic tilted the balance in favor of large life sciences companies with sufficient size and diversity to fund costly drug development and absorb the financial hit when a drug failed to gain approval. But there are encouraging signs that the current environment is leveling the playing field for smaller, private firms—if not providing a newfound advantage to private biotechnology firms that are increasingly developing drugs through a streamlined FDA process. For investors, this is an exciting time to be allocating capital to private markets, and to life sciences in particular.

Entering a new golden age of biotech?

We believe that the post-pandemic era may be a golden age for private investment in life sciences. Innovative firms are designing new drugs and therapeutic technologies to help address a variety of life-threatening diseases, such as obesity, cancer, heart failure, kidney disease and rare genetic disorders. Over the past five years, market tailwinds have driven the accelerating pace of scientific innovation:

• Increased government funding of biomedical research is giving early-stage firms a valuable boost with respect to the cost of drug development.
• Faster regulatory review—spurred by the need to develop vaccines and therapeutic treatments during COVID-19—is leading to more streamlined drug development and faster FDA approvals.
• Technological advances, such as the use of artificial intelligence, are personalizing the medical field and speeding development timelines.

Even before the onset of the pandemic, government spending on health care R&D was growing rapidly. Over the past decade, research funding provided by the National Institutes of Health (NIH) has grown by 131%, reaching $292 billion in 2022. This trend has created a favorable environment for startup biotech companies, which can often benefit from research subsidies (Exhibit 3). 

Equally important, this flow has been accompanied by greater regulatory flexibility focused on streamlining drug approval timelines in a cost-efficient way. The number of new drugs approved by the FDA annually, for example, has nearly doubled over the past five years vs. the historical average (Exhibits 4A and 4B). While the bar for approval remains high, a modernized FDA should provide a conducive environment for further innovation as improvements in drug design and development continue to accelerate. 

Finding the right life sciences partner

Despite this positive backdrop, many institutions are underallocated to life sciences. As with other venture capital strategies, finding the right investment partner is essential to increasing the likelihood of achieving a successful outcome. Investors should look for partners with:

• professional scientific and commercial life sciences networks that enable team members to source attractive investments at an optimal stage in their development
• knowledgeable and well-resourced investment staff with relevant Ph.D.s and medical degrees who can understand and evaluate the science behind each potential investment
• personal experience navigating the regulatory and approval process, since the team will need to provide support to companies seeking to bring drugs to market
• experience with the financial decision-making companies face as they move from early-stage investment through growth rounds and ultimately to IPOs
• connectivity with the publicly traded life sciences community as a pathway to potential acquisition

Applying the “power law” to biotech

Investors in the venture stage of private biotechnology are in a sweet spot: They can benefit from increased research funding available to their portfolio companies as well as the streamlined drug approval process adopted by the FDA, which offers better—and earlier—visibility into the probability of success. Across their portfolios, investors can make more informed choices about where to direct capital, reducing their exposure to companies that fail to reach market viability and increasing their commitments to those that do. In the yearslong process of drug development, even a modest tilt toward success brings the vast gains of the venture capital “power law” to portfolio performance.