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Digital Health: What the Heck is Going on Heading into 3Q20…

Understandably the headlines this past quarter have been consumed by pandemic updates or the financial crisis, both inextricably linked. On April 1, there were sadly 3,746 deaths in the U.S.; on June 30, there were 119,761. Heading into the second quarter, analysts expected a wave of bankruptcies unlike anything seen before, and surprisingly, that did not occur – yet. While the default rate on high yield bonds was estimated to be 5% at the end of 2Q20 (up from 2.3% a year ago), the level of Federal Reserve intervention allowed the capital markets to function relatively well. And in the background the digital health sector recorded a terrific quarter, keeping the sector on pace for 2020 to be a record year for new investment.

It is worth pausing for a moment to put the level of intervention into some context as it will inform how the remainder of the year may play out. Just over $1.02 trillion of debt was issued by Corporate America in 1H20, more than double any previous first-half year ever before according to Dealogic. And while S&P Global Ratings projects default rates to be 12.5% by March 2021, with a range of 6.0% – 15.5% (upside to downside cases), it certainly appears that for much of the rest of this year access to capital will not be as dire as was feared this spring. According to Epiq, over 3,600 companies filed for bankruptcy in 1H20. More than 180 companies in the S&P 500 Index have withdrawn guidance for earnings.

Of course, the pandemic (and perhaps the distraction of the election) will dictate how quickly healthcare technology companies will scale and how predictably they will be able to raise funds. Even in light of the devastating progression of Covid, according to Rock Health nearly 100 healthcare technology companies raised approximately $2.4 billion in 2Q20; five of those financings were more than $100 million in size. For 1H20, this sector saw $5.4 billion invested, putting it on pace to likely be more than $10 billion for the year. While this would be a high-water mark, it also reverses the trend where 2019 was slightly lower than the activity of 2018.

2Q20 Rock Health Funding

One potential telltale sign to assess the balance of the year and how venture investors have recalibrated to an all-virtual investment model is the 2Q20 monthly activity. In April, as the shock / heartbreak / interruption of the pandemic set in, investment activity was only $500 million; by May it spiked to nearly $1.1 billion, but notably had dropped to $800 million in June. Arguably, 2Q20 was a time when investors shored up existing portfolio companies and closed on “in-process” new investments. Tough decisions were made as to appropriate reserve assumptions for existing portfolio companies. By the end of 2Q20, most venture firms were making new investment decisions based largely on Zoom interactions – expect there to be some moderation in activity as everyone gets adjusted to the new “abnormal.”

Obviously, there were some powerful tailwinds that developed last quarter: Centers for Medicare & Medicaid Services (CMS) expanded reimbursement, the reduction (hopefully to be permanent) of state licensure barriers, and the lock-down requiring dramatic adoption of virtual on-demand care. Consumers and employers are scrambling to utilize novel modalities to engage with providers.

While the dramatic reduction of service revenues for providers will undoubtedly compromise technology budgets, there is a market momentum that traditional care delivery models must change in response to current conditions. A Morgan Stanley CIO survey this quarter flagged that should the economic conditions worsen, AI, machine learning and process automation initiatives will be eliminated first. A recent American Hospital Association report estimates the four-month total through June 30 for lost revenues to be $202.6 billion. Research analysts at The Chartis Center for Rural Health estimates over 450 of the 2,000 rural hospitals in America are now at risk of closing. Tragically, this past week only 14% of adult ICU beds were available in Florida given the resurgence of Covid cases due to idiotic state re-opening pressures.

Florida Cases

Rock Health identified 52 M&A transactions of healthcare technology companies, and while slightly lower than the 2019 pace, it still suggests a robust appetite for these innovative solutions. This is particularly notable in light of overall M&A activity which declined more than 50% globally and was down a staggering 90% in the U.S. according to Refinitiv.  MobiHealthNews tracked 34 M&A transactions in the healthcare technology sector in 1H20, 23 of which were in 2Q20 for an announced transaction value of $1.2 billion (only 5 disclosed purchase prices so not a terribly useful number). There is likely to be increased consolidation given the large number of start-ups created in the healthcare technology sector as emerging winners become more evident. Additionally, given the investment surge in 2018 and 2019, many of those companies will need to raise capital over the next 12-18 months, leading some to decide to sell.

The Rock Health Digital Health Index of public stocks increased 30% in 1H20 as compared to Leerink’s Healthcare Tech/Service Public Company Index which was only ahead 0.6% for the year, but was up a robust 32% in 2Q20 (although relatively flat in June with an increase of 1.8%). Market valuations have been reasonably resilient as well. The Leerink index trades at 5.7x and 4.7x revenues for 2020 and 2021, respectively. According to FactSet, 2Q20 revenues and earnings for the S&P 500 Index are projected to decline 11.5% and 43.5%, respectively, which would be the greatest year-over-year decline since the onset of the Great Recession in 4Q08. The healthcare sector earnings are only expected to decline about 10% in 2Q20.

S&P 2Q20 EPS

To underscore the relatively healthy state of the healthcare technology sector, it is informative to look at the job losses and subsequent re-hiring. According to Bureau of Labor Statistics data, there were 43k lost healthcare jobs in March; that number spiked to 1.4 million in April, but May and June saw significant recoveries of 315k and 358k jobs, respectively. Overall, there are 15.6 million U.S. healthcare workers today which implies that net job loss (so far) during the pandemic is approximately 5%.

One other item: the Paycheck Protection Program (PPP), which over two installments is nearly $670 billion in size (~$130 billion has yet to be distributed), extended loans to 265 healthcare technology companies. While the disclosure requirements established by the Department of Treasury make it virtually impossible to tally the total amounts, only four companies took between $5 – $10 million, 15 took between $2 – $5 million, and 43 took between $1 – $2 million, suggesting a relatively modest amount of PPP loans went to this sector. To put that into context, Pitchbook calculates that over 8,100 privately funded companies took $13.4 billion in PPP loans so far.

While a 3Q20 event, Walgreens’ bold $1.0 billion investment in VillageMD underscores the profound role innovative healthcare technology and tech-enabled models will play in transforming the business of healthcare. That is not lost on venture investors, and more importantly, great entrepreneurs who look at the nearly $4.0 trillion of medical expenditures (per CMS estimates) that must be improved upon. Expect continued strength in funding and the consistent creation of important valuable new companies.

