VC talks on CardioMEMS acquisition after 11 years of investment

Originally posted on MassDevice

Heart Love

The CardioMEMS story didn’t end whenSt. Jude Medical (NYSE:STJ) acquired the Georgia-based company in June, paying $375 million for the stake it didn’t already own, valuing the implantable heart failure monitor company at $463 million total.

But the deal did end an 11-year commitment by Boston, Mass.-based venture capital firm Boston Millennia Partners, which first put some skin in the CardioMEMS game in 2003, eventually joining 4 more financing rounds as CardioMEMS fought to bring its device to market in the U.S.

Boston Millennia has been on a bit of a deals kick lately; along with the CardioMEMS acquisition, the VC shop also closed a deal for another portfolio company, Precision Dermatology, which Valeant Pharmaceuticals (NYSE:VRX, TSE:VRX) scooped up for $500 million earlier this year. caught up recently with Dana Callow, Millennia’s managing general partner, to talk about the CardioMEMS investment and what it takes to bring a pioneering medical technology to market these days. Let’s dig into the CardioMEMS story, since we’re now past the FDA win and the acquisition by St. Jude Medical. Can you frame how this is a victory, not just from your perspective as an investor, but also the broader picture in terms of healthcare?

Dana Callow:We looked at [the CardioMEMS investment] early on as a chance to bring something new to the congestive heart failure treatment area and a new way to monitor patients’ health when they’re not in the hospital. We felt that the cost of congestive heart failure treatment, since it was a chronic disease, had a huge opportunity. There hasn’t been a major change in how congestive heart failure has been treated other than the drug regimen. So we looked at it from a technical standpoint, originally, as a non-competitive marketplace that people weren’t necessarily focusing on.

Because we had a fairly long-holding period for the CardioMEMS investment, the company ended up becoming much more important after the implementation of the Affordable Care Act, and various payers, providers and others began to look at the readmission topic.

CardioMEMS HF System

Readmission in the treatment of congestive heart failure to a large degree is intensive care treatment, so the CardioMEMS approach is a bit like preventive medicine and it really moved into a sweet spot that we may not have even predicted when we first did the investment. So you weren’t predicting a massive sweeping change to the healthcare system when you made the investment?

Callow: Well, the technology and the management team looked good. The market got better. As an investor, how do you adjust to something like that? It went positive your way, but is there a way to hedge against huge market shifts?

Callow: It’s not a great analogy, but you never get a perfect game. You might get a no-hitter but you never get a perfect game.

In the case of the device world, the market overall has gotten much, much better for opportunities that can reduce cost. I think in the same sense, we’ll see opportunity coming forward for ideas that improve the quality of care, because right now we’ve dealt with access to a large degree and not necessarily dealt adequately with quality care. It’s really hard to measure quality of care and outcome analysis in the market. I’d also say that the investment wasn’t a no-hitter because, of course, with the ACA brings on taxes at the revenue level for the device world.

For many of the larger companies, that tax may or may not hurt them from their innovation side, but from the standpoint of capital access, the smaller companies get severely compromised. This is something investors and their entrepreneurs are having to deal with. The limited partner investors in our types of funds are sensitive to the returns overall, sensitive to investment holding periods and know that the ACA legislation is a double-edged sword. Boston Millennia Partners made its 1st investment in CardioMEMS in 2003 and participated in 4 more rounds. That’s a long holding period, considering it’s your capital on the line. How difficult was that to manage?

Callow: You have to manage expectations going in. You have to have the right partners around you as investors and co-investors. Our investor group was communicating and cooperative at CardioMEMS. I think the expectations got managed pretty well by the management team also. In this case, I think it was a north-of-20% [internal rate of return], we’re not unhappy at all with the IRR. It’s a good absolute return. We look for higher IRRs, but at the end of the day, the absolute was quite good for us. Nine- or 10-year holding periods are not necessarily out of the ordinary for early-stage investing. If you actually look at the averages of early investing in general, I think you’ll find it’s more than 8 years right now for most transactions to achieve liquidity.

However, the risk in some of these types of binary situations is that you’ve invested and then you have to do another series, or 2 or 3, and you have doubling down without knowing the outcome. Sometimes it’s nice to get the quick ‘no’ on the data so that you can move on. The CardioMEMS opportunity was promising all along. CardioMEMS kept the founder on as CEO, which is also rare.

Callow: Jay Yadoff is a physician who had had success in this space before, had been involved in implantable stents for carotids and other types of vascular work. He was known to us from the Cleveland Clinic where we have had past experience.

The technology was good, the market was good. There was a willingness by the management team to have an active partner, not just passive capital. The other thing was it did not have, and I would say this happens frequently in our world, problems associated with many angel investing deals, such as term structures that prevented the company from moving forward.

