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China in a Healthy Transition…

The first morning after arriving in China last week was the hardest. As I sipped an unusually strong blend of Chinese tea, reading the China Daily, I was pleased to see one of the lead articles describing in glorious detail the health benefits of tea, which evidently was first consumed in 2737 BC in China. Apparently, it has now been shown in a 25-year longitudinal study that tea drinkers had “better organized brain regions” which certainly sounded useful.

Obviously, it is a complicated time for an American to be in China, and absent one of my taxi drivers proclaiming deep affection for the President of the United States, most conversations steered quite clear of the geopolitical tensions. Frankly, it largely appeared to be business as usual, with a slight undercurrent of concern around general economic conditions. The 3Q19 economic growth rate of 6.0% was announced last week, a marked deceleration from prior quarters (although anecdotal evidence suggests actual growth rates may well be quite a bit lower). The state planning agency called the National Development and Reform Commission declared that this was due to an economy shifting from “rapid growth” to “high quality development.” Clearly, though, trade tensions are directly affecting cross-border transaction volumes.

 

China M&A

Notwithstanding that the GDP growth rate over the last five years in China was 3x what was experienced in the United States, the MSCI China Index has increased only 18% versus the 50% increase of the S&P 500 Index over that same period. The International Monetary Fund is now forecasting 2019 global GDP growth to be 3.0% and China economic growth in 2024 to be 5.5%. Notably, the revenues of Chinese operations of U.S.-based companies will be $544 billion this year, underscoring the inter-dependencies of the two economies.

Analysts point to a number of factors for this deceleration including the financial drag caused by the central bank’s dominance of the financial system which tends to crowd out private companies in favor of state-owned enterprises. Clearly, the trade dispute looms ominously given the inconsistent progress after 13 rounds of bilateral talks. Issues including protection of intellectual property, cyber theft, government subsidies, and technology licensing (putting aside NBA tweets, turmoil in Hong Kong, the blacklisting of Chinese technology companies) ensure that the ultimate resolution is not even on the horizon. Barron’s estimates that the trade dispute will cost the global economy $770 billion in 2020, equivalent to the economy of Switzerland.

This week marks the start of the Communist Party’s Fourth Plenary Session of the 19th Central Committee, which is fraught with political intrigue. From such gatherings tend to come broad policy directives which analysts parse very carefully. Out of a similar session ten years ago it was decided with great fanfare that the Chinese renminbi (~7 RMB : $1 US) would play a greater (near equivalent) role in international trade as the U.S. dollar does to reduce China’s exposure to foreign exchange rate risk. Today, according to the Bank for International Settlements, 88% of all transactions involve the dollar while the RMB only accounts for 4%. Only 2% of total foreign exchange reserves are in RMB.

I was also interested in another article in the China Daily that provided progress on the 12th Five-Year Plan of the Healthcare Industry (2016-2020), which has three core tenets: increase the advancement of healthcare technologies, increase the capabilities of the domestic pharmaceutical industry, and drive increased consolidation. While the healthcare industrial complex in China is undergoing extraordinary reinvention to serve the needs of its 1.4 billion residents, centrally managing such a complicated system may at times appear ambitious, if not aspirational. Today, it is estimated that there are 300 million people who have chronic diseases and that by 2030 there will 360 million people over 60 years of age.

Even estimating the size of the Chinese healthcare market is complicated with at times quite divergent assessments. The research firm Eastspring China pegs the market in 2020 to be approximately $800 billion. Notwithstanding that, it is readily apparent that the opportunity is enormous given the stated priority of various central government directives and that it should naturally be on parity with other developing economies. China accounts for only 3% of global healthcare spend yet has 20% of the world’s population.

 

China Market Size

Per: Eastspring China (July 2019)

 

The 19th Central Committee has put forth its national healthcare strategy called “Healthy China 2030” which has set forth private commercial insurance as an essental component of a multi-level health security system. EY estimates that China spends slightly more than 6% of GDP on healthcare and that out-of-pocket is approximately 30% of that spend. There are 149 health insurance carriers operating in China that generated total health insurance premium revenue in 2017 was $62.7 billion. Between 2012 – 2017, the health insurance market grew at over 20% per annum.

