Institutional investors drawn to health-care sector

Opportunities in health-care investing through hedge funds, private equity funds and long-only equity strategies seem to be drawing increasing interest from institutional investors. But not all areas of the sector are flourishing.

One indicator of the interest is the growth of U.S. health-care mutual funds for institutional investors over the last 12 months. According to Morningstar, total net assets for those funds have increased to $1.8 billion as of May 31, up from $1.2 billion as of Nov. 30, 2012, and from $1 billion as of June 30, 2012.

Institutional investors are very interested in the health-care sector now, especially because of excellent returns in health-care subsectors, including the stocks of drug manufacturers, insurance companies and providers, said Roderick Wong chief investment officer and managing partner of RTW Investments LLC, a health-care hedge fund firm in New York with $60 million in assets under management. For some sectors, the returns are about 20% so far in 2013, Mr. Wong said.

RTW's offshore fund (RTW Master Fund Ltd.) was up 26.8% for 2013 through June and up 21.9% for 2012, both net of fees, according to the firm.

The HFRI EH: Sector — Technology/Healthcare Index is up 8.92% for 2013 through June. In comparison, the HFRI Fund Weighted Composite Index is up 3.55% for the same period.

Health-care reform also is driving institutional investor interest in the space, Mr. Wong said. The Affordable Healthcare Act will add up to 30 million people to the insured rolls. The ACA is “clearly a short- and medium-term net positive for many players in health care,” Mr. Wong said.

Carter Neild, a general partner at health-care investment firm OrbiMed Advisors LLC, New York, said he sees institutional investor interest in the health-care sector driven more by innovation in the industry and drug launches, and less by the ACA changes. Last year, for example, the U.S. Food and Drug Administration approved 39 new drugs, a 15-year high.

OrbiMed is considered the largest health-care investment manager in the world, with about $7 billion under management. That includes about $2.5 billion in hedge funds, $2.5 billion in long-only equity funds, $1.5 billion in private equity funds and $500 million in health-care royalty funds.

Within health care, investor interest has varied according to wide disparities in returns. Royalty funds, the illiquid investment vehicles that monetize royalties for drugs or medical devices, are “white hot” and wildly oversubscribed because they provide great returns and steady cash flow in a low/no-interest environment, Mr. Neild said. And only a handful of health care royalty fund managers exist, including OrbiMed, DRI Capital Corp. of Toronto, Royalty HealthCare Partners of Stamford, Conn., Capital Royalty L.P. of Houston and Royalty Pharma of New York.

In contrast, the returns for health-care venture capital funds are tanking, along with investor interest in the space, Mr. Neild said. Health-care venture capital, primarily investing in the biopharmaceutical or medical device space, has typically made up about 25% of the total venture space.

Awful returns for the space are killing fundraising. “Those funds are just dying; there's massive attrition,” Mr. Neild said. “Many of these groups that have been in business for a long, long time will just disband.”

Among the established venture capital firms that have publicly indicated they will not raise another health care venture fund are Skyline Ventures of Palo Alto, Calif.; Scale Venture Partners of Foster City, Calif.; Essex Woodlands Health Ventures of Palo Alto; and Prospect Venture Partners, also of Palo Alto.

For long-only health-care strategies and long-short equity health-care hedge funds, returns have generally reflected the healthy returns of health-care public equities. And the Nasdaq Biotechnology index, for one benchmark, is up about 40.7% for 2013, through July 15.

Whether the health-care sector in general experiences a long-term, sustainable profit boost as a result of ACA reforms will depend on what mechanisms are created to control prices and health-care utilization, Mr. Wong said. But the drug and biotech sectors are well-positioned for long-term profitability, he said.

The current productivity boom in drug discovery will translate into “real value creation” through important new drugs that have a significant impact on disease, Mr. Wong said. “We are in the early stages of a research productivity boom that should fill pipelines for the next decade or more,” he said.

Endowments and foundations in the $500 million to $3 billion range and larger family offices seem to have a real appetite for the health care investment strategies followed by RA Capital Management LLC, said Michael Calore, director of investor relations for the hybrid hedge/private equity fund manager. The Boston-based manager runs more than $500 million, investing in small-cap, development-stage biotech companies.

Health care has become attractive for institutional investors in part because uncorrelated alpha, which is harder to find in other segments, is available from the good managers in the space, Mr. Calore said. And with health care product development companies developing technologies at faster rates and deep-pocketed big pharmaceutical companies looking to acquire technologies through mergers and acquisitions, fund managers have a lot of opportunities in the space, he said.

Ferenc Sanderson, a partner in PrevInvest, a pension fund advisory a pension fund consultant and research firm based in Cleveland and Rome, Italy said institutional investor interest in health care has definitely received a boost from the ACA.

Over the first five months of the year, long-short equity hedge funds have moved more into health-care stocks, Mr. Sanderson said. Through April, year-to-date stock prices in the health care sector of the S&P 500 were up 18.4%, second only to the utilities sector.

Another factor has been the high level of consolidation in the health-care industry, especially with hospitals in urban areas, mostly driven by pressure to reduce costs, he said.

A third factor has been the boom in retirement and specialty health-care facilities, such as those that treat Alzheimer's patients, as occupancy rates have increased. Because this sector is characterized by steady returns over the long term, a lot of private equity firms and some institutional investors, such as university endowments with large real estate portfolios, are jumping in, Mr. Sanderson said.

A lot of the hedge fund money invested in health care is through multistrategy funds, not pure health care plays, rather in stocks of large companies that are outside of the sector but stand to benefit from changes in technology platforms, insurance and pharmaceuticals that ACA will bring.

“That's the opportunity. It's the big picture which is the real alpha story, I think,” Mr. Sanderson said. “When you've got consolidations of companies, there's going to be winners and losers. When you've got consolidation of data, there's opportunities if you can capture that data and manage it.”

Institutional investors also might have more riding on health-care investments than what meets the eye. For a typical global long-short equity hedge fund, health-care sector positions might be less than 5%. But considering related companies — tech, insurance and real estate investments that will be affected by the health-care industry changes — the exposure could be more than 20%, Mr. Sanderson said.

“The opportunity is a lot bigger, and it's a lot more widespread, than buying a cheap drug company and selling a rich one,” he said. “It's a lot more than that. It's the whole ecosystem of health care, which is up for grabs, basically. And that applies globally.”

“I've heard managers talk (up) their book that way, but I haven't heard any clients say: 'Yeah; I've got to have some of that,'” Mr. Sanderson said. While a handful of health care hedge funds have performed well, most of them have struggled, he said.

In all of the three main areas of sector hedge funds — health care, energy and natural resources, and technology — only a few funds have performed well over time, and very few of them are anywhere near their historical asset peak, the consultant said.