Banker sees IPO drought persisting until 2010

Pacific Growth co-CEO Dietz says startups should get busy raising money

Biotech startups that need to raise cash sometime in the next 12 to 18 months should get busy now and keep an open mind about funding sources, says one investment banker who makes his living finding capital for these young health-care firms.

That's because the IPO market, which has been closed to venture-backed startups for months, isn't likely to rebound until 2010.

Even if Congress approves the $700 billion plan to rescue the mortgage industry, "it's going to take a while for all this to shake out," says Thomas Dietz, co-CEO of the San Francisco investment bank Pacific Growth Equities. "It's hard to see how it's going to recover in 2009."

A vibrant IPO market needs a stable stock market and a healthy market for follow-on offerings, and right now neither of those conditions exist.

"This is the worst drought I can remember. I don't see a window between now and the middle of next year where we're going to have a robust IPO market," Dietz told me in a phone interview.

The firm's last follow-on offering was a $175 million deal for Evergreen Solar in February, and its last IPO, a $115 million offering for Orion, was in December.

Unlike Wall Street giants Morgan Stanley, Goldman Sachs, Merrill Lynch and others, Pacific Growth doesn't borrow money to trade shares for itself in the market.

That kind of leverage, which climbed to 20 or 30 times the value of the underlying equity positions held by those firms, is what forced them to either sell out or be bailed out as their mortgage-backed securities tanked and they teetered neared insolvency.

"We don't use leverage and don't do proprietary trading," Dietz told me.

While that's helped Pacific Growth avoid any flirtation with bankruptcy or bailouts, the mortgage-led meltdown of the stock market has hurt the 18-year-old firm.

"This has not been a very attractive year. Our revenue will be down from last year, and like everyone else, we're having a hard time raising capital for our clients."

Health care startups are capital intensive companies that can easily burn through $100 million in a year and so frequently need new infusions of cash.

But the huge price swings that are taking down entire swaths of the market have money managers worried that even successful companies will see their shares drop after their IPOs.

That worry isn't unfounded. Health care companies with market caps of less than $250 million have seen their shares chopped in half during the last year, accoring to Pacific Growth.

As an investment banker, Dietz is an optimist by nature and believes that valuations will come back. "Eventually, people will put money to work."

In the meantime, the current environment is forcing Dietz to find "creative ways" to raise capital, and he's telling startup clients to think the same way.

That means taking investment from large public firms that are willing to share the risk of developing new drugs or medical devices, even if that means diluting current shareholder value.

"Dilutions are relative if you're successful" and are better than some alternatives, he says.

Those include asset sales or re-capitalizations that wipe out equity entirely, as happened when the federal government bailed out the mortgage giants Fannie Mae and Freddie Mac. 

"I believe we will see companies that won't make it." 

Right now, acquisitions are the best bet, and Pacific Growth has "six M&A assignments and two of those have term sheets" that Dietz expects will lead to completed deals within 30 days.

Already, some VC firms are starting to adapt to the new market reality.

A lot of venture firms are continuing to fund their own startups, rather than be forced to take on new investors in a round with a lower valuation, according to Dietz. 

VCs are also investing more in the follow-on offerings of public firms, because stock prices have come down so much that there are better values in that class of companies than in private firms, he says.