The current single payor model with a high degree of government involvement has shown recently a willingness to experiment with novel payment and care models, even involving on a limited basis the private sector to participate. Some of the large successful internet companies (Alibaba, TenCent, etc.) are launching forays into healthcare, not unlike what is unfolding in the United States. According to Dezan Shira & Associates, a leading Asian business intelligence firm, the healthcare technology sector in China should reach $28.6 billion by 2026, which represents a 10-fold increase from 2016.

Given over 700 million Chinese now have smart phones and/or reliable access to the internet, critical early healthcare technology applications include delivery of online medical content, booking patient appointments, online payments, and accessing test results. Notably, the Organization of Economic Development estimates that there are only 1.8 doctors for every 1,000 people in China. There are 2,300 “top-tier” public hospitals and another 950,000 “low-tier” community health centers and clinics. The provider infrastructure is inadequate and must be augmented by innovative technology solutions.

Another article from the China Daily last week heralded the roll out of a centralized platform that inventoried all of the pharmaceutical industry assets in-country. Evidently there are 1,500 CROs, 3,500 pharma companies (although the China Chamber of Commerce estimates that there are 8,500 pharma companies and 16,000 medtech companies!), 2.37 million distinct healthcare products sold in China, and 50,000 healthcare investors.

A consistent theme echoed by healthcare industry leaders was the urgency to migrate from being principally a generics industry to a global leader in “first-in-class” novel therapeutics (95% of existing capacity is generics). According to the Chinese Academy of Sciences, between 2010 – 2018 more than 72% of novel therapeutic development was in the United States, while only 3% was in China. As part of this transition, there is a stated objective to shift to products and services that provide premium clinical benefits, a greater focus on ensuring equitable patient access, and to increase pharmacoeconomic value and affordability – not unlike much of the regulatory debate in the United States today.

Interestingly, the MSCI China Healthcare Index had a cumulative market value of $275 billion at the end of 1Q19 as compared to the U.S. Healthcare Select Sector Index of $3.5 trillion. The publicly traded Chinese biotech companies have historically invested considerably less in R&D as a percent of revenues (see below); given the stated goals to challenge U.S. and European pharmaceutical companies in the novel therapeutic development, one should expect that relationship to change materially. One immediate implication of this is likely to be a more robust market opportunity for AI and Real World Evidence (RWE) solutions that will improve drug development processes.

 

China Pharma

 

One last observation unrelated to healthcare which involves the level of Chinese debt, a constant source of concern among investors which is now generating heighten levels of official anxiety. The National Development and Reform Commission recently observed that high yield debt issuances doubled in 2019 over 2018 to $51.8 billion, 90% of which was issued by real estate developers. Total debt issuances in 2019 are estimated to be over $67 billion. Outstanding real estate debt alone is now estimated to be $571 billion, $28 billion of which comes due in 2020 according to Dealogic. The Financial Times this weekend highlighted that of the 43,600 desks at WeWork China in Shanghai, 35.7% of them were unoccupied (worse in Shenzhen with 65.3% unoccupied). Slowing growth and elevated levels of debt are something to watch closely.

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Greek Life…

Having just returned from a week in Greece, I may well have taken a few years off my life. If you have spent time on some of the Greek islands, you certainly know what I mean. And what a time to have been there, on the heels of a dramatic transition in political power (July 2019) and a resurgent economic environment, there was a sense of optimism that one would not have expected for a country emerging from a crushing economic crisis over the past dozen years.

Analysts assessed the situation in Greece a decade ago as more dire than that of the U.S. during the Great Depression of 1929. Unemployment rates spiked to over 28% from 9.7% in 2009; it now stands at 17%. Promises of meaningful structural reform by incoming Prime Minister Mitsotakis of The New Democracy party were enthusiastically received by global investors this summer, as he ushered out the far left Syriza political party and years of political turmoil. Year-to-date, the MSCI Greek ETF index far outperformed the U.S. Dow Jones index 35.5% to 15.0%, respectively.

