1Q22: Bob and Weave…

It is quite easy to see that general economic conditions are deteriorating; it is considerably harder to know what to do given the many confounding signals. The employment data are nothing short of extraordinary. Over 431k jobs were added last month alone, driving the unemployment rate to 3.6% – essentially returning to pre-pandemic levels with last week registering the lowest weekly unemployment claims in the last 54 years. Wages increased 5.6% year-over-year through March, which while tracking below the scourge of inflation, was certainly a robust pace. Annual corporate profit growth in 2021 increased 35% according to Barron’s. An early April survey of 72 leading economists by Bloomberg concluded that the U.S. economy will expand 3.3% in 2022, 2.2% in 2023 and 2.0% in 2024, respectively.

And yet nearly every asset class was down significantly in 1Q22, other than Commodities which increased on average over 25% in the quarter according to Bloomberg data, with the S&P Energy Index up 37.7%. The S&P 500 and NASDAQ indices were down 4.6% and 9.1%, respectively, while U.S. government bonds lost 5.6%, again in the face of rising inflation. Most acutely, the SVB Leerink Digital Health index was down 76% since its February 2021 high. The S&P Biotech index lost nearly 48% over a similar time frame, erasing the gains achieved since the start of the pandemic. Most ominously, with the Federal Reserve signaling that it will raise rates more aggressively, the yield curve inverted last week with short-term rates greater than long-term rates; such an inversion has predicted five of the last six recessions. Of the economists surveyed by Bloomberg (above), the consensus was a 27.5% chance of a recession in the next 12 months.

Data: FactSet; Chart: Baidi Wang/Axios

In the face of an aggressive tightening monetary policy (to say nothing of a heart-wrenching war in Ukraine), interesting signals of investor sentiment are already revealing themselves in 1Q22 venture funding data. Pitchbook and the National Venture Capital Association just released a flash review of 1Q22 which showed overall U.S. venture investment activity was $70.7 billion, which is the lowest quarterly level since 4Q20. As a point of comparison, investment activity for all of 2021 was $330 billion. Notably, prior to 2013 there had never been a full year that even came close to $70 billion so the pace is still relatively strong but a marked deceleration from recent activity (4Q21 was $88.2 billion). Notwithstanding that slowdown, there were still more than 100 “mega rounds” (greater than $100 million) and little evidence that the corporate venture investment pace pulled back, which one might have expected in the face of market volatility.

Global venture investment activity also has slowed dramatically, dropping 19% from 4Q21 levels to $143.9 billion (8,835 deals), according to CB Insights data. Somewhat confounding, the number of unicorns globally reached another high with 1,070, supported by over 350 “mega rounds” which accounted for 51% of the quarterly investment activity. While there may be signs of nervousness at the earliest stages of investing, it does appear that VCs are fortifying the emerging winners with significant rounds of financing.

The canary in the coal mine this past quarter was the activity in the broader equity capital markets. Overall issuance in 1Q22 was $32.5 billion which was the lowest quarterly level since 1Q09. This past quarter declined nearly 90% year-over-year, led by a stark decline in IPO activity which registered a mere $2.1 billion (a decline of 95% year-over-year). Only 18 companies managed to go public in 1Q22. Furthermore, the Renaissance IPO Index traded down 23.9% in 1Q22.

Special Purpose Acquisition Company (“SPAC”) activity was particularly dismal. Of the approximately 725 active SPACs, only 12 announced an acquisition in 1Q22 with another 17 having completed a pending acquisition. After an extraordinary 2021 when 613 SPACs were created, greater SEC scrutiny and poor post de-SPAC trading (once the acquisition has closed) have greatly reduced the attractiveness of this financing alternative. CB Insights reports that the median SPAC deal size was cut in half in 1Q22. The SVB Leerink Digital Health SPAC index (only 14 companies) is off 48.9% since “de-SPACing” through 1Q22. Many of the cross-over investors (hedge funds, mutual funds, etc.) dance between late-stage private rounds and public companies now trading at dramatically reduced valuations.

Notwithstanding the profound trends powering the healthcare technology sector such as the need to reduce costs, improve clinical outcomes, and engage/activate the patient/member/consumer, this sector was not insulated from the 1Q22 volatility. The SVB Leerink Digital Health Index shed nearly $88 billion of market value as forward 12-month revenue multiples reset from February 2021 highs of 15.6x to 5.0x.

Quite clearly, the investment pace in 2021 of $29.1 billion across 736 healthcare technology companies was a high-water mark, likely not to be eclipsed. According to a recent Rock Health report, the level of investment in this sector in 1Q22 was $6.0 billion across 183 companies, suggesting an annual pace equivalent to the number of companies but likely a ~20% reduction in the dollars invested when compared to 2021. Average round size in 1Q22 was $32.8 million which also was a marked decline from the $39.5 million for all of 2021. In 4Q21, $7.3 billion was invested so the quarterly pace is moderating. Also worth watching is the monthly investment activity: January, February, and March saw $3.0 billion, $1.4 billion, and $1.6 billion invested, respectively, perhaps suggesting an even more modest pace for the remainder of 2022.

None of this should suggest the sector is “unhealthy.” Quite the contrary: 1Q22 investment pace matched the activity for all of 2017 and rivaled the annual pace for both 2018 and 2019. The pandemic, as tragic as it has been for so many, is a massive accelerant for technology adoption across every corner of the healthcare system. Arguably, the public healthcare technology stocks have been uniquely exposed to investor uncertainty surrounding surges of the Covid variants and the concomitant uncertain impact on medical costs, particularly for many of the value-based care companies. Overall, the SVB Leerink Digital Health Index is trading at 4.2x and 20.2x 2022 revenues and EBITDA, respectively, with an aggregate market capitalization of $206.2 billion at the end of 1Q22. The pure-play digital health cohort within that basket of companies trades at 6.8x and 26.4x 2022 revenues and EBITDA, respectively. Still very healthy.

Today’s entrepreneurs are launching and scaling companies that will be talked about for years, likely decades. Notably, the list below (not complete) provides a sampling of the healthcare technology unicorns, many of which were started within the past half dozen years. The ability to generate compelling venture returns is, in part, due to the ability to build big companies. Given the massive size of the healthcare markets, it certainly suggests that there will be many more companies added to this roster.

Due to the essential nature of healthcare, the sector has proven itself somewhat recession-proof. Obviously, early-stage companies are exposed to the risk appetite of institutional investors and given the relative capital intensity of these business models, entrepreneurs need to be especially cautious navigating this volatility.

Investor sentiment has clearly shifted from growth at all costs to proving that profitable unit economics, much less overall profitability, are readily achievable. One might expect to see later-stage rounds creep up in size as “emerging winners” take on a more defensive posture to ensure cash runways that can carry these companies through 2023. There may well be fewer and smaller early-stage rounds as investors react to the sheer number of companies that have been launched over the last few years (competitive landscape and lack of differentiation concerns) and the deterioration of the public market valuation metrics. According to Rock Health, Series D and later rounds were $130 million in size on average. In comparison, Series A, B, and C rounds were $19 million, $36 million, and $81 million, respectively, suggesting highly successful digital health companies require ~$250+/- million of invested capital.

As venture capital partnerships huddle to assess 1Q22 portfolio company performance, where they land on state of the markets will inform whether they assume a more defensive or offensive posture. In either scenario, entrepreneurs will be well-served to be manically focused on knocking down value-creating milestones. In this environment, that list may need to be shortened to fewer milestones over the next handful of quarters until the situation becomes clearer. Like any good boxer, entrepreneurs will need to “bob and weave” carefully through this volatility.

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