Heading For Home – 3Q18 Funding Environment…

The Bureau of Economic Analysis recently announced that the real Gross Domestic Product increased at a 3.5% annual rate in 3Q18, which while lower than the 4.2% reading in 2Q18, continued a streak of six quarters above 2.0%. Notwithstanding strong economic fundamentals, there appears to be evidence that the sugar high provided by the corporate tax cut may wearing off as 35% of the S&P 500 companies missed 3Q18 Wall Street revenue estimates according to FactSet. Year-over-year revenue growth estimates for the S&P 500 is 7.3% although for fiscal 2019, revenue growth estimates have been lowered from 8.2% to 5.4%. According to Evercore ISI, 3Q18 year-over-year corporate earnings will have increased 24% but 13% of that is attributed to the tax cuts, while 11% is organic growth. This broad reset, alongside raising interest rates, are in large measure responsible for the marked increase in public market volatility over the past month.

3Q18 Growth

None of this appears to have rankled the venture capital industry. With great fanfare, and a tinge of trepidation, the National Venture Capital Association recently announced that venture investors invested $27.9 billion in 1,937 companies in 3Q18. The venture industry is on pace to exceed $100 billion invested this year. The average size of investment at $14.4 million, although somewhat meaningless given the range of activity covered, is the largest average round size ever which reveals an important concentration of capital around fewer portfolio companies. Over 24% of all investments in 3Q18 were in late stage companies, which is the highest proportion in seven years. In fact, nearly 29% of the capital invested in 3Q18 was in just 39 unicorn companies. There were 51 financings that were greater than $100 million in size and those captured 64% of the capital invested in 3Q18.

3Q18 deal value

This concentration of capital is also echoed by the continued rotation away from seed and angel investing witnessed in 3Q18, which saw only $1.6 billion invested in 785 companies which was dramatically lower than the $2.1 billion and 1,005 companies in the prior quarter. Seed and angel investments were 5.6% of all dollars invested and 40.5% of all companies in 3Q18. The average round size was $2.0 million, which is significantly greater than every prior quarter (save for 2Q18 when it was $2.1 million). Over 56% of all seed rounds were greater than $1.0 million. The implication is that seed rounds are no longer simply to “prove out an investment thesis” but rather to start to scale start-ups. Another interpretation may be that a level of risk aversion has entered the marketplace, causing timorous venture capitalists to focus on more mature later stage companies.

The early stage sector also saw a marked increase in round size to $12.9 million across the 686 companies. Interestingly, the median deal size was $7.0 million which is twice as large as early stage financings in 2014. Nearly 59% of early stage capital was invested in round sizes greater than $25.0 million. Year-to-date there have been 378 financings that were larger than $50.0 million. These large financings turn the historic definition of early stage milestones on its head and presumably are providing companies with extended runways. Another possible explanation may be due to the dramatic increase in fund sizes as investors look to “put more to work” in any one portfolio company.

Where it gets really interesting is in the late stage category. Quite clearly, we are in an “anoint the winner” cycle of investing with a dramatic increase in average round size of $37.4 million; over the past 10 years, the average round size was $19.0 million for late stage financings.  In 3Q18, while over $17.4 billion was invested in 466 late stage companies, 51 of those financings were greater than $100 million in size and accounted for $11.0 billion or 39% of the entire quarter’s activity. That is right – less than 3% of all companies accounted for 39% of the dollars invested this past quarter.

This stepped-up investment activity is also reflected in quite robust pre-money valuations. Across each stage, valuations were at high water marks, most notably in the Series D and later stages at $285.0 million (year-to-date), which is effectively twice what it was just two years ago. Year-to-date, average round sizes for early stage and late stage companies were $14.1 million and $36.4 million, respectively, which compares favorably to the pre-money valuations (perhaps suggesting more modest dilution than in prior periods).

Valuation A B

 

Valuation C D

There was one other development that was quite noteworthy and that involved the corporate venture investors. Notwithstanding some notable recent announcements of retrenchment (Intel Capital, the most prolific corporate VC, let go 25% of its investment staff this week), corporate investors participated in $39.3 billion worth of financings through 3Q18, which is already greater than any prior full-year period and represents nearly 47% of all deal values. Ten years ago, corporate investors consistently participated in less than $10.0 billion of annual financings.

