Healthcare Technology – A Look Ahead…

Healthcare technology investors are in a quandary. Business was really good this past year yet the world all around us is suffering in so many profound ways. The investment data are in and it was a very strong year for both new commitments and liquidity. According to Rock Health, a record $14.1 billion was invested in 440 companies; nearly doubling the $7.5 billion invested in 2019. Other sources tabulated somewhat different results, but the trend was the same (Mercom – $14.8 billion across 372 companies: MobiHealthNews – $13.8 billion across 637 companies). Notably, healthcare technology investment was just over 9.0% of all venture capital activity in 2020 ($156.2 billion – an all-time record high).

Rock Health identified four significant categories of activity: $2.7 billion invested in “on demand” healthcare; $2.0 billion for drug discovery/development; $1.8 billion invested in behavioral health companies; and, $1.7 billion directed toward fitness/wellness opportunities. Interestingly, there were 40 financings that were greater than $100 million in size, accounting for 57% of the total activity – and undoubtedly explaining why the average deal size spiked to nearly $32 million, more than 50% larger than what was seen in 2019. A clear indicator of maturity in the sector and that there are now a number of “emerging winners.” Liquidity in the healthcare technology sector was also quite robust with 145 M&A transactions, six IPOs, and seven SPAC offerings.

Obviously, the pandemic played a significant role in all of this activity. According to an analysis by Health Affairs, in January 2020 (pre-pandemic) tele-visits were less than 1% of all doctor / patient interactions and is now approximately 6% (and enjoying improved reimbursement rates). Whenever possible, home health replaced nursing home care. As the healthcare system rapidly moved to be more on-demand and virtual, providers scrambled to incorporate innovative solutions to ensure continuity of care. Through the ten months up to October 2020, healthcare spend was trending 2.3% below the similar 2019 period. Just over the course of the pandemic, there has been a dramatic rotation of healthcare spend to more “socially distanced” locations. Interestingly, prescription drug costs are running ahead by 2.9% since the onset of the pandemic.

Both the dramatic re-prioritization of budgets due to Covid-19 and the equally dramatic changing political environment point to continued sector strength. It certainly appears that the Affordable Care Act will endure and will likely be strengthened to drive for lower premiums, better plan design, offering public options, and perhaps even lowering the Medicare eligibility age to 60. Expansion of state Medicaid programs seems a near-certainty, as does regulatory initiatives to lower drug prices (such as allowing the government to negotiate prices). The long overdue scrutiny of racial disparities around access and quality of healthcare will push organizations to incorporate solutions to engage, activate, manage disadvantaged populations more effectively. The recently unveiled $1.9 trillion relief package provides additional tailwinds.

One particularly exciting development in 2021 will be the introduction of Direct Contracting, which is a Centers for Medicare and Medicaid Services (CMS) initiative to move a significant portion of the $450 billion of Medicare medical costs away from fee-for-service beneficiaries into value-based care models. Nearly 15% of Americans are on Medicare (~60 million people) and account for $325 billion of healthcare spend; Medicare Advantage is approximately 40% of that amount. The Congressional Budget Office forecasts that nearly 50% of the Medicare $450 billion may move into such arrangements by 2030.

Many healthcare technology entrepreneurs are eagerly awaiting the April 2021 roll-out of this program which promises to shift significant spend into novel arrangements that will require enhanced solutions to manage. While Direct Contracting patients may be slightly less profitable (given reimbursement benchmark discounts), there will be meaningfully lower member acquisition and claims processing costs. Economic value will be created by meaningfully outperforming the CMS benchmarks which will demand innovative approaches. One note of caution with the uncertain economics is the limited success of the CMS experiment with Accountable Care Organizations, which ultimately realized quite modest premium savings.

Given many of these forces, McKinsey & Co. has identified a number of healthcare technology sub-sectors that will show both high rates of client integration and innovation as the healthcare system is re-architected. These include data and analytic solutions, as well as utilization management, clinical decision support, and network management platforms.

Undoubtedly the healthcare sector will see a significant demand for labor over the next decade. Four of the top ten categories for future employment growth tracked by the U.S. Labor Department are in healthcare. Most notably will be the overwhelming demand for home health aids as payors and providers look to develop cost-effective solutions to provide clinical and social services in the home. Innovative technologies will need to be deployed to make this workforce productive.

All of these forces and the dramatic venture capital inflows in 2020 have pushed valuation levels to historic highs for later stage rounds of financing. Per Pitchbook, the average post-money valuations for Seed and Series A rounds in 2020 were $12.2 million and $40.5 million, respectively, which have remained relatively consistent over the last eight years. Starting in 2018, the post-money valuations of the Series B and C rounds increased significantly, reaching $146.9 million and $313.1 million in 2020, respectively. The average pre-money valuations for those rounds were $112.4 million and $258.0 million, suggesting that the average round sizes for Series B and C were approximately $35 million and $55 million, respectively.

Interestingly, the median post-money valuations over those series of rounds were $10 million (Seed), $30 million (Series A), $95 million (Series B), and $214 million (Series C), highlighting how the “mega rounds” have skewed the averages to be nearly 50% greater than the medians across each stage of financing. Investors track closely the step-up in valuations over successive rounds, which while unrealized, indicates significant value-creation for early stage investors. Notably, the level of dilution incurred in later rounds tended to be between 20% – 25%.

The narrative is even more dramatic for the Series D and E rounds, which have average post-money valuations in 2020 of $384.0 million and $1.23 billion, respectively. The average pre-money valuations were $318 million and $1.15 billion, respectively, while the median post-money valuations were $295 million and $453 million, once again underscoring the dramatic impact of the “mega rounds.” The difference between average and median post-money valuations for the Series E rounds ($1.23 billion vs $453 million) is notable, and likely reflects the minting of a number of new unicorns.

It is estimated that there are now 55 public and private healthcare technology unicorns (according to Flare Capital analysis) which compares to only 12 in 2015; those unicorns are collectively valued at $271 billion. Of the 55 companies, 21 are publicly traded, once venture-backed healthcare technology companies with an aggregate market valuation of nearly $200 billion. And they have traded very well in the public markets. The SVB Leerink Healthcare Technology and Services Index increased nearly 39% in 2020 (versus 16.3% for the S&P 500 index).

In just the past few weeks, this sector witnessed a handful of multi-billion dollar M&A transactions with UnitedHealth’s $7.8 billion acquisition of Change Healthcare, Amerisource Bergen’s $6.5 billion purchase of the Alliance pharmacy business of Walgreens Boots Alliance, and the $2.2 billion purchase of Magellan by Centene. The large incumbents will continue to be quite acquisitive to address gaps in their product portfolios and to drive top-line growth.

As investors now look to 2021, the enduring question as to where we are in the cycle is resurrected. Are valuations too high? Is too much capital coming into the sector, too quickly? It certainly appears that 2015 vintage venture funds will be high performing funds given the number of large and important venture-backed companies that are now successfully operating. In 4Q20 there was $4.0 billion invested (equivalent to all of 2014), suggesting we are now on pace for ~$16.0 billion to be invested in 2021. Place your bets – given the enormity of the healthcare industry, and now the profound urgency to improve how it functions, arguably we are on the threshold of the golden age for healthcare technology, so I will stand by that prediction.  

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Yummy – Synthetic Food…

In 2018 an estimated 69 billion chickens were slaughtered to feed the world’s population. This does not include the 1.5 billion pigs, 656 million turkeys, 574 million sheep and 302 million cows all killed to (still inadequately) provide protein for the 7.8 billion people alive today – see chart below. During the gluttonous excesses of the holiday season between Thanksgiving and New Year there were a number of fascinating announcements of new “agtech” start-ups, juxtaposed with allegations of industry price fixing, broken supply chains, and rampant Covid-19 outbreaks across food processing plants.

Of course, all of this is complicated by the pandemic. According to analysis reported in the journal, Obesity, 27.5% of study participants gained weight since the onset of the pandemic, while 17.0% actually lost weight.