 

Greek Equity.jpeg

 

This is likely to be the best year in the Greek equity markets in 20 years and the Greeks seem to be enjoying it given what we witnessed of the night life in Mykonos and Santorini (of course, maybe it is always like that). The Athens Index price/earnings ratio spiked from 10.4x at the end of 2018 to 14.1x now. The current European Union GDP growth forecast for Greece in 2019 is 2.9%, remarkable given that GDP collapsed by 45% from 2008 to 2016 as the country suffered through multiple austerity plans.

 

Greek GDP

This was considered the greatest economic collapse for any country during peacetime. Three out of every ten companies failed this past decade according to the Greek Center of Planning and Economic Research. The level of public debt in 2018 was 183% of GDP and according to International Monetary Fund forecasts, will only be down to 135% by 2028. Currently, with $218 billion in GDP ($20.5k per capita), Greece only ranks #51 in size of economy. The ability to raise capital in the midst of the crisis became prohibitively expensive and restrictive.

 

Greek_bond_10_year_historical_STL (1)

In the midst of all of this economic carnage was the historic refugee crisis, with hundreds of thousands of people literally washing up on the shores of the Greek islands. According to the International Rescue Committee, Greece today hosts approximately 50k refugees, this in a country with only 11 million residents. Unfortunately, there has been a recent spike in arrivals, at rates greater than at any time over the last three years when the European Union severely restricted inflows.

The hand that PM Mitsotakis was dealt was quite problematic. Greece ranks as the second lowest in overall competitiveness in the European Union. Of the 140 countries ranked by the World Economic Forum, Greece was #44 in something called “innovation capability,” #72 in business dynamism, and #129 in access to venture capital. In fact, according to the Found.ation Accelerator in Athens, there was a mere 117 million euros in venture capital investments in 2018 with three companies accounting for nearly 70% of that.

Of particular interest, as a healthcare investor, was to better understand the impact of this period of severe economic distress on the general health of the Greek population. With an increasing understanding on the role of social determinants of health, what would be the impact when the entire system is completely overwhelmed.

The Greek National Health System, established in 1983, has been fraught with numerous inefficiencies from an overly centralized decision-making framework, to poor resource allocation models, and inadequate investments in healthcare technologies. Notwithstanding that average life expectancy now stands at 80.9 years, the current healthcare system is not considered at all patient-centric and inadequately responsive to current demands. Of note, Greece ranks #31 in life expectancy of the 228 ranked countries; as point of comparison, Monaco tops the chart at 89.3 years while Namibia ranks devastatingly last at 50.9 years. Years from now, it will be quite informative to see the impact of the economic crisis on longevity trends.

As part of the bailout terms set by European Central Bank and International Monetary Fund, Greece had to open historically protected economic sectors, implement austerity steps, address systemic corruption, and dramatically reduce public expenditures, notably those on public health services. According to the World Health Organization in 2014, public healthcare spending was 13.2% of overall government expenditures in 2006 which dropped to 11.5% in 2012, which was nowhere close to the established target of 6.0% by the terms of the bailout (equivalent to 9.0% of GDP). Just the level of pharmaceutical spend declined by more than 32% between 2006 and 2012. The chart below highlights how much of an outlier Greece was during this period for social expenditures.

Euro HC Spend

An analysis conducted by the German Institute for Economic Research, which isolated on the period of 2008 – 2015, concluded that there was a staggering 10 point decline in the Visual Analogue Scale (86.1 to 76.7) when assessing overall healthcare status of the Greek population. During that period, healthcare expenditures dropped by 41%, wages declined by 35-45%, and in 2014 alone, 36% of the population was deemed “at risk of poverty.”

The Lancet recently published a comprehensive research study which concluded that for every 1.0% increase in unemployment rates, there was a corresponding 0.8% increase in suicides and an equal 0.8% increase in alcoholism. The European Observatory on Health Systems and Policies in 2014 released a study that saw a 45% increase in suicides during 2007-2011 (most pronounced among working men). There was a 19% increase in low birth weight babies and an increase of 43% in infant mortality during 2008-2010. Ironically, there was a 24% decline in the number of car accidents given the dramatic decline in economic activity during that same period.