This is thankfully nothing like the recent history in the energy sector, which is forecasting 2Q20 earnings to be down more than 105%. Oil prices started the year at more than $60 per barrel, dropping below $0 per barrel (!), before ending 2Q20 at $40 – an increase of 92% in the quarter. Head-spinning…

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Another Member Joins the Band…

As it does not happen very often, we are particularly excited to announce that Margaret (Gaby) Malone has joined the firm as a senior associate, adding yet another important member to the Flare Capital team. While the pandemic has created unique challenges, we are even more excited about our investment strategy today than before COVID (and we were super excited back then) to address a number of the acute issues confronting the healthcare system. Expect us to continue to add to the team in important ways as we navigate this new “abnormal.”

Margaret’s passion for the business of healthcare is reflected in her professional experiences and her academic work. After nearly six years of working with early stage healthcare technology start-ups as an investor and advisor, Margaret earned her MBA from the University of Chicago Booth School of Business. Notably, we have already worked with her for over a year as she was a Flare Scholar (more below) in the great Class of 2019 and was with our terrific co-investor (7Wire Ventures) when we together invested in higi, a leading telehealth company based in Chicago. Before all of that, Margaret received her BA in Medicine, Health and Society from Vanderbilt University.

There were two other elements of her background that resonated with us, even more so now given the current healthcare crisis. Margaret has significant experience advising providers, having worked with a number of leading academic medical centers to re-architect clinical workflows. Additionally, she has a keen interest in building highly functioning executive teams given her focus on human capital; undoubtedly, she learned all of that at another one of our favorite firms – Oxeon Partners. She will be a lightning rod for the next generation of great healthcare technology entrepreneurs.

Actually, there was one thing that made me nervous. We use our initials internally when referring to each other so I was pleased to learn that “MG2” would be getting married this summer and slightly modifying her name.

Please welcome M(G)M to the firm.

Quick update on our Flare Scholars program and our recently launched, Flare Scholar Ventures. Earlier this year we announced the commitment to invest a portion of our new fund in the pre-seed rounds of Flare Scholar sponsored projects. Today we have over 150 Flare Scholars, who are younger brilliant passionate emerging healthcare technology entrepreneurs. We would not be surprised, in fact excited, if this initiative did not directly lead to the formation of a dozen or more exciting cutting-edge new companies in relatively short order. Last week we closed on our first Flare Scholar Ventures investment – we wish Susan Conover and the entire LuminDx team all the best. And there are a number of others in pipeline, following closely behind.

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Life on the Edge…Suicide

Over 1.2% of us will commit suicide.

According to the American Foundation for Suicide Prevention, 48.3k people successfully killed themselves in 2018, and this was out of 1.4 million attempts, making suicide the tenth most prevalent cause of death. Each day over 130 Americans take their own lives. Setting aside the nearly $69 billion cost in direct medical expenses and work-loss issues ($1.4 million per death), the devastation to each of those families is immeasurable.

Mental Health America, a 110-year old advocacy group offering anonymous online screenings, reported a 4x increase in screenings in May as compared to January. A shocking 42% of respondents exhibited anxiety or depression and a staggering 10% acknowledged that they have considered suicide. Not surprisingly with increased anxiety, social isolation, and for many, crippling economic conditions, the healthcare system is bracing for significant increase in suicide ideation. The act of quarantine has raised real issues of “time distortion” for many, at times equivalent to PTSD symptoms for some. While there is real debate as to the true unemployment rate given data collection issues, the chart below points to the sudden onset of real financial hardship for nearly 20% of working Americans.

 

Unemployment

 

Since 2000, the suicide rate increased by approximately 35%. Of particular concern was that the rate spiked in 2008, amidst the Great Recession. Centers for Disease Control and Prevention (CDC) data over the last century (below) points to the collective fears of what the pandemic has unleashed for those most at risk. The prevalence is greater among men than women: 1.5x in the developed countries and 3.5x in developing economies, underscoring the correlation to financial hardship. While suicide tends to skew to older and poorer men, there is considerable alarm about youth suicide which spiked 56% between 2007 – 2017 according to the CDC. In 2017, the second most prevalent cause of death for people between 15 – 24 years of age was suicide (behind accidents). While convenient to point to the increased availability of opioids, access to firearms, and troubling usage of social media, the causes are multifactorial and require significantly more study.

 

Suicide Rates

 

It has become quite apparent that the perception that incidence of suicide spikes around year-end holidays has proven untrue. In fact, suicides tend to peak during the spring season, which has tragically coincided with the onset of the pandemic. Speculation holds that longer days, coupled with seasonal allergies and other upper respiratory diseases which may affect certain areas of the brain, exacerbate existing mood disorders.

A leading researcher in the field of adolescent suicide is Dr. Cheryl King at University of Michigan, who has run multiple clinical studies to identify contributing factors and possible protocols to intervene with youth with suicidal tendencies. Her research has shown 50% – 85% reduction in successful suicide attempts, arguing for more research funding to identify scalable approaches to managing at-risk youths. In 2017, the National Institutes of Health (NIH) funded $6.6 billion in cancer research, yet only $37 million for suicide prevention research. In 2018, the NIH funded a total of 295 research areas with suicide ranked #206; neuroblastoma research is #205 and yet has only 650 new cases annually. Dr. King’s work raises difficult questions as to how the healthcare system perceives the “value of a teen’s life” given the absurd lack of funding.

 

Suicide by Age

 

According to a recent Wall Street Journal study, 70% of all suicides in 2017 were white male, 19% were white female, 8% men of color, and less than 3% women of color. Over 56% of male suicide was by firearms, poking at another unfortunately confoundingly controversial topic, which is the ready access to guns. CDC data below from 2015 presents a sampling of suicide data by profession, perhaps suggesting that suicide is materially less prevalent for those with well-paying jobs. While more research is clearly required before declaring a precise causality between income and suicide incidence rates, a relationship most likely exists.

 

Suicide by Job

 

Globally, according to World Health Organization data, every 40 seconds one person commits suicide. In 2015, there were over 828k suicides placing suicide as the tenth leading cause of death. It is estimated that there are between 10 – 20 million suicide attempts each year worldwide. No community is immune to this. For those who have been hospitalized for attempted suicide, nearly 9% will go onto to successfully take their life post-discharge.

