Spain is En Fuego…

When I arrived in Spain a few weeks ago the newspapers were bemoaning the extraordinary loss of global soccer star Neymar from Barcelona to Paris St.-Germain for a staggering $262 million transfer payment. Grown men were crying in the streets. A popular storefront in Ibiza captured the despair many felt, as they searched for meaning post-Neymar.

Ibiza 2017

Tragically, only days later, everyone was now crying in the streets after the horrific terrorist attacks in Barcelona. In addition to the obvious devastation, tourism is 14% of the Spanish economy and given problems elsewhere in European, Spaniards were expecting a bumper summer season of 38 million visitors.

Spain had been relatively insulated from Islamist terrorist attacks, although Barcelona which is in the Catalonia region of Spain has had a restive past with sporadic separatist violence. In three weeks, Catalonians are to vote in a referendum to determine if the region will separate from Spain. This action was just ruled unconstitutional by the Spanish Constitutional Court so expect continued unrest. Three years ago, Catalonia, the most economically powerful of the 17 administrative regions of Spain, held a non-binding referendum that saw 80% of voters pushing to leave Spain.

All of this turmoil belies what is an extraordinary story of economic recovery and a real resurgence of entrepreneurial activity over the past ten years. Gross Domestic Product (GDP) is expected to increase 3% in 2017, which is remarkable given how severe the situation was just a few years ago. The economy contracted 10% from the pre-Eurozone crisis levels of 2008; the unemployment rate was north of 26% and is now at 17%. The IBEX 35 index trades at 13.9x forward P/E, not an unreasonable level given that the Euro Stoxx index is at 14.8x.

This summer most European banks reported relatively stable financial results and appeared to finally be adequately capitalized. Non-performing loan balances at Spanish banks are estimated to be 5% which compares very favorably to their neighboring Portuguese banks which are running at 18%. This is all the more remarkable given the reputation for lax corporate governance, particularly at Spanish banks. The sixth largest bank by assets, Banco Popular Espanol, was sold this summer for 1 euro to Banco Santander SA when the true quality of its balance sheet was revealed, turned upside down by the disastrous level of inside deals with affiliates.

Arguably the harsh steps taken to address the crisis created by the credit-fueled construction boom were quite successful, notwithstanding the pain incurred. The dramatic reduction in government spending led to lower wage levels across the board which analysts attribute to why Madrid is 36% cheaper than London and 28% below Paris. Average Madrid rents are 345 euros per square meter now, which is well below the 504 euros rate in 2008.

This lower wage level had the effect of spurring a significant amount of entrepreneurial activity. Barcelona, which happens to be the location of Amazon’s European headquarters, recently developed 22@District, which is a 40-acre technology zone on the waterfront (no cars are allowed). Regularly we hear from interesting Spanish start-ups as they contemplate raising additional capital and/or expanding into the US market. For instance, Lug Healthcare Technology, a Spanish start-up providing technologies for hospital pharmacies, is deployed in five leading Spanish hospitals and is now looking to expand overseas.

The Spanish healthcare system has always been considered one of the best in the world and should continue to be a source of future healthcare innovation. The World Health Organization places women longevity at 85.5 years, second only to Japan. With a population of 46.5 million, the Spanish spend 9.3% of GDP on healthcare and enjoy universal coverage with no upfront payments and modest co-payments for pharmaceuticals based on an income test. Over 90% of the population uses the public health system, which is quite decentralized across the 17 regional health ministries. Some of the greatest health concerns are obesity at 15% of the population and something called “hazardous drinking” which 7% of men and 3% of women are guilty of.

The Spanish healthcare system was dramatically restructured as part of the General Health Law of 1986 which extended coverage and access to all. As healthcare costs accelerated over the following decade, the 1990s saw a greater focus on cost containment and management reform. This not surprisingly led to a tension in the 2000s between a more federalist approach versus a nationally coordinated system.

