2Q21 Digital Health – Halftime Show…

Good golly. The mid-year funding data were released this week and the numbers are nearly off the charts – literally. In 2Q21, $75.0 billion of venture capital was invested in 3,296 companies across all sectors, bringing the total through June to $150.0 billion, according to National Venture Capital Association and Pitchbook data. Were the year to end today, it would be the second most active year of all time, just behind 2020 (which is only about 10% greater than where we are now). This is the all-time greatest level of quarterly venture activity, only tied with last quarter. Globally, Crunchbase identified $288 billion of venture capital investments in 1H21, more than 2x last year’s pace.

The greatest contributor to this surge was the prevalence of Late Stage investment activity, which was nearly 69% of all capital invested in 2Q21 (and perhaps not unexpectedly only 31% of all companies given relative round sizes). Mega-rounds (greater than $100 million) accounted $42.2 billion (56%) of the activity across 198 companies in the quarter. CB Insights tallied 136 new unicorns created in 2Q21. A number of non-venture investors (hedge funds, mutual funds, private equity firms) have become considerably more active in this market, accounting for over $116 billion (77% of the total) in 1H21, more often than not investing in significantly de-risked Late Stage companies. The presumption of significant Late Stage “up rounds” may be contributing to the recent spike in Series A valuations.

Surging public equity valuations, robust M&A activity, and greater investor liquidity bolster later stage investor confidence. According to the CFO Journal, there was $1.74 trillion in M&A transactions that involved U.S. companies in 1H21. In that same period, Refinitiv recorded $2.82 trillion of global M&A volume across 28k deals, an increase over 1H20 levels of 132% and 27%, respectively. Pitchbook identified a blistering $372 billion of exits across 883 venture-backed companies already this year, and importantly, 2Q21 is the fourth straight quarter with exit proceeds in excess of $100 billion.

In the past six months, U.S. venture firms have raised over $74 billion in new funds. Preqin reported that over $459 billion was raised by private equity and venture firms globally so far this year. According to recently released Cambridge Associates data, venture capital returns in 1Q21 and the 12 months ending 1Q21 were 16.4% and 81.9% (horizon pooled returns), respectively, which is driving much of the obvious investor interest.

Not even the specter of inflation can dent investor enthusiasm (yet). While the Consumer Price Index spiked up 0.9% in June and increased 5.4% since June 2020, many analysts dismiss this as “transitory” as supply chains stumble back into place.  Against that backdrop, the S&P 500 Index soared 14.4% in 1H21 finishing with an aggregate market capitalization of nearly $36 trillion. FactSet data for 2Q21 forecasts that S&P 500 earnings should increase 64% year-over-year, while earnings in the healthcare sector is expected to grow only 11.3%.

The Altarum Institute calculated the trailing 12 months of healthcare spend to be $3.98 trillion through April, which remarkably is now on pace to be back to pre-pandemic levels. At the outset of the pandemic, monthly healthcare spend declined ~20% when compared to 2019 levels but have since surged back over the past few months as in-person visits increased and delayed procedures ramped back up. Interestingly, the healthcare sector experienced little inflationary pressures (below) as compared to other sectors over the course of the pandemic.

The pandemic, move to value-based care models, and cost pressures have conspired to drive frenzied adoption of novel innovative solutions in healthcare. The next two years will define the strategic agenda for the next five years; the next five years will frame the next twenty years. This is not lost on venture investors. According to Rock Health data, through 1H21 there was $14.7 billion of investments in the digital health sector across 372 companies (average deal size of $39.6 million). For 2Q21, the $8.0 billion was another highwater mark, surpassing the $7.7 billion for all of 2019, a mere 18 months ago. Notably, the digital health sector in 2Q21 was nearly 11% of all venture capital investment activity, up from just 5% five years ago. Almost 60% of the capital invested was in 48 mega-rounds ($100 million or greater), already more than the 44 companies that accomplished that in all of 2020.

While multiple winners can co-exist given the extraordinary size of the healthcare market, those with first-mover advantages will enjoy a valuation premium which is driving such urgency. And the activity was broad based: six categories accounted for 80% of the capital invested. Year-to-date, the drug R&D solutions category accounted for $2.7 billion of investment, on-demand care was $2.6 billion, and fitness/wellness was another $2.0 billion. Treatment of disease, consumer, and non-clinical workflow categories were an additional $4.5 billion collectively. Highlighting the adoption of intelligent solutions to connect consumers with payors and providers, the Consumer Technology Association estimates that there will be $13 billion of health and fitness devices sold in 2021. According to a recent U.S. Census Bureau survey, 24.5% of all Americans has had a virtual visit in the last month.