Suicide is considered preventable. In addition to a range of more traditional time-tested solutions that exist, such as behavioral health treatments, intervention, reducing access to means of suicide (firearms, drugs), it is clear that technology will likely play an increasingly important role in a coordinated set of treatment protocols. Many of the initial approaches tend to be device-centric: algorithms that review mobility and connectivity data to assess dramatic changes in behavior or that analyze voice patterns or assess radical changes in social media consumption.

While informative, like most diagnostic tools, clinicians will insist on very high and reliable predictive powers to determine the onset of a crisis episode. These initial solutions are not quite there yet. The role of telehealth and how those platforms will be utilized will be important. There is considerable enthusiasm that future iterations of smartphone sensing coupled with powerful AI capabilities, in coordination with other traditional forms of intervention, may create more efficacious suicide prevention tools.

The field has certainly come a long way since 1846 linking that first glass of wine to inevitably taking one’s life…

 

Suicide

 

Related topic of substance use disorder was addressed by one of my partners, Dan Gebremedhin, in his recent article for MobiHealthNews.

 

If you have any thoughts of self-harm or suicide, please pick up the phone right now and call the National Suicide Prevention Hotline at 1-800-273-8255

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Pulling Back the Veil Surrounding Nursing Homes…

There is a reasonable chance that you will be admitted to a nursing home or cared for in a long-term care facility at some point in your life – certainly, someone close to you will have been. The adult care industry is massive, currently estimated to be $140 billion in size, and remarkably complex. According to the Center for Disease Control and Prevention’s (CDC) most recent industry survey in February 2019 (Long-term Care Providers and Services Users in the United States), 2.45 million people were either enrolled in adult day care or residents of nursing homes and long-term care facilities. Another 4.46 million were discharged from a home health agency while 1.43 million received hospice services in 2015-2016.

The number of service providers were numerous, creating a chaotic patchwork system with 15.6k nursing homes, 28.9k assisted living facilities, 4.3k hospice providers, 4.6k adult day care centers, augmented by over 12.2k home health agencies. And the need for these services is only increasing as the population ages. According to the National Investment Center for Seniors Housing and Care, the percent of the population 75+ years old in twenty years will be nearly 12%.

 

Nursing Home Ages
Undoubtedly, these very difficult work environments, made dramatically more challenging by the COVID-19 crisis, have been hit particularly hard. The mortality rates are confounding and staggering. Like prisons, the communal settings found in nursing homes and the fragility of the residents have given us heart-breaking stories of loss while exposing significant industry shortcomings. In mid-March, there were an estimated 28.1k deaths among both nursing home residents and staff with 153k reported cases. These residents were only guilty of being old.

 

Nursing Home Death by Age

 

Given inconsistent reporting guidelines by state and the profound lack of testing, there is considerable debate as to the true mortality rates in nursing homes. AARP estimates the mortality rate to be approximately 20% – 25% while the Foundation for Research on Equal Opportunity has painfully tabulated results by each state to conclude the rate is closer to 42% (see map). Commentators have taken to estimating that cases in nursing homes tend to be 10% of the total but 33% of all deaths.

 

Nursing Home Deaths

The nursing home industry is very competitive, and success is largely dependent on case mix and occupancy rates, which have been running around 90% across all senior housing. There was a significant and immediate decline in occupancy rates at the onset of the pandemic, largely attributed to fewer discharges to post-acute settings. At the outset, hospitals were discharging COVID-19 positive patients to woefully unprepared nursing homes in search of beds. In 3Q19, the most recent available quarterly data, “fee-for-service,” Medicare reimbursement rates were on average $523 per day, while Medicaid rates were $214 per day. With expansion of Medicaid rolls, expect this situation to get worse. In fact, 3Q19 was the first quarter where more than half the nursing home days were Medicaid at 51.5%. Analysts estimate that the profit margins tend to be 3 – 4% at these facilities.

 

Nursing Home Occupancy

The leading nursing home operator in the United States is Genesis Healthcare with nearly 400 facilities and is also a provider of a number of ancillary services (more on that shortly). In 2019, revenues were $4.6 billion and after a handful of years of significant operating losses ($1.8 billion cumulatively for four prior years), pretax income was barely $10 million. With an overall occupancy rate of 84% and 76% Medicaid patient-days, Genesis has a market capitalization of only $170 million, which increased 35% last Friday likely on news that the Department of Health and Human Services would provide $4.9 billion of federal aid to nursing homes and that a number of influential states (now over 30 states) will provide liability immunity shields related to COVID-19.

Given the high fixed cost structure and razor thin operating margins, it is no wonder that these facilities tend to be “under-utilizers” of technology. According to the CDC National Health Statistics analysis in March 2020, residential care facilities that utilized electronic health records (EHR) increased from only 20% to 26% from 2012 to 2016. Of those that actually used EHR platforms, only 55% actually had health information exchange capabilities with doctors and pharmacists in 2016. In general, larger facilities (presumably better capitalized, better resourced) were more likely to use technology, while paradoxically, “for profit” operators were less likely to do so. Shocking.

 

Nursing Home EMR

Approximately 70% of the nursing home industry is “for profit,” with private equity investors playing a significant ownership role, and not always a great one at that. Since 2000, a recent New York University study concluded that there were 119 leveraged buyouts in the nursing home sector. Often times these nursing home investors controlled companies that were providing necessary services such as cleaning, facilities management, medical equipment leasing, and other ancillary services at significant margins (see Genesis Healthcare above) to those same homes. Notably, in “for profit” facilities the number of hours of care per patient declined 2.4% and according to federal quality guidelines, staff quality decreased by 3.6% since being acquired. Investor appetite has not let up – according to a survey by Senior House News (February 2020), nearly 40% of respondents assumed private equity will continue to be the leading investor in the asset class.

Nursing Home Owners (2)

An analysis by the Journal of Post-Acute and Long-Term Care Medicine, determined that the Omnibus Reconciliation Act of 1987 was a landmark in overhauling nursing home quality assurance systems and led to much more impactful oversight. Given the “lock down” now in place at nursing homes, the first two lines of oversight (family members, government regulators) are blinded to conditions inside of most facilities. According to U.S. Government Accountability data, the number of abuse violations more than doubled from 430 to 875 between 2013 and 2017. It is estimated that 20% of all emergency room visits by nursing home residents is due to neglect. There are now significant concerns about current conditions.