The impact of this increased commitment to national wellbeing was dramatic: vaccination rates were 80% in 1985 and are now well above 95%, leading Spain to be ranked fifth globally. The number of CT scanners and MRI machines per million residents was 14.4 and 9.2, respectively in 2008 according to the National Catalogue of Hospitals (last year of data), which compares impressively to other advanced European economies such as the United Kingdom which was 7.4 and 5.6, respectively. Today the central health minister is principally focused on four areas:

  • Chronic and rare disease management
  • National safety issues
  • Resource allocation to regions to endure uniformity and balanced care across the country
  • Nationalized IT system (single patient ID system, single EMR)

As a healthcare tech investor, the fourth priority is most interesting. In addition to a robust “health card” platform which allows access to all Spanish healthcare facilities, the analytics the system generates give administrators effective tools to combat unwarranted regional variability by procedure and outcomes. For instance, it was recently shown that there is up to 12x variability by region for avoidable hospitalizations due to diabetes complications.

Like many summer trips to Europe, one often needs to recuperate upon the return. At least in Ibiza, you can stay on east coast time, US east coast time.

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Dramatic Capital Inflows Continue in 2Q17…Trouble Ahead?

In an environment of microscopic interest rates, it is particularly interesting to read the Preqin 2Q17 Quarterly Update which exhaustively tracks all things private equity and venture capital. At the end of June 2017 there were 1,998 funds in market raising a total of $676 billion – a staggering sum – indicative of global investors desperately looking for alpha. Admittedly, Softbank’s $100 billion Vision Fund skews the data somewhat but at the beginning of 2017, there were 1,834 managers raising $525 billion which were already all-time highs.

In 2Q17 private equity funds raised nearly $121 billion across 206 funds; buyout funds accounted for $88 billion of the totals, which coincidentally was approximately how much was invested ($83 billion) in 1,001 buyout deals. This investment pace comfortably returns the private equity industry to levels not seen since the Great Recession nearly eight years ago.

Amidst of all the distractions swirling around the Russia Probe and “Repeal and Replace,” the venture capital industry also reported startlingly strong results for 2Q17. According to the National Venture Capital Association (in partnership with PitchBook) nearly $21.8 billion was invested in 1,958 companies across all sectors. When the first half of the year is annualized, the industry is on pace to invest over $75 billion in 7,750 companies and would mark the third year comfortably above $70 billion invested. Venture funds raised $11.4 billion in 2Q17 and may well be on pace to exceed 2016’s ten-year high of $41 billion raised. Indicative of the robust level of activity, round sizes and valuations remain somewhat elevated, while the “time to exit” also remain extended with average holding periods of just under six years for venture-backed companies.

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Much of this activity reflects the “unicorn” phenomenon which investors are anxiously watching play out. At the end of 2Q17, according to the Wall Street Journal’s “Billion Dollar Startup Club,” there were 167 unicorns. While 41 unicorns raised capital in 2Q17, only five could go public. As these companies chose to stay private longer, meaningfully larger round sizes are required which likely accounted for the nearly doubling of financings greater than $200 million in size as compared to 2016 levels. In many unfortunate cases, unicorns may not be choosing to stay private but rather are recognizing that IPO valuations are likely to be quite a bit below the last private round’s valuation. The very public failures of companies like Theranos and Jawbone, coupled with the disappointing IPO performance of Blue Apron and Snap, have reminded investors that the exit environment is as important as the early-stage financing environment.

And it may be issues around liquidity that rattled investor confidence among Silicon Valley VCs. The “Silicon Valley Venture Capitalist Confidence Index” (such an index actually exists – its a 5-point scale) dropped to 3.52 from 3.83 quarter-over-quarter, underscoring anxieties about lofty late-stage valuations, a disappointing exit market, and political uncertainty.

Not to be lost “below the fold,” so to speak, was the news reported by CB Insights and PricewaterhouseCoopers that in 2Q17 for the first time ever private Asian technology companies raised about the same amount as their U.S. brethren. To highlight how significant this convergence is, the U.S. venture market was over twice the size of Asia’s in 2016.

More specifically, the healthcare technology sector continued its run of impressive strength in 2Q17, in part as a reflection of the category’s maturity and that very substantial business needs exist across the entirety of the healthcare industry. Per Rock Health, $3.5 billion was invested in 188 companies year-to-date which rivals the annual totals of more than $4 billion in each of 2014, 2015 and 2016. The average size of financing was $18.7 million which is significantly greater than any prior period when round sizes never exceeded $15 million. Notably there have been seven companies that have raised more than $100 million in a 2017 financing, another high-water mark and indicative that many healthcare technology companies are scaling rapidly.