Liquidity and generating superior returns drives the venture capital industry. The exit environment in 3Q18 remained strong with 23 venture-backed IPOs (17 of which were biotech companies). Additionally, a handful of very late stage companies “nominally” went public, selling a very small portion of stock suggesting that the IPO was less of a financing event but rather to provide founder liquidity. There were 182 venture-backed exits for $20.9 billion in 3Q18. For the year-to-date, there have been 637 exits for $80.4 billion (which coincidentally mirrors closely the $84.3 billion that has been invested year-to-date). Arguably a more relevant barometer as to the health of the venture market is how many new companies are being funded versus being sold; that ratio has been above 10:1 since 2013 (save for 2014 when it was 9.6:1) which reflects the reality that companies are staying private longer and that consistent investor liquidity is still somewhat elusive.

Cambridge Associates (CA) data highlight the strong venture capital returns which outperform broader public equity indices in nearly all timeframes. Specifically, for year-to-date, 1-year, 5-year and 10-year periods net returns for the CA Venture Capital Index (2Q18) and the S&P 500 Index are 11.7%, 20.1%, 17.4%, and 10.9% versus 2.7%, 14.4%, 13.4%, and 10.2%, respectively. The comparisons are likely even more attractive given the public market turbulence this month. The ever-important distributions back to limited partners increased 17% to $21.5 billion in 2017 over 2016 levels and are expected to be strong again in 2018.

All of this has clearly benefited fundraising, although similar to the dynamics many entrepreneurs are facing (fewer but larger financings), the venture industry continues to be barbell – small handful of large venture funds alongside numerous smaller focused funds. Year-to date the venture industry has seen 230 new funds close on $32.4 billion with median fund size of $68 million and the average fund size of $151 million (the highest level since 2011). In 3Q18, venture capitalists raised $12.2 billion; the top ten largest funds accounted for $8.2 billion of that total (or in other words, just ten funds in 3Q18 represented over 25% of all capital raised so far in 2018). Twelve of the largest 25 funds raised in 3Q18 were based in San Francisco and 7 were in Asia.

The healthcare technology sector was white hot in 3Q18. Both Rock Health and MobiHealthNews reported that $3.3 billion was invested in 71 companies this past quarter – the best quarter ever. Year-to-date there have been 290 financings totaling $6.8 billion, which is tracking to make 2018 the most active year yet and likely to be between 8-10% of all venture capital activity (this was low single digit percentage points a decade ago) suggesting that this sector is reaching a level of maturity. In 2011, there was $1.2 billion invested in 93 companies. The chart below from Cooley points to the number of significant companies now scaling to provide enterprise solutions.

Digital Health Landscape - October 2018

Domestic spending on healthcare is over $3.2 trillion. As a point of comparison, the U.S. advertising industry is estimated to be $190 billion and launched thousands of valuable start-ups over the last 20 years. This augurs for even better times ahead as new revenue and risks are reapportioned across the healthcare industry. The FDA is playing a particularly supportive role, in large part through Commissioner Gottlieb’s pre-certification program which has seen 34 FDA approvals or clearances in this sector so far in 2018. Notably, there have been a series of significant strategic partnerships announced such as GSK’s $300 million investment in 23andMe.

According to Statista, there will be 5.8 billion smartphones globally by 2020 and over six million apps across various app stores. The Institute for Human Data Sciences at IQVIA estimates that 318,000 of these apps are healthcare specific, and most have never been tested much less widely utilized. This harkens back to the Dot.com phase nearly 20 years ago when thousands of content and commerce companies were launched, many of which struggled to create enduring economic value. The enormity of the healthcare industry suggests profoundly important healthcare technology companies will emerge, but more often than not, they will need to offer comprehensive end-to-end solutions which both lower costs and improve outcomes.

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Collison Course: Observations from Shanghai…

Jet lag is a strange and mysterious thing. In the middle of the night a few weeks ago I found myself on a treadmill in my Shanghai hotel gym riveted to the Poland vs Iran men’s volleyball match on Chinese State Television. It was a welcome respite from CNN International and the battering ram of worsening news on U.S. – China relations. As many of you know, Twitter, Google, Facebook, etc are blocked in country and even certain CNN segments are blacked-out when covering awkward China-related stories. Whenever the recurring piece on the disappearance of Fan Bingbing played, my tv went dark as if someone pulled the plug from the wall.