Tragically unforgiveable, there also appears to be a racial overlay to this nursing home crisis. A recent detailed New York Times analysis determined that 60% of all nursing homes with a minority census greater than 25% of residents had at least one COVID-19 case, which was twice the rate in facilities with minority census less than 5%. This phenomenon did not correlate to location, size or quality rating.

The immediate path forward is unclear. Recent Centers for Medicare & Medicaid Services (CMS) guidance strongly endorses that nursing homes should be the last facilities to re-open, providing a nearly unattainable checklist of conditions to be met. Massachusetts recently put forth a four-page “Nursing Facility Infection Control Competency Checklist” with 28 required items! The American Health Care Association estimates that it will take at least 2 – 3 months to have adequate protective equipment and 4 – 6 months before appropriate testing capabilities can be instituted. But what regional case counts will be acceptable to allow visitors? Quite clearly, inexpensive healthcare technology platforms such as telehealth, remote monitoring, and contact tracing will be an essential cornerstone of managing nursing homes going forward.

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2Q20 – Groping in the Dark…

Good God, everywhere you look there is bad news. Obviously, other than for the public equity markets, the question now is not can it get any worse (yes, which will likely be revealed in the May data) but rather, when might we start to see a recovery. The venture capital investment activity over the course of prior corrections may be an interesting indicator for what to expect over the balance of 2020.

But first, what did we see this past quarter? Overall, $34.2 billion was invested in 2,298 companies which was consistent with 1Q19 activity and suggests that at least at the outset of the year, the investment pace was likely to be in line with 2018 and 2019 levels. Upon closer inspection, one can see a marked decline in the number of deals, implying a significant increase in the average round size ($11.4 million in 2019, $14.9 million in 1Q20).

 

1Q20 Activity

 

Valuations in 1Q20 were reasonably resilient as early stage and late stage investments were mostly flat in the quarter when compared to all of 2019: $28.0 million vs $29.4 million in early stage and $75.0 million vs. $80.0 million, respectively. The seed and angel stage pre-money valuations hovered between $7.5 – $8.0 million. According to Fenwick & West, the increase in share price over the prior round were 117%, 76% and 46% in January, February, and March, respectively, clearly underscoring more compression on valuations as 1Q20 progressed. In March 2019, the step-up was 63%. Flat may soon be the new “up round.”

There does appear to be a greater prevalence of downside protection terms such as full-ratchet antidilution, liquidation preferences, pay-to-play, and deeper discounts on bridge loans – all of which serve to provide greater investor protection. This also reflects a more challenging fundraising environment coupled with expectations for more modest exit valuations. Corporate venture capital (CVC) groups tend to retreat quickly when market conditions deteriorate, which appears to be the case now. According to Global Corporate Venturing, CVC participation decreased by 21% and 12% in terms of number of investments and amount invested in March when compared to a year earlier.

The closely watched Silicon Valley Venture Capitalist Confidence Index has never been so low, registering a 2.33 (on a 5-point scale) down from 3.60 at the end of 2019. This 35% decline is the greatest decrease in the 16-year history of the survey and eclipsed the prior low point of 2.77 set in 4Q08, amid the Great Recession.

One other contributing factor to the chaos before us. Typical fundraising rounds provide companies with 12 – 18 months of cash “runway.” The significant investment activity of 2018 and 2019 (according to Pitchbook there were nearly 22,900 financings over those two years) has created an extraordinary number of companies poised to come back to market. Pitchbook estimates that there are approximately 7,200 that now need to raise additional capital.

Silicon Valley Bank (SVB) estimates that 82% of all venture-backed companies were founded by entrepreneurs who have not experienced a recession – a dynamic exacerbated by the fact that 61% of venture firms today have not had to navigate such a downturn. For venture firms that have median fund size greater than $100 million, SVB determined that 52% of them have not had to manage through a recession. Since March 11, when the coronavirus was declared a pandemic by the World Health Organization, 45,243 people were laid off by start-ups according to the “Layoffs.fyi Coronavirus Tracker.” And all of those participants are now staring at the chart below (and that is not the more inclusive U6 Unemployment Rate which is 22.8%)…

 

2Q20 Unemployment

 

Twenty years ago, there was another venture industry correction. In 2000, the quarterly investment pace was between $25 – $27 billion. In 2001, with the correction well-underway, the quarterly investment pace dropped to nearly $10 billion, only to drop to a $4.0 – $5.0 billion quarterly pace starting in 2002 and lasting for the next four years. Analysts peg that market peak to have been in 2Q00, suggesting that investors in 2001 were mostly only funding those existing portfolio companies deemed able to weather the storm. Once the immediacy of the crisis abated, a more normalized level of investment activity was only around 20% of the high-water mark set in 2000.

During the Great Recession a dozen years ago, there was a more modest re-set in overall investment activity, in part due to the fact that the venture industry never fully recovered from the Dot.com debacle. Total investment in 2007 and 2008 was $36 billion annually, decreasing to $27 billion and $31 billion in 2009 and 2010, respectively.

Arguably, 2020 looks more akin to 2001 than 2009, given that the industry is coming off of a very robust pace in 2018 and 2019 a la 1999 and 2000. The step-down is likely to be steeper, obviously made enormously more complicated by the fact that investors are not able to actually meet with entrepreneurs and visit the prospective companies.

One mitigating consideration will be the appetite of limited partners to commit to new funds. In 1Q20, the fundraising environment was reasonably strong as 62 venture funds raised $21.0 billion. Of that total, 70% was committed to funds greater than $500 million in size, suggesting further consolidation around larger established venture franchises. There were only nine new investment firms, raising $1.1 billion, further underscoring the consolidation. In fact, limited partner sentiment has shown to be quite resilient, at least at the outset of the pandemic and for branded firms. According to a recent Preqin survey (below) of 110 institutional investors, only 9% will reduce commitments to alternative asset classes. Notwithstanding that, over $4.65 trillion is now held in money market accounts, which is $700 billion more than the greatest level during the Great Recession, punctuating the overall flight to safety.