Additional evidence of strength in the U.S. healthcare sector was a recent report from Silicon Valley Bank which highlighted that venture investors had raised approximately $5 billion year-to-date, which is on pace to be one of the most robust VC fundraising years ever.

The political landscape remains uncertain at best. The potential cuts to both Medicaid and federal insurance cost subsidies could be profound with uncertain implications on IT budgets. Fortunately, the dysfunction all of us are watching painfully play out in DC has had so far a surprisingly muted impact on the healthcare technology sector. Analysts are encouraged by the new FDA Commissioner Gottlieb’s positions on regulatory front, and in particular, the early drafts of the “Digital Health Innovation Plan” appear strongly to endorse the continued movement to value-based models. Our core investment themes remain very much intact and perhaps are even more compelling in this environment.

But in light of the emerging political imperatives, there has been some rotation of the sub-categories within the healthcare technology sector. In recent years, the consumer health information, telemedicine and population health categories have given way to greater investor interest in consumer engagement, digital therapies and analytics. There does seem to be evidence that the “quantified self” phenomenon now is either fully penetrated and/or consumers have lost some interest as the wearables category has attracted significantly less capital in 2017.

One other indicator of sector strength is the geographic breadth of healthcare technology innovation. Important and relevant companies are being built in many cities which historically have not attracted significant venture capital. Rock Health estimates that year-to-date, 25 states have seen healthcare technology companies raise capital. Notwithstanding this breadth, certain states such as California, Massachusetts and New York continue to be particularly important hubs of innovation.

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Essential to a compelling investment strategy is a robust exit environment. Limited liquidity options have been a concern across all sectors for venture capitalists the last few years. PitchBook recorded 348 exits of venture-backed companies year-to-date 2017, 58 of which Rock Health noted were healthcare technology companies (which disappointingly was behind the 87 exits in 1H16). One of the hallmarks of the healthcare technology sector is both the breadth and depth of the universe of acquirers from large established enterprise technology vendors, insurance companies, traditional business service providers to increasingly other strategic pharma and medical device companies.

Public markets have offered mixed signals as well. Notwithstanding that there have not been any healthcare technology IPOs this year, the Leerink healthcare technology/services public stock index has increased nearly 26% this year and up nearly 12% in 2Q17 alone. The average 2017 revenue and EBITDA trading multiple for this index at the end of 2Q17 was 4.3x and 14.7x, respectively. According to Leerink data demonstrated that this past quarter the payer sector traded much more favorably than the provider section – 20% versus 3%, respectively.

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Circulation and “On Demand” Healthcare…

This morning Circulation, one of our portfolio companies, announced a very exciting Series A financing of $10.5 million to scale one of the emerging leaders in the “on demand” healthcare economy. Circulation is the second of our Flare Ignite seed companies and with this financing, both companies have now successfully converted to be significant core holdings of the fund (Bright Health was the other).

There are several elements to this story which are quite instructive. First and foremost, it is very rewarding to work closely with world-class entrepreneurs (Robin Heffernan and John Brownstein) who are also great friends of mine. Robin and I have worked together for nearly a decade over three companies – she was an investor at my prior venture firm, we backed her when she helped start one of our other portfolio companies, and now at Circulation. In parallel, I have been collaborating with John as a member of his advisory board at Boston Children’s Hospital where he is the Chief Innovation Officer. And with this financing, one of Flare’s Executive Partners, Chris Kryder (who founded D2 Hawkeye, Generation Health, and ran Verisk Health) has also joined the board.

There are two other more fundamental observations to be made here. One is how the team rapidly iterated both the product and business model. Today, the company which launched less than a year ago, has over 50 active accounts touching well over 1,000 locations, and can already demonstrate outstanding metrics for better health outcomes, cost savings and rider satisfaction. The broad theme of “on demand” healthcare is profoundly interesting and echoes many of the forces at work in other industries. The team felt it was critical to get out early to assume category leadership versus being too deliberative.

 

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Being early can be hard in healthcare given unique customer demands and that the cost of failure is so high and visible. Robin and John readily identified a very significant market opportunity with non-emergency medical transportation and envisioned a powerful launch partner with Uber, where John is the Healthcare Advisor. Rather than debating who should be Client #1, the team determined that being first to market was more important than being the “first second” entrant in the market.