The headlines in the U.S. are often at risk of masking some of the extraordinary advancements in the Chinese capital markets as well as the dramatic success stories in their innovation economy. While there certainly does appear to be troublesome signs in China’s $12 trillion economy (softening consumer spending, signs of inflation, currency weakness, debt levels in the shadow banking system, level of venture funding), the pace and consistency of global success stories is impressive and feels profoundly disruptive. That was certainly brought home when visiting what is considered to be the largest Starbucks in the world.

China Starbucks

Over the four days that I was there, economists pointed to several indicators that suggested the U.S. – China trade war was starting to have some measurable impact, particularly on the consumer class. For decades, my greatest concern for China has been the “revolution of rising expectations” (some may know that I grew up in Hong Kong so have marveled that nearly a quarter of the world’s population has come of age over a generation). With wealth and greater access to information, many Chinese will continue to insist (demand) better goods and services like food, education and healthcare. Obviously, the government is also worried about how best to manage this. A selection of some of the troubling headlines in the local papers over those few days included:

  • The renminbi (Chinese currency) has weakened by 10% since mid-summer
  • Auto sales in July 2018 were down more than 5%, leading to widespread discounting between 11% – 27%
  • Asian gaming stocks have declined between 15% – 18%, directly attributed to reduced Chinese gambling
  • Pork prices spiked in August 2018 by 8% due to concerns related to import restrictions and in part to an outbreak of African Swine Fever, which is fortunately not transmitted to people

Arguably, over the arc of history, this is just background noise for the Chinese – and that is clearly how they view it. The “One Belt One Road” Initiative, which seeks to connect China through Central Asia to Europe via massive public works programs such as ports and highway infrastructure, will recreate the Silk Road. The notable escalation of hostilities and militarization of the South China Sea with the Nine-Dash-Line framework seeks to extend its footprint over major trading routes. These initiatives underscore the country’s super power ambitions – and increase the likelihood of an inadvertent international incident (as evidenced by the incident involing U.S. and Chinese warships coming within 50 yards of each other last week).

China Collide

These political developments, which China’s neighbors and the U.S. at times find quite threatening, are supported by rapid maturation of the Chinese capital markets. The world’s largest bank is the Industrial & Commercial Bank of China and is a major financier around the world. Chinese finance authorities have carefully managed a deleveraging campaign of the countries’ major lending institutions. There was $100 billion of securitizations in 1H18 in China, which was an increase of 44% since 1H17. The government has instituted several other policies to ensure that there is adequate trade credit, particularly for exporters in the face of trade hostilities. While there, Chinese Premier Li Keqiang assured a global audience at the World Economic Forum of China’s embrace of pro-business policies.

Interestingly, China has become meaningfully less dependent on the rest of the world. According to China’s National Bureau of Statistics, manufacturing exports have been essentially flat for the past four years. As a percent of GDP, exports were 35% in 2006 and are now only 18% of GDP, suggesting that leadership is “Making China Great Again.”

The success of transitioning the Chinese economy is in part due to the deep commitment to developing a local technology economy. While in Shanghai, the city government announced the formation of a 100 billion yuan ($14.6 billion) venture fund. This announcement was made at the World Artificial Intelligence Conference, one of the largest AI gatherings all year. Over the course of my short visit there were a handful of notable venture financings including:

  • Meituan Dianping, a leading internet lifestyle-services platform, raised $4.6 billion in an IPO at a $60 billion valuation
  • Lianjin, a leading real estate brokerage firm, raised $2 billion from TenCent and Warburg
  • 111, an online Shanghai-based pharmacy, raised $99 million in an IPO
  • And on and on and on these financings keep coming – to such an extent that they stop being newsworthy

There are approximately 90 million Chinese retail investors. It is estimated that foreign investors own between 3.5% – 5.0% of all Chinese debt and equity securities. Recently, leading equity indices rebalanced their underlying share weightings which is increasing international funds flow into the country. For example, the MSCI Emerging Markets Index doubled its weighting to yuan-denominated shares. This adjustment alone is projected to bring an additional $22 billion of inflows.

Ironically, though, there may be subtle signs of investor fatigue. There were “only” 3,111 new private equity funds raised in China in 1H18 (just wrap your head around that number), which was a decrease of 60% from the same period in 2017, according to Jingdata, a start-up database. According to Zero2IPO, the level of private equity investments dropped by nearly 11% in 1H18, while the amount invested in early stage companies plunged 53% in the same period. Zero2IPO goes on to report that the amount of capital raised by venture firms dropped by 44% in 1H18. Only 49% of all IPO filings were approved by regulators in 1H18 versus 79% in 1H17. Many Chinese VCs are bemoaning the onset of a deep freeze in early stage financing market. It certainly feels like the environment is cooling – not at all what it was actually like in late September.