 

2Q20 LP Sentiment

 

The investment activity in China may also provide guidance as to what the entrepreneurs in the U.S. should expect over the next few quarters. Arguably, the impact of the coronavirus hit the Chinese market at least 90 days before the U.S. According to Fortune, venture investment in the technology sector declined 30% in 1Q20 from the prior year ($16.8 billion vs. $24.0 billion) and the number of transactions declined 45% to 634 deals in 1Q20. A fairly rapid and dramatic correction.

None of this is to suggest that the correction and subsequent recovery will be swift or predictable. Given the level of systemic debt (several trillion dollars) that has been issued and the global sweeping nature of the pandemic, the path forward will be very difficult. The capital markets are seeing a level of financial distress not seen before.

 

2Q20 Debt

 

With the Congressional Budget Office now forecasting a U.S. budget deficit that will be $3.7 trillion this year and public debt to now be 101% of GDP, the consumer has been upended as economic activity continues to drop precipitously. The International Monetary Fund in its recent World Economic Outlook has already called this the most devastating economic crisis in nearly a century, and it is just starting. The ultimate impact is near-impossible to even forecast. Already it is believed $9 trillion of economic value has been lost globally even should there be a rapid recovery in 2H20; that is the equivalent of the GDP of Japan and Germany combined.

 

2Q20 Consumer Credit

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Locked Away…

Today nearly 2.3 million people are incarcerated in the U.S., distributed across a patchwork criminal justice system of over 7,100 prisons, jails, correctional facilities and detention centers. And what they all have in common is that they are quite likely confined to Covid-19 hot spots.

At the outset of the pandemic, national attention was either on cruise ships, which appeared to be viral petri dishes of captive passengers destined to all become infected, or how each of us could possibly survive household confinement with just Zoom. While some were also focused on whether Joe Exotic should actually still be in prison (what is this guy from Oklahoma doing with 197 tigers?), the tragic dilemma of life behind bars did not become a topic of discussion until late March; by then, Covid-19 was spreading rapidly throughout many of the country’s most notorious prisons.

Over the course of two weeks in late March, the number of Covid-19 cases in Cook County jail in Chicago spiked from 2 to 238 in a population of 4,500 prisoners (today it is over 500 cases) – and in a setting where systematic testing does not exist, most likely severely understating the true extent of infection. And this does not even include the 115 prison staffers who also tested positive in that two-week window. With over 600k total Covid-19 cases in a country of approximately 330 million people, the infection rate in prisons is many orders of magnitude worse for those in captivity.

Before tackling some of the emerging ethical, and frankly practical, implications this raises, where one is incarcerated meaningfully determines one’s risk of exposure. Each year nearly 600k people are sent to prison, yet over 10.6 million people are arrested and sent to jail (which is very different than prison). It is estimated that 200k people are in and out of jail every week, creating a profound and little understood disease vector back into populations at risk. A fully 74% of people in jails are actually not yet convicted of a crime – they are unable to post bail or are awaiting the next step in the judicial process. Median bail for a felony in America is $10k – an insurmountable hurdle for many. While statistics are shockingly hard to determine, it is estimated that between 80k – 100k people are currently in solitary confinement, presumably at relatively low risk of Covid-19 infection.

Prison Population

In addition to the inexcusable racial inequities created by the criminal justice system, it is also well understood that the prison population has unique and significant health issues, particularly when compared to the general population. According to The Prison Policy Institute, across a number of critical chronic health conditions, the prevalence among prisoners far exceeds what is present for those outside of the criminal justice system. All of the conditions highlighted below significantly increases the risk of death when infected with Covid-19, making captivity an even more daunting reality for many vulnerable prisoners.

Prison Health

Should a first-time offender arrested for a non-violent crime now be placed in such an environment? What about the elderly prisoner having served most of his sentence – should he be released early? The pandemic has raised many profound health-related questions which the Federal Bureau of Prisons (FBP) is scrambling to sort out. Last month, the FBP instituted a policy which mandates that all prisoners are to be secured in their cells for 14 days, which is set to expire today.

Partially in response, the Prison Policy Institute released five recommendations to reduce the virulent spread of Covid-19 in the prison system: (i) release medically fragile and elderly prisoners; (ii) lower jail admission rates to reduce “churn;” (iii) limit unnecessary parole and probation meetings; (iv) cease revocation of release for technical parole violations; and (v), do not charge medical co-pays that dissuade prisoners from seeking treatment. But do these proposals start to impede on the rights of the general population, perhaps being put at further risk by these prisoners? We shall see as the American Civil Liberties Union recently filed suit advocating for the compassionate release of those at highest risk. Super complicated issues.

There is clearly evidence of far fewer arrests since the pandemic took hold of the country. The New York State of Criminal Justice Services recently reported that crime in New York City declined in March over 43% year-over-year. Is that because there is less crime or that the criminal justice system is trying to lessen the health burden on the prison system by “slow walking” cases?

Notably, there is a significant for-profit prison ecosystem that has built up around the U.S. criminal justice system, from food concessions, telephony services and healthcare services. There are a number of private prison operators; two of the most notable public companies include Corrections Corporation of America (now “CoreCivic”) and GEO Group, Inc, both nearly $2.0 billion in market capitalization. It is estimated that 8.4% of all prisoners are housed in private for-profit prisons. According to Private Prison News, these facilities generally have worse conditions than government-controlled locations. In 2016, the U.S. Department of Justice reported that privately managed federal facilities were less safe and more punitive than other federal prisons.

Underscoring these significant concerns, in 2014 an important study of Brazilian prisoners infected with tuberculosis found that they represented 8.4% of all cases in the country yet were less than 0.3% of the general population. Over a five-year period, when TB rates in the nonincarcerated population declined, overall infection rates in Brazil increased in large measure due to the “churning” of patients in/out of the justice system. An ominous study as one looks at the current pandemic.

Perhaps lost among the news that Rikers Island in New York just released 650 non-violent prisoners with less than a year to run on their sentences or that Iran recently freed 25% of its prison population, was the fact that even Michael Avenatti was released from prison due to Covid-19 concerns.

Arguably more shocking, bookings for cruises in 2021 are up 40% according to CruiseCompete.com – who are those people?

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Digital Health Prospects for 2Q20…

Now that the economy is in a medically induced coma, venture capital firms are scrambling through their versions of “three stages of grief”

• What is the status of each portfolio company? Which ones need to raise capital? What cost reduction steps must reluctantly be taken? Are the current reserve assumptions appropriate?
• How do we feel about all of the in-process investments that have been diligenced for the last few months?
• When do we begin to consider new investment opportunities? And how can we do that if we are not even able to meet the team? Or visit the company?

