The New Science Behind Medical Investing: Big pharma companies increasingly are relying on venture capitalists who generate their own ideas and then build companies around them


The New Science Behind Medical Investing


Big pharma companies increasingly are relying on venture capitalists who generate their own ideas and then build companies around them.

The senior management of Third Rock Ventures knows something about making money from biotechnology. Back in 2008, co-founder Kevin Starr and his partners, Mark Levin and Bob Tepper, raked in $8.8 billion for themselves and investors by selling Millennium Pharmaceuticals, a global drug giant, to a Japanese drug maker. After a celebratory weekend in Las Vegas, the three decided they wanted to try their hand at medical start-ups in a new kind of venture firm that would address what they thought was a broken model for funding biotech and drug introductions. In six years, they’ve raised $1.3 billion in three funds, backed three successful initial public offerings, and had a couple of their fledgling companies acquired. The IPOs include gene-therapy maker Bluebird Bio(ticker: BLUE), up more than 48% from its June pricing, cellular-metabolism specialistAgios Pharmaceuticals (AGIO), which has gained more than 52% following its July pricing, and Foundation Medicine (FMI), which provides molecular information about cancer patients and has seen its stock rise 91% since its September pricing. In light of their success in a revved-up market for biopharmaceutical IPOs and the debate about the state of American health care, we thought it a good time to chat with Starr at the firm’s offices on Newbury Street in Boston.Barron’s: Tell us how Third Rock came into being.

Starr: Quite simply, we were looking for a way to work together. We found that our skills were quite complementary. Mark Levin was the chief executive officer in charge of the organization at Millennium. Bob Tepper was the cancer doctor in charge of things medicine—the science behind it—and I was in charge of strategy and finance. We wanted to find a way to repeat the fun we had together.

But you also saw a need developing.

“The first sequence of an entire genome cost $2 billion; now, sequencing is down to $10,000 to $20,000 per person. Soon, it could be $3.” — Kevin Starr

We believed that the current method of financing medical breakthroughs was broken. The standard system of bringing firms public had become too much of a mutual-fund business, with venture capitalists funding tech just as they would pick stocks in a mutual fund. Venture firms had become too corporate and risk-averse and were even overlapping. It was like what happens with blockbuster films: too much reliance on tired, old formulas. We asked ourselves, “What do we need to make it work?”

This emerged from your observations about the state of the market?

Right. Big pharmaceutical companies were also backing away from financing early-stage companies. The reason: the huge expense of in-house research. Pharma appeared to have lost its nerve. The companies saw their strengths as being in large-scale chemistry manufacturing and distribution. But the absence of products in the development pipeline made them even more desperate for new product. Ironically, and most importantly, the academic community was producing more-innovative research than we had seen in years.

So, new business ideas were getting scarce, even as research discoveries were proliferating in academia?

Yes. The business of scientific research has changed markedly. Robotics, imaging science, and microfluidics [a fast way to isolate single cells for examination] allow scientists to do experiments in an hour that would normally take a single scientist months. This rapid-fire testing gives firms a way to quickly find the most promising ideas and develop them.

Innovation from academia is the greatest we’ve seen in our lifetimes. In this post-genomic world, all these tools allow us to industrialize the interrogation process [making the research faster, easier, and more systematized] to find the best products that can be developed the quickest. Remember, the first sequence of an entire genome cost $2 billion; now, sequencing is down to $10,000 to $20,000 per person. Soon, it could be as low as $3.

What effect is this having on biotechnology?

Transformative. Before, we didn’t know what genes did. Cancers were named after the place where the tumors occurred. If it was on the lung; it was called lung cancer. We now know how to interrogate tumors to find out what genes have gone awry. We’re using special tools. Solutions often result in custom treatments designed to treat specific problems revealed by genomic research. These tools have allowed us to find out exactly what is going wrong in the tumor.

Now, cancer is defined by the genetic mutation that occurs no matter where the disruption occurs. By redefining the disease, we can treat the genetic mutation disruption.

So it’s this rapid-fire conversation that allows you to find the breakthrough ideas?

The key question at Third Rock is when. If it’s not going to mature in 15 years, it’s not good enough for an investment. A successful idea must reach proof of concept within three to five years.

You seem pretty proud of your ability to collaborate on ideas drawing from a wide range of experience.

In a venture operation, you see four or five dominant partners operating within the silos of their expertise. With us, it’s much more hands-on. We employ 50 people, many times more folks than the venture firms do. And we use our senior managers in a much more collaborative way. Everyone here punches timecards, believe it or not. That’s so we can use our senior managers most effectively. None of us—Mark, Bob, and I—feel like we’re smart enough to make these calls. We try and make team decisions, bringing together science, business, strategy, and medicine. All those angles must be assessed for technical success. We’re not so concerned about whether they wind up as IPOs or get purchased by bigger companies. We think that most of our deals will ultimately be acquisitions.

Our process works this way: We see the same 1,000 or so ideas that our competitors do, but we invest in very few. Instead, our successful projects most often begin with an academic study—or breakthrough. But we do a lot more sifting, testing, and development early on to make sure that the science is fresh, and that the proposition is grounded before we ever move into development. We’d rather fail early in the process when the costs are lower than later when the costs are much higher. Sometimes, we will joint-venture with other biotech venture firms.