In addition to breaking from the gates quickly, the company has embraced working with strategic investors early on. Some entrepreneurs are leery to engage with strategics or expose the “secret sauce” to them too early but in healthcare doing so can often be quite powerful. As evidenced by the composition of the Circulation financing syndicate, four of whom are Flare limited partners, it was important to have leading healthcare companies under the tent early to provide feedback on the product roadmap and possible use cases. In fact, each of the strategic investors will be board observers/advisors and come to this with substantial needs that the Circulation platform will quickly address.

One other observation, and a theme we have been developing, is that there are a series of other successful and innovative business models outside of healthcare that will be translated for the healthcare industry. At its core, this theme underscores the transition from a “passive” model where patients receive care to an “active” model where patients consume care. Patients will increasingly insist on convenience, choice, and price transparency. This “always on” approach to healthcare consumption makes essential the precisely coordinated logistics of patient, product and service movement. The move to “on demand” platforms introduces no shortage of other opportunities for care at the right time, right place, right cost.

 

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Crazy Crypto Times…

Several years ago, chatter started to emerge about Bitcoin and blockchain technologies. Given that one of our core healthcare investment themes at Flare Capital is broadly labelled “Payment Reform,” we have been getting smarter about the implications to the “business of healthcare” as these technologies became more robust, more established. Little did I know what this search would uncover.

Analysts are already now talking about Digital Currency 2.0. How did I miss 1.0? Regularly there are spectacular stories of wild Bitcoin trading activity or some instance of fraud or a “flash crash” as what occurred two weeks ago, when the digital currency, Ether, collapsed from $300 to $0.10 in minutes. Undoubtedly, while these cryptocurrencies are still somewhat under construction, there is something profound emerging that may have far reaching impacts – maybe in healthcare but certainly on my industry, venture capital.

crypto currency for blog

The graphic above from the Digital Currency Group nicely captures the rapid evolution of the cryptocurrency ecosystem in the last half a dozen years, which is not unlike the cycle times of Web 1.0, 2.0 and 3.0. First enabling infrastructure must be built to allow for enterprise products and applications to then develop. Blockchain is often described as digital ledgers managed (validated) by a network of computers (“miners”) to enable transactions and commerce. Specific capabilities around security, governance and payment settlement needed to be developed before wide-spread application usage would occur.

A handful of cryptocurrencies like Bitcoin had relatively broad applicability, while most other cryptocurrencies have been introduced as payment methods for the very specific products and services of a specified network. This has become a very robust method to crowd source development capital for certain companies. These cryptocurrencies for open source networks allow the developers to capture the value of the networks they are building, unlike earlier iterations of other open source networks such as Wikipedia or Linux, where the developers were unable to monetize what became extraordinarily valuable networks. Ironically, new concerns are emerging for Bitcoin as a widely used currency given the data processing framework only allows for seven transactions per second, which is leading to fees of up to $5 per transaction (there are estimated to be 260k daily transactions now).

Some specific examples of the current landscape are quite informative and harken back to the late 1990’s investor frenzy (are you old enough to remember theGlobe.com’s IPO?):

  • According to WorldcoinIndex.com, there are 400 cryptocurrencies today that trade on 35 exchanges (coincidentally, there were 486 and 406 IPOs in 1999 and 2000, respectively)
  • Ethereum, one of the most popular cryptocurrencies today to support online services and apps, was valued at $10 per token at the beginning of 2017 and now trades at $250, creating an aggregate market value of nearly $24 billion – its token price chart is below
  • Bitcoin, the grandfather of cryptocurrencies started in 2008, was trading at $5 per token; now one can buy a Bitcoin for $2,500. There will only be 21 million Bitcoins created – 16.4 million have already been mined
  • There are 16 million Bitcoin addresses with less than $60 account balances but only 1,780 with more than $608,000 in value each
  • It is estimated that between 0.5% – 0.75% of Americans have ever used Bitcoin, which while sounding like a small number, equates to between 1.2 – 1.9 million people

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Arguably with the dramatic price appreciation of tokens, popular investor interest has been stoked. Trading volatility is dramatic with daily double-digit percentage price swings the norm. In an environment of epic low volatility in other financial assets, speculative cryptocurrency trading activity is staggering. A criticism of many central banks around the world has been that much of the stimulus spending went to financial assets and not to real economic activity (thus record high public stock prices with very modest real economic growth). Now as those same banks look to reduce liquidity and tighten monetary policies, expect to see some potential sharp token price corrections. Compounding this is the expectation that many of these start-ups funded by novel cryptocurrencies will undoubtedly fail.

