Start-ups turning to hedge funds
Shift is challenge to venture capital
When the private biotechnology company Microbia Inc. closed a $75 million round of funding in February, investors sat up and took notice. Not only because the Cambridge firm had just landed the biggest local round of biotechnology venture financing in two years, but also because a large chunk of the money came from hedge funds.
A month later, its Cambridge neighbor, Merrimack Pharmaceuticals Inc., reported its own large financing round -- $65 million, also driven by hedge funds.
Hedge funds are unregistered money-management operations that typically make a wide range of global investments. Their arrival in the delicate ecosystem of local biotechnology investing sent a shudder through the venture-capital community, whose firms not only finance, but also grow, counsel, and help staff young companies, all in exchange for the potential to cash out on the companies that succeed.
``People just sat up and said, my God, those are investment opportunities that would traditionally be done by venture capitalists," said Michael Greeley , managing partner of IDG Ventures, a Boston venture-capital firm.
With hedge funds setting their sights on young companies before they go public, some venture capitalists worry about losing out on potential returns, especially in the more secure later stages of private financing.
The National Venture Capital Association doesn't keep records of hedge-fund involvement in private-company finance, but says that anecdotal evidence suggests it is increasing.
``The trend is something that people are interested in," said Emily Mendell , vice president of the National Venture Capital Association. ``Clearly, this is a phenomenon that's beginning to occur more and more."
To some, the arrival of hedge-fund money seems like a logical, even inevitable development. With more than $1 trillion under management nationwide, hedge funds are always on the hunt for a wider range of investment vehicles. In biotech, they are meeting an industry always hungry for money.
``Biotech companies have an almost infinite appetite for capital, and many are staying private longer now -- the public markets haven't been as friendly to biotechs lately," said Laura Hodges Taylor , a hedge-fund lawyer at Goodwin Procter in Boston.
Private biotech companies without a drug on the market have recently found themselves in a financing crunch: A successful public stock offering depends on having data from late-stage human trials of their drugs, which can cost tens of millions of dollars.
And that's on top of the tens of millions already invested by venture capitalists. Without a favorable initial public offering market that offers the quick prospect of raising $50 million, $100 million or more, the companies have to look elsewhere for cash.
``We're at a state where the financing market is going through great change and upheaval," said Robert Mulroy , chief executive of Merrimack Pharmaceuticals. ``Traditionally venture capitalists were the ones who brought the company through the IPO, but that's a model that venture capitalists aren't making a lot of money on right now."
Merrimack is developing a protein in goat milk that could treat autoimmune diseases. To fund its human-testing program, Mulroy asked investment bankers at Credit Suisse Group to play matchmaker with a number of hedge funds.
In what he calls a ``mini-road show," Mulroy flew from city to city with his chief financial officer and head of research, showing a 45-minute PowerPoint presentation to potential backers.
In the end, Merrimack's $65 million fund-raising round was about 60 percent financed by so-called ``public investors" -- hedge funds and mutual funds that traditionally focus on trading public company stock, including Jennison Associates, Modal Capital, TPG-Axon Capital, and Noonday Asset Management .
In contrast to the public image of hedge funds as being run by secretive financiers chasing exotic investment strategies, Mulroy said, the hedge-fund analysts were deeply informed about the industry and easy to deal with.
``People were able to determine in one meeting whether they were interested or not, and that clarity of focus was great," he said. ``In the traditional venture-capital process you tend to work with somebody for months. They tend to hire consultants and look at everything about you."
At Microbia, which is running clinical trials on two potential drugs, chief executive Peter Hecht saw a strategic value in adding hedge-fund investors to his current mix of financial backers, which include highly regarded venture firms such as Polaris Venture Partners and Venrock Associates .
Hecht said he considers his recent $75 million finance round not only an injection of cash, but a way to boost Microbia's profile with hedge funds and mutual funds that may invest in a future IPO.
``When we did this round, we really wanted to use this financing to introduce the company to some of the best public investors," he said.
Hecht's venture backers say that so far they aren't worried about rubbing shoulders with hedge fund managers. The funds haven't taken any seats on the board, and made up less than half of the last financing.
``There's always a risk there, but you end up trying to mitigate it by choosing people who appear to be good partners," said Bryan Roberts , a Venrock partner who sits on Microbia's board of directors.
For large funds, some investors point to another reason for the deals: Taking a private position may be a way to hedge other investments in drug companies whose top products are threatened by new competitors.
The California biotechnology company FibroGen Inc. , for example, is trying to develop a pill that would compete with the multi billion-dollar anemia drugs made by Amgen Inc. If FibroGen succeeds, Amgen stock could suffer, but taking an early position in the biotech company would offer some protection for companies with large holdings of Amgen. Last year FibroGen closed a $100 million funding round fueled by hedge-fund and mutual-fund money.
An early investment in a young research-driven company also gives big funds an advantage over competitors who may also consider investing in a future stock offering.
``These investors are actually able to come, kick the tires on it, watch it work," said Merrimack's Mulroy.
``If there's a company coming along that might be public in a year or two, they can really get inside of it. Whether they invest in it or not, they'll know the story better than anyone else."
Stephen Heuser can be reached at sheuser@globe.com. 