Venture's stress

Why Prospect will return $150M to LPs rather than invest new biotech VC fund

Prospect Venture Partners created surprise and unease last week when it decided $150 million was not enough to support a new fund and released its LPs from their commitments. It now remains to be seen if the decision turns out to be the canary in the coal mine warning about the dynamics driving limited partners from the U.S. life sciences sector.

There is no doubt that five years ago a top-tier VC like Prospect wouldn't have gotten hung up on one LP that couldn't commit to a new fund. But the list of issues LPs now face is daunting: illiquidity and the length of time their money is committed in venture funds, along with the fact that there are no longer up rounds that allow them to mark up their investments, while fees and early write-offs create a drag on performance.

Meanwhile, the effects of regulatory and healthcare reform are expected to drive up costs for portfolio companies on the one hand and diminish returns on the other. On top of that is the limited IPO market and the buyer's market for M&A.

And these healthcare-specific issues don't even count the competition for capital, at least until recently, from social networking plays.

Last week, Prospect thus opted to return $150 million LPs had committed for a fourth fund rather than proceed with a war chest that the firm believed was too small to pursue its investment strategy.

"That amount of money wasn't going to allow us to execute on our strategy. We determined that it wouldn't have provided for enough diversification and the reserves necessary to pursue the investment strategy that had been working well for us," Managing Director Alex Barkas told BioCentury.

Warning signs

In 2008, Prospect set out to raise $400 million for a new fund.

"When we tested the market in October of 2008 we had over $400 million of soft circled expressions of interest, which in prior experience would have led to over 90% commitments," Barkas said. "By December that became $150 million of hard circled commitments, with no change in our performance. And what we heard from many LPs was that they were going to be essentially out of the market until at least 2010 or in some cases entirely."

Prospect put its efforts on hold during the financial meltdown in the fall of 2008 and started fundraising again last year with a $200-$250 million target.

"Interestingly, the $150 million of commitments stayed entirely intact and our performance actually improved. As we looked at the new environment in late 2010, we decided that we could manage a fund with even better returns at a smaller size - $200-$250 million," Barkas said.

The key would be a narrower focus on investing and trade sale exits in late preclinical to mid-stage clinical drug development plays, "where most of our returns over the last 10 years have been generated," he said.

The firm thought it had secured $200 million in commitments, but one new LP that had pledged $50 million was unable to come through due to internal issues, according to Barkas.

"Under the circumstances, we thought the best thing for our LPs and Prospect was to not deploy the capital and release the $150 million of commitments to the LPs who had supported us so loyally," he said. "Frankly, in retrospect, we probably shouldn't have relied so much on what

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