The Scott Letter: Closed-End Fund Report©
Published by Closed-End Fund Advisors, Inc.

October 2003, Volume III, Issue 8
George Cole Scott, Editor

H & Q Healthcare Investors and
H & Q Life Sciences Investors

H & Q Healthcare Investors (HQH-NYSE) is a Massachusetts business trust organized in 1986 which commenced operations in April, 1987. The fund is registered under the Investment Company Act of 1940 as a closed-end management investment company. The assets of HQH on September 30, 2003 were $290.5 million. The net asset value for HQH on October 10 was $20.09; the closing price on the same date was $18.71 for a discount of -6.87%. HQH has a sister fund, H & Q Life Science Investors (HQL-NYSE), founded in 1992. HQL had assets of $192.9 million on September 30, 2003; its net asset value on October 10 was $17.07; the closing price was $16.27 for a discount of  –4.69%.

Alan G. Carr managed both funds until 2000, at which time Dr. Daniel R. Omstead joined Mr. Carr. Dr. Omstead was named President of both funds in 2001. Mr. Carr, 69, remains a trustee as well as President Emeritus of both funds. The Scott Letter interviewed Mr. Carr many times in visits to his Boston office and by telephone in the 1990s.

The investment objective of HQH and HQL is long-term capital appreciation through investment in securities of companies of the healthcare industries. The securities held are of public and private companies that are believed to have significant potential for above-average growth.

The investment advisor is Hambrecht & Quist Capital Management LLC, (Boston office) which is paid a monthly fee at the rate when annualized of (i) 2.5% of the average net assets for the month of its venture capital and other restricted securities up to 25% of net assets and (ii) for the month, for all other assets, 1.0% of the average net assets up to $250 million, 0.9% of the average net assets for the next $250 million, 0.8% of the average net assets for the next $500 million and 0.7% of the average net assets thereafter.

Venture Capital and other Restricted Securities

The funds may invest in venture capital and other restricted securities if these securities would currently comprise 40% or less of net assets. On September 30, 2002, the cost of the venture and other restricted securities for HQH was $84,458,658 and the value on the same date was $72,959,684. In comparison, the cost of the same securities on September 30. 2003 was $89,197,136, and the value was $68,342,587.

Distribution Policy

The current distribution policy of both funds is to declare distributions in stock. Stock distributions will automatically be paid in newly issued shares unless otherwise instructed, at the rate of 2% of the Funds’s net assets per quarter to shareholders of record. Each of the funds intends to use net realized capital gains when making quarterly distributions. This could result in a return of capital to shareholders if the amount of the distribution exceeds the fund’s net investment income and realized capital gains. It is anticipated that net realized capital gains in excess of the total distribution under this policy would be included in the December distribution.

Daniel R. Omstead(50) has been with Hambrecht & Quist Capital Management since 2000. Previously, he was President and CEO of Reprogenisis, a private stage biotech company in which HQH and HQL funds had invested. Before joining Reprogenisis, Dr. Omstead was Senior Vice President of Research and Development at Cytotherapeutics, a public biotech company. Before entering the biotech industry, Dan was employed at both Johnson & Johnson and at Merck and Co. for a total of approximately fifteen years. Dan also has M.S. and doctoral degrees in Chemical Engineering and Applied Chemistry from Columbia University.

We interviewed Dr. Omstead on October 10 by telephone in Hyannis, Massachusettes. The focus of the interview will be on the older fund, H & Q Healthcare Investors, as this fund is held in the portfolios of Closed-End Fund Advisors.

Scott: We will start with the larger companies in the portfolio, what you call “Big Pharma”. I notice that the only names I recognize in the whole HQH portfolio are Pfizer and the biotech company, Amgen. Would you enlighten us some about the pharmaceutical industry with its pricing problems, the cheaper Canadian drugs, increased competition and so on. What are your thoughts on how this segment of the healthcare industry is doing?

Omstead: In general, I think the healthcare and, in particular, the pharmaceutical industry is going to do just fine. Certainly, there are some problems that they will have to get over, as you mentioned, but the trends are in the right direction for the healthcare group and the pharmaceuticals. The population is aging; these companies are exceptionally well-organized and prudently well-managed. Their financial situations, with few exceptions, are very strong. There are some issues, such as the generic competition and re-importation and so on, but I think the upsides of these companies are dramatically bigger than the downside. I look for in the immediate and long-term performance a pretty impressive impact on the quality of life of people.