Naturally, the first two items can be assessed quite quickly, and remedial action plans are likely already being deployed. The third item is a bit trickier to predict. When the Flare Capital team members were surveyed as to when we would all be back in the office, the answers spanned from early May to mid-July.

So it was with great interest to review the 1Q20 Rock Health data released today which registered nearly $3.1 billion of new digital health investments in 107 companies. This was the second largest quarter ever, behind 3Q18. Interestingly, the average size of investment was approximately $29 million, in part reflecting that there were six financings greater than $100 million (there were more than 100 such financings across all sectors in 1Q20). Later stage investments accounted for 31% of the financings, further underscoring the maturation of this sector. Rock Health also points out that 63% of all companies financed in the quarter sell into the provider segment, which as we painfully know, is solely focused on the Covid-19 crisis now.

1Q20 Rock Health

There is a nuance buried in the monthly data this past quarter that may inform what the next few quarters might look like. The January 2020 activity was very robust: 41 companies raised $1.4 billion – but the pace started to markedly slow as the quarter unfolded. February saw 33 companies raise $898 million while March saw a further moderation with 32 companies raising $603 million, just 40% of the investment activity two months earlier. As the volume of new commitments comes down over the next few months, it certainly appears that 2020 will look more like 2016 or 2017 than 2018 or 2019 in terms of overall investment activity.

1Q20 Avg Deal Size

Arguably, healthcare technology and services investment opportunities are even more of a priority today given all of the shortcomings that have been exposed over the last few months. The profound need for innovative new clinical care models, remote management, predictive analytics to identify and manage high-risk members of our society, solutions to accelerate drug discovery and regulatory approval, novel approaches to population health management, and solutions for patient financial responsibility have never been more important. And importantly, many of the onerous regulatory frameworks that slowed adoption of novel care models have been reformed, particularly for virtual care.

Thus, the dichotomy – enormous and painfully evident market needs staring at a deeply impaired capital markets. Entrepreneurs should expect a dramatically lower level of investment activity and with that, dramatically lower valuations (a review of trailing valuation multiples shows that 2H19 may well have been a highwater mark). Round sizes are likely to be considerably smaller, often tranched to value-creating milestones as investors scramble to manage liquidity and portfolio reserves. Terms are likely to be more investor friendly, reflecting the new risk environment. In times of dislocation, many corporate venture funds significantly pull back or leave the market altogether. Obviously, prospects of near-term compelling exits just evaporated. Management teams will be pushed to extend operating runways with the cash on-hand, as syndicate members nervously look around the board table to assess which funds will struggle to support the company.

And the cruel irony is that the healthcare needs are overwhelming. Axios recently reported that quarantined Americans are reverting back to many bad health habits:

Nielsen data for the week ending March 21 showed alcohol sales spiked 55%; online alcohol sales jumped 243%
Evidation Health data from 68k fitness trackers shows over the course of March activity dropped 39%
Marijuana sales are increasing dramatically – up 56% on California alone

With some epidemiologists estimating that the death total could ultimately be as high as 500k, a second order concern may well be acute malaise that sets in over the next few quarters as we collectively process such a catastrophe. Nearly 7,700 Americans pass away every day in this country which starts to put daily death tolls of a few thousand into some context. Inevitably, many of us will be personally touched by this virus, either will get sick or know someone who was sick or even died from this. There will also be third and fourth order effects as delayed attention to other chronic diseases catches up or a resurgence of Covid-19 returns.

Covid Cycles

While of little solace in this moment, the healthcare system is quite resilient and there are great entrepreneurs who already envisioning solutions to address many of the systemic issues we now are confronting.

Stay healthy…six feet apart.

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Whistling Past the Graveyard…

As we are now all expert on surge capacity and what it means for the U.S. healthcare system, we have tragically come to learn how woefully unprepared we are for a crisis of this magnitude. Shortcomings in supply chain are now frighteningly evident. Hell, even the lack of adequate labor is alarming as we now start to envision scenarios where some of the essential staff are taken offline. The New York Times recently highlighted that healthcare workers (orange dots) are literally in close proximity to disease daily. At the end of the supply chain is the Death Care industry which is also likely to be overwhelmed given how it is structured.

Risk Exposure

Within weeks (or less), U.S. hospitals will be overwhelmed with COVID-19 cases. The healthcare system is mobilizing, setting up ancillary care units, recognizing the expected inability to house all of those people. With approximately 2.4 beds per 1,000 residents, the U.S. is nearly one-third the per person capacity of countries like South Korea, which appears to have more effectively managed this crisis. If half of the 330 million Americans are infected, and if 5-10% of those cases are critical, it is near-impossible to see how 8 – 16 million people will fit in ~100k ICU beds.

Beds

According to the Centers for Disease Control and Prevention (CDC), more than 2.8 million people die each year in the U.S. (in 2017, 56 million people died globally or 150k per day). On average, 7.7k people die in the U.S. every day which puts the current crisis in such stark relief. About 2.5 million people live in nursing homes and long-term care facilities in the U.S. – 380k already die from infections in those facilities annually.

Dr. Neil Ferguson at the Imperial College in London, a prominent English epidemiologist, recently published models which estimated a range from best to worst case scenarios for deaths due to COVID-19 in the U.S. of 1.1 – 2.2 million people. Think about that. This pandemic has the potential to increase the annual number of deaths in the U.S. by 35 – 80% this year. Thus, the question now is what is the surge capacity of the Death Care industry?

There were an estimated 2.7 million funerals last year. The Death Care industry employs 123k people and is forecasted to be approximately $68 billion in 2023, after a long period of very modest growth according to Research & Markets, Inc. It is principally comprised of three sectors: funeral homes, cemeteries, and memorial products. According to the National Funeral Directors Association (NFDA), there are nearly 19.3k funeral homes (11k of which are members of the NFDA). Funeral home revenues are estimated to be $16.8 billion per IBIS World, with the six largest companies controlling nearly 30% market share. The dominant player is Service Corporation International (NYSE: SCI) with $3.2 billion in revenues, operating margins around 20%, and a market capitalization of $6.8 billion (~2x revenues).