The “protein production” industry has been posed for disruption for generations. With all the direct and indirect costs (feed, land, irrigation, pollution, transportation, wastage), raising livestock can be a highly inefficient approach to providing each of us the 50-70 grams necessary to satisfy daily protein requirements. The United Nations Food and Agriculture Organization estimates that 26% of the earth’s surface is used for the grazing of livestock.

The pandemic has also exposed the inadequacies and vulnerabilities of the food supply chain. Product pricing is quite volatile and often whipsawed by sudden unforeseen changes in weather, international trade disputes, and animal diseases which can quickly decimate flocks and herds. Last month, the U.S. Census Bureau calculated that 12.7% of all Americans regularly suffer from food insecurity, and this in a country where it is believed that 42% are obese and another 30% are deemed overweight. A number of entrepreneurs look at all of these issues and see the potential to profoundly re-architect this sector to ensure consistent, high-quality supply of protein for human consumption.

Entrepreneurs salivate when looking at all of this. According to AgFunder, in 2019 approximately $19.8 billion was invested in 1,858 foodtech and agtech companies globally, of which $1.0 billion was invested in alternative protein start-ups. In general, innovation in this sector cuts across a few dimensions: (i) utilizing plant-based proteins to manufacture meat-like products or (ii) novel biology to manufacture sources of protein, predominantly using cell cultures or other biological approaches or (ii) altered production processes to make existing methods more efficient, higher yielding. These approaches are in response to the existing enormously burdensome “protein production” methods on the climate per calorie produced. Yet, entrepreneurs appreciate that there are meaningful scientific, regulatory, and consumer preference obstacles ahead. Incumbent producers have aggressively litigated use of “meat” or “poultry” description for cell-based products. This does not even account for the consumer fears of GMO (genetically modified organisms) labels.

Label Insights, Inc. estimates that there are 323 plant-based meat alternative products under development now. Lux Research has identified over 60 cell-based meat producers globally which have raised $314 million in 2020. In the past quarter a number of interesting announcements crossed the tape: Meat Tech 3D, an Israeli-based public company utilizing 3D printing platforms to cultivate cells from animals, indicated plans to start trading in the U.S. this year. Eat Just (formerly Hampton Creek Foods), based in San Francisco, received approval in Singapore to sell cultured meat products suitable for human consumption. BlueNalu has raised nearly $25 million to develop cell-based seafood products. Unfortunately, initial costs are between $900 – $4,500 per pound of cell-based meat on pilot production lines versus about $4 for ground beef.

Eggs are entirely different beast altogether. The U.S. Department of Agriculture estimate that Americans on average consume 293 eggs each year; Californians alone eat over one billion eggs each month. Eggs saw dramatic price swings over the course of the pandemic, increasing 3x this past spring in response, in part, to a spike in consumer demand – and this in the face of numerous other food products dropping in price with all of the restaurant closures. In the fall of 2019, the price of eggs dropped 18% due to glut of laying hens which was due to soybean trade tensions with China which led to large grain stocks much of which was to fed chickens, expanding flocks…crazy.

All of these dramatic egg price swings have naturally led to litigation. Various state attorneys general filed lawsuits, alleging price gouging and “excessive, unfair, illegal profits” during the pandemic. Egg producers (i.e., chickens) also were the source of litigation over the last few months. Pilgrim Pride, a large chicken producer, paid a $110 million fine for price fixing which then prompted Chick-fil-A to file a sweeping lawsuit against all chicken producers alleging that for years they have paid too much for its chicken. Given chickens live approximately eight months before slaughter, it is unlikely any of them will see the resolution of this legal action.

All of this activity has emboldened a number of companies to re-invent the egg industry. Eat Just, mentioned earlier, started as a plant-based egg protein producer, and now is estimated to be valued at $2.0 billion. Other egg producers are focused on improved agricultural processes. Vital Farms, which recently went public and trades at over $1.0 billion market valuation, has developed high-end gourmet eggs as does Cooks Venture, which recently raised a $10.0 million Series A round. Confronting all of these innovative egg producers is the industrial scale of the incumbents and that the industry has meaningfully lowered the cost of eggs over time, likely making initial egg substitutes not cost competitive. Case in point: over the last five years, Tyson Foods has invested $215 million in production automation and computer vision to just track their chickens, counting them only after they have hatched.

One other quite unexpected source of protein may well be the elements found in air. Air Protein, which just raised a $32.0 million Series A led by Archer Daniels Midland, is also developing consumable protein products without requiring arable land. Evidently, when combining certain basic elements (oxygen, nitrogen, etc) with a proprietary probiotic mix, Air Protein is able to make a meat-like material.

Over the last few months there has been a cavalcade of large company (Unilever, General Mills, Kellogg, Danone) announcements of exciting development programs for meat and dairy substitute products. According to Euromonitor, the global market for meat substitute products will grow 28% through 2023 to be $23.8 billion. Unilever is quite excited about the potential of a microalgae called “chlorella vulgaris” which is apparently rich in nutrients – and likely a marketing executive’s biggest headache.

There is even a plant-based only meal delivery company called Sprinly – with over 31k followers on Instagram so you know it is a thing.

It is estimated that 8% of the world’s population is vegetarian, while only 5% are in the U.S. Given the claims that consuming plant-based foods lowers risk of death by 30% or that it reduces risk of death by heart disease by 40%, and that there are plenty of plants available, analysts suggest simply increasing the number of vegetarians may have a more dramatic and immediate impact on the goal of moving away from animal-based proteins. Certainly worth considering, especially when an estimated 13.9 million American children now suffer with food insecurity given the pandemic, per U.S. Census Bureau data.  

Interestingly, there will always be meat products that simply cannot be replaced, some of which also received some scrutiny recently. Most pork products are not offered by fast food restaurants other than for the popular McRib sandwich from McDonald’s. An analysis by Axios determined that the McRib is usually offered when pork prices are low – and yet it is now back after an eight year hiatus. In 2019, 200 million hogs were slaughtered in China due to African Swine Fever, leading to dramatic increases in pork prices that year. China is scrambling to re-stock its hog populations, now at 370 million, which may put significant upward pressure on the price of pork. Unless of course we can make some in a lab.

Data: FactSet, Axios research; Chart: Danielle Alberti/Axios

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Permission Granted to Make Healthcare Better…

In 2018 there were over 182 million prior authorizations conducted nationally according to the alliance of health plans called the Council for Affordable Quality Healthcare (CAQH). That same year, Health Affairs reported that $54 billion of medical spend was challenged by insurance companies. After that level of scrutiny and approval seeking, it is remarkable that so much spend is still disputed. Clearly the level of friction and frustration in the healthcare system is damaging to all involved and promises to be dramatically re-architected by innovative new technologies.

According to the political advocacy group America’s Health Insurance Plans (AHIP), less than 15% of all healthcare products and services even need prior authorization (PA). Of the 182 million interventions, only 23 million were fully automated; the balance either included some level of automation or were entirely manual. An analysis by the American Medical Association concluded that 73% of providers wait on average of at least one day for approvals (21% wait between 3 – 5 days). Tragically, 28% of providers reported at least one severe adverse event due to PA delays.

Overall, the CAQH estimates that $350 billion is spent annually on healthcare administrative costs, of which PA is around $25 billion. Nearly 20 years ago, it was mandated that PA needs to become more automated. The CAQH posits that $102 billion has been saved through (partial) automation of this administrative function and that there is another $13.3 billion of savings readily identifiable with further automation. Across the many PA steps, the significant contributors to potential cost savings due to increased automation include improved eligibility and benefit verification ($5.2 billion), claims status inquiry ($2.8 billion), and remittance advice ($2.7 billion).  It is believed that the healthcare system could save $42 for each patient encounter when PA is fully automated.

The impediments to automation are many from inconsistencies in data formats and codes, to the lack of integration of clinical and administrative operating systems, and quite simply, inferior software products in the market to address this problem. Additionally, there are long-standing regulatory requirements at the state level which mandate a certain level of manual intervention to ensure proper compliance, avoid diagnostic mistakes, etc.

