Jeff Calcagno of Scale Venture Partners sees reason to be optimistic about the biopharmaceutical sector, even in a recession

In the midst of this historic economic meltdown, it's easy to feel gloomy about investing in any sector, let alone one as traditionally capital intensive as biopharmaceuticals. But we believe the combination of strong long-term fundamentals and marked short-term price drops creates unusually attractive opportunities for biopharma venture investors, particularly those with adequate reserves and a focus on capital efficient company models.

1. Health care is demand inelastic. Consumers squeezed by the credit crunch may not rush out to buy a Hummer, or even another Botox injection, but they will continue to pay for basic medical care. We consider core health care spending to be relatively resistant to changes in GDP.

According to the Centers for Medicare and Medicaid Services, U.S. health care spending was $2 trillion in 2006 and, driven by an aging population, will outpace GDP growth by 2% annually, doubling to $4 trillion by 2016. Prescription drug spending will grow faster, at 9% annually, to nearly $500 billion by 2016. Even with significant reforms coming, biopharma will continue to be a growth market.

2. Drug treatment is relatively efficient and scalable. Despite the high costs and long timeframes to develop new medicines, drug treatment costs are mostly fixed; extending treatment to more patients requires relatively low incremental costs.

This cost structure—different from that of surgical intervention, for instance—can create efficiencies, particularly for treating common diseases in an aging population, like Alzheimer's disease or diabetes. With the cost of one ICU day averaging over $3,000, it's apparent how medicines to keep patients out of the hospital become efficient.

3. M&A exits for small, innovative biopharma companies will further increase. In "The Innovator's Dilemma," Clayton Christensen explains why small companies are better than large companies at fostering innovation. Even in times of economic turmoil, innovators prefer smaller, more entrepreneurial companies.

As the number of new drug applications for new chemical entities in the United States has fallen (from 48 in 1995 to 32 in 2005), big pharma companies have increasingly looked to smaller biopharmas for in-licensed products, which now account for over 30% of revenue.

"The combination of strong long-term fundamentals and marked short-term price drops creates unusually attractive opportunities for biopharma venture investors."

According to Ernst & Young, the number of biopharma companies acquired in 2006 was 73, a 22% increase from 2004. And the total potential value of U.S. biopharma deals announced in 2007 was nearly $60 billion, the most ever. With 25% of their revenues disappearing in 2012 owing to patent expirations, big pharmas will increasingly look to innovative venture-backed biopharma companies.

4. Venture-backed biopharma deals are becoming less expensive. Venture funds and syndicates with large capital bases and adequate reserves can support their current portfolio companies while taking advantage of the current pricing climate to buy larger stakes in new investments at lower pre-money values. Unlike hedge fund investors, venture investors can employ longer term investment strategies with less pressure for near-term exits.

5. Biopharma companies can generate value cost effectively. In this time of scarce and costly capital, venture-backed biopharma companies cannot afford to spend the $500 million that traditional pharma spends, on average, to discover and develop a new drug.

The Scale Venture Partners' team continues to focus on relatively capital-efficient companies. For example, one of our portfolio companies recently developed a "repurposed" combination product from inception through 1,500 patients of positive Phase 3 data with only three full time employees and just over $50 million in capital.

As Warren Buffett wrote, "An investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace."

Rarely have those emotions been as contagious as in the last several months. When we look to biopharma industry fundamentals, we see opportunities now to generate unusually strong venture returns.

Dr. Jeff Calcagno is a principal on the health care investment team at Scale Venture Partners.