Unless the decline in first-time funding is reversed, fewer innovative drugs will come to market.

Venture capitalists invested significantly more money in biopharma companies during the fourth quarter of 2011 and all of last year compared with a year earlier. Those promising numbers, however, masked an erosion in first-sequence VC activity that one venture capitalist said would mean fewer new drugs and technologies coming to market over time.

Nearly $1.3 billion was invested in a total 111 biopharma company deals during Q4 ’11, up 45% from $874.3 million in Q4 2010, according to the quarterly MoneyTree Report, issued Thursday by PricewaterhouseCoopers and the National Venture Capital Association (NVCA), based on Thomson Reuters data. The report also showed a 22% gain in total biotech investment during all of 2011, to $4.7 billion from almost $3.9 billion in 2010, even as the number of deals dipped 9% year-over-year from 488 to 446.

In the year’s biggest deal, Reata Pharmaceuticals racked up $300 million during Q3 (13th sequence). Biopharmas accounted for three of the top 10 VC deals of Q4: Portola Pharmaceuticals (nearly $89 million, 8th sequence), Agios Pharmaceuticals ($78 million, 4th sequence), and an undisclosed Cambridge, MA, firm ($75 million, first sequence).

First-sequence investment activity in biopharma showed even higher year-over-year gains for Q4 and all of 2011. But the seemingly healthy numbers reflected a doubling in the size of the average first-sequence investment, since the number of such deals tumbled year over year by roughly 20% for both the fourth quarter and the full year.

During Q4 ‘11, about $236.6 million in first-sequence capital was invested in 21 companies, compared with roughly $136.3 million in 27 companies. For all of 2011, $841.8 million was invested in 98 companies, versus $593.6 million in 121 companies.

“This decline in first-time funding speaks to the precarious state of life sciences venture funding and with it the entire medical innovation paradigm in this country,” said Jonathan Leff, a partner and managing director with Warburg Pincus, during a conference call with reporters. “We continue to see great potential in life sciences innovation. However, like other investors in the space, we have found that the life sciences investment environment has grown significantly more challenging in recent years.”

Challenging enough, he said, that VCs continue to shun riskier early-stage startups in order to keep more capital for follow-on financings in existing companies, for later-stage investments, and for investments in companies overseas, especially in China.

While fewer first-sequence deals got done, their average size more than doubled during Q4, to almost $11.3 million last year from just over $5 million in 2010. For the full year, the average nearly doubled to $8.6 million in 2011 from $4.9 million a year earlier.

The increase in deal sizes and total investment activity seen in 2011, Leff said, came mostly from companies formed 10 to 15 ago with VC money, either during the 1990s tech boom or soon after. Of the 30 drugs approved by FDA in 2011, half (15) were labeled priority drugs, of which 13 originated with venture-backed biopharmas.

As these companies advance, fewer companies will take their place, Leff added. “Unless this trend is reversed and unless the capital begins coming back into new formation and supporting new innovative products and technologies, this will result in a real decline in the number of new innovative drugs and medical devices that will come to market in the years and decades ahead,” Leff declared. “VCs are finding that the cost, time, and uncertainty involved in developing innovative drugs and medical devices have all escalated to the point where increasingly, the economic math just doesn’t work.”

Several VC firms have reduced or eliminated biotech investments in recent years. That could change, Leff said, if Congress approves several regulatory reforms under review as part of the fifth authorization of the Prescription Drug User Fee Act (PDUFA V) for the five federal fiscal years starting October 1.

The reforms, designed to speed up FDA reviews, commit the agency to three meetings with drug developers on an application as well as to reviewing and acting on 90% of standard NME, NDA, and BLA submissions within 10 months to 12 months from the date of filing, and on 90% of priority NME, NDA, and BLA submissions within six months, or eight months from date of filing.

“There is reason for optimism that the situation is poised to at least begin improving,” Leff said. Answering a GEN question, Leff said any impact on VC investment from PDUFA V regulatory reform “will certainly take time,” as much as a decade or more given the typical drug development timeframe, and will depend on how much any changes add predictability and reduce the cost and time of FDA reviews.

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