There are over 115k cemeteries in the U.S., which is actually a difficult number to determine given many are not actively managed. SCI estimates that “for profit” cemeteries generate around $4.0 billion in annual revenues with “healthy” operating margins of nearly 30%.

The third significant sector of the Death Care industry is something called memorial products and includes items such as funeral planning, cremation, body preparation, transportation and other assorted merchandise. There are over 300 brands of caskets. While the cost of a funeral may be $8k – $10k, all the additional add-ons likely make these ceremonies meaningfully more expensive. It is estimated that Michael Jackson’s funeral cost well over $1.0 million.

Innovation, believe it or not, is an important recent industry development as issues like brand and environmentally sensitive procedures are becoming much more relevant. And now grieving-at-a-distance. It has also been an industry that has had to gently navigate cultural and religious norms and peculiarities. Now other powerful forces are at work. In 1970, 5% of all funerals involved cremation, but with increasing environmental concerns of placing so much steel and embalming fluid in the ground, cremation is now approximately 56% of all funerals (annually, enough embalming fluid is used to fill eight Olympic-size pools and enough steel is used to build the Golden Gate Bridge). Now that there is a new emerging concern about greenhouse gases as over 600 million pounds of “pollutants” are released, alternative procedures such as alkaline hydrolysis or “green burials” are becoming more prevalent. Cremation is thought to be much less profitable than traditional burials.

Interestingly, until recently, industry analysts had warned that with the dramatic decrease in tobacco usage and increased life expectancy, the Death Care industry was in for relatively difficult times. In 1882 in Rochester, NY, presumably given the needs highlighted by the 620k Civil War fatalities, the first ever National Funeral Directors convention was held. One cannot help but wonder how the industry now will navigate this expected surge, particularly when groups no larger than 10 can congregate. Hopefully, as McKinsey & Co. underscores below, necessary steps can be taken to dramatically reduce the mortality rate and viral reproduction dynamics in the population otherwise this surge will be devastating even to the Death Care industry.

COVID

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Pandemic Bonds and Peru…

It certainly appears that I missed some extraordinary events while in Peru last week. While every week now feels quite extraordinary, the across-the-board asset price correction was deeply unsettling. Equities plunged into “correction” territory. Investors sought security as government bond prices hit historic highs, driving yields to 0.7%, alongside accelerated withdrawals from riskier high-yield bond funds. Price of gold soared 6.8% just last week alone. OPEC, unable to agree to proposed 4.0% production cuts, saw Brent crude prices drop 9.4% (and another 30% in early-morning trading in Asia!). In light of the unfolding coronavirus crisis, analysts up and down Wall Street were “adjusting” U.S. GDP growth projections. For example, Deutsche Bank revised 1Q and 2Q growth rates from 1.7% and 2.2% to 0.6% and negative 0.6%, respectively; a net 2.8% change in 2Q is staggering. All of this has created volatility not often seen in the capital markets.

Trump Volatility
One other recent announcement merits highlighting and that is the federal government’s $8.3 billion coronavirus relief package (~$25/person), of which $3.1 billion is for public health and social services. A further $2.2 billion was directed to the Center for Disease Control and Prevention of which $1.0 billion is to go to local facilities and interestingly $0.3 billion was for international needs (more on that shortly). With global reported cases now exceeding 100k and nearly 4k deaths, challenging questions about U.S. preparedness are being pressed. Shockingly, a recently leaked presentation used by the American Hospital Association to prepare for worst case scenarios estimated that there could be as many as 96 million cases of coronavirus with 460k deaths in the U.S. alone.

Peru, a country of 32.8 million people nestled comfortably on 500 million square miles of some of the most staggeringly beautiful vistas in the world, would certainly be runover by a coronavirus outbreak. According to the World Health Organization (2017), Peru spent just 3.7% of its $505 billion in GDP on healthcare, and has run consistently 50% of what most Latin American countries spend. Over half  of the population is indigenous, while 19% of the country is below the poverty level and 79% live in urban settings. Across many of the leading healthcare indicators, Peru compares poorly to its peers. Life expectancy is 77 years (74.5 for men, 80.2 for women), ranking 65th in the world according to the United Nations Population Division (50 years ago, life expectancy was 54 years). The obesity rate is 19.7%, putting it #109 globally (interestingly, Vietnam is #1 with 2.1% while tiny Nauru in the Australian Ocean waddles in last place with 61% of its 13k residents deemed obese).

Today Peru is a democracy spanning across 25 regions. For a dozen years starting in 1980, the country suffered through a terrible period of bloody insurrection led by the Shining Path, a communist organization determined to overthrow the government. The end of the twentieth century also saw periods of hyperinflation, which occasionally reoccur as much of its economy is tied to prices of important commodity exports such copper, gold and zinc. The boom and bust cycles are very evident as most houses look mid-construction with rebar poking through first floor walls, waiting for additional floors to be built. And rarely was there construction work being done.

Peru Building

The last decade saw relative economic prosperity and fostered a greater commitment to improve public health (similar dynamic I saw in Colombia last year). In 2009, a universal health insurance law was passed which now effectively covers 80% of Peruvians. There was a significant investment in primary care infrastructure (there are now 1,078 hospitals in Peru) and outreach to rural communities (36% of all births are still outside of hospitals). Half of the population is indigenous and still quite reliant on “traditional” medicines and shamans which is readily apparent given how often one is offered coca tea. It is somewhat unsettling to see hanging in the markets alpaca fetuses which are considered spiritually beneficial. Unfortunately, today it is estimated that the top 20% spend ~4.5x more on healthcare than the bottom 20%. Thus, my concerns as I watched the pandemic unfold (fortunately, Peru still does not have a reported case). Peru is also hosting 860k Venezuelan refugees, per Financial Times estimates, further stressing local healthcare infrastructure.

In 2017, as the Ebola crisis was winding down with “only” 11k deaths and at an estimated $53 billion economic cost, the World Bank developed a novel (controversial?) financing instrument affectionally called “Pandemic Bonds.” Up until that point, there had not been a structure to allow institutional investors to participate in such events. Insurance and the derivative markets are very sophisticated in underwriting most other risks (flood or fire insurance, natural disaster insurance, etc) but had yet to create an instrument for investors to mitigate pandemic risks we see emerging today. Financial instruments are meant to spread risk while rewarding investors who take on those risks.