Now through the VC lens, what I was most struck by the last few months is the ability for these novel currencies to upend how capital is raised and invested – particularly by the magnitude. Many VCs were rattled in 2012 when Pebble raised $10.3 million to build a smartwatch in one of the largest Kickstarter crowdsource campaigns ever (notably, the company was shut down four years later). Notwithstanding the hyper-unregulated nature of these platforms and the chronic association with illicit activities, a few recent anecdotes underscore the disruption these platforms may poise, particularly with “Initial Coin Offerings (ICO)” and special purpose investment funds denominated in tokens.

  • In mid-June 2017, Block.one raised $185 million in five days which represented only 20% of the 1 billion tokens they will ultimately sell
  • This eclipsed the $150 million raised by Bancor a few weeks before that
  • And was blown away by Tezos’ “ICO” of $212 million which took three days in early July
  • Brave Software raised $36 million in digital coins in 30 seconds
  • Blockchain Capital was able to raise $10 million in six hours to launch a dedicate cryptocurrency fund
  • Hedge fund, Polychain Capital, was established to invest in tokens pre-product launch and will hold no equity

So, should Wall Street investment bankers be nervous? In some cases, quite clearly yes. Wall Street had been breathlessly waiting for many months for the $300 million Blue Apron IPO in June, which ultimately was quite disappointing. On the other hand, “ICOs” allow companies to create proprietary digital currencies that are to be redeemed later for products and services developed by that company (or that can be sold on crypto-exchanges) very quickly. And this is completely unregulated with meaningfully lower issuance costs. In the past 18 months, there have been 124 “ICOs” which raised $984 million according to CoinSchedule.com, not including Tezos’ “ICO” in early July.

Interestingly, year-to-date 2017, venture capitalists have invested $295 million in cryptocurrency companies which pales to the nearly $1 billion raised via the 78 “ICOs” – in both cases, proceeds were to effectively do the same thing – build the product and scale the company.

Now to come full circle back to where this exploration started – what is the impact of cryptocurrencies on healthcare? Without debate, the handling of medical data today is poorly managed. Blockchain promises to meaningfully improve the security and provenance of data as they will be stored across a distributed architecture (not in one location). Additionally, security is improved given the encryption technologies core to blockchain, which should then further improve the quality and fidelity of the data. Arguably these architectures should also lower the cost of data management through better standardization. Frost & Sullivan anticipates more immediate opportunities to reduce the need for prior authorizations as an initial use case.

But this may not happen in the near to medium term in healthcare. Obsessive concerns around privacy and HIPAA are heightened with each Mt Gox incident (in 2014, $450 million of bitcoins vanished from this exchange, which subsequently went bankrupt) or last week’s hacking of Bithumb, one of the largest cryptocurrency exchanges (32k accounts were compromised), and with any “flash crash.” These technologies need to be more mainstream before more than just pilot activity develops in healthcare.

Notably, the Securities and Exchange Commission has yet to weigh in on whether cryptocurrencies should be regulated securities. And not to be left out, the Internal Revenue Service announced a probe of Coinbase, a popular cryptocurrency exchange with 500k active users, because only 802 people declared Bitcoin capital gains and losses in all of 2015. Recall that Elliot Ness initially brought down Mobster Al Capone over issues of tax evasion. The authorities are slowing trying to get their heads around what this is all about.

But other industries are beginning to explore specific use cases for cryptocurrency and blockchain technologies, particularly in financial services. The NASDAQ is creating an exchange to buy/sell advertising inventory, while many European banks are working with IBM to develop trade finance platforms utilizing these technologies. Last week the leading art and antiques fair (TEFAF) announced that 75% of the 39 top online art sales exchanges are now developing blockchain platforms.

Given venture investors are to invest in technologies that are “over horizon” today, I certainly do not want to wait for Digital Currency 3.0 to realize we missed compelling companies during the 2.0 version. In the meantime, expect to see a new class of “crypto day traders” emerge. Just waiting for the day my Uber driver tells me about the killing he/she made in flipping Siacoin tokens.

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Related Events?