One of the strategies we used with CardioMEMS (which we often do with our medtech investments) was adding a partner along or several partners from the potential acquirer side. Boston Scientific (NYSE:BSX), Johnson & Johnson (NYSE:JNJ) and Medtronic (NYSE:MDT) also were investors with us in the deal. We had 3 of the potential acquirers at the table with us as we were building the business. While they didn’t have board seats and didn’t have structural issues that gave us limitation on the exit path, we were able to design and craft the building of the business around what the buyer wanted, which is a common strategy for us. We’ve done that before. We decided that we don’t simply just want to bring in a corporate partner later on, in a much higher price, but have multiple partners be with us to assist and also get to know our company. It’s interesting that none of those companies ended up acquiring CardioMEMS, that it was St. Jude Medical …

Callow: There were  several competitive bids put on the table. In fact, 1 of those players, I won’t mention who specifically, but 1 of those participants did in fact make a bid to buy the company. For a variety of reasons, it did not end up closing.

One of the outsiders, specifically St. Jude, paid attention and CardioMEMS fit their strategy. What happened for other groups is that their strategic priorities moved in different spaces.

Now, you have a really important point in medical device investing, in our opinion. If you’re going to make a medical device investment, you need to look at the entire macro-environment really well. You need to know who the buyer is very specifically, and their priorities, as they have many acquisition alternatives available. Why did you go into this space and why do you continue to invest in this sector, given that there are quicker ins and outs and perhaps lower regulatory bars in other sectors?

Callow: I would say it’s different today than it was when we first did these investments, in terms of the market and the return expectations. The uncertainty at the FDA continues, and to invest in this space has a much higher hurdle rate now to compensate for the risk level.
There are many later-stage medical device companies out there, which need some more capital and can be acquired at reasonable value. Our investment strategy has in fact moved later-stage, like many firms in our industry. We’re looking for situations that went through some of the early cycles, made some mistakes and now can be pulled together to form more stable growing business.

I actually believe that there is a consolidation of many technologies that might come together to form some interesting larger-sized medical device companies going forward. In fact, I’ve had other investors call me and say, “Would you like to do a consolidation roll-up?” There seems to be considerable consolidation up at the very top of this of the industry. As you look at the landscape now that the Medtronic (NYSE:MDT) is to be coupled together with Covidien (NYSE:COV), what’s different?

Callow: I think this is no different from a lot of other industries. Consolidation is happening in the CRO industry as well, where you’re seeing the majors now control 35% to 40% of the business, and then you have 300 fragmented players out there.

I think there are niches of unmet needs, but the question for medtech companies is, “Can you get scale, and then can you get access?” None of these small companies can afford to hire 100 salespeople. I think partnering is going to be important. I think you are going to see that the larger companies will continue to deal with their own consolidation, particularly worldwide. It’s a huge unmet need in some of the other area of the world, Asia for example, where we have not necessarily played as of yet.

We will see more M&A happening, given the cost of capital being the way it is. The cost of borrowing is so low that I think there are some attractive strategic plays.

We are also sensitive to the ability of small companies to access the market and build stable distribution platforms. I think more relationships with providers directly may be necessary for growth. It seems that there is a minimum scale for a company in this space to survive. My suspicion is you got to be above $50 million in revenue to have a viable entity. How do you get to that north-of-$50 million mark as an early-stage company?

Callow: You do roll-ups, you do consolidations, you get patient capital. If we were to do another investment in this space, we would certainly look at it as a 5- to 8-year investment period. We’re getting an awful lot of companies showing up. Partially, no doubt, this  is a result of our past experience and success in the space.

I think it’s unrealistic for some of the entrepreneurs to think they’re going to build these businesses independently and flip them. The buyers are seeing everything. This is a sophisticated market. They want something really, truly unique. They clearly want 15%-to-20%-plus growth rates, and with that growth rate a seller can achieve a higher multiple-of-revenue transaction. At lower growth rates, these multiples compress significantly. So 15%-to-20% growth in terms of sales before you can attract a potential acquirer, in your opinion?

Callow: Yes. If you’re running at 5% growth rate, you’re going to have a harder multiple, obviously, unless you can prove something on pure IP and quality of the outcome. Proving quality outcome takes a long time. You asked about the holding period. Part of the problem on all this stuff is you have to have time to show how long a product has been used and its proven success in the clinical setting.

I do wonder whether or not the consolidation at the top level of the market will once again move the minimum hurdle rate up from the $50 million to the $75-million range. If you’ve got an interesting story at $5 million, the strategic buyers are not going to typically take notice. It’s inconsequential to their business model, near-term.

I think the hurdle’s gone way up. I really do. Now, I think the hurdle of professionalism all around has gone up. That’s not necessarily all bad.