China Weather

There were also a few fascinating healthcare announcements which underscored both the rapid convergence of the clinical sector in China with advanced analytics, as well as the ability to compete with global healthcare technology companies. According to the National Health and Planning Commission, the rate of birth defects is 5.6% (as of 2012) which obviously has a myriad of associated costs and societal issues. In response, the National Development and Reform Commission for its 13th Five-Year Plan covering 2016-2020 set a host of ambitious goals. At a cost of one billion yuan ($145 million), this organization has set out to provide non-invasive prenatal tests for 50% of all newborns. Additionally, there was the creation of a national gene bank which will provide researchers and clinicians datasets to better diagnose and treat inherited diseases. A prominent company called Berry Genomics (Illumina’s China partner) announced that it already has a one-million-person gene pool. The first of its kind drug-coated stent, the Firehawk developed by Shanghai-based MicroPort Scientific, was cleared for clinical trial use in Europe.

China Plan

Undoubtedly, this is a complicated time and a complicated part of the world (maybe it is always complicated everywhere?). As I settled into seat 34C on my flight home, as exhausted as I was, it was nearly impossible to sleep recalling all that I had seen while there. Actually, that is not true – I had run out of sleeping pills.

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Easy Rider: Circulation Case Study

The sale of Circulation, which was a Flare Capital portfolio company, closed two weeks ago. The company successfully deployed a leading patient-centric transportation exchange for non-emergency medical rides (“NEMT”), leveraging a virtual national transportation provider network anchored by Lyft and Uber. This announcement was concurrent with CareMore Health’s announcement of the results from its two-month Lyft pilot, which were nothing less than startlingly positive. CareMore is an integrated health plan with over 100,000 members; the cost savings were so significant that they were able to offer 28,000 rides at no additional cost to the plan. Rides were 39% less expensive with meaningfully shorter wait times and much greater member satisfaction.

NEMT

It was a terrific outcome for the team and investors. Flare Capital was the largest investor, having seeded the company less than two years ago. Upon reflection, there were a handful of critical elements to the Circulation story which may be applicable to other healthcare technology start-ups that are attempting to scale in these complicated times.

  • An Unfair Advantage: Quite clearly the founders and team were special. It is an easy observation to make, and it is one that is often made too freely. But the Circulation team was unique. One of the co-founders (CEO, Robin Heffernan) and I had worked together multiple times over many years. The other co-founder (John Brownstein, Chief Innovation Officer at Boston Children’s Hospital) had a deep understanding of the clinical need, and as importantly, was Uber’s healthcare advisor, affording him a privileged set of insights and relationships that were unrivaled. The CTO and third co-founder (Jared Hawkins) is a rock star, who built a product on-time, below budget. This was clearly a unique asset of the company and one that no other emerging competitor has. And they had been successful together in a prior company.
  • Enormous Market Opportunity: The NEMT market is estimated to be $6 billion. It is hard to build a big company in a small market. And there were no shortages of use cases for the Circulation platform once it was operational. One of the great frontiers in healthcare is the home and Circulation nicely “connects” the home to the healthcare system. NEMT is also a market in transition. Legacy transportation brokers are under siege by the “gig economy” players like Uber and Lyft, and are looking for greater functionality in their products, which led to the next success factor.
  • Contextual “Moment in Time”: In addition to the NEMT market being in transition, there were a number of adjacent developments which underscored and validated the power of a virtual transportation and delivery network like the one Circulation built. Transportation, delivery and logistics are being redefined in every sector. A cursory review of the business headlines quickly confirms that: SoftBank’s announcement with Toyota to deliver healthcare services and meals to the aging population in Japan in self-driving vehicles; Amazon just announced the purchase of 20,000 vans to build a captive delivery network; Walmart launched Spark Delivery, its response to Amazon; Careem, the largest transportation provider in the Middle East just raised $500 million and acquired Commut in India; then rumors spread that Uber was going to acquire Careem; and, Grab, a leading provider in Southeast Asia, announced the NEMT rides was one of its fastest growth categories – and that was all just in the past few weeks.
  • Role of Strategic Investors: Perhaps most particular to healthcare, strategic investors can be powerful advocates and sources of product validation when they are an early investor in a start-up. Often there is a perspective to engage strategic capital later in the journey as a way to price a growth stage financing. Circulation wisely included five leading strategic investors in the Series A, all of which brought unique use cases to the company. In fact, one of them pre-emptively acquired the company. Embrace the strategics.
  • Business Model: Flare Capital tends to gravitate toward business models that lower costs in the near term (months or quarters) on a fully attributed basis, as well as improve quality and outcomes in the medium term (few years). This is by no means a hard and fast rule but companies that can claim success along those two dimensions, in healthcare, are able to raise significant additional capital at attractive valuations. Circulation clearly addressed both of those conditions. Furthermore, the revenue model aligned well with customers and contemplated a value sharing component. Additionally, the product and commercial milestones were well-understood and straightforward.