As a partnership, we will make a few dozen investment decisions across any given fund and as a group we will make hundreds of other decisions together in simply running the firm day in, day out. When it comes to expanding the team though, that is a very different matter. Venture firms add very few people so each addition is a big deal.

And as such, we are very excited that Vic Lanio has joined Flare Capital as a Senior Associate. What initially struck all of us about Vic was his passion for the “business of healthcare” and how he was thinking about the implications of the transformation we are all now witnessing. Vic’s depth of understanding of the emerging new business models and novel technologies that are coming to market is exceptional. The fact that he has worked for a handful of successful healthcare technology companies was critical. When those experiences are married to both classic consulting experience (McKinsey) and top-shelf academic credentials (MIT, Boston College), we felt we had a winner. It also did not hurt that Vic is a Flare Scholar alum from the great Class of 2016, so he was someone we knew well.

Coincidentally, the same day Vic joined the firm, StartUp Health published its Mid-Year Insights Report – a “must read” for anyone operating in the healthcare technology sector. It is a wealth of industry data, covering important themes and providing funding data. We were quite pleased to be ranked as the third most active venture firm year-to-date, listed alongside several world-class investors.

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As much as we think about Vic and his tremendous potential with the firm as an investor, sadly we had to tell him that these were unrelated events!

Please join us in welcoming Vic to Flare Capital.

 

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“Service-enabled” Tech Models…

Around venture capital water coolers everyone brags about the latest “tech-enabled” service business model but in healthcare maybe these conversations need to be turned on their heads to focus on “service-enabled” tech models with the emphasis squarely on services. As the business of healthcare is transformed, many of the companies that appear to be scaling are fundamentally services businesses. Most healthcare SaaS businesses have always had a large services component, underscoring the balance (or tension) between services and product revenue. In fact, a review of recent funding data suggests that there are significantly fewer pure-play technology companies, raising less capital.

Thanks to one of our star Flare Scholars, Carlos Rodriguez (recently of Harvard Business School), who looked at the aggregate of both Rock Health and MobiHealthNews 2016 funding data (340 transactions and $4.4 billion of invested capital), what is quite evident is that the more labor intensive sub-sectors of healthcare technology were the most active. Carlos – bless his heart – mapped all of these transactions to Flare’s core investment themes, listed below.

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Anecdotally, this feels right and reflects much of what is seen in the market today. The emergence of novel care delivery models across healthcare (primary care, elder care (PACE), hospital-at-home, behavioral, palliative, etc) has taken hold over the last few years. Technology has made many of these services better and more efficient, but at a very fundamental level, effective healthcare is one human being helping another human being. Left to its own, technology alone does not provide healthcare.

Ideally, real-time intelligence across a population will make the healthcare delivery system smarter and able to better anticipate both acute and chronic medical issues. The system today is finely tuned for episodic issues, not chronic conditions. A system redesign with more effective services and more robust incentives to prevent disease are expected to reduce the incidence of high acuity cases. The migration to a more integrated care delivery model to better manage all the variability of care and patient hand-offs can be bolstered by technology, but it is still fundamentally a “services” challenge.

The healthcare technology venture landscape continues to be quite active, despite what is clearly a moderation in the overall venture capital activity. Industry analysts are using words like “disciplined” and “normalized” to describe the overall venture capital market for the first 90 days of 2017, which is obviously not how we might characterize the current political climate. As always, the headlines belie what might be more turbulent private capital markets under the surface, as quite clearly there is a continued and pronounced rotation away from the earliest stages of investment. Notwithstanding that, the healthcare technology sector continues to attract significant amounts of capital. For 1Q17, nearly $1.0 billion was invested in over 70 companies, which suggests that we are on pace to have the fourth year in a row with over $4.0 billion invested in nearly 300 companies, signaling continued maturation and depth of the sector.

Globally, according to Mercom Capital, over $1.6 billion was invested in 165 companies in the healthcare technology sector. Notably, Mercom also counted 49 M&A transactions in 1Q17, underscoring for investors that more predictable liquidity is available for many of these companies. For all sectors of healthcare, there were 390 announced M&A transactions with an aggregate value of $38.5 billion in 1Q17.

