Say "health care" to investors, and you're likely to make them ill. Major health-care companies such as Aetna and Oxford are still reeling from the effects of higher costs and legal threats. But there's more to the sector than just HMOs, say the experts at Advanced Technology Ventures (ATV) a 20-year-old Waltham (Mass.) venture-capital firm with $350 million in assets under management. In fact, ATV continues to invest about a quarter of its fund in health-care opportunities at a time when most venture-capital firms are either getting out of health care altogether or segregating it. The firm currently has about 25 to 30 health-care investments at $4 million to $7 million a pop.

Its fifth fund, with $175 million of investment capital, is in the final stages of investment. ATV plans to raise $400 million for its sixth and largest-ever fund by yearend. The firm buys into software companies, Internet plays, communications ventures, and health-care investments.

Business Week Online's Margaret Popper spoke with ATV principal Mike Carusi about the fund's health-care investment strategy.

Q: So many venture capital firms have pulled out of health care in the past year. Is health-care investing dead?
A: A lot of people say that. Health-care investing is not dead. It's just that the bar is much higher. A lot of biotech companies can't get there. First off, they take too long. Second, you have to invest too much money before you know you actually have something. And finally, the technology risk is too high. Only one out of 10 drugs makes it through to final approval.

Q: Are there other sectors of the health-care industry that are worth investing in?
A: The health-care landscape has different segments: There is the traditional biotech focusing on drugs and therapeutics, biotech that is pharmaceutical outsourcing, medical devices, e-health, health-care IT, and health-care services.

Q: Are the returns the same on health-care investing as those on Internet and telecommunications?
A: In a balanced fund, the IRR [internal rate of return] has to be equal, but not necessarily the multiples. You won't get the same absolute return in dollars on health care that you do on telecoms or the Internet. There will be very few $1 billion devices -- $5 million to $10 million is more normal in health care.

Q: Are you applying different time horizons to these investments than you used to?
A: Yes. I'm targeting two to four years. Before it was four to six years. So we're trying to get our average lead time down from five to three years.

Q: Given the competition with high-yielding, quick-turnaround Internet plays, will biotech investing dry up altogether?
A: New business models are emerging in the biotech sector. Early-stage biotech companies in therapeutics have changed their business models to produce revenues faster. They have become tools, providing platform technologies to pharmaceuticals. But there are 10 or 20 pharmaceuticals that are overwhelmed with new technology. It's tough to get above the noise.

And you need to have a lot of capital. The investments are in the hundreds of millions, vs. traditional venture-capital investments.

In venture capital, the health-care-only groups are the ones that might invest in early-stage biotech [therapeutics, i.e., drug-development] companies, while a balanced fund like ourselves won't. We see a number of plans, and typically, it'll be a very bright scientist with nothing more than an idea and a few clinical tests. Maybe there's a receptor in the body he wants to block as a cure for cancer. But the time to market for that kind of thing is too long.

Q: Aside from biotech therapeutics, are there any other sectors you're avoiding?
A: I'm not touching services. A couple of years ago there were all these roll-ups of physician practice management groups (PPMs). Things like free-standing dialysis centers, such as Renal Treatment Centers or Evivera. You would use your stock issue to acquire them. The stock price would go up with the acquisition. It was a bit of a Ponzi scheme. The idea was by creating a national network, you would get operating efficiencies and greater negotiating power with the HMOs.

Somehow the operating efficiencies didn't bear out. Maybe these centers weren't as inefficient as people thought to begin with. It also turned out that negotiating power on a national level wasn't that important in an industry where things are still played out on a regional level.

Q: What areas do you favor?
A: We are looking for products that address unmet needs in areas with high mortality or morbidity [people who need significant care for life] or high economic burden, or that affect younger patients. Products like these have rapid market adoption. [Insurers] give them a favorable reimbursement rate, so there is less price pressure on these products. Payers tend to push back less on products that save lives. We also want to invest in technologies where industry consolidators exist.

We are looking at medical devices on the theory that as long as people are dying, there will be a need for new technology. We are especially interested in cardiovascular and neurovascular technology -- hearts and brains. Devices don't have as long a development time as drugs. They usually have to go through a pre-market approval (PMA), but that takes three years, not five or six, like with drugs.

I like devices because they present an engineering challenge, not a medical challenge. They have inherently less technical or scientific risk than drugs. The market adoption tends to be faster in cardiovascular and neurovascular devices, and there are major players who have shown they have an appetite for these investments. Guidant, Metronic, and Johnson & Johnson are all interested and have venture-capital funding available for this technology.

Q: Are there any up-and-coming areas in health-care venture capital?
A: E-health -- where the Internet and health care come together. One of the big issues that people are trying to solve is connectivity. That means companies are trying to connect patients, physicians, and hospitals over the Internet. The successful companies will be the ones that figure out a way to integrate with the legacy system in the short term. That's the real IT challenge.

I'm looking at a company right now in this area that I really like because it's taking baby steps. The big ones like Healtheon have the right model, but they're talking about a very big play.

We're seeing three types of companies in this field Ð- the ones that operate on a national scale like Healtheon, the ones that operate regionally, partnering with hospitals and doctors' offices, and the ones that are a one-product company. For the most part, the third tier is too small to be of much interest...

But the landscape is not that defined yet. There are still IPO opportunities. Then we'll move into the acquisition phase.

By Margaret Popper margaret_popper@businessweek.com