Uber Cool

  • “Be Cool”: Circulation was a “buzzy” company, in large measure due to its partnerships with Lyft and Uber. There is a very clear sense of mission, which made recruiting easier and built great culture. Who cannot be excited about disrupting a massive market and in the process drive down missed appointments from mid-20% to low single digit percentage points. Or get the frail and elderly better connected to the healthcare system.

Interestingly and not immediately related, there was other news in the transportation sector that should be considered in many of the emerging “gig economy” businesses. Fortune magazine recently published the results of a J.P. Morgan Chase Institute study which concluded that over the past five years ride-hailing drivers’ monthly income dropped by 50% to an average of $762. The success of many of these companies have been, in part, predicated on unnaturally low labor costs. At a time when Amazon just increased its lowest minimum wage to $15 per hour, and with unemployment below 4%, there will be pressure on transportation providers to service more valuable rides like those in the NEMT sector.

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Escape to Singapore…

Having been chased out of Hong Kong by Super Typhoon Mangkhut on Friday, a few days in Singapore with investors and entrepreneurs offered a modest respite. Actually, no…it was the Singapore Formula One Grand Prix weekend at the sovereign city-state, which coincided with the Singapore Summit that convened global leaders (quite different from the notorious June 2018 summit with other leaders, Trump and Kim). Not surprisingly, Lewis Hamilton below in the silver “car” (more like a rocket with wheels) won the race.

Singapore 2018

This island country of less than 280 square miles, sitting on the southern tip of Malaysia balanced on the equator, has become a global powerhouse in commerce, finance, education and healthcare since securing independence in 1965 from said Malaysia. Home to 5.6 million people, 74% of whom are ethnic Chinese, Singapore ranks third in the world in GDP per capita and fourth in quality of healthcare.

Unfortunately, like many countries in Southeast Asia, the current economic climate is being battered by bellicose trade rhetoric between the U.S. and China. The Singapore Straits Time Index is trading at its lowest level in the last 18 months. The Singapore Commercial Credit Bureau just significantly moderated its 4Q18 Business Optimism Index, which tracks the top 200 companies in country. This theme seems to be playing out across the region.

Singapore spends 4.6% of its GDP on healthcare, which is less than the 4.9% it spends on its military (the U.S. is approximately 19% and 3%, respectively). The healthcare system struggles with many of the same structural issues experienced in the U.S. – how to provide care in non-traditional settings, drive down cost of care, and how best to utilize many of the innovative healthcare technology solutions coming to market. While there over just a few days, there were several interesting healthcare announcements:

  • The Ministry of Health established a “regulatory sandbox” for telemedicine providers, announcing the creation of four telehealth start-ups
  • Formation of several community health centers to address chronic conditions for the elderly, with an objective to dramatically increase the number of health assessments across the population
  • Installation of automated external defibrillators across the city

And given Flare Capital’s investment in Circulation (more to come on that later), it was particularly notable that Singapore-based Grab, the leading regional provider of ride-hailing services (Grab acquired Uber’s Southeast Asian operations in 1Q18), announced this week that transportation volume to / from medical centers increased by 500% since 2015, making those facilities the third most popular destinations. A leading medical tourism survey recently ranked Singapore as the most attractive of all Asian countries.

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Calm Before the Storm…in Hong Kong

While in Hong Kong this past week, it appeared that there were only three stories that the newspapers wanted to cover. Quite clearly, the first and by far the most important was Super Typhoon Mangkhut which made landfall the day after I headed out. It was forecasted to be the worst storm to hit the colony in recorded history, graded a level T10 which is the highest possible level. And it did not disappoint.