And the enthusiasm for healthcare services models has not been lost on public stock investors. On the heels of unprecedented political uncertainty last year, in general healthcare stocks are ahead 9% year-to-date while the broader S&P 500 index is up only 7%. More specifically, the iShares U.S. Healthcare Provider ETF has increased by 13% while the NASDAQ Biotech ETF has gained only 10%.

Last month Flare hosted its annual investor meeting. Several important observations emerged over the course of the day including: (i) tremendous opportunities exist as the healthcare system develops effective approaches to manage chronic conditions; (ii) notwithstanding the issues confronting the public insurance exchanges, there was consensus that affordability and not adequate coverage was the central concern; (iii) more effective management of social determinants will play a critical role in how the healthcare system is transformed; (iv) significant opportunities exist in the Medicaid population, particularly with improved access; and, (v) while somewhat elusive, the “tipping point” from fee-for-service to value-based models is now on the horizon. All of this overlays nicely with our core investment themes.

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One of our keynote speakers, who was also a CEO of one of the country’s largest health insurers, articulated a migration path to more fully developed integrated care models which highlighted the need to directly impact downstream healthcare costs. Wholesale healthcare system redesign, including the introduction of meaningful incentives to prevent disease, should materially lower the incidence of high acuity episodes. Specific areas of focus to reduce “friction points” in the delivery of care included more comprehensive and transparent network design and more effective scheduling capabilities.

Many of the speakers observed repeatedly two significant unaddressed market opportunities: (i) healthcare delivery systems that dramatically reduced variations in care by provider, which will likely be addressed by evidenced-based approaches; and, (ii) solutions that will better manage end-of-life situations.

In addition to highlighting the need for business model innovations, it was important to review developments in the field of artificial intelligence (AI) and how these emerging solutions might either impact existing products and services, or should be incorporated into product design plans. One of the country’s foremost authorities on the field of AI in healthcare is Dr. Zak Kohane, who chairs the Biomedical Informatics Department at Harvard University and sits on the Flare Industry Advisory Board. At its essence, AI will – sooner than later – enable computers to replicate existing human behaviors. It is quite clear that, as Zak so eloquently stated, the “high-touch shamanistic” aspects of medicine will be significantly reinvented as AI proliferates across healthcare. According to HealthcareIT News, 35% of all healthcare organizations will “leverage AI” within the next two years; 52% will not for another five years.

Ironically, per a recent Circle Square study of 31 million EHR, it was determined that physicians now spend less than 50% of their time in face-to-face patient interactions with the balance being “desktop medicine” (3.1 hours vs 3.2 hours daily, respectively).

Separate, and only slightly related, Sanford C. Bernstein’s restaurant analyst (Sara Senatore) recently published a report on the “restaurant of the future” which will have far fewer employees, and all interactions will be electronic in virtual reality environments with robotic chefs and servers, replicating 5-star meals in almost any setting. Senatore concludes that there will be significant reductions in time and a much more pleasing overall experience, which will encourage greater patronage. How much of that promise could we see in healthcare, another labor-intensive industry? Actually, do we even really want to see it?

So, go ahead healthcare service models, embrace your lower gross margins.

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Not Really a Ho Hum Quarter…

Now that most of the investment data are in for 1Q17, analysts are using words like “disciplined” and “normalized” to describe the activity of the first 90 days of 2017 – obviously not how we would characterize the current political climate. As always, the headlines belie what might be seen as more turbulent private capital markets under the surface, as quite clearly there is a continued and pronounced rotation away from the earliest stages of investment. Modest but encouraging exit activity has continued to generate strong limited partner interest as 58 new funds raised $7.9 billion, according to NVCA and PitchBook data.

Nearly $16.5 billion was invested in 1,797 companies in 1Q17, which was the fewest number of companies in the last 22 quarters. Much of this decline was in the Angel/Seed stage which over the past handful of years has accounted for roughly 55% of overall deal activity but only 45% this past quarter, signaling that investors may be somewhat more risk averse as they focus on later stage companies. The number of Seed companies dropped by 46% over the past eight quarters. While Seed rounds have consistently stayed at $1 million in size, average Later Stage VC round size was $10 million as compared to $5.5 million for Early Stage VC rounds.

