Bolus of Capital…Hard to Swallow?

It has been exactly seven years to the week that the American Recovery and Reinvestment Act was signed into law, committing the federal government to invest $787 billion (later “bumped” up to $831 billion) across a range of economic stimulus measures. Nearly $150 billion was directed toward healthcare, of which $36 billion was budgeted as cash outlays for Medicare and Medicaid incentives to deploy health information technologies; as of January 2015, $29 billion of that had been deployed. What has been the impact from all of that investment?

Arguably, as has been shown over many generations, the period after significant government investment in critical infrastructure (railroads, highway systems, airports, broadband), profound waves of innovative products and services were unleashed. Now that EMR penetration is nearly ubiquitous, a number of new value-added solutions are being introduced to drive greater utility from this significant infrastructure investment. In fact, we are already entering a comprehensive upgrade and replacement cycle of early EMR deployments, a sign of market maturation.

Stepped up investment and regulatory reforms have contributed to business model innovation as well as creative partnerships and acquisitions between technology vendors and healthcare companies in every corner of the healthcare industry. The recently announced acquisition of Truven Health Analytics by IBM for $2.6 billion is enormously validating. Another example of the forces of change at work would be the accelerating consolidation of Managed Care companies, which is generating significant pressure on drug discovery and distribution companies, leading to fascinating PBM consolidation. The ripples spread far and wide.

This is not lost on many entrepreneurs who seek to exploit this recently installed digital infrastructure. Attendance last year at the Healthcare Information and Management Systems Society (HIMMS) annual conference was 43,129, which was up meaningfully from the 35,065 attendees just two years before (interestingly, last year 44% identified themselves as being from a “Provider” and 31% declared that they were from the “C-Suite”). A more powerful barometer of healthcare technology’s importance is the amount of venture capital invested in the sector. The three most commonly cited sources tabulated a 2015 range from $4.3 – $5.8 billion:

  • Rock Health – $4.3 billion which was essentially flat from 2014
  • StartUp Health – $5.8 billion which was a decrease from the $7.0 billion in 2014
  • CB Insights – $5.8 billion (see below)

Digital Health Funding

At a time when there are 500 million primary care visits each year, and yet across all telehealth providers there might just be 2 million telehealth interactions, the role of technology is only just beginning to be felt. According to Berg Insights, only 5 million people globally are monitored remotely and yet there are over 7.3 billion of us (United Nations Department of Economic and Social Affairs – July 2015). Furthermore, technology companies from outside of healthcare are getting in on the action, with a no more intriguing case study than that being of Uber and Lyft entering the medical logistics space (Medicaid spends around $3 billion per year on third-party transport services). The potential for technology in healthcare continues to be very seductive.

A number of investment themes seem to be emerging from the 2015 funding data which should inform what we might expect to see over the next few years, so in no particular order, below is a list of some of the specific areas of investor interest.

  • More dynamic and flexible EHR products which will aggregate, analyze and present disparate data generated across numerous devices and platforms, often gathered in non-medical settings – arguably V2.0 which will get at issues of interoperability
  • Greater transparency as to the cost, pricing and availability of healthcare services and products
  • More effective search and navigation tools as the consumer strives for greater healthcare data access and understanding, and then better outcomes
  • Greater emphasis on wellness
  • Better tools around medication management and adherence (interestingly, less than 2% of hospitals are thought to engage with patients via text messaging)
  • Impact of less expensive genetic sequencing and multiplexing those data with other data for more precise diagnostics

But as exciting as all of that sounds, there are also concerns on the horizon. The general economic backdrop has clearly – and materially – changed. In early January 2016, S&P 500 earnings were forecasted to increase 0.8% this quarter; 45 days later that same indicator has been revised downward to a decrease of 5.3%. That is a significant re-set. Shockingly, Walmart today announced its first annual sales decline since 1980 – 35 years ago – with uninspiring guidance for 2016.

Additionally, regulators seem to be directing more scrutiny at healthcare technology solutions increasing the clinical burden to prove outcomes and efficacy. Not lost on anyone has been the harsh light pointed at Theranos, and less brightly on Lumosity, which paid a $2 million fine to settle FTC claims of deceptive advertising linked to boasts of “brain training” (this does not include the $50 million judgement, suspended because it would bankrupt the company).

Of particular interest to track will be the return expectations associated with the $10 – $12 billion invested over the past 24 months in healthcare technology. Venture investors look to generate at least 4 – 6x return from any given investment, ideally meaningfully more if possible. The CB Insights data suggest that approximately 1,600 companies were funded over the past two years, implying that they are expected to collectively create between $50 – $60 billion of value over the next few years. At a 2 – 4x multiple of forward revenue (there has been significant multiple compression over the past few months), generating $15 – $17.5 billion of incremental revenue in the near to medium term by these companies may seem like a stretch but attainable, although many will fail along the way. Obviously this math is crude but directionally highlights the potential for investor disappointment.

It also underscores how hard it is to successfully scale a healthcare technology company and the need to be very thoughtful about operating milestones, capital efficient product development roadmaps and effective “go-to-market” commercialization strategies. Obsession to growth to support lofty valuations appears to have led to a series of significant management lapses now unfolding at Zenefits. In 2014, revenues were estimated to be $20 million with a $100 million target for 2015, which is well ahead of the $70 million estimated to have actually been achieved. Another high flier is Oscar Insurance which expanded to California this year. According to Covered California, the state’s insurance exchange, Oscar only acquired 2,000 new members or 0.1% of the 1.57 million people who purchased on that exchange.

This issue of “capital absorption” plays itself out time and again in the investment world. Sectors get hot, too much capital floods in which drives down returns, with tears soon to follow. Undoubtedly the broader venture capital market is cooling. The unicorn phenomenon looks perilously under siege. Ironically, just when SEC regulations no longer force companies to go public when above a certain shareholder count, and with the JOBS Act of 2012 now firmly in place, being public appears to be less interesting to many companies, certainly given recent stock market volatility. Of the 142 biotech IPOs in the last three years, 74% of those companies are trading at levels below the IPO price (median decline is 35%). Case in point, LinkedIn saw nearly 50% of its market capitalization erased two weeks ago when reporting disappointing guidance.

Against a back drop of more and more “pulled IPO’s” we are starting to see pre-emptive lay-offs at venture-backed companies as they brace themselves for more hostile capital markets. While Sound Cloud is not a healthcare technology company, investors were shocked to see that the company was issued a “going concern” opinion by its auditors last week, and this after having raised $80 million at a $700 million valuation a little over a year ago – and Sounds Cloud has 175 million subscribers. This will not be an isolated phenomenon.

Gallows humor occasionally likens venture capital investing to philanthropy, particularly in times when losses are widespread. So as an interesting point of comparison, the Top 50 benefactors donated $7 billion in 2015 to charitable causes (nearly 20% more than was invested in healthcare technology companies); this was down quite sharply from the $10.2 billion gifted in 2014, according to a recent Chronicle of Philanthropy study. Notably, since 2000, the “Tech 50” donated a total of $33 billion which is a pittance when compared to the “Finance 50” who crushed it with $82 billion in donations over the past 15 years. Must be all those evil hedge fund managers – certainly not the VC’s.

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