Digital Health: The End of the Beginning…

Upon the conclusion of a very tough week for U.S. consumer internet and technology stocks that saw over $550 billion of market value evaporated at Alphabet, Amazon, Apple, Meta and Microsoft (combined market value now sits at $6.64 trillion), coupled with the news of the 70% decline upon the first anniversary of the largest bitcoin ETF (Proshares Bitcoin Strategy fund), it is a good time to take stock of the healthcare technology sector. While there has also been significant volatility with healthcare technology stocks, the resilience of top line revenues has been impressive. Admittedly a rather small sampling, the Flare Capital portfolio saw 12% 3Q22 over 2Q22 aggregate revenue growth and nearly a 60% increase 3Q22 over 3Q21. Overall, revenues are tracking ahead of plan for the year, even in spite of worsening economic conditions.

The pandemic obviously triggered a massive acceleration in technology adoption across the healthcare landscape which in turn let loose a wave of digital health investment activity. The healthcare system was forced to become virtual, real-time, on-demand, predictive, intelligent, distributed, empathetic, even more transparent – all capabilities ultimately enabled by novel healthcare technologies. Secondary issues have emerged such as labor force disruption and productivity which also demand robust solutions. McKinsey & Co. estimates that just the pandemic will burden the healthcare system with an additional $220 billion of costs by 2027, this to a system already struggling to be self-sustaining, much less being profitable.

Coming off a record year in 2021 of $29.2 billion invested in 736 companies according to Rock Health, the 3Q22 data show a continued slowing in the investment pace as the sector confronted more hostile economic conditions and worked to absorb the extraordinary amount invested last year. This past quarter saw $2.2 billion invested in 125 companies, which was the lowest amount invested in the past eleven quarters. This puts 2022 on pace to hit nearly $17 billion invested in over 600 companies, which would still be the second most active year yet. Unfortunately, though, this deceleration suggests that 2023 may be a relatively lean year. Interestingly, $17.6 billion was invested in 1H22 globally in digital health according to CB Insights data.

Importantly, the average deal size dropped from $39.7 million in 2021 to $27.4 million so far in 2022, indicating the relative dearth of large late-stage rounds. Much of the deal size compression occurred in the later stage rounds of financing, particularly with Series C rounds that saw median deal size of $71 million in 2021 drop to $55 million year-to-date in 2022. Rock Health tallied only six Series C financings in 3Q22 and only two rounds that were greater than $100 million.

This past quarter might well have marked the “end of the beginning” of the first phase of healthcare technology sector development. Arguably there will still need to be a few more quarters to recalibrate to this new normal when capital is no longer free and revenue growth is harder. It is informative to compare prior year rounds by series to the next year by the subsequent series (e.g., compare number of Series A rounds in 2019 to number of Series B rounds in 2020/2021) to gauge “graduation rates,” that is the proportion of companies that are able to raise subsequent rounds. One should expect a lower graduation rate as capital becomes scarcer with a concomitant increase in private-to-private combinations (and smaller round sizes as investors limit exposure and/or put struggling companies on tighter leashes). 

A detailed McKinsey & Co. analysis projects that national healthcare expenditures will grow at 7.1% between 2022 – 2027, well ahead of the 4.7% forecasted general economic growth, exacerbating the acute need for greater productivity. The Association of American Medical Colleges recently estimated that there will be a shortage of 200k nurses and 50k doctors in the U.S. in three years.

As tragic as the pandemic has been for literally billions of people, this will likely be looked upon as the inflection point ushering in decades of terrific investment activity. The enormity of the market opportunity, coupled with the deeper appreciation that these value-based models do indeed create significant economic value, will welcome an exciting period of prolonged growth and investment activity when important valuable companies will be created.

McKinsey & Co. estimates that there is $1.0 trillion of improvement to be realized as the healthcare system is rearchitected to optimize limited resources, improve outcomes, and drive enhanced productivity. Bain and KLAS recently released a survey of providers to better understand investment priorities which highlighted the urgency to strengthen both infrastructure and analytics capabilities.

The strategic imperatives of the healthcare system are reflected in which sub-sectors are attracting the most capital. On-Demand Healthcare has consistently been the top funded sector until recently when Non-Clinical Workflow jumped from a distant seventh place to first in 2021. Research and Development investments captured the third slot this year. 

Perhaps not at all surprising, mental health remained the top clinical indication this year with $1.7 billion invested (nearly 15% of all investments) so far this year in 53 companies, which is coming off of $4.8 billion in 2021. According to Grand View Research, the global mental health app market alone is $4.2 billion and is expected to grow at 16.5% annually to 2030. One risk is that arguably too many companies have been funded in some of these sectors, which will likely lead to painful consolidation as the sector rationalizes. The next most popular indications this year are oncology and cardiovascular followed by diabetes and “femtech.”

Notwithstanding the acute and obvious needs, this past quarter also was one of the most challenging quarters to price new investment as companies held on to legacy valuations for financings that closed in 2021. Many investors focused more on seed and early-stage opportunities where pricing was consistently in-line with historic norms and/or they focused on supporting existing portfolio companies.

Public stock market performance provides a difficult benchmark and further exacerbates the valuation debate given how poorly many of the public healthcare technology companies have traded. At the end of 3Q22, the SVB Digital Health and Heath Tech index was down 31.8% year-to-date (in September alone the index dropped 46.5%, underscoring the sector volatility) and was trading at a 3.3x estimated 2023 revenues with a total market valuation of approximately $90 billion. SVB goes on to highlight that since the index peaked in early February 2021, it has declined by 66.8%.

What will need to happen in order to see a significant recovery? In the midst of the madness last year, the SVB Digital Health index traded at 6.9x revenues in 2Q21, a far cry from where it sits now. Clearly, there will need to a be general recovery of investor sentiment and some clarity of the war in Ukraine and China – U.S. relations. Broader capital flows back into risk assets will create a rising tide. Valuation multiples will likely settle somewhere between 3.3x and 6.9x.

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 15-18 months of runway implying that many of the companies that raised in 2021 are now thinking about the next round; frankly, not a lot of time given the sales cycles in healthcare. A common critique is that too many companies have built products that are too narrow or solve a small piece of the puzzle. Oftentimes, what is built is a limited point solution, when 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.