Typhoon.jpg

Growing up in Hong Kong, I had become somewhat accustom to significant tropical storms battering the island. In fact, Hong Kong has become quite resilient to these storms, and as devastating as Mangkhut was, there was very modest loss of life (initial counts point to less than five fatalities in Hong Kong, although there was significant carnage in the Philippines). All the focus on the typhoon underscored how impressive the Hong Kong healthcare system is but also was a jarring metaphor for its current economic condition as it is further absorbed into China.

The quality of healthcare in Hong Kong is surprisingly exceptional. There are 11 private and 42 public hospitals for a population of 7.3 million people. There are 1.7 doctors for every 1,000 residents so relatively rapid access to care is assured. Fortunately, there are also 6,000 practitioners of traditional Chinese medicine. This week there was great fanfare around the “Tap the Hidden, Tap Your Talent” collaboration by many of the public hospitals to provide more aggressive outreach programs to address mental illness in the community.

In fact, Hong Kong is considered one of the healthiest places in the world, with average life expectancies of 85.9 years (women) and 80.0 years (men) putting it third in the world according to the World Health Organization. Interestingly, greater China has average life expectancy of 76.4 years. Infant mortality in Hong Kong ranks ninth in the world with 2.73 deaths per 1,000 births. Perhaps more ominous is that 18% of the population is now over 65 years old. And these results have been achieved quite efficiently; total healthcare expenditures are approximately $17.5 billion or 6.0% of GDP.

Unfortunately, this past week also witnessed the Hang Seng stock index entering “bear market” territory as it is now more than 20% off trading levels at the beginning of this year. The Hang Seng has a total market capitalization of $2.1 trillion and is comprised of 50 large cap stocks, just over half of which are Mainland Chinese companies. Tencent alone has lost $200 billion of market value since its January 2018 highs. Trade tensions with the U.S. have a direct impact on local business sentiment as does the strong U.S. dollar. Notwithstanding the numerous full-page financing tombstones in the business press, Hong Kong is tragically on a path to be further marginalized on the global stage as China aggressively develops other economic centers.

One of the other stories which captured a number of headlines was the disappearance of China’s most famous and wealthy actress, Fan Bingbing. She has not been seen for three months now, right after she was accused of tax evasion. The release this week of a state-sponsored study on social responsibility for the top 100 performers in China, Hong Kong and Taiwan did not help as it had her last with a total score of zero out of a possible 100. Evidently, not being socially responsible can be bad for one’s health. Undoubtedly, not paying one’s taxes is also unhealthy.

The other story that fascinated many this week in Hong Kong was the murder trial of Professor Khaw Kim Sun who stands accused of filling something called a yoga ball with carbon monoxide and placing it in his estranged, now dead wife’s car. The good professor was an anesthesiologist at the Prince of Wales Hospital and claimed that he was stockpiling the poisonous gas to eradicate rats in his home. Quite clearly, he would have benefitted immensely from tapping his hidden talents in that community outreach program.

 

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Twilight Zone…

What a remarkable week, and not just because of the political “twilight zone” we are now dialed into, but the current S&P 500 bull run officially became the longest one over the past 70 years. Since this run started in March 2009, the index has increased 323% over the past 3,452 days. Unfortunately, over the past 20 years, U.S. public equity markets have returned only 6.5% per annum, which is well below longer term equity returns of 10%, per DataTrek Research. Inevitably this has caused many institutional investors to seek greater returns elsewhere. Against this backdrop, seemingly unrelated occurrences such as the crash of cryptocurrencies, performance of emerging market equities, repatriation of overseas cash, and the level of household debt start to make more sense. Mostly due to levels of unprecedented innovation, these fund flows have also contributed to what has been yet again another very strong quarter in the venture capital industry.

Bull Run

Quite clearly, 2018 is on pace to exceed 2017 in overall venture capital activity, which would make it the most active year in nearly two decades. Per the National Venture Capital Association and Pitchbook, this past quarter $27.3 billion was invested in 1,859 deals, for an average of $14.7 million, which given the diversity of activity is a relatively meaningless number. For instance, more than 60% of all deals included non-traditional venture investors and 20% of all capital was invested in “unicorns” which suggest very large round sizes. As a point of comparison, Chinese venture capital firms have invested $2.4 billion in U.S. companies through May 2018 per the Rhodium Group. In 2Q18, $11.5 billion was invested in 592 early stage deals but this includes 24 financings that were larger than $100 million (recall these are “early stage” companies); more than half of these 592 financings were larger than $25 million. The median Series A and Series B round sizes were $11.3 million and $29.3 million, respectively. Keep those numbers in mind when we look at the exit environment.

