2015 Had Promising Signs Amid Tough Fundraising Climate for Dx Cos

Last year was a "banner" year for investment activity in the health care industry. Overall, in 2015, venture capital (VC) investment in health care hit a 15-year high, reaching roughly $59 billion. The picture was particularly bright for the biopharma sector, which saw record VC investment, even at the earliest of stages, along with increases in mergers and acquisitions (M&A). The diagnostics and tools sectors lagged significantly behind biopharma in both of these measures. Silicon Valley Bank's report, Trends in Healthcare Investments and Exits 2016, along with DTET interviews with analysts, point to some continuing investor concerns over diagnostics and tools sectors, but with some emerging signs of optimism.

"The two things that are bothering almost everybody are a lack of certainty around reimbursement and the lack of certainty around regulation," says Harry Glorikian, a diagnostics industry consultant and director of the Diagnostics Marketing Association. "If you look at the proposed regulations and you look at your assay, you should have an idea where you fall, and hopefully you are planning ahead. But, ideally the FDA will put a stake in the ground so that investors and companies can understand the rules of engagement. We might not like them, but we will have the marching orders or you may have some companies decide it is so expensive, we can't play this game."

VC-Early Investment Down, But New Funds Entering
Unlike in biopharma, which saw an increase in early-stage funding (97 deals in total), the diagnostics and tools sectors saw a sharp decline in series A investments from 45 deals in both 2013 and 2014 to only 17 in 2015. On the positive side, some larger venture capital investors, traditionally more active in other sectors, like WuXi Venture Fund and Morningside Group, made some bets in the diagnostics and tools industries. Silicon Valley Bank's Jonathan Norris, lead author of the report, tells DTET he anticipates seeing some "stabilization" in early-stage funding of diagnostics and tools companies in the coming year, but points out a third area of concern for investors looking at the space—intellectual property protections.

"As an investor it is difficult to look at these three challenges and understand how to get to a return in a reasonable amount of time," Norris says. "These three inputs lead to question marks and question marks need more time and more money. It is difficult to predict how to get a decent return with these question marks."

Exits Declined for Diagnostics/Tools in 2015
Investors realize their returns when companies are able to "exit" either through M&A or an initial public offering (IPO). Last year both M&As and IPOs declined in the diagnostics and tools sectors, according to Silicon Valley Bank analysis. However, experts predict an uptick in M&A in the diagnostics industry in 2016.

"We are seeing new companies created over the last few years that have a different makeup than those created six, eight, or ten years ago," Norris explains. "Back then there was a lot of promise in the market, but there were some things in the market that needed to develop and these developments took time and cost early entrants. Now companies are more cost effective at developing the technology and with their capital structure and number of employees."

This "capital efficiency" led to a significant decline in time-to-exit in 2015 in the diagnostics/tool sectors. Years to exit reached the lowest since 2010 with a median of 3.5 years.

Norris says he expects to continue to see a "barbell" look to acquisitions with activity among these efficient, emerging companies and also among more mature, commercial stage companies that may not have enough revenue to be IPO candidates, but are finally breaking even.

For instance, analysts expect Thermo Fisher to be a big newsmaker this year, even after its January announcement that it purchased Affymetrix for $1.3 billion. Analysts anticipate seeing a continued trend of "tuck-in M&A" in 2016, particularly among smaller, specialty diagnostics companies, which offer the potential for higher- margin, higher-growth testing.

Takeaway: Analysts expect to see an uptick in M&A activity in the diagnostics and tools sectors this year, along with a continuation of tight VC investment capital in early-stage companies.