Now in an environment when capital is relatively scarce and expensive, one should expect a dramatic bifurcation between high- and low-quality companies – the latter will quickly experience a bout of significant consolidation and company closures. The hidden cost of chronically low interest rates has been to forestall the failure of bad businesses. And the warning signs are everywhere.
Obviously, the Silicon Valley Bank (and Signature and Silvergate banks) debacle was the most notable fissure to emerge. Once the immediate shock and realization that many companies had wildly deficient risk management strategies subsided, the fear that in a liquidity crisis many companies now have much shorter cash runways took hold. This is also settling in as the anxiety of an impending recession looms. An analysis by Bank of America and the Federal Reserve shows that tighter lending standards correlate closely with recessions.
Net Percent of Banks Reporting Tighter Lending Standards
Source: Federal Reserve, Haver Analytics, BofA Global Research
Specifically, significant declines in liquidity such as the tightening of bank lending standards have been associated with dramatic economic pain which is now causing industry analysts to speculate about the severity of the impact on the remainder of the year. Typically, there has been a 10-15% decline in capital expenditure over the next six to ten quarters and a 2-4% decrease in employment over the next year and a half following a credit tightening.
Interestingly, this is now playing out while the S&P 500 index remains mired in the twentieth bear market of the last 140 years. While the average decline from the peak to trough is 37.3% and lasts on average 289 days, this bear market which started in January 2022 is now longer than most (although the downdraft has not been as severe). In fact, the S&P 500 rallied in 1Q23 increasing 7.0% but that was a disappointment when compared to orange juice, which was the best performing asset which rallied 30.6% in the quarter. The worst performing asset in 1Q23 was surprisingly the NYMEX Natural Gas index given the relatively mild winter. Notably, the Ukrainian currency (hryvnia) was precisely 0.0% for the quarter. The NASDAQ had a terrific 1Q23 increasing 16.8%.
Systemic financial liquidity will require close monitoring over the balance of the year. In 1Q23, over $508 billion flowed into cash accounts with a staggering $142.9 billion of cash inflows just during the last week of March alone (the most since March 2020 with the onset of the pandemic) as investors sought safety. As economic conditions continue to deteriorate and with companies desperate for investment, this amount of capital on the sidelines may prove to be problematic.
Money Market Funds ($T)
Source: Bloomberg
The venture capital industry has not been insulated from these broader economic forces. According to Crunchbase, venture funds invested $76 billion globally in 1Q23, which is a steep decline from the $162 billion in 1Q22. The National Venture Capital Association and Pitchbook just released their flash 1Q23 report which tallied $37 billion invested in 1Q23 as compared to $82.4 billion in 1Q22. In fact, this was the lowest quarterly volume since 4Q19 and well-below the average 2022 quarterly level of $52 billion. The 2,856 companies which raised venture capital in 1Q23 was the fewest number since 4Q17, 21 quarters ago.
Across the board, the decline in activity was most pronounced in the Late-Stage category of financings. There were only 19 “mega rounds” (greater than $100 million raised) in 1Q23. The two other barometers that venture capitalists are willing to take on risk in this new environment are reflected in round size and pre-money valuations. The average early-stage and late-stage round sizes for all of 2022 as compared to 1Q23 were $21.4 million down to $18.7 million (early-stage) and $28.2 million down to $16.4 million (late-stage) – meaningfully smaller financings.
More notably is the compression of pre-money valuations. The average early-stage and late-stage pre-money valuations for all of 2022 as compared to 1Q23 were $131.7 million decreasing to $113.9 million (early-stage) and $286.2 million decreasing to $159.1 million, respectively. In addition to the drop in “mega rounds,” the near-immediate reset in valuations, particularly in the late-stage category, does not portend well for many late-stage investments made in the 2021-2022 timeframe.
In addition to concerns about access to capital on reasonable terms has been the abysmal level of exit activity for venture-backed companies. In 1Q23 there was only $5.8 billion of exits which is less than 1% of all the 2021 exit activity. This past quarter only saw 19 exits of greater than $100 million, which compares very poorly to the pre-money valuations cited above. It is very likely that there will be a significant number of private-to-private M&A transactions with “terms not disclosed” as we grind through the balance of 2023.
Not lost on anyone has been the disappearance of the Initial Public Offering market as institutional investors continue to operate with a “risk-off” mindset. In addition to the traditional IPO activity shown below, there was a frenzy of SPAC (special purchase acquisition company) merger activity over the last two years; just in 1Q21 alone there was $173 billion of SPAC activity as compared to only $8 billion of SPAC mergers in 1Q23 according to Dealogic. This has now come home to roost – and not in a good way. With approximately three-quarters of public companies having now reported 2022 results, the 39 post-SPAC companies reported $11.6 billion of goodwill impairment charges according to analysis by the Wall Street Journal. In 2020 SPAC impairment totaled a mere $4 million, further highlighting the valuation lunacy of the past two years. And the amount of valuation compression likely still to come.
