You know it is bad out there when the best performing financial asset in 2Q22 was the Russian ruble which appreciated 48.6% – the next closest investment was orange juice which was up 18.2%. Even the Kazakhstani tenge far outpaced the S&P 500 and Nasdaq Composite indices, generating a return of 0.1% versus –16.5% and -22.5%, respectively. On real terms, this has been one of the worst starts of any year for the S&P 500 since 1872. With a myriad of issues swirling around us – inflation, war in Ukraine, China geo-economic tensions, domestic political paralysis, climate concerns, racial inequities – it is a wonder that the U.S. equity markets have not suffered more greatly. J.P. Morgan is even teasing at perhaps a strong 2H22 in the capital markets.
Not to diminish at all the numerous problems confronting policy makers, the inflation concerns are real (obviously) and insidious, compromising basic economic decision making. When looked at historically below, just how extraordinary this new investment climate is becoming is starkly apparent. There is an entire generation (maybe two) of investors who have never experienced this before, much less a public market correction of this magnitude. To confuse matters further, June’s strong jobs report with 372k new jobs created (well ahead of analyst expectations) is hard to reconcile with the 1Q22 GDP decline of 1.6% heightened concerns that the U.S. economy may be stumbling to the feared “two-quarter GDP decline” definition for recession.
An interesting corner of the market to look for signals of this recalibration is the venture capital investment activity. Pitchbook and the National Venture Capital Association recently published a flash 1H22 analysis which showed a significant decline in investment activity in 2Q22 but a marked increase in the number of deals. In 1H22 there was $144.2 billion invested in 9,421 deals which implies an annual rate of $288.4 billion and 18,842 deals, as compared to $341.5 billion and 17,637 deals in 2021. This would be a 15.6% reduction in the annual amount invested yet a 6.8% increase in the number of companies.
A deeper review of the 2Q22 data highlights the dramatic reduction in average round size: in 2021 average round size was $19.4 million; in 1Q22 it was $19.0 million; but in 2Q22 it collapsed to $12.9 million. A critical question is the mix between new investment activity versus follow-on investments in existing portfolio companies. While Pitchbook estimated that only 5% of 1Q22 financings were “down rounds,” the expectation is that it spiked in 2Q22 and is likely to eclipse the 10-15% levels seen over the past decade or so.
Very clearly venture investors have tightened the reins. While there continued to be strong interest in early-stage private companies, investors appear to be providing shorter runways, likely focusing more intently on near-term milestones. And while averages can easily mask other trends, there is no doubt that late-stage crossover funds have dramatically pulled back, perhaps given the relative attractiveness of fallen public stocks or yet again with the realization that they may have strayed into a part of the market which is not their strength. A small sampling of what just occurred can be found when looking at the crushing rise and fall in the fintech sector, as valuation multiples collapsed by well more than 50%.
By definition everything that priced over the last two years was overvalued when looked at through today’s lens. The Chief Investment Officer of Bridgewater, a leading global hedge fund, recently observed that more than 40% of all public companies are reliant on raising additional capital which will be very tricky in this environment when liquidity is being taken out of system. Coincidentally, 43% of S&P 500 companies provided negative guidance in 2Q22 with FactSet reducing EPS estimates for the index by 1.1%, the greatest decline since 2Q20. According to Renaissance Capital, only 21 U.S. companies completed an IPO in 2Q22, raising a paltry $2.1 billion, a level not seen since the depths of Great Recession in 2Q09; the median IPO raised only $22 million. Furthermore, 2Q22 IPO performance has been abysmal – the worst quarter in history in fact – with the Renaissance IPO ETF down 32.5%.
The secondary market may offer another avenue for investor liquidity – and there are some fascinating signals emerging there. Forge Global, which operates a private stock marketplace, has seen a reversal in Indications of Interest (“IOI”) between buyers and sellers over the last six months which is putting pressure on valuations. In 4Q21, 58% of all companies traded at a premium to their last round’s valuation yet in 1Q22 that declined to 24%.
Interestingly, this is against a backdrop of a significant decline in M&A activity. Globally through 1H22 M&A activity decreased by 21% with a 28% decline in U.S. activity alone. The decline appears to be even more pronounced for venture-backed companies. Through 1H22, the M&A volume was $48.8 billion with 831 exits, which when annualized ($97.6 billion, 1,662 deals) compares poorly to the staggering $777.4 billion and 1,880 exits in 2021. This would be the lowest annual M&A volume since 2016.