While this investment in automation has been a priority for many, the chaotic patchwork nature of the U.S. healthcare system has made this utopian vision challenging to reach. Interestingly, the pandemic has brought renewed attention (maybe even institutional commitment) to address this issue. The Commonwealth Fund reported a nearly 60% decline in patient visits at the outset of the pandemic, which has slowly recovered to pre-COVID levels. Many health insurers “turned off” PA at the beginning of the pandemic, providing a glimpse of the possible.

This groundswell of support to “close gaps in automation” was reflected in the 2017 “Patients Over Paperwork” initiative put forth by Centers for Medicare and Medicaid Services (CMS), which set out to improve patient experience, lessen administrative burdens, and drive operating efficiencies. There have been some notable recent improvements such as streamlining office visit documentation, addressing evaluation coding frameworks, and overhauling the Medicare quality payment program. Most recently there have been indications coming from Office of Management and Budget that new rules will be promulgated to “improve electronic exchange of healthcare data and streamline prior authorization.” Tantalizing.

Inherent in this discussion is the tension between provider and payor. Doctors feel second-guessed and frustrated by the interminable disruptions with utilization management disguised as PA, while payors are focused on the amount of unnecessary procedures and amount of waste. Certainly, providers are leery of any actions which disrupt the continuity of care and often find step therapy frustratingly problematic, searching for lower cost alternative treatments.

The Institute of Medicine recently estimated that from 10% – 30% of healthcare expenditures are unnecessary, pointing to an estimated $200 – $800 billion spent each year on testing in an AHIP letter to Administrator Verma at CMS last year (almost an unbelievable figure). The debate between cost containment versus proper medical need rages on. This adversarial relationship is made worse by incentives for third-party outsourced providers who share in any savings found in recovery audits.

Overarching all of this is the undeterred march to value-based care delivery models and the need for greater simplicity and transparency. Setting aside the obvious patient benefits with greater transparency from radically improved PA, a more streamlined administrative process promises enhanced working capital for providers, and for the better providers, presumably greater patient volumes and market share. With better PA, payors will see a marked decline in member abrasion which presumably will lead to better member satisfaction and retention. Inevitably, health insurers should be able to design more appropriate narrow networks of providers offering higher quality care at lower costs.

In addition to a number of large legacy vendors such as Optum, Evicore, Magellan, and AIM Specialty Health, there have been a handful of exciting early stage companies created to address this market opportunity including Olive (which recently raised $255 million and acquired Verata Health for over $120 million) and Cohere Health, a Flare Capital portfolio company. Interestingly, this past week saw the proposed $28 billion combination of Salesforce with Slack, pointing to a future of deeper integration of collaboration tools for the enterprise. The industrial logic of this merger should play out in the healthcare sector.

The Cohere platform automates the collaboration process among specialists, payors, and patients, dramatically reducing the administrative burden while ensuring adherence to clinical guidelines. Such a science-based approach promises to meaningfully reduce wasted expense and eliminate unnecessary friction and delays in care. As Gary Gottlieb, Cohere’s Executive Chairman and Flare Capital Executive Partner, states “such an intensely transparent process takes everyone away from being the villain.” A data-driven focus on processes at the point of clinical decision will dramatically improve care at lower costs while improving patient and provider experience.

Siva Namasivayam, CEO of Cohere, observed that with better PA at point of care there will be a host of future benefits realized including a dramatic reduction in the number of denials, improved care coordination, more effective provider performance with greater level of data analytics and transparency, and significantly lower healthcare costs. Platforms such as what Cohere is bringing to market will facilitate the adoption (finally) of evidenced-based care bundles. Ultimately lower costs should also be reflected in lower premiums with much better experience ad outcomes for patients.

The healthcare world changed profoundly this year. The dramatic move to make the system virtual, on-demand in response to the pandemic also must now more effectively assess and “underwrite” procedures as spending and volumes quickly recover.

Reproduced from Peterson-KFF Health System Tracker; Chart: Axios Visuals

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Tired of Sleep Deprivation…

For over 30% of our lives, we are sound asleep. While we all need sleep, actually crave sleep, it is an enormously complicated and dynamic process and yet its biological purpose is not well-understood. Clearly there are restorative powers associated with a “good night” of sleep including the removal of metabolic wastes and the increase of brain’s supply of adenosine triphosphate (ATP). It is not just the brain that needs quality and recurring sleep but virtually all of the organs do to reduce risks from high blood pressure, cardiovascular disease, diabetes, depression, and obesity.

According to the National Institute of Neurological Disorder and Stroke, there are broadly two types of sleep (rapid eye movement (REM) and non-REM) which cycle between 4 – 6 times each evening, lasting around 90 minutes for each cycle. Non-REM sleep has three different stages which culminate with REM sleep, which is characterized by elevated brain activity, heart rate and breathing. It is also when one most often dreams. During REM sleep, one is effectively paralyzed which is believed to shield us from actually acting upon our dreams and hurting ourselves. The combination of the pandemic, the elections, and the economic crisis often leave many of us literally short of breath, further disrupting sleep. Interestingly, over the course of a typical day humans take approximately 25k breaths.

Obviously, sleep can be disrupted by a number of environmental and physiological stressors. Notably the Covid-19 pandemic has created a “sleep crisis” for many. Express Scripts reported that in the first month of the pandemic sleep medication prescriptions spiked by 14.8%. Obviously, the presidential election was an enormous contributor to many restless nights over the last few weeks. Oura, which sells the Oura Ring to track personal health data, reported that election night caused the loss of nearly 139 million hours of sleep across the country while increasing our collective heart rates by 1.4 beats/minute that night.

A recent Harris poll for the American Psychological Association (APA) reported that 68% of respondents said the 2020 election was a “significant source of stress.” Quite forebodingly, the APA also reported that the “grief cycle” tends to last at least six months, after which time, individuals start to exhibit more normal sleep patterns. This does not augur well for the nearly 74 million voters struggling with the election’s outcome. As we have now entered into this terribly confusing, disorienting lame duck period between the inauguration and an unlikely Trump concession, clinicians are reporting precipitous declines in worker productivity due to extended poor sleep.

In addition to impairing sleep, stressors also triggers more intense, more vivid dreams. In an effort to better understand the role of dreams, researchers at Cambridge University have created a DreamBank of 38k dreams that have been annotated and digitally curated. While this research is nascent, the goal is to develop better behavioral health diagnostic tools through “dream catcher” technologies. Early results suggest that men tend to have more aggressive, negative dreams. No surprise there. Disturbingly, one of the most common dreams is being attacked by bugs.

In addition to numerous academic studies, there are a handful of commercial initiatives to better understand – and treat – dream disorders. Nightware recently received De Novo FDA clearance for its Apple Watch and iPhone app to diagnose and treat nightmare disorders linked to post-traumatic stress disorders. The promise of such technologies is to address behavioral health conditions that might lead to suicide or other devastating outcomes.

There are several hundred apps, devices, and therapeutics to address issues confronted during the 70% of the time when we are awake, yet there are relatively few (credible) products focused on when we are asleep. Quite clearly the landscape is fundamentally changing in the face of the pandemic. Regulatory frameworks, reimbursement levels and consumer proclivity to use these types of products have meaningfully improved their commercial prospects. Juniper Research suggests that there will be 1.4 billion users of digital therapeutics and wellness apps alone by 2025.

For example, Pear Therapeutics recently released its Somryst prescription digital therapeutic for chronic insomnia. Using cognitive behavioral therapy for insomnia (CBTi) to retrain the brain to better embrace sleep, this product has demonstrated a 45% reduction in symptoms of chronic insomnia. Big Health, another exciting digital therapeutic company (which recently raised a large round of financing), has released its Sleepio product, armed with numerous clinical studies claiming to improve sleep by 76%.

