Biotech’s dirty little secret: VCs are heading for the hills — fast

(UPDATED: See below.)

At first glance, life-sciences investments seemed largely to hold steady in the third quarter, despite failing to match a 7.6 percent rise in overall funding, according to data from VentureOne and Ernst & Young. A closer look, however, reveals a very different story — namely, the fact that venture capitalists appear to be fleeing the biotech sector with great speed. Private equity and other non-VC funding sources are presumably taking their place, at least for now.

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Biotech startups raised $1.4 billion in equity financing during the quarter, according to the top-line data VentureOne/E&Y normally makes available (click on the chart thumbnail at left for more detail). It turns out, however, that only 62 percent of that, or $871 million, originated with VCs, with private equity and other non-VC sources making up the difference.

Overall VC investment in biotech dropped by more than a third — 38 percent — in the quarter compared to a year earlier. That precipitous drop stands in sharp contrast to 2006 and the first half of 2007, when VCs accounted for the vast majority of biotech financings. (According to VentureOne, VCs still account for almost all medical-device investments as well, although now I wonder if that data can still be trusted on that point; see below.)

As you’d expect, many of the top biotech deals in the quarter involved non-VC investors. GlobeImmune, which raised $41.2 million in September in the quarter’s third-largest biotech funding, counts a number of private-equity and hedge funds among its investors, including Wexford Capital. (See a detailed list in our coverage here.) Tengion, which raised $33 million last month, was backed by non-VC financiers such as Deerfield Partners, Bain Capital and Johnson & Johnson.

That said, the reason for the sharp one-quarter drop in VC funding remains kind of a mystery. VentureOne’s quarterly financing data is often pretty “chunky,” in the sense that the numbers can swing wildly based on whether a just a few deals fall on one side or the other of the quarterly cutoff. On the other hand, a few VC firms with interests in life science have recently announced cutbacks or cancellation in new fundraising — see, for instance, news on Enterprise Partners here, while Matt Marshall noted problems at Sequel Venture Partners in Boulder, Colo., here — and while there’s not exactly an avalanche of such issues, these announcements might be trailing indications of bigger problems to come. I’ll be looking into this more closely as soon as I can.

On a separate note: What seemed like a nascent revival in innovative, early-stage biotech companies earlier this year may have petered out. Looking only at VC fundings, seed rounds accounted for only 6.9 percent of all deals, compared to 11 percent a year ago. Second and later-stage fundings accounted for 60 percent of all VC biotech fundings, way up from 47 percent last year.

Overall, healthcare-related equity financings rose a meager 3.7 percent in the quarter compared to a year earlier. By contrast, total startup investments rose 7.6 percent. Biotech fundings dipped slightly compared to a year earlier, falling 2.3 percent to $1.4 billion. Medical-device investments continued to rise sharply on that basis, jumping 19 percent to $830.3 million, although funding was down compared to the first and second quarters.

Major deals in medical devices during the quarter included Globus Medical ($110 million), Simplex Diabetic Supply ($50 million) and Satiety ($30 million). Arguably, however, neither Globus nor Simplex really qualifies as a VC deal, as I noted at the time (here and here). Which could, in fact, suggest that VCs may be pulling back from the device sector as well, and that only definitional issues with the data are obscuring that fact for now.

UPDATED: Rewritten to focus on the sharp decline in biotech VC financing.

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UPDATE REDUX: I’ve since taken a closer look at the data with the help of VentureOne. Things aren’t exactly what they seemed, although the outlook for biotech still isn’t good: See here.