When we have questions on the science, we pursue them ourselves, in-house.

How then do you go about turning ideas into business propositions?

We start early and intensively, long before the so-called first phase in drug development. Before Phase 1, we have three stages for ideas, in a process we call Third Rock Discovery. The ventures move in stages from C to B to A. The C area is fully three to five years away from ever being a company. It could be an idea we read about in a science journal, or an academic study with promise. These ideas get thrashed out at our all-day Monday partners’ meetings.

Simultaneously, we run five permanent subcommittees that represent the areas of medicine that we think most ripe for development. We’ve boiled our committees down to rare gene disorders, oncology, neuroscience, metabolic diseases, and personalized medicine.

Could a small investor play these themes?

A Sampling of Third Rock’s Medical Portfolio

Company Description/Treatment
Blueprint Medicines Highly selective kinase inhibitors for treating cancer
Eleven Biotherapeutics Treats ocular diseases with protein-engineering technology
Zafgen  New drug beloranib for severe obesity
Sage Focuses on brain diseases; received $20 million in financing
Jounce Therapeutics Using immune system to attack specific cancer cells
CytomX Expanding use of therapeutic antibodies
Source: Third Rock Ventures

Offhand, I’d say invest in companies that are at the forefront of cutting-edge science—companies like Celgene [CELG], which has done several strategic alliances with us.

Going back to the process, what is stage B?

If the idea survives our initial scrubbing process, we might move it on to stage B, where we try and infuse the venture with what we call TRUK, or Third Rock ultra killer criteria, which tries to develop the idea more fully along the lines of science, business strategy, or medicine. Here is where we put together a business with a senior partner in charge, and someone in charge of the science or medicine. We normally put together a task force to do wet lab work, investing from $300,000 to $2.5 million. At any one time, we might have three or four of the ventures moving through the B stage. [In all, the firm has 31 companies in its portfolio.]

But you also do a lot of consulting, both with hospitals and Big Pharma companies, during these A and B stages.

That’s another area where we’re different. We really go after our customers. We have a partner-development team in B stage. It will have from as few as three to as many as 500 meetings with the heads of research and development at major pharmas, biotechs, health-care payers, and others. We ask them what they think about certain key questions, or what they think of this area of science. If they love what we’re doing, and say they’re doing the same thing, it’s sort of counterintuitive. We drop it. We don’t need to produce another mousetrap. We need something that’s really different. Instead, if they express an interest in the idea or area of early science, and say they would be potentially interested if it all checks out, that gets us excited. We may have just found a powerful potential funding partner. We can then enter into joint-development ventures that will give the partner an option on the company or products if the science pans out. Big Pharma finds it much easier to deal with us on any number of ideas than to develop the science in house. These days, they operate like bankers to firms like us that develop the ideas. We believe that the future of pharma depends upon its ability to develop portfolios of new drugs and applications that will sustain profitability. So I’d expect you will see more of these deals being done, where large parts of a pharma’s net worth lie hidden in special option-purchase agreements governing the fate of these tiny development companies, whether public or private deals.

What happens in stage A, as you prepare these ventures for prime time?

Here, the venture is within a year of being a company. This amounts to pre-company building. We have three or four of these going on at any one time, as well. Here is where we start assembling the academic teams; we hire people, get our facility lined up. And if the venture still looks good, we put in between $35 million and $45 million in the full expectation of compounding our investment five times. And we have our own guys run the start-ups. That’s a far cry from the old days when start-ups used to have $5 million. Five million dollars amounts to a bridge to nowhere. It ensures that the CEOs will be tin-cupping back to other venture [firms], spending all their time raising money. We need management to focus on bringing the scientific enterprise to life. We’ve already cleared away most of the problems in the earlier stages. We typically put in between 10,000 and 15,000 man hours, or 12 to 18 months. We then recruit superstar CEOs to run the companies.

How does it all work out then?

Third Rock is really a front-end supplier of these development ideas. We put $17 million in preclinical testing into Agios, during which we found a source for shutting off cancer’s appetite for sugar. Celgene became interested in the science and put in $130 million in a deal that would split the products going forward. Later, Fidelity, Wellington and others invested another $80 million in private placements. Agios came public, producing a $120 million offering, with five potential products.

The pharma industry has evolved to where scale interferes with innovation. That’s why they come to us. It’s a new collaborative game with players that didn’t exist 10 years ago:Gilead Sciences [GILD], Celgene, Biogen/Idec [BIIB].

And you think these changes will ultimately help us reorganize our medical system?

At the end of the day, the U.S. spends about $3.3 trillion on health care. We have diseases that we haven’t even started to fix—devastating disorders. At the same time, we’re running up against costs that test affordability. What we need is a new way to look at profit maximization. We like to call it systemwide maximization. With all the players—venture firms, payers, hospitals, insurers, doctors—maximizing their profit, the result is unworkable. We take a system-wide view when putting together these ventures. We talk to as many parties as we can, from payers to providers to insurance companies, and try to come up with products and services that will address all needs. The trick is in maximizing integration.

Thanks, Kevin. 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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