A powerful new investment theme has been the creation of dedicated care models by disease, tailored to the needs of those specific populations, often times taking risk on outcomes. Rock Health also analyzed the 1H21 data by clinical indication and holding steady at the top of the list is mental health with $1.5 billion invested in that category. The remaining five leading indications are cardiovascular ($1.1 billion), diabetes ($957 million), primary care ($910 million), substance use disorders ($706 million), and oncology ($654 million).

An important implication of this surge of capital into the digital health sector is directly related to the increase in average size of financing by round. Perhaps not unexpected given the size of the market opportunities entrepreneurs are going after, dramatically increased post-money valuations can be challenging should a company stumble. While round sizes increased across all stages, the most notable expansion was seen for Series D rounds; in 2020, the average size was $76 million and in 1H21, it was $131 million. Across the earlier rounds (Series A, B, C), the increases ranged from 1.1x to 1.4x in round size. Presumably, this phenomenon is providing greater runway to achieve important value-creating milestones. If that does not happen, it may be problematic for those companies.

Amidst all of the investor euphoria, a number of important business models have taken hold and are scaling. Obviously, the role of the consumer is critical, and as such, in 1H21 27% of all investments were in B2C models, a nearly 2x increase from levels seen four years ago. The seduction of the market size is enticing but can be illusive. Often requiring out-of-pocket payments (or via HSAs) and sophisticated customer acquisition skills, entrepreneurs new to healthcare tend to gravitate to these models.

Four other models that are well-understood are defined by the customer base served: payor, provider, employer, and pharma. These B2B models accounted for 52% of all companies funded in 1H21. Investors have come to appreciate the idiosyncrasies of each vertical (i.e., how painfully slow decision-making can be) and are factoring that into financing strategies. SaaS and PMPM pricing models dominate and the ever-present hope for “at risk” revenue streams endures, notwithstanding the paucity of those arrangements. Another emerging model that is getting traction (finally) is in the digital therapeutics (“software as a therapy”) space. The blurring with biotech business models that come with regulatory and reimbursement risks can be challenging for tech investors to intuit.

Liquidity has been exceptional over the last six months and puts 2021 on pace to be one of the strongest years yet. According to Rock Health, there were 131 digital health M&A transactions in 1H21 with just over 60% of those being acquisitions by another digital health company, suggesting we may be entering a phase of some significant consolidation. Given the profound sense of urgency entrepreneurs are operating with today, this is perhaps not unexpected; arguably over the next few years, this sector will establish category-leading companies that will scale over the next decade plus.

Given the stepped-up increase in investment activity between 2014 – 2016, it is also not surprising that mature healthcare technology companies are now going public in such a strong capital markets environment. In 1H21, there were 11 public offerings (6 IPOs, 5 SPACs) with another 11 announced SPAC mergers in process for 2H21. Rock Health is tracking 39 announced SPACs with $9.5 billion in proceeds that have a stated interest in the healthcare technology sector. Notably, though, the basket of 18 public digital health companies that Rock Health follows under-performed in 2Q21 when compared to broader benchmarks.  

While not quite as buoyant as the trading activity with the S&P 500 Index, the broader Leerink Healthcare Technology/Services Index increased 11.2% in 1H21 and an impressive 67.7% over the last twelve months. At the end of 2Q21, the mean revenue multiple for the Leerink index was 6.9x and 5.7x for 2021 and 2022, respectively. The comparable EBITDA multiples are 16.1x and 14.8x. The forecasted revenue growth for the composite is a healthy 19.5% (2021-22) and 18.5% (2022-23), contributing to the attractive valuations in the public markets and leaving public investors quite insouciant heading into 3Q21.

So, where does that leave us? It certainly feels like the healthcare technology sector will see low to mid $20 billion of investment this year across approximately 700 companies. While investors should be wary of “capital absorption” issues (is too much coming in too fast?), the enormity of the market opportunities and the quality and impact of the solutions being delivered, provide some degree of comfort that these investments will continue to be productive and profitable. Undoubtedly, there will be examples of pain given that valuation levels arguably are ahead of fundamentals for many companies, but entrepreneurs who are focused on building solutions that (i) significantly lower clinical/administrative costs in the near-term and (ii) have a compelling outcomes story in the medium to long-term, with full attribution, will create important and valuable companies.