Additional color is provided when looking at either end of the investment spectrum. There were 792 angel and seed stage deals which accounted for $1.8 billion (average of $2.3 million per deal). It is quite clear that there is now a relatively large amount of “pre-seed” investment activity given the significant inflation in the size of seed rounds. Furthermore, this is the fewest number of seed investments since 4Q13, quite notably given quarterly seed activity has been consistently greater than 1,000 deals per quarter. Conversely, the late stage activity has remained quite strong with $14.9 billion invested in 475 deals. This is the third greatest quarterly investment pace in a dozen years. Investors seem to be eagerly looking for “de-risked” venture investment opportunities, possibly at the expense of the most nascent emerging ideas.

2Q18

Exit activity has improved, without debate. Year-to-date there have been 419 venture-backed exits for $28.7 billion in (disclosed) value. This year has seen a marked step-up in exit valuations. The median acquisition exit was $95 million (see below) while the average was $225 million, suggesting that there were some very significant liquidity events this year. Year-to-date there were 43 venture-backed IPOs for $6.3 billion of exit values with 29 of them in 2Q18 alone. Interestingly, there are only 3,671 public companies in the U.S. today as compared to over 7,300 in 1996, to underscore that going public is hard and quite a rare feat.

What is less obvious is how much capital was required to achieve these outcomes. Recall above that the median Series A and B rounds raised $40 million of capital in aggregate, which is tricky when exits are only $100 million. This dynamic really underscores the requirement to be capital efficient and for investors to own a lot of each company. Appreciate how over-used this phrase is but the math starts to breakdown much above these investment levels.

Exit no data

The most recent venture performance data reported by Cambridge Associates (1Q18) for one-year net returns was 15.0%, which should only improve with greater liquidity in subsequent quarters. The three, five and ten-year marks are 9.4%, 16.8% and 10.1%, respectively; the longer durations consistently outperform comparable public benchmarks, underscoring why venture funds are ten-year commitments. And these are NET return data after fees and expenses, which makes comparisons even more favorable.

Venture Capital - Fund Index Summary - Horizon Pooled Return

Interestingly, a survey conducted by Wilshire Trust of over 1,300 pension plans highlights this chase for returns. Over 59% of all pension assets are in stocks, an increase from 57% in 2Q17. More specifically, pension funds greater than $5 billion in assets allocated 20% to alternatives (including venture capital) which is significantly above the 17% in 2Q17.

This improved exit environment supports a robust fundraising environment for venture firms. In 2Q18 72 funds raised $10.8 billion, slightly exceeding 1Q18’s strong pace. While the median fund was $65 million, notably firms raising successor funds do so at 1.4x increase in fund size. Interestingly, 26 first-time funds raised $1.9 billion through the first six months of 2018 which, notwithstanding the continued concentration of capital around a few dozen firms, the venture industry does accommodate new venture managers with novel investment strategies. In fact, there have been 15 “micro-venture” firms created which have raised in total $308 million year-to-date.

This gap between invested and raised persists and is getting more accentuated. Venture-backed companies have become quite reliant on non-venture sources of capital such as sovereign wealth funds, private equity funds, corporates and family offices. Preqin tallies that there is $1.1 trillion of “dry powder” just with private equity funds. And then there is SoftBank’s Vision Fund which has created somewhat of an arm’s race amongst the larger venture franchises to raise ever larger funds.

Raised vs invested

Arguably the collapse of cryptocurrencies captured the greatest number of financial headlines this quarter. From the January 2018 highs, the total market capitalization of all cryptocurrencies plummeted from $800 billion to below $200 billion now. Bitcoin is trading around $6,000 per token, which seems inconceivable given it was at $19,000 in December 2017. Perhaps this is all due to the lack of regulatory clarity or maybe it actually was a speculative bubble after all, one that took six months to deflate, littered with numerous fraudulent ICOs. And recall that the total crypto market capitalization was a mere $18 billion at the end of 2016 – so perhaps we have not yet touched bottom. Those seeking greater returns need to step carefully through the token minefield.

The collapse of many foreign currencies also may reflect some of the desire to find greater returns in other seemingly attractive asset classes. Putting aside the self-inflicted wounds in Turkey, Venezuela, Argentina, etc, these issues have the risk of being more systemic than the bursting of the cryptocurrency bubble. These difficulties overseas will have investors seeking safety and returns in U.S. alternatives, suggesting supportive fund flows for venture managers, at least in the short to medium term.