Data: Dealogic; Chart: Axios Visuals
Strong investment returns drive venture capital fundraising. While private equity and venture capital consistently – over long timeframes – generate superior returns over all other asset classes, venture capital funds’ ability to raise capital has been under significant pressure. In 1Q23 there were 99 funds which raised a total of $11.7 billion as compared to the 199 funds in 1Q22 which raised $73.8 billion. There were only two $1.0+ billion funds this past quarter as compared to the 36 raised in 2022, which will likely be seen as the high-water mark for fundraising for some time to come. A recent Pitchbook analysis concluded that mega-funds consistently underperform smaller funds and in fact that “poor performance of billion-dollar funds has caused investors to temporarily stall new commitments to their managers and consider smaller funds that can more effectively deploy capital to venture stages that are more insulated from public market volatility.”
There is a cruel irony now as thousands of venture-backed companies recalibrate operating plans for the remainder of the year with investment partners who are anxious yet are evidently sitting with unprecedented levels of “dry powder.” SVB Leerink recently concluded that there was over $560 billion of venture capital raised but yet to be invested as of December 2022 (Crunchbase tallied $580 billion). If conditions rapidly deteriorate, one expects that valuations (and terms) will become attractive enough to prod venture capitalists out of their hypnopompic state to start investing again. We are not there yet; according to Carta which tracks 30k start-ups, March 2023 investment activity was down 83% from March 2022. Is this now the “new normal” with constrained liquidity and a real cost of capital?
Venture capital funding in the digital health sector continues to be relatively robust. Were one to annualize the 1Q23 pace of $3.4 billion invested according to Rock Health, 2023 should be largely in line with 2022 and 2020, excusing for the extraordinary level of activity in 2021 ($29.3 billion invested, arguably due to pressing issues illuminated by the pandemic). While showing signs of resilience, the current economic and financing climate will still drive further bifurcation of high- and low-quality healthcare technologies companies. High quality companies will be able to raise capital. While the annual investment pace may have declined by ~50% from the 2021 level, it is not as if the number of problems to be solved in healthcare were just cut in half.
First and foremost, those companies best able to raise capital this year will have complete and proven executive leadership teams. Full stop. Healthcare is too complicated for inexperienced teams to navigate in good times, to say nothing of the sector headwinds now. Companies will need to bring to market products that drive either near-term client revenues or show cost reductions within one budget cycle. Customers are under significant financial pressure and must show hard ROI right away.
Investors will struggle with value-based care models that only create economic value at scale, when to reach “scale” requires up to several hundred million dollars of private capital. Many companies showed profound member or patient level impact on outcomes but overall were quite unprofitable before reaching “scale;” those companies will sadly struggle to raise significant capital as the sector works to find its footing this year.
Interestingly, healthcare technology investments in 1Q23 accounted for approximately 9.2% of all venture investments in the quarter, which is up sharply from 7.2% in 2022. Notably, though, only six companies in 1Q23 accounted for nearly 40% of the amount invested, perhaps offering a preview that high quality companies will successfully attract capital and that “emerging winners” will be anointed in this period of sector consolidation. The median size for early-stage financings in 1Q23 was consistent with prior years, while there was significant reduction in Series D and later round sizes from $104 million in 2021 to $58 million in 1Q23.
According to SVB Securities, the public companies in the digital health sector had a reasonably strong 1Q23 trading up 10.2%, while unfortunately declining 32.9% over the last twelve months. That cohort is trading at 4.7x and 3.9x 2023 and 2024 revenues, respectively. The overall average revenue growth from 2022 – 2024 is projected to be 17.9%, but with only a 2.5% EBTDA margin expected in 2023.
Last week the Department of Labor released March employment data which showed that the healthcare sector accounted for 51k of the 236k jobs created in the month, just slightly ahead of the 47k government jobs created. Healthcare was the second most active sector behind leisure and hospitality. The Department also reported that there were 1.5 million layoffs in February (most recent month with data), and that there was a 64% increase in jobs lost in the Information sector.
Hopefully some of those displaced tech workers can fulfill the promise of healthcare technology to make the healthcare system more effective, while reducing costs. The system will need to staff up to turn around the drop in life expectancy from 79 years to 76 years since the onset of the pandemic. There is still so much more to be done.
On the Flying Bridge 