In addition to this class of products, there are a number of traditional medical devices now in the market from mundane sleep monitoring wearables to sleep robots – true story. Somnox is now selling what is claimed to be the first “spoonable” sleep robot that helps regulate breathing and heart rate. Sounds intriguing. Perhaps a more appropriate device might be the headband from Ebb which distributes cooling fluids around one’s frontal cortex to reduce forehead temperature, presumably lowering brain activity. For a mere $500, one could purchase the UrgoNight headgear system which is to be worn just three times a week for 20 minutes at a time during the day to retrain the brain to increase the production of sleep-promoting brain waves. Wow, that sounds slick.

Of course, one could turn to more “traditional” sleep aids like psychedelics which are experiencing a (legal) renaissance as numerous states are now decriminalizing treatments like psilocybin (magic mushrooms) or 3,4-Methyl​enedioxy​methamphetamine (MDMA, the active ingredient in Ecstasy or “molly”). Since this spring, have been three IPOs of biotech companies repurposing psychoactive compounds to treat sleep disorders and depression for what is estimated to be several million Americans with “treatment resistant” conditions.

One very real step to improve sleep conditions for all of us being put forth by the American Academy of Sleep Medicine (AASM) is to get rid of Daylight Saving Time. The AASM argues that simply better aligning biological clocks to “social clocks” (people should wake up with the sun and prepare for sleep when the sun sets) will meaningfully improve everyone’s sleep. Hard to argue with that.

Not to be overlooked is the 2018 study by Mattress Advisor which determined that 58% of respondents slept naked. It is not at all clear if they slept better than those properly attired.

Enjoy your food-induced sleep coma this week…

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Digital Health: Sprinting to Year End…

Notwithstanding the election results tomorrow / next few days / next few weeks (God forbid), the investment activity in the healthcare technology sector will continue to power ahead. The pandemic and its assault on public health infrastructure and the healthcare system has exposed significant shortcomings, all to be solved by transforming the “busines of healthcare.”

In part a response to COVID-19, investors have poured $4.0 billion this past quarter into 97 digital health companies (per Rock Health), suggesting that this sector will likely see more than $12.0 billion invested in 400 companies for the year. Interestingly, the average round size in 3Q20 was $41.2 million, greater than the year-to-date average of $30.2 million, suggesting increasing investor enthusiasm as a number of emerging winners become clearer. Across all industries, venture capitalists invested $37.8 billion in 2,288 companies in 3Q20, implying that the digital health sector is now nearly 11% of all venture investment activity.

A MobiHealthNews analysis tabulated an even more robust $4.6 billion invested in 109 digital health companies in 3Q20. In addition to the obvious investor interest in telehealth and virtual care models, a number of other themes emerged this past quarter such as prescription management and on-demand pharmacies, remote monitoring, patient triage and advanced data analytics. Year-to-date MobiHealthNews identified 24 companies that raised rounds larger than $100 million which accounted for 41% of all dollars invested in the sector so far. The three most dominant themes in 2020 have been on-demand services ($2.0 billion, of which $1.6 billion was for telehealth), technologies to accelerate R&D programs ($1.3 billion), and the fitness/wellness sector ($1.3 billion).

Much of this investor interest has been reflected in the public stock market as well. According to SVB Leerink, the public “HC: Tech/Services” index has increased 44% over the last twelve months, dramatically outperforming the S&P 500 index which only gained 8%. Furthermore, valuation multiples for this sector are quite robust. At the end of 3Q20, the average Enterprise Value (EV)/Revenue multiples for 2020 and 2021 were 6.9x and 5.6x, respectively, while the average EV/EBITDA multiples were 15.0x and 13.9x, respectively. The average P/E multiples were 24.0x and 20.9x for 2020 and 2021, which according to a Barron’s analysis is still below the current S&P 500 Information Technology index P/E multiple of 27.0x.   

In addition to the promise of disruptive novel technologies creating valuable new venture-backed companies, the size of the healthcare technology markets are also quite seductive. Pitchbook recently sized just the health and wellness sector to be $640 billion, growing to $1.3 trillion by 2025. Additionally. the impact of the COVID-19 crisis has identified a number of new urgent priorities that policymakers, employers, and healthcare organizations will need to address, which should drive increased investment in this sector and further consolidation. Flare Capital has identified this as the “Response to Pandemic” phase of the healthcare technology sector.

In the wake of the $18.5 billion merger of Livongo and Teladoc, TripleTree flagged a number of specific M&A themes that have taken on greater prominence: improved risk and compliance solutions, enhanced payor technologies, greater attention on post-acute models, and improved risk-bearing primary care services. Two other themes were flagged: increased M&A activity by SPACs (see MultiPlan, Clover Health, Augmedix) and the continued engagement of corporate venture capital entities, currently participating in ~15% of all digital health financings.

Notwithstanding all of the investor excitement, it is quite clear that the entire healthcare system will not be virtualized. Even with COVID-19 cases surging now, the number of telehealth visits are declining as a percent of all visits. According to an analysis by The Commonwealth Fund, the incidence of telehealth visits has settled in at about 6% of all visits, which somewhat tempers the starry-eyed enthusiasm of uncapped upside to these solutions. Quite clearly while hospitals and doctors’ offices are still operating below pre-COVID levels, the role of traditional in-person care models will be quite enduring. In fact, the leading public medical real estate investment trusts (REITs) continue to trade in a relatively robust range of 18x – 22x operating income, suggesting quite a bright future still.  

Obviously, the next few days will be nerve-wracking, anxiety inducing, sleep depriving. I am glad that I do not wear a Whoop which would be firing all sorts of alerts (although it did just raise $100 million round which will be reflected in 4Q20 data), further elevating the stress levels. I may be enticed to purchase hologram machine from PORTL Hologram which just raised a seed round to build a machine to transport ourselves far away (of course, the first generation of their machines will just be our images). In any event, the volatility index (VIX) clearly is anticipating a very rocky period in the public markets. Any resemblance to my EKG chart is coincidental. Thank goodness it is not a flat line…

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Investor Amnesia in 3Q20 Sets Up Year-End Push…

Do you remember that the President was impeached earlier this year? Easy to forget amidst the pandemic, recession, stock market crash, then raging stock market bull, record low then record high unemployment, and a nasty presidential election. Head spinning. Through it all, the venture capital industry has shown extraordinary resilience with another terrific quarter – $37.8 billion invested in 2,288 companies.

Confoundingly, 3Q20 saw a strong, yet incomplete, financial resurgence alongside a staggering resurgence in COVID-19 cases; three days ago we saw an all-time daily high in cases. As cases surged over the last few months, the S&P 500 index increased 7.9% in 3Q20, while the NASDAQ was up 9.2%. U.S. large cap stock funds powered ahead 11.8%. On the heels of unprecedented job losses this spring, the unemployment rate is steadily improving – although too slowly for many and still miles from where we were pre-COVID.

According to National Venture Capital Association (NVCA) data, $112.3 billion has been invested in 7,891 companies year-to-date. One might have expected a pause this summer, but that did not happen. While the deal count is decreasing, the amount of capital invested continues to be quite robust. The size of the average investment in 2020 so far is $16.5 million, well ahead of the $11.7 million this time last year. Quite clearly, there is a greater proportion of Later stage deals and a greater number of large financings this year, perhaps signaling further concentration around fewer companies as well as a greater degree of risk aversion among VCs who may be shifting attention to more mature businesses. The number of financings greater than $50 million in size so far this year was 6% of the total count yet accounted for 63% of all dollars invested.

This quarter saw the continued collapse in seed investments, both in numbers and dollars. There were 469 seed deals, nearly half as many just two years ago, and a more modest $2.0 billion invested (average size of $4.3 million). Interestingly, angel investment activity remained relatively consistent over the past five years with between 500 – 600 deals per quarter. Early stage also continued the steady decline in activity first seen in early 2019. This past quarter $9.2 billion was invested in 657 Early stage companies for an average round size of $14.0 million. Later stage also saw a marked decline in the number of deals, decreasing to 662 in 3Q20. The quarterly pace was between 750 – 850 over the last six quarters. The amount invested in Later stage companies was $26.6 billion for an average deal size of $40.1 million.