One possible silver lining that may provide lifelines to many private companies is the amount of capital being raised by venture capital firms. Year-to-date U.S. venture firms raised $121.5 billion across 415 funds, which is an unrivaled pace unseen in any year prior. According to Preqin, the venture capital industry added $43.1 billion in dry powder in 2Q22 on top of the $478.5 billion already amassed, suggesting many venture partnerships will be having the ever-present “sunk cost” debate to either continue supporting existing, possibly struggling companies, or look for new opportunities.
One resilient bright spot on the venture landscape had been the healthcare technology sector but even that may be changing. Rock Health, the leading research firm that covers the digital health sector, just published its 2Q22 investment activity report showing a marked decline in both dollars invested and number of companies ($4.1 billion and 141 companies). Through 1H22, there has been $10.3 billion invested in 329 companies suggesting the sector is now on pace to see between $16 – $20 billion invested in approximately 600 companies, which while below 2021, would place this year comfortably in second place well ahead of any year prior. Investment activity in June 2022 was $1.45 billion suggesting a $17.4 billion pace. Notably, the average deal size in 2Q22 was $28.1 million which likely indicates increased caution as round sizes decline.
The average round size is directly influenced by the size of the later stage rounds, which is where there has been a significant pullback. For instance, Series C average round size in 2021 was $90 million; it was $81 million in 1Q22 and is now $70 million through 1H22, suggesting that the 2Q22 average round size was considerably smaller than that. This is a critical metric to monitor as many successful digital health companies require a few hundred million dollars of invested capital to achieve scale and/or liquidity.
The mix by stage of financing is informative as well. Over the last five years, Series A financings accounted for ~25% of all financings, Series B was 15-17%, Series C was 8-10%, and Series D or later was another 8-10% (the balance included seeds, bridge rounds, and other equity financings). While this has remained relatively consistent, the “graduation rate” (the ability to raise a subsequent round) will be closely watched as capital becomes scarcer and more expensive. Notwithstanding the decline in 1H22 M&A activity to 16 transactions per month (versus 23 per month in 2021), one would expect to see a significant increase in private-to-private M&A activity in 2H22 as companies fail to hit value-creating milestones, perhaps implying a lower prevalence of later stage rounds.
Rock Health has also analyzed investor type concluding that 70% of investors in digital health companies in 1H22 are repeat (presumably more expert) investors, which had been consistently 55-60% in prior years. If this trend holds, one might expect to see relatively less capital available to healthcare technology companies as more casual, generalist investors focus elsewhere. Notably, the number of investors by round per company in 1H22 was 2.3 as compared to 1.7-1.8 in prior years, suggesting that entrepreneurs are building larger investor syndicates with greater financial capacity.
The atmospherics around this sector is somewhat confounding. The promise of healthcare technology solutions has never been more evident, yet the public markets have been unforgiving over the last handful of months. The median revenue valuation multiples for the SVB Leerink Digital Health index (21 companies) for 2022 and 2023 are 2.9x and 2.4x, respectively (the average multiples are greater at 5.5x and 4.4x), yet the companies in the index in aggregate are projecting a relatively robust 25.3% revenue growth (2021-2023) with an average 2022 projected gross margin of 61.0%. Since the index’s peak in mid-February 2021, it has declined 64%.
The regulatory situation is also running at crosscurrents. There is significant support for greater data liquidity, interoperability, and transparency, yet in a post-Roe world, there has never been greater anxiety about the misuse (abuse) of intensely private information around reproductive rights.
One issue that has concerned healthcare technology entrepreneurs over the last three years has been access to great talent. In light of an historically low unemployment rate of 3.6%, there does seem to be an emerging group of available and talented labor. The website layoffs.fyi has been tracking the number of laid off start-up employees, and with the implosion of the crypto, fintech, and “proptech” (real estate) sectors, there has been a spike in the number of people suddenly available to join other hot start-ups. According to the Bureau of Labor Statistics, the unemployment rate in the healthcare and social assistance sector is 2.4%, so this may actually be a silver lining for digital health companies.