3Q21 Digital Health: Perpetual Motion Machine…

A whirling dervish…a ball rolling downhill. The investment activity in the digital health sector is extraordinary – and arguably overdue given the enormity of the market opportunity and the urgency created by the pandemic to re-architect such an important sector. According to Rock Health data, this past quarter saw $6.7 billion invested in 169 companies for an average deal size of $39.4 million. The investment activity for 2021 is on pace to reach $28 billion, which would effectively double the 2020 highwater mark of $14.6 billion.

And the robust investor enthusiasm is not exclusively a U.S. phenomenon. According to CB Insights data, across all of healthcare globally there has already been $97.1 billion invested, putting this on pace to be nearly $130 billion, which would be nearly 60% greater than last year’s highwater mark of $79.9 billion. Interestingly, CB Insights flags that the 3Q21 investment of $30.5 billion marks a deceleration from the prior two quarters although the number of deals spiked to 1,901, which is 15% greater than 2Q21, and itself the most active quarter ever. 

As highlighted with the Rock Health data, we should pause on the average round size to better understand what appears to be unfolding. Year-to-date there have been 62 “mega rounds” of financing (greater than $100 million) which represents nearly 12% of all financings. Arguably, the digital health sector is entering an “anoint the winner” phase. Entrepreneurs and investors today experience greater urgency than ever as the next few years may well define the sector’s strategic agenda for the next five years – and the next five years will quite likely define the landscape for the next twenty years.

This commentary is too central to be incidental and influences financing strategies and product roadmaps. The irony of the need to accelerate development cycle times in an industry that confronts crushingly long sales cycle times is not lost on many investors. Companies today appear to be raising larger rounds to bridge this divide. Typically, product/market fit is clarified during the Series A and B rounds. Rock Health data (below) illuminates this dynamic: early stage round sizes have significantly increased in size, yet the average age of the companies has remained relatively constant – plus or minus a quarter. Focusing just on averages can at times be misleading, but directionally the average Series B company had raised just under $50 million in 2020 and now in 2021 that amount is running just over $60 million. Building an enterprise-ready digital health company will take over five years and $60 million – no small undertaking.

The Series C round, in general, is considered to be the “commercialization” round. Of course, management is selling throughout the life of the company, but the first handful of years are mostly spent nailing down product/market fit. The implication of the chart above is profound: nearly eight years and now another $100 million is required, thus the increased incidence of the “mega rounds.” This is compounded by the heightened levels of investment between 2018 – 2020 as all of those companies are coming back to market.

One might also expect an increase in “private-to-private” mergers as many companies struggle to get through this knothole. Typically, each round of financing provides another 15-18 months of runway before management needs to think about the next round; not a lot of time given the intense competitive dynamics of the digital health sector today. A common critique is that too many companies have built too narrow an offering: it is a more limited point solution, and the customers require a broader, deeper set of capabilities. Expect also to see horizontal acquisitions that seek to expand into adjacent customer bases (providers + payers) or bolster distribution capabilities, especially for those companies that may not have sorted out product / market fit (see below).

Notwithstanding those concerns, there is ample evidence that the healthcare technology sector has created a number of important companies that are reducing clinical and administrative costs, while improving outcomes – while creating extraordinary shareholder value. According to an analysis prepared by Flare Capital, these last five years (2015 – 2020) has witnessed a 4.4x increase in market value of both private and public companies to $271 billion. Over the course of that same period, per Rock Health, $42.3 billion was invested in this sector. According to EY, there have been 132 healthcare start-up IPOs already in 2021 (admittedly, though, a number of them were biotech companies).

Essential to the healthcare technology sector’s success has been the emerging evidence of impact that these solutions are having in the market. Clearly, the pandemic has also super-charged the need for a more responsive, intelligent, predictive, and virtual healthcare system. In a recently published report by the Centers for Medicare & Medicaid Services, the CMS Innovation Center reflected on the more than 50 test models introduced over the last decade. While only six of them are considered to have created material savings to the system, just in the last two years alone over 28 million patients have been served. The insights from these models support a narrative that technology will be able to drive important improvements to care delivery in profound and systemic ways. This augurs well for an important upcoming decade as these lessons are more broadly deployed.

Notably, the research firm ATI Advisory recently released an assessment of how Medicare Advantage (MA) members have managed through the pandemic as compared to traditional “fee-for-service” (FFS) members and the results were striking. Mortality rates for hospitalized MA members with Covid were 15% as compared to 22% for FFS members. This is in light of the fact that 7% of all MA members have tested positive for Covid as opposed to only 3% for FFS members. Much of this improvement is attributed to the fact that risk-bearing models tend to provide more responsive, flexible care and offers a more-appropriate menu of supplemental benefits.

Naturally, investment capital has tended to be directed toward diseases that either exhibit the greatest urgency or burden on the healthcare system. Year-to-date, according to Rock Health data, $3.1 billion has been invested in companies that are addressing mental health conditions, while cardiovascular disease, diabetes, and primary care have attracted $1.4 billion each. Oncology ($1.2 billion) and substance use disorder ($0.8 billion) make up the next largest categories tracked. These six clinical indications accounted for nearly 45% of all digital health funding in 2021. Mercom Group (below) tracks venture investment by technology category, highlighting that telehealth investment activity was both the most active sector these past two years and also spiked in 2021. This is not at all surprising given the urgency to create robust virtual care offerings.

Finally, the lingering question for entrepreneurs and investors centers around what the next handful of years will look like. With nearly $4.0 trillion of healthcare expenditures in 2020 (per CMS data), the enormity of the need coupled with the size of the market opportunity strongly suggests a continued robust investment pace. Undoubtedly, in certain sub-sectors and with certain companies, valuations are heady and arguably ahead of the reality of those companies, but directionally this is a category that can productively support investment levels at this pace.

I have been a broken record on this analogy. The U.S. advertising industry is a massive industry – $240 billion spent annually – and over the last twenty plus years as that sector was re-architected over $10 trillion of venture-backed public market capitalization (Google, Facebook, Apple, Twitter, etc) was created.

The U.S. healthcare industry is nearly 17x larger…

2 Comments

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2 responses to “3Q21 Digital Health: Perpetual Motion Machine…

  1. Michael – nicely done as usual. I had a digital music “sabbatical” from healthcare for a few years at the turn of the millennium so my personal reference point for the success of an industry transformational digital technology is the change in sales of physical recorded music from $21.5 billion in 1999 to about $6 billion in 2015. In the deconstruction process consumers purchased less music that they did not want (i.e. most of the tracks on most albums) and gained flexibility to find and listen to music from the entire world (revenues are now increasing again). (https://www.visualcapitalist.com/music-industry-sales/)

    Digital health will prove itself when we see this type of effect for relevant parts of healthcare.

    Your comment on the higher covid hospitalization rate/lower death rate of MA patients compared with traditional Medicare patients is interesting. Perhaps MA doctors and their patients are quicker to hospitalize due to the absence of cost pressure on the patient, resulting in less average acuity compared with FFS Medicare. I imagine MA companies would say that the numbers prove that their patients are sicker and the care they provide is better than traditional plans. Perhaps we will sort this out some day.
    Rob

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