The story in 3Q20 centers mostly around the number of “mega rounds” of greater than $100 million in size. The chart below shows the median round size by stage, highlighting the impact of a few large financings when only focusing on average round size (above). There were 79 “mega round” financings this past quarter, totaling $17.7 billion; strangely ten of these were considered Early stage. Companies raising such large rounds tend to be meaningfully de-risked and are now scaling, maybe (again) suggesting less risk tolerance among venture investors. To underscore this development, there were only 542 first-time financings this quarter, which is the lowest level in a over a decade.

There were a handful of other interesting insights in the 3Q20 data. Year-to-date $63.7 billion has been invested in West Coast companies, which is more than the rest of the country combined. While the dollars are more concentrated in fewer geographies, the number of companies appear to be more distributed, perhaps in response to the pandemic. So far this year, only 38% of companies raising venture capital are on the West Coast. The top three states (California, New York, Massachusetts) represented 75% of the capital invested but only 53% of the number of companies.

One other observation in the funding data worth highlighting: the level of participation by corporate venture capital groups continued its sharp decline and was only 17.6% in 3Q20, a level not seen in nearly a decade. This participation rate tends to be between 20 – 25% of all financings. Such a pull-back may be a direct result of the financial pain inflicted by the pandemic.

Arguably, the strong investment activity this past quarter was bolstered by the exceptional level of exits, driven by a very robust IPO market. The $103.9 billion of exits in 3Q20 was the second-best quarter, nearly 4x the prior quarter and only below the high-water mark of the “Uber IPO quarter” of 2Q19 ($144.8 billion). More typical quarterly exit activity for venture-backed companies tends to be between $20 – $30 billion. Globally, M&A activity surged 80% in 3Q20 while in the U.S. merger activity increased 23.5% quarter-over-quarter.

Exit activity is best considered alongside private round valuations. Median valuations have steadily increased by stage over the course of the last decade and saw no appreciable COVID impact. In fact, given the impact of “mega rounds,” the average Later stage round valuation was $672 million (versus median valuation of $90 million). Median Early stage round valuation of $30 million year-to-date is modestly higher than $28.1 million in 2019, underscoring the significant step-up in valuations available to companies once important milestones are achieved. Given average round sizes, these data also imply that investors tend to end up owning roughly one-third of Early stage companies.

In a period of extraordinarily low interest rates, returns generated by venture capital funds both on a relative and absolute basis continue to be very compelling. Since 2011, according to NVCA data, the venture capital industry has generated net cash distributions each year through 2019 and is expected to do so again in 2020 given the level of exit activity. This dynamic likely accounts for the strong fundraising environment many established firms now enjoy.

Eighty funds raised $13.9 billion in 3Q20, averaging $173 million per fund; this level already exceeds all of 2019. For the year so far, venture capitalists have raised $56.6 billion across 228 funds. Notably, 35 of these funds were larger than $500 million, furthering the concentration of capital with a relatively small number of tenured branded firms. Year-to-date, there have been 30 “first time” funds which have raised $19 billion; in 3Q20 only 16 “first time” funds raised $390 million ($24 million average size).

Separate but related, this past quarter saw the explosion of Special Purpose Acquisition Companies (SPAC), blank check public shell companies that have a limited window to close an acquisition, often of mature venture-backed companies. There are now 185 such vehicles with $58 billion of capital trolling around the market looking for assets to acquire. While in recent weeks there is evidence of waning public investor appetite as a number of pending SPACs have been downsized, this is undeniably an important development in the venture industry, offering yet another potential path to liquidity.

Of course, there are a number of other significant issues weighing heavily on 4Q20 activity. According to the U.S. Treasury, the national debt now stands at a daunting $27.1 trillion which tends to put everything else in sharp focus. Unfortunately debt isn’t what it used to be. According to Blackstone, debt incurred today has much less of an impact on GDP growth than it did decades ago.

And then there is the pandemic, elections, elevated unemployment levels, tensions with China…oh wait, all of those have existed for some time now. Let the good times roll.

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Pandemic Further Exposes Systemic Racism…

This will be ugly and sad. Racism has cost this country $16 trillion over the last twenty years according to a recent Citigroup report. Much of this loss ($13 trillion) was attributed to discriminatory lending practices and the 6.1 million fewer jobs created as a result, while disparity in wages ($2.7 trillion) and discrimination in housing policies and lost income due to restricted access to higher education accounted for the balance. The report estimates that if these gaps were to be closed, an incremental $5 trillion can be added to U.S. GDP over the next five years alone. Obviously, this does not even begin to account for the extraordinary pain and suffering racism inflicts on our country, much less the dramatic implications to the health and wellbeing for those impacted by racism.

The dramatic increase in unemployment since the onset of COVID-19 has garnered significant attention. While the overall unemployment rate of 7.9% in September is down from the pandemic-high of 14.7% in April, this improvement masks the dramatic discrepancies in rates for minorities; according to U.S. Bureau of Labor Statistics, white Americans are 7.0% unemployed while the Black unemployment rate is 12.1%. Somewhat jarring, last week Columbia University published an analysis showing that eight million more people are now living in poverty just since the expiration of Cares Act three months ago, disproportionally hitting minorities.

The story is even more dire when looking at the “True Rate of Unemployment” as defined by the Ludwig Institute for Shared Economic Prosperity which presumes that one needs to earn a minimum living wage of $20,000 to be deemed employed. Under such a definition, Black unemployment is 30.4%, although an improvement from what was seen for the ten years after the Great Recession of 2008.

Data: Ludwig Institute for Shared Economic Prosperity; Chart: Axios Visuals

It is estimated that 100.6 million Americans are out of the labor force now, many of whom are from disadvantaged segments of the population. In fact, for those earning more than $60,000 annually, the unemployment rate is a mere 1.0% below where it stood at the onset of the pandemic. For those who make less than $20 per hour (equivalent to salary of approximately $27,000), the unemployment rate is 17.5% below where it was in February 2020 according to Opportunity Insights. Shockingly, America’s billionaires net worth has increased more than $850 billion since April.

The difference in life expectancy between white and Black Americans is criminally high – nearly five years, even when adjusted for gender, according to Centers for Disease Control and Prevention (CDC) data. While the underlying causes are complex and fraught with political overtones, this issue is now front and center as the country struggles with the pandemic.

Sutter Health recently published COVID-19 data that attributed the 2.7x increase in hospitalization rates in their hospitals for Black patients versus white patients to, in part, more advanced illness at the time of admission, arguably reflecting a cultural aversion to the healthcare system or challenges around adequate access. CDC data are even worse, tabulating a 5.0x higher rate of hospitalization, 2.3x greater mortality rate, and 3.0x greater infection rate for Black versus white Americans, respectively.  This is particularly troublesome now with case counts spiking 17% just this past week and as winter sets in.

Life Expectancy

The Kaiser Family Foundation (KFF) forecasts that Medicaid roles will increase by 8.4% in 2021; in June there were 67.9 million Medicaid beneficiaries. It is quite clear that the pandemic is hitting minority and less educated segments of the population harder, often because they tend to be front-line essential workers and/or struggle with greater levels of unemployment. McKinsey recently estimated that as many as 10 million Americans will lose employer-sponsored health insurance due to COVID-19 by the end of 2021.

KFF also highlights the discrepancies in private health insurance rates by race: in 2018, white, Black, and Hispanic uninsured rates were 7.5%, 11.5% and 19.0%, respectively, which further exacerbates difficulties for minorities to access effective healthcare. The Affordable Care Act had a dramatic impact over the past decade as uninsured rates in 2010 were 13.1%, 19. 9% and 32.6%, respectively. This year the average family health insurance premium rose by 4% to more than $21,000.

While there is a heightened level of concern about the pace of coronavirus vaccine development, and whether there will be inappropriate political pressures applied to compromise long-cherished safety protocols, the Black community is expressing a particularly high level of skepticism. According to another KFF study, just under 50% of Black respondents would not take a free and safe vaccine, while only 17% would “definitely” do so. While further underscoring long-held distrust of the healthcare system, this phenomenon risks perpetuating the relatively poor health conditions experienced in many of those communities.

