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 More than 180 companies in the S&P 500 Index have withdrawn guidance for earnings.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.
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.
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.
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…