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Psychedelics are evolving as research has shown their potential to help treat a range of mental health and behavioral issues. Long cherished for their medicinal and recreational uses, psychedelics have many parallels to cannabis, but also many differences.

Palo Santo is a U.S.-based psychedelics investment fund which recently raised an initial $35 million with an active portfolio of 20+ companies. The fund is focused on tackling the growing global mental health crisis by investing in innovative psychedelic-based and adjacent therapies that are poised to shape the future of psychiatry and fields beyond.

We interviewed Tim Schlidt, co-founder, and partner at Palo Santo. Prior to founding Palo Santo in 2020, Tim worked in private equity and investment banking in life sciences and healthcare sectors. We caught up with Tim at the November MJ BizCon event.

Aaron Green: How did you get involved in the psychedelics industry?

Tim Schlidt: Anyone who knew me in college would be shocked that I am even touching psychedelics with a 10-foot pole. But what really got me over the hump was the very interesting clinical data that’s come out of Johns Hopkins, NYU, Imperial College London, and many other universities. The moment you have clinical data it starts to get interesting. When you have human use, you have endpoints that are very targeted, you can test your statistical significance – all those factors – and you start to go, “Okay, this is really interesting.” We know pharmacologically, psychedelics are non-toxic – aside from psycho activity – there’s a low risk profile, and you can control for that when you’re under therapist supervision. So, that really convinced me about the therapeutic potential of psychedelics about four years ago.

Professionally, my background was in life sciences early in my career and healthcare services later on. I started in investment banking, focused on pharmaceuticals, biotech, and then after that the clinic and healthcare services aspect of the healthcare ecosystem. My experience has plugged in nicely with psychedelics, as we see these go much more of a healthcare-oriented and FDA approval-type route than cannabis, which has been much more of a recreational model for the most part.

Personally, I’ve had a fascination with these therapeutics over the past four years, since there is such a plethora of data around them, so I just started digging. The more I dug into it, the more I became convinced that I think there’s profound therapeutic potential behind psychedelics.

Green: Tell me about Palo Santo and the fund.

Schlidt: We are a VC fund. We launched about a year and a half ago, investing across the psychedelic ecosystem. Our main vertical is biotech and psychedelic biotech. We do focus on tech, with some healthcare services and clinic-type models weaved in there a bit. That’s the primary focus of the fund. We’ve raised our first $35 million to date. We’ve deployed about $15 million across 25 portfolio companies. We’ve been very active in the ecosystem. I’d say we see a lot of deal flow out there and we’ve been there since the early days of this space.

Green: How much do you hold in reserves and what does your dry powder look like?

Schlidt: We’ve reserved about 40-50% of the fund for follow-on so our real dry powder in the new deals is about $5 to $10 million that we deploy to new companies. With the remainder we like to reserve to follow on in financings with our portfolio companies.

Green: Are you leading rounds?

Schlidt: We do lead some rounds. We co-led on Journey Clinical. We led the round on Reset Pharma – another really interesting company. In other deals we’ll happily follow, for example with Delix Therapeutics, Artis Ventures lead that round. So, it’s a mixed bag, but yes, we do lead rounds depending on where our expertise plugs in, where we can really help and how early we are to the game on sourcing the opportunity. We’ll certainly take the lead in some cases.

Green: Do you find yourself participating in rounds together with the same co-investors frequently?

Schlidt: We do. I think what’s interesting about this space is that the aggregate capital needs in biotech are large. To take a drug all the way through to market is going to be between $100 and $200 million in clinical trials spending. So, you think about us, a $35 million (target size $45 to $50 million) fund alone, we couldn’t even fund one company all the way through to commercialization. So, there’s a very collaborative ethos in this space and a lot of deal flow sharing. A lot of us have our hearts in the right place and want to see this space advance. Foremost, we’ve had a personal attachment to these medicines so there’s a very collaborative attitude between us and other investors in the space. Our LP base also will certainly syndicate things out so there’s a lot of piggybacking off each other and collaboration.

Green: What stage are you typically investing in?

Schlidt: We’re financing Seed and Series A, primarily for clinical stage or preclinical stage startups. We’re talking from lead optimization in preclinical where you’re past high-throughput screens and some of the preliminary screening where you’ve identified a scaffold and are trying to find a lead, all the way through to about Phase II of development.

Normally, we probably wouldn’t be Phase II if we were just a Seed stage or Series A focused biotech fund. However, psychedelics are interesting in that some of these technologies are later stage since we know so much about them, so the preclinical work you have to do is a lot more muted than what you would do with brand new compounds. We do have some Phase II assets in the portfolio. Nothing beyond that, though, at this stage.

Green: How about partnerships with some of the organizations that are out there promoting psychedelic therapies. Do you tie into MAPS or any of those guys?

Schlidt: We do. We certainly stay plugged in. We’ve donated to MAPS and are very much in support of what they do. They’ve greased the skids in a lot of ways for the for-profit space and I think a debt of gratitude is owed. I think had they not blazed that trail; we may not be here with for-profit entities. So, MAPS is one, the Usona folks as well. I really like what they’re doing. I think there’s a lot of synergies between non-profit and for-profit in this space and certainly a lot of collaboration between the two as well.

I think the baton is slowly getting passed to the for-profit space, more just from a practical angle. You look at the range of indications that these therapeutics could address, and the aggregate funding needed to get a drug to market across each one of those indications – that’s potentially billions of dollars in clinical trial spending. I think it’s tough to raise enough non-profit funds to do that. You can do that for one or two compounds and indications, but to do that across a wide range is pretty difficult. So, there’s definitely going to be a need for for-profit enterprise in the space and I think we’re seeing that emerge slowly.

Green: How do you define psychedelics at Palo Santo?