Recognizing this and the other numerous challenges introduced by the pandemic, the Healthcare Anchor Network (HAN) of 39 provider systems (many of whom are Flare Capital LPs) reiterated in September that racism is a public health crisis, putting forth a number of steps to chip away at these issues. First and foremost was a commitment to dramatically improve access to testing in underserved communities, as well as more robust inclusive hiring practices and greater spending with diverse suppliers and vendors. 

Importantly, the HAN spotlighted that systemic racism uncouples the public health infrastructure from the private healthcare system, often leading to “generational trauma and poverty.” A profound characterization. A recent Wall Street Journal analysis of CDC data showed a strong link between racism and mental health: in the week following the murder of George Floyd in May, 40.5% of Black adults exhibited symptoms of anxiety and depression (a five point increase from the week just prior). While somewhat similar to post-traumatic stress disorders, racism is chronic and on-going much like an injury and should not be considered a disorder. Clinicians have now developed a “Race-Based Traumatic Stress Symptom” scale when evaluating minority patients.

Advances in healthcare technology hold profound promise to improve the health and wellbeing of those most afflicted by racism, particularly during such difficult economic times. According to a provocative analysis by McKinsey (below), many of the most seminal transformative reforms in healthcare have come on the heels of major recessions. Arguably, what has been unleashed on the U.S. economy by COVID-19 may lead to a dramatic restructuring of the healthcare industry, which could usher in a wave of significant innovation to improve conditions for those most disadvantaged.

Entrepreneurship has been one of the great elixirs in the face of such devastating economic conditions and is often looked upon as one approach to reduce economic disparities due to racism. Here, unfortunately, the record is mixed. Given how critical access to capital is, the evidence that racial discrimination compromised many minority groups from accessing emergency funding programs like the Payroll Protection Program (PPP) this past spring is particularly painful. According to the Center for Responsible Lending, 46% of white-owned businesses had accessed bank credit over the past five years (compared to less than 25% for Black-owned businesses) which meaningfully facilitated their ability to secure PPP loans from those same institutions.

Furthermore, a 2016 Federal Reserve Bank study found that only 40% of minority credit applicants secure the full requested amounts of credit when applying as compared to 68% for white-owned applicants. Consistently minority-owned companies pay higher interest rates and have more onerous borrowing terms according to the Department of Commerce’s Minority Business Development Agency. The financial landscape confronting Black-owned businesses is materially more hostile than what white-owned businesses face. Full stop.

Source: Federal Reserve Bank of Atlanta

Rock Health, a leading seed stage healthcare technology investor (and partner of Flare Capital), recently conducted an extensive diversity survey. These sober findings further highlight the issues around access to capital for minority entrepreneurs. White and Asian founders were nearly twice as likely to backed by venture capitalists; 48% of Black founders bootstrapped their companies versus 25% of white founders. Of the nearly 250 founder respondents in the survey, 12% identified as Black but only a disappointing 5% of the 425 senior executives in those companies were Black. Just over 80% of Black respondents felt that the digital health sector was either the same or less inclusive from when they initially joined the industry. Obviously, much work is still to be done.

These issues are not at all lost on my partners and our firm. Since we started Flare Capital over six years ago, we have been committed to diversity and inclusion. In addition to simply being the right thing to do, it is the best thing for our business. We will make better investment decisions with a broadly diverse set of perspectives and experiences. 

But as inclusive as we felt we were, it is time to do even better. There are systemic causes to these inequities in our industry that we can help address. Over the last four months we developed a set of new initiatives (summarized below) that we implemented earlier this summer. In summary, we identified two broad dimensions that we are committed to improving upon: more equitable access and accelerated career development. Structural challenges exist for many underrepresented entrepreneurs to meet with venture capital firms, much less successfully raise capital. These are fundamental problems that require deliberate, measurable steps from engaging with more diverse founding teams, recruiting more diverse management teams, and partnering with venture firms equally committed to diversity.  

BIPOC = Black, Indigenous, People of Color

We recognize that it will take time and significant effort to address these inequities, and that success will be built, in part, upon many small victories. Arguably, Black Lives Matter is the largest movement in our country’s history. The New York Times recently estimated that between 15 to 26 million Americans likely participated in demonstrations since the death of George Floyd in late May. We are proud to be a part of that movement.

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Need Eyes on Our Kids…

There were a staggering 7.8 million children across 4.3 million child abuse and neglect cases referred to Child Protective Services in the U.S. in 2018. Of those cases, 2.4 million were deemed serious enough to require intervention. The Centers for Disease Control and Pevention (CDC) estimated that in 2018 over 678k children were “victimized.” What role can technology play to address this vicious scourge of society, further exacerbated by the pandemic with so many children hidden in the shadows, not in school? Clearly, better analytics and monitoring solutions should improve public healthcare infrastructure’s abilities to fight this type of abuse.

In the very earliest days of the pandemic, before the scope was fully appreciated, school closures in the early spring were thought to be temporary; a significant inconvenience for many, but manageable. The scramble to virtual curricula was challenging, and nearly always a very poor replacement for the in-person classroom experience. By April, though, it became apparent that this impact was going to be meaningfully more devastating with disruption to regular meals, social interactions, and most critically, separation from a social infrastructure of teachers, care givers and other trained professionals.

What a terrible tradeoff: open the schools and risk widespread COVID exposure or keep them closed and introduce a host of other risks. A recent analysis by The 74 Million, a leading non-partisan news site covering the education sector, in partnership with the Organization for Economic Cooperation and Development, found that the long-term economic impact in the U.S. tied directly to school closures to be nearly $14.2 trillion over the rest of this century. Should schools be closed throughout this fall, the cost will increase by another $28 trillion.

What is not fully understood is the incidence of child abuse during the pandemic. Initially, the number of reported abuse cases dropped dramatically. In New York City alone, case count dropped 51% through the summer; California and Texas dropped 45% and 30%, respectively. But while the number of reported cases dropped, the number of actual cases admitted to hospitals remained largely unchanged, a pattern eerily reminiscent of 2008 during the Great Recession. Without the ability of other adults to monitor children, the pandemic has pushed the abuse out of the purview of trained professionals. This week Mayor de Blasio announced a delay to New York City school re-openings and is instituting a “blended learning model” for the 1.1 million school children, 114k of whom are homeless.

What is absolutely understood is the profound emotional and financial costs of child abuse. Often caused by parental stresses, financial pressures, and substance abuse behavior, the CDC considers child abuse (and other domestic violence) “preventable” – really? More than 67% of abuse referrals are made by community professionals such as teachers, law enforcement and social services staff; teachers alone account for over 20% of all referrals. That essential window for many children is now closed.

Importantly, while 83% of abusers are between the ages of 18-44, more relevant is that for 78% of cases, the perpetrators are one of the victim’s parents. Women account for 54% of all abusers. Experts are now most worried about “opportunity crimes” with newly unemployed relatives or quarantining college kids back in homes with housebound children who otherwise would be in school.

The CDC tabulated that the economic costs of child abuse in 2015 (most recent year) to be $428 billion of “lifetime economic burden.” Setting aside the staggering direct financial costs, the other costs from future violence, increase in substance user disorders, lower education and employment levels, and greater likelihood of future victimization are immeassurable. In 2018, over nine per 1,000 children were victimzed; one in five reported being bullied in school while one in seven were “electronically” bullied on social media. Tragically, 1,770 children died of abuse in 2018; 47% of whom were younger than onen year old.

The pandemic has had other devastating implications for child welfare. The last 20 years has seen significant improvement in the reduction of childhood mortality rates (from mid-70 per 1,000 to the mid-30s per 1,000). According to the global health organization PATH, this progress has been jeopardized by the pandemic, principally by the inability for children to access reliable healthcare services. In models that assume the most “severe disruption” the progress has been set back a decade.