Scott: Is the biggest issue the pricing, competition or, on the positive side, the number of new drugs coming? Even though you don’t own that many pharmaceuticals, what about the issue of going generic by Congress?

Omstead: I think everyone in Congress understands that it costs a lot of money to develop a drug. They will not disenfranchise the pharmaceutical companies. Generics will be an issue, but the companies that really make a difference will not have a problem. Because of that, pricing for generics will be an issue, but getting reimbursement for drugs that really make a difference will not be too difficult in the future. I think you will have some problems when pharmaceuticals try to bring out “me-too” products that don’t make such a difference. Some drugs for cardiovascular diseases, for example, and some of the anti-biotics are potential “me-too” drugs, but I am not too concerned.

Scott: What are your thoughts about the Medicare drug plans in Congress?

Omstead: I am a little skeptical of the Government in terms of their ability to solve the problem. I will wait to see if we really get a bill and see what it looks like. The one’s out there look like they won’t be a huge positive or a huge negative.

Scott: How do you think this issue will impact your portfolio?

Omstead: Remember, our portfolios tend to focus on small and emerging companies almost without exception. When you focus on the emerging companies, you tend to be less concerned about the exact date of projected approval and more focused on the overall potential for medical benefit to the patient. If the net benefit is profound, when the drugs are approved, they tend to do really well in the marketplace.

Scott: In your latest reports, you talked about “collaborative agreements” between companies. What does that mean?

Omstead: Yes, from my perspective, these are partnerships between the big pharmaceutical companies and the smaller emerging technology companies that are on the “cutting edge” of new technologies in biotech and basic science. The “Big Pharma” companies are more and more focusing on marketing and sales of big blockbuster products. Their research is more and more focused on a smaller number of bigger drugs whereas the emerging companies are also developing small and medium-sized products.  Many of these small companies would be happy to commercialize some products by themselves but would also be glad to partner some of their products to Big Pharma. Such collaborations would help the bigger companies fill their product pipelines.

Scott: You also said that these agreements could be in competition with each of the companies.

Omstead: Sure, traditionally, the pharmaceutical companies have tried to do both that is basic research and development(R&D) and sales and marketing well. I think that you are going to see less emphasis on that in every field of medicine. Big Pharma will have to deal with the fact that the small companies are equally smart in developing new technologies and new products. That will be a good thing for all.

Scott: A lot of our clients do not understand what you mean by what you call “drug discovery technologies”, which are about 10.9% of the HQH portfolio. Could you define this?

Omstead: What we call drug discovery technologies are with small companies that use& novel approaches and genomic approaches (using genetic material) and personalized medicine to discover new drugs. This is using basic science to find new chemical entities that can be used for medicines. That is where 10% or so of our companies are focused as opposed to later stage development of drugs. Some of our companies are using a combination of chemistry, biology and basic genomics in trying to find new molecules that can have an effect on diseases. That is the basic discovery approach.

Scott: What is the status of the emerging biopharmaceuticals?

Omstead: That is the next step past drug discovery. These companies may have already found one or more compounds or chemical structures that may have an apparent laboratory effect on a disease-associated target. They may have found certain “leads” that may have an apparent effect in treating diseases in an animal model. These companies tend to be focused on the activities you need to undertake before you enter into clinical trials.

Scott: How do you define “medical devices and diagnostics”, another category in your portfolios?

Olmstead: This is a group of other companies that make instruments or hardware that may focus on treating occluded or otherwise damaged blood vessels and other diagnostic work such as measurement of cholesterol and so on.

Scott: Have those stocks been acting well?

Omstead: Yes, but there has been a general up-trend in these stocks.

Scott: Finally, what about healthcare services?

Olmstead: This is a group that uses technology such as computers to deliver good healthcare information. They may be able to improve the efficiency of transactions between the patients, doctors and healthcare payers.

Scott: In the biotech sector, we have seen that many companies are running out of cash, the so-called “burn rate” of cash is quite high as many of them haven’t been able to bring new products online. Some go broke while others may be lucky to find a merger with or funding by larger companies. Would you comment on that aspect of the business?