1Q17 investments

The “bread and butter” of the venture market are the Early Stage financings and there the data are also mixed. Deal volume has declined quarter-over-quarter for each of the last eight quarters and in 1Q17, Early Stage accounted for only 30% of all deals, and at $5.7 billion of transaction volume, was only 35% of all dollars invested. The landscape is quite different in the Later Stage VC rounds where the number of deals has increased sharply over the past three quarters, accounting for nearly 25% of all financings yet 57% of all dollars invested. This concentration is underscored when one considers that the top ten financings were 17% of all dollars invested yet were only 0.6% of the companies. Two of the top five venture deals were in healthcare.

Arguably even more striking as a barometer of venture investor risk tolerance is the dramatic pull-back away from companies which are raising capital for the “first time.” Only 497 of the 1,797 companies in 1Q17 raised venture capital for the “first time” which is the lowest number in 27 quarters and half of what it was just three years ago; together those companies only accounted for 10% of dollars invested in the quarter. First time entrepreneurs are not excited about this “disciplined and normalized” market.

Undeniably, corporate venture funds have played an important, perhaps even stabilizing, role in the venture capital industry. Corporates have consistently invested in between 270 to 350 deals over the last five years, with much of their participation being in Later Stage investments. Overall, Corporate VCs participated in 38% of all 1Q17 financings.

Exit activity is what makes the venture model sing, and the news in 1Q17 was encouraging. Overall exit values for venture-backed companies was $14.9 billion across 169 companies. While the number of exits has not been this low for the last 24 quarters (maybe reflecting corporate chieftain uncertainty in light of the election results), the value of deal activity is consistent with that of the prior eight quarters. Unfortunately, there were only 7 venture-backed IPOs but anecdotally investment bankers, who are normally an anxious lot, appear to be encouraged with both the number and quality of companies in front of the SEC waving their draft S-1s. Somewhat disconcerting, though, was that Snap likely overwhelmed the IPO market in 1Q17, raising $3.4 billion of the $4 billion of total IPO proceeds. The sector with the largest number of exits was Software (96) which was 57% of all exits, and compares favorably to the fact that Software was only 37% of all deals financed in 1Q17.

1Q17 exits

This introduces another interesting metric which investors are increasingly grappling with. Since 2013 the ratio of new investments to exits has been between 10 – 11x, which is nearly 3 to 4 points higher than what was experienced ten years ago. Of course, the math is crude given the timing differences, but undeniably, companies are staying private longer, and for some, that has been aided by aggressive hedge funds and mutual funds. For others, this may not be of their own choice. There are many market whisperers now speculating which of the 153 “unicorns” (per Venture Source) are facing a dystopian future should they not get liquid in the next 12 months.

For the past four years, there have been consistently between 60 and 70 new funds raised each quarter. Between 2014 – 2016, the venture industry has raised between $35 – $40 billion annually and appears to be on pace to raise in the low $30’s billion in 2017. This past quarter was the first one in recent memory when there had not been a $1 billion fund raised (Mithril was the largest at $850 million). Notwithstanding that, the ten largest funds raised accounted for $4.3 billion or nearly 55%, yet represented only 17% of all funds raised.

Other fun “quick hit” venture facts from this past quarter:

  • According to Preqin, $31 billion was invested in 2,420 venture deals globally
  • Since 2013, over $1.5 trillion has been distributed back to investors from private equity and venture capital firms
  • This liquidity may account for why there was $90 billion raised by 175 PE and VC firms
  • It is estimated that there are over 1,900 PE and VC funds “in market” now, targeting to raise $635 billion, inclusive of the unprecedented $100 billion Softbank Vision Fund
  • And staying with Preqin, at the end of 1Q17 it is estimated that there is $683 billion of PE and $159 billion of VC “dry powder” capital still to be invested globally

There were two other market developments that many found surprising. Given all of the political volatility, the Dow Jones Industrial Average had the quietest trading quarter since 1965, with average daily price movements of only 0.3185%; for the S&P 500 it was only 0.3172%. The lack of volatility has put many market analysts on edge – ironically.

And business lending (bank loans and leases) increased a very modest 3.8% year-over-year in 1Q17. Over all of 2016, business lending rose 6.4%. Admittedly corporate bond issuance increased 18% as large issuers locked in historically low interest rates (and maybe even paid off some bank debt). Why this is somewhat disturbing is the downstream impact on growth; Goldman Sachs estimated that this deceleration effectively created a $100 billion loan shortfall.

Maybe Softbank can fill that void.

 

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