Schlidt: It’s a good question. There are some people who apply a very broad definition, some very narrow, so I’ll start with the narrow definition. The purists would say that a psychedelic is an agonist at the 5-HT2A receptor. It’s the serotonin 2A receptor, which is the source of psychoactivity with these compounds and, we hypothesize, the source of the antidepressant effects of psychedelics as well. That would be the very pure definition. The drugs that fall in that class would be the tryptamines, psilocybin, DMT, phenethylamines, herbalines, LSD, 2C-B, mescaline, peyote, those sorts of compounds. That would be the purist definition. I think others will venture beyond that. A lot of us call ketamine a psychedelic even though the mechanism of action is very different. It’s an NMDA antagonist; a very different receptor target with a very different mechanism of action, but is not hallucinatory, and is instead characterized as “dissociative”. Or you think about salvinorin A or Ibogaine – those are also very different mechanisms of action. We still loosely bucket those into psychedelics. Some would argue cannabis is even a psychedelic, in high doses. It’s pretty psychoactive in a lot of ways. So, the definition is loose.

We see a lot of investors either deviating in the definition of psychedelics or trying to stay pretty close to one another. I’d say we’re open to deviation a little bit. One thing you don’t want to do in life sciences investing is have a lack of correlation with mechanism of action. So, if you have a lot of exposure to 2A agonism, and that mechanism ends up not working out, we find out that you have a lot of eggs in one basket. So, we’re certainly open to other more loosely defined psychedelics with our thesis, but we do think that psychoactivity is important in a lot of ways.

Green: Psychedelics have been around for a long time and there is lots of old research and patent literature. What do you think about protecting IP in the psychedelic space, specifically?

Schlidt: For the generics, the way I characterize it is you can generate IP if you have a novel delivery method or novel formulation. If it’s a salt form, you find that interesting polymorph and you can have IP. Now, it’s narrow IP that’s the problem. Someone could have a polymorph of let’s say, psilocybin, and advanced their own formulation of psilocybin. So, it is tougher to build a defensible business model. Composition of matter is the Holy Grail for patents.

For us, there’s a big focus on gen-three, this next generation of compounds, which would be new chemical and composition of matter patents. That is certainly the Holy Grail. With that said, you can get delivery methods, you can have chemical manufacturing controls… There is some IP that can be generated around the generics, but I do think it’s going to be flimsier IP.

Part of our thesis is that the market is so large currently when you look at the patient population sizes, and so daunting post-COVID that I think there’s enough pie to go around for a few big players to emerge in the space.

Green: Cannabis has gone down a path of recreational and medical. Do you see a place for recreational in psychedelics?

Schlidt: I’m admittedly very bearish on recreational for psychedelics the way cannabis has been recreational. Going to a dispensary and picking up your psilocybin microdoses or mushroom pills… I’m more reticent around that model. Now you could see an Oregon-type model emerge where it’s still very medical in nature and you have a lot of clinician supervision. I think that will be the main model emerging. Now the difficulty of the clinic model is that clinics don’t produce a ton of cash flow, or at least when we’ve looked at ketamine clinics, they’re not incredibly profitable operations. The same may be true for psilocybin clinics in a lot of ways. So, whether VC investors want to participate in that will be a much bigger question.

We like the medical model in a lot of ways. I like the ability to make medical claims and healthcare claims that are supported by an FDA pathway. I think there’s much more safety and we need to have that around these therapeutics. We don’t want a backlash like we saw in the 60s. A lot of us have an abundance of caution mentality like “Let’s be patient. Let’s do it slowly,” and take these to market in the right way with the proper protocols in place. We are leaning largely into the medicalization model with Palo Santo.

Now, with that said, we fully support decriminalization. The ability to create a business around decriminalization is going to be very different. I think anyone going to jail for the use of these is sad. So, that’s kind of how we see it. We’re pro-medicalization. We like the healthcare pathway. I think it’s very safe and in a lot of ways, from a regulatory standpoint, superior to get a drug to market.

Green: What does your LP base look like? Are you seeing any interest from institutional investors?

Schlidt: There are a lot of high-net-worth individuals interested in the space. High net worth certainly dovetails with family offices. It’s kind of your semi-institutional and family office – they do have a funding structure.

At the institutional level you’re seeing interest from life sciences funds, that is for sure. So, the RA capitals of the world, the Deerfields, the BBS… Those sorts of funds are interested in psychedelics. It seems to be at later stages or if there is a really interesting IP they’re stepping into. We’re not seeing a lot of pension funds stepping in. They’re still very hesitant. I’m admittedly a bit surprised by that, because from a legal standpoint, these companies are completely aboveboard. If you have a DEA research or distribution license, you can work with these companies and you can go through the usual banking channels. So, legally, we are not in a gray area like cannabis. I think a lot of folks don’t know that and they kind of analogize psychedelics to cannabis. So, it’ll be kind of slow going for them to get up that education curriculum, but eventually you’ll see pension funds play in this ecosystem. I have no doubt about that.

Green: What in psychedelics or in your personal life are you most interested in learning about?

Schlidt: I think the pharmacology around psychedelics is fascinating. I think the fact that you can have a ligand alkaloid find a receptor in the brain and from that, you get this whole cascade, and beautiful, rich, subjective effect. It’s very simple molecular biology occurring there. The fact that you can have that still blows my mind. The fact that we don’t fundamentally understand how that process works from a first principles level, and how that builds up to a neurological level and then a psychological level, I think, is fascinating. I think it’s a rich field for discovery.

I think there’s a lot of white space for research around psychedelic analogues, these certain third-generation compounds and new designer drugs. There’s a wide-open space there to make new drugs. So, I see this as a multi-decade trend around psychedelics in a lot of ways. The future is very bright.

Green: Great, that concludes the interview!

Schlidt: Thanks, Aaron.