Omstead: Yes, my impression is that the biotech and healthcare companies have gotten a little high in their burn rate in the last year. Those that haven’t good products or good technology have difficulty raising money. I think you will see more of that happening. On the other hand, I believe there will be a lot of secondary offerings as well as IPOs (initial public offerings of shares to the public) this year.

Scott: Good. That will make your shareholders happy if it includes some of your portfolio companies. That has happened many times through the history of your two funds.

Omstead: It is hard to say. We have a number of private companies with the possibility of going public, but right now many are waiting to see how things develop.

Scott: Do think that Wall Street will be receptive to many IPOs?

Omstead: Yes, you may see a number of IPOs in this area.

Scott: Along the lines of Corporate Governance of the two funds, how long have you had the 2% per quarter distribution policy?

Omstead: We instituted the policy in the year 2000. For each fund, it is 2% of the net asset value for the first three-quarters. In the December quarter we distribute any remaining capital gains in excess of the already distributed gains.

Scott: Do the shareholders seem happy with these distributions?

Omstead: Yes, at the annual meeting in June, after the sector did pretty well, many shareholders who attended the meeting were pretty happy with us and with the distributions.<

Scott: Do you see this a continuing trend with this sector?

Omstead: Yes, I think healthcare is the place to be. People will need more healthcare as they get older. Many of our companies will benefit. All of that argues for a general uptrend in the sector. The general stock market is harder to predict, but I believe that 2003 will be a pretty decent year. In 2004, it is a little harder to predict, as I can’t see, for sure, how that will turn out.

Scott: OK, to get to the heart of the matter, we like to buy closed-end funds at decent discounts, by being able to buy $0.90 cent dollars or better (for a 10% discount to net asset value). This way we can have that much more money working for the shareholder than with mutual funds. Does your management have any concerns when your funds sell at discounts that are deeper than normal?

Omstead: Well, sure. We try to keep the discount as low as possible by having the distributions as well as keeping good stocks for good performance to keep the discount narrow.

Scott: Yes, that helps your performance, but it makes it a little harder for new shareholders who want to enter at deeper discounts. (The discount has narrowed recently to less than 7% for HQH and HQL). If performance is good, as it is this year, shareholders are less concerned about discounts.

Omstead: We want new shareholders, but our primary responsibility is to our current shareholders. As you know, part of the discount is out of our control, such as how the sector in the marketplace is behaving. Hopefully, continued good performance will keep the discounts narrow.

Scott: Sometimes a fund will go to a premium, which makes it tough for us to buy it. When was your last rights offering and have you considered doing one lately?

Omstead: We last had a rights offering in 1997. The discounts would have to be at a certain level before we would do another one. In conjunction with our Trustees, we are always evaluating whether a rights offering would be a good thing for us and particularly for our shareholders.

Scott: We have mixed feelings on this issue. Often the discounts on the funds will widen whenever the rights offerings are announced, which can defeat your reasons for doing them as deeper discounts can mean a lot of dilution. It is also a lot of work for money managers to get it right. We have to set aside the cash and if the shares are in an IRA account, there may not be enough cash for participation. A fund’s argument is usually for more liquidity or to create more assets to increase diversity in the portfolio.

Our view is that if the rights offerings are carefully structured and shareholder friendly with little or no dilution, we have no problem with them. If you decide on another one, we hope you will do it carefully.

Omstead: If we do one, it will be fair and right for everybody.

Scott: I expect a fund with your record of management excellence will do that.  Would you wrap-up with some concluding remarks.

Omstead: We have had a couple of years that weren’t what we had hoped, but we have had a pretty good year this year, one of the better years for the funds. We think we have a very good team of people, a number with advanced degrees in science, two with their Doctorates, one MD and two MBA’s These people are very talented, and we think they are doing a great job at picking stocks. We think the trends are right and that we have a good chance for a positive year ahead.

Scott: Does your team spend much time visiting with companies or their managements?

Omstead: Yes, we have the advantage of being in Boston where a lot of CEOs are located. Many visit us and we visit them. We try to have contact with our companies on a daily basis.

For more information, contact:   Hambrecht & Quist Capital Management, LLC
30 Rowes Wharf, Suite 430
Boston, MA 02110
Tel: 617-772-8500
Fax: 617-772-8577
Shareholder questions: 1-800-426-5523

Interim daily net asset value may be obtained from the web site ( or by calling 800-451-2597.

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