Digital Health in 2023: Envelope Please…

Obviously, the problems addressed by healthcare technology did not just get cut in half. So, what accounts for the rather dramatic decline in venture investment in digital health from $29.3 billion in 2021 to $15.3 billion in 2022, according to recently published Rock Health data. There has likely never been a more complicated and confounding time to be investing in healthcare than now. Against a backdrop of daunting macroeconomic issues, the problems confronting the healthcare industry requiring innovative solutions continue unabated.

This past week we learned that the U.S. has hit the debt ceiling of $31.4 trillion. The Wall Street Journal’s year-end survey of leading economists peg the likelihood of a recession in 2023 at 61% with a meager 0.2% annual GDP growth rate; fortunately, inflation is expected drop to 3.1% by the end of 2023. GDP growth over the past 12 months was only 1.4% while employment has increased by 3.0%, strongly indicating a rather dramatic decline in worker productivity, which is a leading indicator of recessions. Bank of America now forecasts a 1.1% decrease in GDP in 2023, which would be one of the mildest recessions in decades. Ominously, though, Deutsche Bank expects default rates on high yield bonds to be 5.6% in 2023 and a frightening 11.3% in 2024 – near historic highs.

Paramount to all of this is liquidity and fund flows to determine whether investors are seeking exposure to risk-based assets. Sharp declines in monetary growth inevitably lead to dramatic declines in asset values. Data from the Investment Company Institute over the past few years show significant equity mutual funds outflows, largely accounting for the dramatic reset in equity prices.

As healthcare technology investors gameplan for 2023, it is informative to look at prior sector corrections, none more notable than the bursting of the Dot Com bubble over 20 years ago. According to an analysis by SVB Securities, its Digital Health Index declined by just under 70% since peaking in February 2020 (nearly 700 days ago) tracking very closely to the trading activity of the NASDAQ Index from March 2000 to Spring 2002. The NASDAQ Index touched bottom almost 950 days after peaking in March 2002 suggesting, if the trend holds, that the digital health sector will mostly trade sideways through 2023. Underscoring the reset in valuations, the median twelve month forward revenue multiple for the SVB Digital Health Index declined from 15.0x to approximately 3.0x during this timeframe.

Public markets were not the only markets impacted. With an increase in relative liquidity and sophistication of the secondary markets, a more robust trading environment for securities in private companies has emerged. An analysis by Forge Global highlights the dramatic correction in valuations just over the past year, with median pricing declining by ~50% of the prior round of financing. With the shock of the pandemic in early 2020, this discount was only about 20%, recovering to be ~10% premium in 2021.

Interestingly, an early readout of overall venture capital investment activity from Pitchbook for 2022 totaled $238.3 billion as compared to $344.7 billion in 2021, a rather dramatic pullback of new investment activity undoubtedly impacting follow-on rounds for venture-backed companies. Analysts estimated that there are now 2.5 sellers for every buyer for private shares, a modest improvement from 4:1 six months ago but nowhere near the balanced 1:1 in 2021. Fortunately, the healthcare sector has been relatively resilient in the secondary markets.

Other barometers as to the health of the financing markets are the IPO market and M&A activity. Overall, exit activity of venture-backed companies was nothing short of abysmal in 2022. According to Pitchbook data, there was $71.4 billion of exit activity across 1,208 transactions in 2022 versus a staggering $753.2 billion and 1,925 transactions in 2021 (average deal sizes of $59 million and $391 million, respectively). This past year looks to be the weakest IPO year since 1990, according to Axios, with a mere $8 billion in proceeds across 74 IPOs.

Data: Dealogic; Chart: Axios Visuals

Indicative of the general lack of liquidity in the market, 70 special purpose acquisition companies (“SPAC”) have shut down just since last month, more than the total number of shutdowns in the market’s history, according to SPAC Research. These 70 SPAC sponsors are estimated to have lost $600 million. In total, there are still approximately 400 SPACs holding about $100 billion still sitting on the sidelines. Notably, Chinese companies that went public in the U.S. in 2021 only raised $536 million, which is down 96% from 2021.