Technically called the Pandemic Emergency Financing Facility (PEF), the World Bank heralded the creation of these super complex $500 million specialized bonds, as they were 2x oversubscribed. At its essence, the bonds were designed to assist poor countries to finance a response to a healthcare crisis, while offering investors attractive returns. Structured across two-tranches (Class A and B), payouts were based on predetermined mortality rates (number of deaths over certain time frames). Class B investors were paid LIBOR +11.1% but faced complete loss of principal, while Class A investors earned LIBOR +6.5% with losses capped at ~16% of principal.

Naturally with complexity and given the exposure to catastrophic loss of life, there is now controversy as to how these bonds really work. Have enough people died, fast enough? Is this a “qualifying” pandemic? Most analysts expect that the bonds (which do not trade publicly) should start to payout in April 2020, which likely accounts for the rumored discounted private market pricing of $0.64 on the dollar. Obviously, the complexity is bad, but importantly, the returns are actually correlated to broader capital markets. Ideally, these types of financial instruments should be more valuable as the health crisis unfolds, attracting additional capital to support these poorer countries.
The reality is that these pandemic bonds will at most pay approximately $195 million to just the poorest countries, a relative pittance given the overall costs to contain and treat.

Unfortunately, these are also the countries (like Peru) with the weakest healthcare systems, least likely to capture accurate and timely data to even begin to assess the severity of an outbreak. Iran has already run out of hospital beds in the hardest hit northern provinces. The only public health signage I saw all week in Peru was as I was boarding the flight back. This starts to explain the World Bank announcement on March 3 of a $12 billion coronavirus aid package.

Peru Public Health.jpeg

Since early February 150 Chinese companies have issued $34 billion of “coronavirus bonds.” State-owned banks were the principal buyers and at what was deemed to be below market rates, certainly not priced to reflect the true economic risk. These issuances allowed many of these companies to fund accumulating losses associated with the global disruption caused by the epidemic. Chinese exports have already tumbled 17% in the first two months of 2020. For instance, Didi Chuxing (“China’s Uber”) just spent $14.3 million to install plastic sheeting between the driver and passengers in all of its vehicles and in the face of dramatically reduced ride volumes. Passenger car sales fell 80% in February in China, according to Reuters.

At least the sun was out at Machu (“Ma-a-achoo”) Picchu which was breathtaking but in a good way…

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Chocolate Mess…

As we now languish in the chocolate void between Valentine’s Day and Easter, it was with great sadness that I learned that the formation of the “Chocolate OPEC” (“COPEC”) by the Ivory Coast and Ghana, which together account for 60% of global cocoa production, is expected to cause the price of chocolate to increase significantly. While most commodities have experienced notable price declines with continued global trade concerns and the spread of Covid-19, cocoa prices have risen, spiking nearly 7% just in the first two weeks of 2020 alone. Cocoa is (obviously) the principal ingredient in chocolate.

Chocolate Prices

Data: FactSet; Chart: Axios Visuals

Over the last five years, cocoa prices have swung wildly from highs around $3,400 per metric ton to lows of $1,800 just two years ago. While prices today are closer to $2,900, a few years ago “COPEC” initially considered instituting a price floor but later determined that adding a $400 per ton premium was more beneficial to cocoa farmers. The goal was to ensure that farmers would realize at least $1,800 per ton, which is challenging given the complexity of the supply chain with local government squatting right in the middle. According to the International Cocoa Organization, last year 4.8 million metric tons of cocoa were milled. The World Bank goes on to observe that 80% of all cocoa farmers, which equates to 4 million people, subsist on an income of $3 per day. Forty-five 141-pound bags of cocoa generate $3 to a farmer.

 

Cocoa Prices (2)

The chocolate industry is estimated to be over $107 billion. The National Confectioners Association estimated that $21.1 billion of chocolate was sold in the US last year (of the $34.5 billion of total candy sales). Global consumption rose 5.7% over the five years from 2012 – 2017. With premium craft chocolate bars now retailing for more than $8, one would to expect to see continued strong growth.

In fact, the industry has worked hard to promote the health benefits of dark chocolate with its cocktail of antioxidants that, in moderation, may prevent cardiac disease and type 2 diabetes, as well as being a mild sexual stimulant – true story. Obviously, in excess, chocolate is quite likely to be unhealthy. It is rich in caffeine (20 mg per 100 grams) and theobromine, which has several toxic side effects. It is believed that as earlier as 1750 B.C. Mexicans enjoyed chocolate drinks as a source of healthy nutrition. Undoubtedly, though, chocolate (and other refined sugars) have contributed directly to the fattening of Americans over the last half century.

Average Weight

In addition to weight gain, there are other elements of the chocolate industry which are unhealthy. “COPEC” is in part a response to the very difficult labor conditions and poor wages facing cocoa farmers. It is also an industry that is fraught with child labor issues, as it is estimated to “employ” upwards of 2 million children.

This is largely due to the intensity of developing this crop. It takes 3 – 5 years for a cacao tree (which grow cocoa beans) to begin to bear fruit. It takes 4,000 cocoa beans to produce one pound of chocolate (which is about 10 Hershey bars). One cacao tree can produce between 1 – 3 pounds of chocolate per year (or between 4 – 12k beans). This begins to put the scale of human labor required into proper context. With global climate change, producers in “COPEC” are worried about the ability for cacao trees to continue to be as productive so in 2010, after the cacao tree genome was sequenced, scientists started to bioengineer new strains of cacao trees.

There is another constituent which finds chocolate quite unhealthy: dogs. According to the American Society for the Prevention of Cruelty to Animals, there were 20,865 calls for something called “canine chocolate exposure” in 2018 (versus 33,486 calls for prescription pills). In fact, 11% of all calls to the ASPCA were for eating chocolate with the monthly rate doubling in December as dogs found their way to Advent calendars and other holiday gifts. It turns out that as little as 3.5 ounces of chocolate can kill a 20-pound dog. Each treatment cost approximately $450, mostly to induce vomiting.

And on the brighter side, there appears to be a very strong correlation for countries with high (excessive?) per capita chocolate consumption and the number of Nobel Laureates. Evidently, Switzerland has a high number of really smart but fat people jacked up on caffeine.

Chocolate vs Noble Prizes

Mark your calendars: National Chocolate Day is November 29.

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