Data: PATH estimates from disrupted maternal, newborn and child health services, drawing on modeling from Lancet Global Health; Chart: Axios Visuals

In addition to losing regular connection with many children who are now homebound, there is a staggering incidence of food insecurity. The U.S. Census Bureau estimates that 13.9 million children now suffer from food insecurity, an unprecedented level when compared to 2.5 million in 2018 or 5.1 million during the Great Recession in 2008. In June alone, it is estimated that one in three Black children did not have sufficient food access. Perversely, the Trump administration this month made eligiblity requirements more stringent for low-income students to access meals will not in school.

Technology has a role to play here. As much of healthcare delivery has gone virtual during the pandemic, the ability to be connected with children in-home remotely via Zoom and Facetime has afforded the potential for new insights into what children may be suffering, not unlike what is being experienced with elder care. Obviously, inadequate wireless infrastructure and poor access to devices disproportionately affects low income students. In spite of that, novel behavioral health platforms are being deployed to assist families deemed at-risk. Anecdotally, typical no-show rates for medical appointments dropped from ~30% to low single digits with the advent of virtual visits.

Dr. Christopher Greeley, a leading national expert on child abuse at Baylor College of Medicine (and my brother), points to the emergence of better predictive risk modeling in the field of child welfare. Such an approach allows clinicians and policy makers to identify circumstances that create clusters of common characteristics most associated with child abuse. Determining the “gradient of health” in a certain census tract  facilitates the deployment of resources (i.e., child care centers) into a particular community. Big data analytics allows for the creation of a “Social Vulnerability Index” to determine how best to prioritize resources. This summer the Office of the Inspector General issued guidance to CMS to utilize Medicaid data to better identify patterns of child abuse, acknowledging the potential of these new analytical tools.

Of course, the proliferation of virtual visits and improved analytics does not solve the “last mile” issues, forever chronic with social services. In addition to enhanced public engagement and education campaigns, there needs to be a strong legislative approach. For instance, corporal punishment of children needs to be more aggressively persecuted. Tax policy can play an important role as well. CDC studies have shown that child tax credits can meaningfully move families with children out of poverty: a $1,000 tax credit can lower childhood poverty rates from 26% to 23%; a $4,000 tax credit can lower it to below 15%.

In addition to the various (often inadequate) public safety nets in place, ordinarily families would look to the private childcare industry for assistance. Barron’s recently estimated that school closings may cost the economy up to $700 billion in lost revenue and productivity this year which is approximately 3.5% of GDP. Analysts at the Center for America Progress estimate that roughly half of day care centers will fail which would reduce capacity by 4.5 million slots, leaving 4.2 children for each available slot. The day care industry received $3.5 billion of aid from the CARES Act and only 25% of childcare operators received Paycheck Protection Program loans. Even the private backstops are significantly compromised during COVID.

With everything that we are struggling with today, one thing we absolutely should not have to worry about are ridiculous QAnon conspiracy theories that leading Democratic figures are consuming children for their “Adrenochrome,” a magical psychedelic drug in their blood. There are simply too many real-world problems our children face.

#SaveTheChildren

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Staggering to the Halfway Mark…

Well, that sucks.

2Q20 GDP

In the face of unprecedented economic devastation, investors were expecting a very challenging 2Q20. Au contraire. Domestic equities crushed it: the Russell 3000 Growth and Russell 3000 Value were up 28% and 15%, respectively – admittedly on the heels of a dramatic 1Q20 downdraft. The broad U.S. bond market unexpectedly increased 2.9%. Price of gold increased 12.5%. According to Refinitiv, through 1H20, venture capital performance was up 26%. Does this mask deeper concerns?

Venture investors for the first time this past quarter invested more in Later Stage than Early Stage deals, highlighting the desire to invest in what is familiar and arguably more “de-risked.” Similarly, VCs invested in more follow-on opportunities than first time financings. Notably, 37.5% of Early Stage investments in 1H20 were greater than $10.0 million, which was also a highwater mark. In fact, 15.0% of Early Stage investments were greater than $25.0 million which is somewhat oxymoronic.

2Q20 VC Activity

Given that the first part of 2Q20 was spent triaging existing portfolios, not unexpectedly the level of venture capital activity was down across all stages. According to Pitchbook and the National Venture Capital Association, the number of deals declined by 23.2% to 2,197 with $34.3 billion invested, which is still a robust pace, in large measure due to the prevalence of “mega” financings. In 2Q20, there were 57 venture rounds greater than $100.0 million.

Round size is closely watched by industry analysts. When economic times are good and capital is plentiful, round sizes tend to drift upwards as investors are flush and entrepreneurs are eager to exploit new market opportunities. Year-to-date median round sizes have stayed consistent with 2019 levels – Early Stage at $6.0 million and $8.8 million for Later Stage in 2020.

A potential warning sign involves the level of venture-backed exit activity which was at a decade quarterly low of $21.2 billion across 147 transactions. At $45.3 billion year-to-date, the venture industry is on pace to have the lowest level of exit activity in the past five years. Of greater importance are the valuations realized upon exit which remained reasonably strong: the median acquisition, buyout and IPO valuations were $82.5 million, $120.0 million, and $636.0 million, respectively. According to Pitchbook, the number of U.S. M&A transactions in 2Q20 declined 24% while the overall transaction values dropped 41% when compared to 1Q20. Capital efficiency becomes even more critical to generating compelling returns when M&A outcomes are below $100 million.

Significantly, 2019 was the first year in the last decade when limited partner contributions to the venture capital was greater than distributions made by venture capital funds. The robust exit environment and strong returns over the last handful of years facilitated the raising of larger and larger venture funds. In 2Q20, there were 148 funds which raised $42.7 billion. Year-to-date there were 24 funds raised by established firms that were greater than $500 million causing the average fund size in 2020 to be slightly larger than $300 million (median fund size is $101 million year-to-date).

The theme of concentration, be it around fewer established venture firms or fewer Later Stage companies, is echoed in the global data as well. Preqin tabulates that $61.3 billion was raised by 292 firms in 1H20 which is 35% fewer firms than in 1H19. Globally, $112 billion was invested in 6,379 deals, which while a modest 2% decline in invested capital, it is a 20% reduction in the number of companies. In 1H20, 31% fewer private equity firms (552 firms) raised $259 billion, which was only 4% less than was raised in 1H19.

Analysts estimate that there is approximately $120 billion of “dry powder” managed by U.S. venture capital firms. Much of this capacity is a function of recent venture capital performance, particularly when compared with private equity which was quite exposed to the early 2020 downdraft. According to Refinitiv, through 1H20 venture capital performance was up 26% while private equity was down 11%. Venture capital benefited from the strong performance from the healthcare and technology sectors during the early days of the pandemic. Interestingly, Preqin estimates that there is $1.45 trillion of private equity “dry powder” globally but that approximately 85% of it is held by funds raised between 2017 – 2019, which would not be able to bail out older struggling leveraged portfolio companies – expect the number of busted LBOs to spike.

The economic uncertainties in 2Q20 caused more than 40% of the companies in the S&P 500 Index to withdraw full-year earnings guidance. Corporate earnings in 2Q20 are estimated to have decreased 44% which would be the largest quarterly decline since 4Q08 (69% decrease) which was the depths of the Great Recession. In 1Q20 net profit margin for the S&P 500 Index was 7.1% which is meaningfully below the five-year average of 10.6% and the lowest since 4Q09 according to FactSet. Paradoxically, in the face of falling (collapsing?) earnings the public equity markets keep surging.

2Q20 Real GDP

While the merits of causing such deliberate economic devastation at the pandemic outset might be debated, it is instructive to look at other parts of the world, specifically China, to see how the approach to dramatically locking down the “hot zone” around greater Wuhan to arrest the spread of COVID-19 allowed the economy to recover more swiftly. In 2Q20, China’s GDP rose 3.2% year-over-year, after “only” decreasing by 6.8% in 1Q20. SMH…shaking my head.

