At an Inflection Point: The Challenges and Opportunities in the Canadian Life Science Sector Demand Leadership

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By Peter van Der Velden

PricewaterhouseCoopers, in their recently released report on the state of the life sciences industry in Canada, nailed it when they described the industry as being at an “Inflection Point.” As a result, I fundamentally believe that the actions, or perhaps inactions, of stakeholders this year will define the Canadian industry for at least the next ten years. Poised for growth or positioned for failure, the choice is ours. While there are many issues I could tackle in the context of this inflection point, the PwC report highlighted respondents’ belief that raising capital would be the single biggest challenge in the coming two years, and that raising capital would be the key issue for the Canadian industry to overcome if it is to emerge as a global competitor. I will look to tackle this topic by addressing two challenges/opportunities:
1.     How best to rebuild the venture capital engine in this country, and
2.     How to engage effectively the largest corporate beneficiaries of healthcare spending in Canada (big pharmaceutical, biotechnology, and medical device firms) in the innovation economy.

Regarding the venture capital question, I recently spoke at a conference on the state of the VC industry in Canada where numerous participants argued one or both of two hypotheses – namely that the “VC model is broken” and that information and communication technology (“ICT”) is a much better sector to invest in than life sciences or medical technology. As a 22-year veteran of the industry, I had to take umbrage with both of these statements as they simply are not true and are not anchored by facts or data.

Rather than espousing my view of the VC model, let me share some insights from a recent publication by two preeminent scholars of venture capital and private equity. Steven Kaplan from the University of Chicago’s Booth School of Business and Josh Lerner from Harvard Business School refute the notion that the VC model is broken:

That’s not to say that during the past 10 years Canada hasn’t also had a unique set of issues and problems. However, if you peel the onion, the Canadian issues really aren’t that difficult to understand. Among other factors, in this country we had too many VC managers and operating CEOs without deep domain expertise or operating experience; a lack of focus within VC firms leading to the pursuit of generalist strategies; a bias to regional investment strategies and economic development mandates as opposed to best-in-class investing; an overabundance of companies pursuing incremental rather than innovative technologies; an oversupply of capital often managed by relatively inexperienced managers; and a lack of financial accountability and alignment (i.e. tax-driven widows’ and orphans’ money rather than capital from sophisticated investors).

Virtually all of these issues have been addressed in more mature markets like the U.S., where limited partners, venture capitalists, and the companies they finance have lived through numerous investment cycles. If we want to revive the industry in Canada, then perhaps we should strive to better understand the behaviours, strategies, team profiles, and structures of the top VC firms around the world and model those before we look to implement programs that will fundamentally distort the venture capital market once again. For those who have heard the Lumira story, you will know that we lived through a significant change process that focused on adopting best practices to be best-in-class. This process, while extremely painful to execute, has rewarded our investors with a 38 per cent IRR on capital invested since our transition began five years ago. It can be done. It just takes the will, leadership, and a commitment to excellence.

Now let’s address the second VC myth: ICT investments outperform life sciences investments. Again, there is no data to support this oft espoused view. In fact, Lerner cites data that shows that with the exception of the “bubble years” of 1996 to 2000, healthcare investments have outperformed ICT investments. Separate data shows that from 2007 to 2009, in terms of liquidity, M&A exits from venture-backed life science companies have accounted for 42 per cent of cash distributions to limited partners ($8 billion) despite representing just 26 per cent of all VC dollars invested.

More importantly, virtually all the drivers that have supported the outperformance of the life science sector remain entrenched or have improved in the past 24 months, but that is fodder for another article.

Unfortunately, simply debunking these commonly held views is not enough to reengage the corporate and institutional investors that have withdrawn from the VC asset class over the past eight years.

Figure 1 shows that in recent years institutional investors such as pension plans and corporate investors have virtually abandoned the asset class. So where to turn? In mining, tax policy – specifically flow-through shares – has been boon for the industry, but unfortunately seems to come with no accountability or management alignment and does nothing to address the structural issues described earlier. Despite the emergence of a viable commodities industry that no longer needs this support, the government continues to subsidize investment in this sector to the tune of hundreds of millions per year. The venture capital arena has also seen tax policy as an enabler of significant capital formation, predominantly through the labour-sponsored investment fund program from 1995 to 2005, but without accountability, alignment (managers rarely invested any significant amounts in their own funds), and other market-driven control mechanisms, investment best practices often did not prevail and abuses were not uncommon.

As an alternative to these prior approaches, I would like to see a focus on reengaging sophisticated institutional investors (pension funds, endowments, and trusts) that have the investment infrastructure and evaluation processes required to identify objectively and support best-in-class managers. Furthermore, these groups have the capabilities and clout to enforce industry best practices and ensure alignment along the venture investment continuum – from limited partner to venture capital firm to investee company. At the same time I would like to explore how we put in place incentives that encourage the for-profit players in the Canadian healthcare system to more actively participate in building and supporting the local innovation economy.