GDP growth in 2Q18 was a robust 4.1% and with 91% of all the S&P 500 companies now having reported second quarter results, it is not surprising that 79% of them have exceeded analyst forecasts. It is somewhat surprising though, that of the $2 trillion of cash held overseas by U.S. companies, only $218 billion (through 1Q18) has been repatriated. Perhaps executives are struggling to find productive uses for all that cash. Coincidentally, there were $189 billion of stock buy-backs in 1Q18, which was a dramatic increase from the $50 billion in 4Q17. And was done with public equity markets flirting with near-record highs.

The Federal Reserve Bank of New York recently announced that at the end of 2Q18 U.S. household debt had reached a record level of $13.293 trillion, which was an increase of $82 billion from 1Q18. This level is now 65% of aggregate GDP, which is somewhat confounding given the rising interest rate environment, yet likely reflects consumer confidence given the robust public equity markets and low unemployment levels. Living in the shadow of the longest bull market can induce anxiety in some. In the midst of the Great Recession of 2009, debt was 87% of GDP, which was not that long ago.

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Art of Healthcare in Basel…

What a remarkable time to have traveled to Switzerland and the United Kingdom. After a series of meetings with healthcare industry leaders in Switzerland and England last week, the trip put some of the raging healthcare policy debates into better context. Unfortunately, the current U.S. political situation was at times quite distracting with revelation upon revelation unfolding throughout the trip; but no less so than the debates raging around Brexit, bickering over tariffs, Europe’s own version of Russian meddling, and the “baby Trump balloon.” What a surprise to learn that the State Department had issued a travel advisory warning for Americans traveling in London of all places.

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Often U.S. politicians opposed to the Affordable Care Act point to the “single payor system” in Europe which unfortunately ignores the fact that there is not one system in Europe and that while countries like Switzerland achieve universal coverage, they do so through a mosaic of private, non-profit and for-profit organizations. There are three principle health insurance models across Europe: (i) the government manages both the insurance and provider sectors; (ii) government provides insurance but leaves the provider sector private; or, (iii) both sectors are private yet the government mandates that all citizens must have coverage. Switzerland falls into this last category.

According to the Euro Health Consumer Index (2017), Switzerland is consistently ranked second (behind The Netherlands) for quality and cost effectiveness of its healthcare system. The study concluded that there is little correlation to quality of healthcare and money spent to deliver it, but that in fact, healthcare is a “process” industry that excels with well-managed systems. Think of Swiss watches. In 2015, Switzerland spent 11.7% of G.D.P. on healthcare, notably less than the U.S. healthcare system. Switzerland has the highest percentage of nurses per thousand citizens at 17.4 (in 2013) and has 313 hospitals, underscoring the depth of commitment to a distributed care delivery system. General life expectancy is 82.6 years, which places Switzerland near the top of all countries.

Basel is an extraordinary city with a population of only 175,000, and yet, it is home to some of the largest pharmaceutical companies in the world (Novartis, Hoffman-La Roche, Ciba Geigy, Syngenta, Actelion). Much like the Kendall Square phenomenon in Boston with Harvard and Massachusetts Institute of Technology, this cluster of leading drug development companies is anchored by the first university in Switzerland which was founded in 1460 and is particularly expert in the medical and chemical sciences. Conversations with a number of these executives revealed that talent is quite mobile from company to company, and yet there is a fierce pride associated with the role these companies play in the global pharma industry.

Despite the myriad of reasons to be troubled by the situation in the U.S., my Swiss hosts were incredibly respectful (at one company I was provided a set of guidelines with the first point being “Avoid contact with chemicals.”) Notwithstanding the current rhetoric in the U.S. concerning drug pricing, one leaves with a sense that executives view this to be temporal and will not unduly impact their core programs.

In addition to the pricing concessions offered by Novartis concurrent with my trip to Europe, there were two other “medical discoveries” announced while I was there. To screaming tabloid headlines in the U.K., researchers with the Cochrane Library on behalf of the National Health Service (NHS) announced that Omega-3 and fish oil supplements are useless. Apparently, the English spend 420 million pounds on supplements annually and the NHS is worried that much of it is wasted.

Perhaps more timely, given the proclivity of the U.S. President to tweet, the Journal of the American Medical Association released a study that confirmed heavy social media use may make one twice as likely to develop attention deficit hyperactivity disorders. I better tweet that right away.

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