Notwithstanding the many financing headwinds, the resilience of the healthcare technology sector should be supported by the continued migration of patients/members into value-based, digital-first solutions. As the pandemic morphs into an endemic, there is an expectation of increased hospital utilization, an increase in previously deferred elective procedures, and a relatively supportive reimbursement environment including for telehealth and other virtual services. Telehealth visits seemed to have settled at 14% – 17% of all visits, up from ~1% pre-Covid. The role of the consumer will continue to be important, underscoring the need for better, more effective engagement and care management platforms.

While the 2022 downdraft in digital health funding mirrors investor concerns more broadly, given the enormous market opportunity to transform the business of healthcare, this past year still recorded the second most active year ever. In fact, the 4Q22 investment pace of $2.7 billion was more than 20% ahead of 3Q22 activity of $2.2 billion, pointing to continued sector strength, but also that the “new normal” will likely be annual investment activity between $10 – $15 billion. Entrepreneurs will need to recalibrate to this new reality – capital will be less plentiful and likely more expensive.

What does that practically mean? Average round size collapsed to $26.7 million down from $39.7 million in 2021. Of course, averages can be misleading. According to Rock Health, there were only 35 financings greater than $100 million (“mega rounds”) while there were 88 and 43 in 2021 and 2020, respectively. Those 88 companies in 2021 consumed 56% of all invested capital that year, while mega rounds represented only 39% in 2022. In addition to fewer mega rounds, there was significant compression in round size for both Series B and C financings according to analysis prepared by my firm, Flare Capital (my thanks to my colleague, Parth Desai). The implications of smaller round sizes will require companies to operate with greater capital efficiency and/or focus on more modest milestones with each financing given the shorter runways.

There was a dramatic spike in valuations at the outset of the pandemic as investors embraced novel technologies as the healthcare system was forced to be virtual, intelligent, predictive, and real-time nearly overnight. Interestingly, pre-money valuations held up remarkably well in light of recent volatility in the public markets. There was evidence of softness in Series B rounds but valuations for most stages were either flat or up slightly over prior years, with notable strength in the Seed stage rounds.

While admittedly somewhat nonsensical, adding the average round sizes from Seed through Series C rounds in 2022 (total of $104.6 million) compares favorably to the average Series C pre-money valuation of $421.6 million (or 5x post-money valuation to capital raised). In 2019, prior to the onset of digital health investor euphoria, on average $77.4 million was raised to reach Series C stage (or 2.2x post-money valuation to capital raised). One should expect a more measured capital appreciation dynamic going forward with less liquidity sloshing through the market.

As a cohort, healthcare technology unicorns (Flare Capital tracks 86 of them) saw significant valuation compression in 2022, consistent with the overall public equity markets, declining in aggregate value to $281 billion from $416 billion in 2021. While valuations of privately held unicorn shares tend to reset slower than comparable public stocks (that might be changing – slowly – with greater liquidity in the secondary markets – see above), one should expect further reduction in valuations in 2023 as those companies come back to market to raise additional capital. This will be great theater as many of those companies still require significant capital to reach breakeven and will find capital availability much more limited and with potentially onerous terms. Also expect extensions of prior rounds with significant existing investor support to be quite prevalent.

According to analysis by Refinitiv, overall healthcare and life science M&A declined from $505 billion in 2021 to $329 billion in 2022. Arguably, a few hundred healthcare companies will be coming to market to raise capital in 2023; not all of them will be successful. This will undoubtedly generate a spike in private-to-private M&A activity which may reverse the trend in 2022. Specifically, exit activity in the healthcare technology sector saw a dramatic reduction in 2022 to a miniscule $2.2 billion according to SVB Securities. It is a safe bet that this will increase meaningfully in 2023.

But no need to be so dour. A reading of the Center for Medicare and Medicaid Innovation (“CMMI”) 2022 Report to Congress (someone had to) is energizing as a healthcare technology investor. There is no shortage of innovative models and solutions demanded by the market, coupled with a sophisticated and talented entrepreneurial community set on transforming healthcare. Over the past two years, CMMI has tested 32 novel payment and service delivery models that touch 41.5 million lives and 314k providers; eight models have already shown significant cost savings or meaningfully improved quality of care.

As more of these initiatives and the few hundred digital health companies launched in the past five years show impact with data and can claim attribution, there should be adequate capital available to fund future growth. And maybe even tap into the nearly $300 billion of venture capital raised (according to Pitchbook) but yet to be invested sitting on the sidelines waiting to jump in.

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