All things considered, U.S. IPO activity in 2Q20 was reasonably strong with 62 offerings that raised $18.5 billion, which was an increase of $8.7 billion from 1Q20 but $14.2 billion lower than the 2Q19 level. In June 2020 alone, there were 28 IPOs that raised $13.5 billion, pointing to a strengthening market heading into the summer. Much of this activity was driven by the explosion in SPACs (Special Purpose Acquisition Company) or “blank check” companies.

According to SPACInsider, there were 48 SPACs which raised $18.6 billion in 2020, which easily beats the $13.6 billion raised in all of 2019. In 2Q20, there were 24 SPAC IPOs which raised $7.2 billion or nearly 40% of all IPO proceeds. Of the 318 SPACs ever created, there are now at least 108 with $40 billion per Barron’s trolling around for something to acquire (recall that SPACs have a pre-determined amount of time to close an acquisition or they are liquidated). In 2020, the average SPAC IPO was $400 million in size.

Of course, financial alchemy in the pursuit of investment returns often turns out poorly, and now it is further complicated by a pandemic, recession, and disruptive national election cycle. Through 2Q20, the number of corporate defaults globally equated to the entirety of 2019. So, while investors seem cautiously enthusiastic about the “recovery” since 1Q20, there are a number of flashing warning lights, not least of which how quickly it all can be reversed as witnessed in March 2020.

2Q20 Defaults

Source: S&P Global.

 

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Digital Health: What the Heck is Going on Heading into 3Q20…

Understandably the headlines this past quarter have been consumed by pandemic updates or the financial crisis, both inextricably linked. On April 1, there were sadly 3,746 deaths in the U.S.; on June 30, there were 119,761. Heading into the second quarter, analysts expected a wave of bankruptcies unlike anything seen before, and surprisingly, that did not occur – yet. While the default rate on high yield bonds was estimated to be 5% at the end of 2Q20 (up from 2.3% a year ago), the level of Federal Reserve intervention allowed the capital markets to function relatively well. And in the background the digital health sector recorded a terrific quarter, keeping the sector on pace for 2020 to be a record year for new investment.

It is worth pausing for a moment to put the level of intervention into some context as it will inform how the remainder of the year may play out. Just over $1.02 trillion of debt was issued by Corporate America in 1H20, more than double any previous first-half year ever before according to Dealogic. And while S&P Global Ratings projects default rates to be 12.5% by March 2021, with a range of 6.0% – 15.5% (upside to downside cases), it certainly appears that for much of the rest of this year access to capital will not be as dire as was feared this spring. According to Epiq, over 3,600 companies filed for bankruptcy in 1H20. More than 180 companies in the S&P 500 Index have withdrawn guidance for earnings.

Of course, the pandemic (and perhaps the distraction of the election) will dictate how quickly healthcare technology companies will scale and how predictably they will be able to raise funds. Even in light of the devastating progression of Covid, according to Rock Health nearly 100 healthcare technology companies raised approximately $2.4 billion in 2Q20; five of those financings were more than $100 million in size. For 1H20, this sector saw $5.4 billion invested, putting it on pace to likely be more than $10 billion for the year. While this would be a high-water mark, it also reverses the trend where 2019 was slightly lower than the activity of 2018.

2Q20 Rock Health Funding

One potential telltale sign to assess the balance of the year and how venture investors have recalibrated to an all-virtual investment model is the 2Q20 monthly activity. In April, as the shock / heartbreak / interruption of the pandemic set in, investment activity was only $500 million; by May it spiked to nearly $1.1 billion, but notably had dropped to $800 million in June. Arguably, 2Q20 was a time when investors shored up existing portfolio companies and closed on “in-process” new investments. Tough decisions were made as to appropriate reserve assumptions for existing portfolio companies. By the end of 2Q20, most venture firms were making new investment decisions based largely on Zoom interactions – expect there to be some moderation in activity as everyone gets adjusted to the new “abnormal.”

Obviously, there were some powerful tailwinds that developed last quarter: Centers for Medicare & Medicaid Services (CMS) expanded reimbursement, the reduction (hopefully to be permanent) of state licensure barriers, and the lock-down requiring dramatic adoption of virtual on-demand care. Consumers and employers are scrambling to utilize novel modalities to engage with providers.

While the dramatic reduction of service revenues for providers will undoubtedly compromise technology budgets, there is a market momentum that traditional care delivery models must change in response to current conditions. A Morgan Stanley CIO survey this quarter flagged that should the economic conditions worsen, AI, machine learning and process automation initiatives will be eliminated first. A recent American Hospital Association report estimates the four-month total through June 30 for lost revenues to be $202.6 billion. Research analysts at The Chartis Center for Rural Health estimates over 450 of the 2,000 rural hospitals in America are now at risk of closing. Tragically, this past week only 14% of adult ICU beds were available in Florida given the resurgence of Covid cases due to idiotic state re-opening pressures.

Florida Cases

Rock Health identified 52 M&A transactions of healthcare technology companies, and while slightly lower than the 2019 pace, it still suggests a robust appetite for these innovative solutions. This is particularly notable in light of overall M&A activity which declined more than 50% globally and was down a staggering 90% in the U.S. according to Refinitiv.  MobiHealthNews tracked 34 M&A transactions in the healthcare technology sector in 1H20, 23 of which were in 2Q20 for an announced transaction value of $1.2 billion (only 5 disclosed purchase prices so not a terribly useful number). There is likely to be increased consolidation given the large number of start-ups created in the healthcare technology sector as emerging winners become more evident. Additionally, given the investment surge in 2018 and 2019, many of those companies will need to raise capital over the next 12-18 months, leading some to decide to sell.

The Rock Health Digital Health Index of public stocks increased 30% in 1H20 as compared to Leerink’s Healthcare Tech/Service Public Company Index which was only ahead 0.6% for the year, but was up a robust 32% in 2Q20 (although relatively flat in June with an increase of 1.8%). Market valuations have been reasonably resilient as well. The Leerink index trades at 5.7x and 4.7x revenues for 2020 and 2021, respectively. According to FactSet, 2Q20 revenues and earnings for the S&P 500 Index are projected to decline 11.5% and 43.5%, respectively, which would be the greatest year-over-year decline since the onset of the Great Recession in 4Q08. The healthcare sector earnings are only expected to decline about 10% in 2Q20.

S&P 2Q20 EPS

To underscore the relatively healthy state of the healthcare technology sector, it is informative to look at the job losses and subsequent re-hiring. According to Bureau of Labor Statistics data, there were 43k lost healthcare jobs in March; that number spiked to 1.4 million in April, but May and June saw significant recoveries of 315k and 358k jobs, respectively. Overall, there are 15.6 million U.S. healthcare workers today which implies that net job loss (so far) during the pandemic is approximately 5%.

One other item: the Paycheck Protection Program (PPP), which over two installments is nearly $670 billion in size (~$130 billion has yet to be distributed), extended loans to 265 healthcare technology companies. While the disclosure requirements established by the Department of Treasury make it virtually impossible to tally the total amounts, only four companies took between $5 – $10 million, 15 took between $2 – $5 million, and 43 took between $1 – $2 million, suggesting a relatively modest amount of PPP loans went to this sector. To put that into context, Pitchbook calculates that over 8,100 privately funded companies took $13.4 billion in PPP loans so far.

While a 3Q20 event, Walgreens’ bold $1.0 billion investment in VillageMD underscores the profound role innovative healthcare technology and tech-enabled models will play in transforming the business of healthcare. That is not lost on venture investors, and more importantly, great entrepreneurs who look at the nearly $4.0 trillion of medical expenditures (per CMS estimates) that must be improved upon. Expect continued strength in funding and the consistent creation of important valuable new companies.

This is thankfully nothing like the recent history in the energy sector, which is forecasting 2Q20 earnings to be down more than 105%. Oil prices started the year at more than $60 per barrel, dropping below $0 per barrel (!), before ending 2Q20 at $40 – an increase of 92% in the quarter. Head-spinning…

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