The underlying fundamentals in the healthcare technology sector continue to be strong and supported by important transformative forces. Some observers were anxious exiting 2018 that perhaps the sector had entered into a “bubble” phase with too much capital being invested in wobbly business models. That certainly does not appear to be the case at all. And while the $7.4 billion invested in 2019 (Rock Health data) was a decrease from the high-water mark of $8.2 billion in 2018, the number of funded companies has been relatively consistent over the last handful of years.
As a point of comparison, StartUp Health which includes global data and has a more expansive definition of “digital health,” tallied $13.7 billion invested in 727 companies in 2019 which also was somewhat down from 2018’s level of $14.7 billion. The sectors that saw the most investment activity in their data were Patient Empowerment ($2.7 billion), Clinical Worflow ($1.9 billion) and Wellness ($1.7 billion). Interestingly, StartUp calculated that there has been over $70 billion invested in the healthcare technology sector since 2010.
Arguably, this sector may be poised for some rationalization as “emerging winners” become more evident and investors drive larger, later stage financings. Per Pitchbook data, median early stage round sizes were consistently in the $5 – $7 million range, and when compared to median early stage round valuations in the $15 – $17 million, this suggests that entrepreneurs were incurring ~33% dilution (see charts below). While 30% – 40% dilution was incurred all stages, there was a notable drop in valuations for late stage rounds from $325 million in 2018 to $185 million last year.
The other important barometer of industry health is the step-up between post-money valuations and the pre-money valuations of the successor round. Meaningful step-ups strongly suggest that companies are executing well and hitting important commercial and product milestones. To set context, financing rounds tend to provide around 12 – 18 months of runway. Essentially, the median data suggest that early stage round investors were realizing ~2x step-ups from one round to the next, while there may well be some multiple compression at later stage rounds; that is, the step-ups are not nearly as significant given the size of the rounds. This is something investors watch closely, particularly given there were only 112 M&A transactions, and that was down 40% from 2018. The ability to privately finance growth is critical.
Some of this enthusiasm may be due to a belief that the IPO market was opening, at least for successful healthcare technology companies that had reached a sufficient commercial scale and were either profitable or converging on profitability. There were six successful IPOs in this sector in 2019 which today trade at a cumulative market capitalization $17.5 billion. This is even more impressive given those companies collectively raised $1.8 billion (admittedly does not include Change Healthcare data, which was spin-off). Rock Health’s “digital healthcare” IPO index increased 31% in 2019, right in line with the 30% increase for the S&P 500 index. Additionally, One Medical had a very successful IPO in 1Q20.
At its essence, the investment strategy of our firm (Flare Capital Partners) is informed by the observation that as other industry verticals (financial services, adverting, commerce, etc) were re-architected over the last twenty years, profoundly disruptive venture-backed companies emerged generating enormous shareholder value. For instance, the U.S. advertising market is estimated to be $240 billion (Statista) and attracted $1.9 billion of venture capital investment in 2019 ($4.5 billion in 2018). The U.S. healthcare industry is nearly 15x larger and arguably has the potential to create several hundred (if not thousands) of valuable companies over the next few decades. The complexity and numerous sub-specialties provide no shortage of markets to reinvent.
Bruce Broussard, CEO of Humana (Flare Capital Industry Advisory Board member), recently observed that the core issue healthcare needs to solve is one of affordability. In order to make progress against this goal, there were three paths forward: significant investment in technology, payment model reform, and change the role of the consumer. Improved analytics will assist in delegating decisions and allow novel entities to more effectively take on outcomes risk. Broussard is excited about transforming data to be more clinically oriented versus claims oriented. Increased consumer centricity implies a much greater reliance of effective primary care services and improving access into the member/patient’s home.
All of this implies that one should see continued convergence of technology and services to create novel offerings in 2020 – neither component alone is enough to drive down costs and improve outcomes. Specifically, “digital front-ends” to manage members/patients more effectively over time and over their healthcare journeys will be more prevalent. In parallel, the convergence of payor and provider business models will increase. Expect to see investors continue to embrace healthcare services, notwithstanding the capital intensity implied. Notably, the number of Medicare Advantage members grew by 9.4% in 2019 to 24.4 million people.