Many of the largest pharmaceutical, biotechnology, and medical device firms in this country are simply sales organizations for foreign multinationals and often do not actively pursue research, development, and commercialization in Canada. Given the diversity of these stakeholder groups it is clear that to engage each will require a distinctly different approach.


Proposal 1: To encourage institutional investment in venture capital funds, the federal and provincial government could offer pension plans, endowments, and trusts a guaranteed rate of return (for example 2 per cent) on investments in venture capital funds, with the caveat that the institutional investor and the government agency split the investment return above the threshold rate. Enacted over a finite period of two to three years, an initiative like this could catalyze over $1 billion of capital formation in Canada. Under this structure, investment decisions would be made and funds would be managed by the private sector, and it would give venture capital managers and institutional investors the opportunity to build new relationships.

Pension funds, endowments, and trusts would have the opportunity to participate in an asset class that has the potential to generate significant returns with very limited risk. Such a program would in fact have the potential to achieve a triple bottom line: real profits from fund performance, real tax revenues from a growing high-value labour force, and the generation of a sustainable innovation economy in Canada.

To further this country’s innovation agenda, we also need to engage more effectively the pharmaceutical, biotechnology, and medical device firms that market and sell products to Canadians. First, some background: In 1988, in exchange for market exclusivity, the pharmaceutical industry agreed to invest 10 per cent of Canadian sales revenues in research and development in Canada, and an agency known as the Patent Medicines Pricing Review Board (PMPRB) was established, in part, to monitor compliance with this objective. From 1988 to 1997, the R&D to sales ratio for Rx&D member companies grew from 6.5 per cent to 12.9 per cent, and R&D expenditures consistently grew year over year. Unfortunately, in 2003 the industry began to fall short of the 10 per cent ratio, and it has not recovered since. In 2009, the R&D investment deficit relative to the target was $433 million, and the cumulative deficit from 2003 had risen to $1.6 billion (Figure 2). During the same period, Rx&D companies enjoyed substantial revenue growth (Figure 3). It appears that the parent companies of some Canadian subsidiaries are seeking to maximize shareholder value by investing in high-growth economies to gain market access.

However, compliance varies between firms. Companies like the sanofi-aventis Group and GlaxoSmithKline consistently meet or exceed the 10 per cent threshold, while some other companies reporting to the PMPRB invest less than 2 per cent of sales per year. In fact, if you remove compliant firms from the count, the 10 most non-compliant firms generated a deficit in excess of $600 million in 2009 alone.


Proposal 2: Change the PMPRB guidelines so that direct investments in innovative Canadian pharmaceutical, biotechnology, and medical device companies and VC funds domiciled in Canada that invest in the sector qualify as R&D for measurement purposes. Furthermore, government could consider strategies that provide favoured formulary access and pricing to compliant firms while subjecting non-complaint firms to price reductions or an innovation tax on existing and new products as long as they fall below the R&D threshold. Engaging the leading pharmaceutical, biotechnology and medical device firms more deeply in the Canadian innovation economy will likely require better coordination among the provincial and federal health and innovation ministries. The key here is one standard for all, with an enforcement process that does not exist today.

Like the first proposal, the goal here is to create a truly win-win scenario. Under this proposal, multinational pharmaceutical firms would be given more ways to achieve the 10 per cent target that are directly aligned with building a domestic innovation economy.

Big pharma would be investing in businesses and VC funds that have the potential to generate significant returns, and by doing so they would be supporting and building the innovative products they so desperately need to replace the $100 billion of revenues derived from products coming off patent over the next three years. Non-compliant players would be more incented to act like market leaders, and could no longer coattail on the investments of their peers. A 10 per cent commitment to R&D spending is not a high bar relative to other OECD countries, and it is an objective for which even the new chairman of Rx&D is publicly advocating. For governments, laggards will actually drive down healthcare costs and provide funding to support initiatives such as the OETF and OVCF programs in Ontario that are designed to support and invest in innovative companies in the country. Finally, for operating companies and VC firms dedicated to the sector, there will be a substantial pool of new capital from aligned and value-added partners. This solution would be potentially accretive to all players in the healthcare innovation economy, and similar initiatives are at work in other jurisdictions around the world.

We are truly at an inflection point. The solutions outlined herein and those proposed by some others are achievable with leadership, hard work, and a commitment to bettering this country. These strategies have the potential to allow Canada to emerge as the global healthcare leader it is truly positioned to be. Failure to act, failure to provide leadership, and failure to think and act on behalf of future generations of Canadians will result in this country squandering literally billions of taxpayer dollars and immeasurable amounts of human capital. During a dinner I recently attended, a former Prime Minister said “achievement occurs when challenge meets leadership.” We clearly have the challenge. The question is do we have the leadership to accept the challenge?

References
1.     http://www.wamda.com/web/uploads/resources/ItAint_Broke-Steve_Kaplan_and_JoshLerner.pdf

Peter van der Velden is the President and CEO of Lumira Capital, Canada’s largest life science and medical technology investor.