While further longitudinal study is necessary, it is unambiguously clear that severe economic stress has devastating implications on population health. Greece witnessed significant rotation from the private healthcare system, which for many became immediately unaffordable, to an overwhelmed and inadequate public healthcare “safety net” system. The healthcare journal Hippokratia in 2014 highlighted the substitution of quality food for cheap energy foods which led to a spike in diabetes, obesity and hypertension (although confoundingly, Hellastat reported that pizza consumption dropped 30% that year). Three other meaningful contributors to overall decline in health conditions included a drop in medication adherence, increase in chronic stress, and decline in monitoring and follow-up.

For many populations and geographies, what was experienced by the Greeks during their devastating economic crisis, is their everyday reality. The promise of robust healthcare technology solutions may assist some of these people confronting such conditions, but when the overall healthcare system is so severely compromised, the problems become nearly intractable with far-reaching and damaging implications.

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Environmental Determinants of Health…

July 2019 was determined to be the hottest month in recorded history according to scientists at the U.S. National Oceanic and Atmospheric Administration. The temperature was 1.71 degrees above average July temperatures over the entire twentieth century. In fact, nine of the ten hottest Julys occurred since 2005.

The healthcare technology sector is all afire with identifying solutions to manage a range of social determinants of health such as access to quality food, affordable and safe housing, underemployment and relative economic and social stress levels. Irrefutably, at least for many of us, environmental conditions are known to play a dramatic and direct role in one’s overall health and well-being. Effective and comprehensive solutions are illusive though, in part because the problems are systemic, and the investment required for systemic solutions can really only be made by governments in a somewhat coordinated fashion. The investment models for therapeutics, medical devices or healthcare technologies are reasonably well-understood but what is the investment model to lower the earth’s temperature by 1.71 degrees?

Obviously, climate change is a public health crisis and according to my good friend, Margo Oge, former director of the Environmental Protection Agency, it is not adequately addressed by current medical school curricula. At particular risk with climate change are the elderly, the young and the poor, a population that promises to be most advantaged by the development of innovative healthcare technology solutions. Oge highlighted the shocking situation in Flint, Michigan as just one example where generations of residents consumed lead-tainted drinking water when simple inexpensive water quality tests existed. How worried should the rest of us be about more insidious environmental developments when such obvious environmental factors are missed?

More affluent regions of the world appear to suffer fewer deaths due to climate change. In November 2018, The Lancet published a seminal global analysis sponsored by the United Nations which linked clearly the state of the environment on healthcare. Specifically, the report focused on “heat stress” created by a warming climate and determined that 157 million additional people were subjected to heat-related health issues above levels in 2000, directly responsible for a loss of 153 billion hours of labor. These health issues manifested in significantly greater incidences of kidney and heart diseases. Furthermore, the report projected an additional 50-100 “heat deaths” per one million people by 2050.

Climate Deaths
Perhaps more devastating are the collateral issues that elevated heat levels will create, such as a greater incidence of major storms (like Hurricane Dorian this past weekend, considered the strongest storm to ever hit the Bahamas) and flooding. These weather phenomena will reduce crop yields, lower overall quality of food stocks, and may well damage the healthcare infrastructure itself. It is estimated that one billion people live below 33 feet above sea level. In the U.S. alone, scientist project that 2.4 million homes will be flooded by 2100. Just this year, U.S. farmers are expected to grow 13.4 billion bushels of corn and 3.5 billion bushels of soybeans; both meaningfully lower than the definitive Pro Farmer estimates from earlier this year of 14.5 billion and 4.7 billion, respectively. The National Climate Assessment warned of a dramatic increase in mosquito-borne diseases, even in regions that have not confronted such diseases before.

Interestingly, Axios recently projected the economic impact by U.S. county by the end of this century (see below). Perhaps not unexpectedly, there is a rotation to regions further north, presumably cooler geographies, as the earth continues to warm.

Economic Impact

 

In addition to purchasing real estate in Alaska and Maine, there are other interesting investment strategies to capitalize on these environmental developments. While the energy sector has been the poorest performing S&P industry sector index this past decade, returning only 4.4%, the S&P Global Water Index has increased 15% year-to-date. Clearly the slowing global economy, overall capital intensity, and the constant battering by climate-change activists have hurt the stocks of traditional energy companies.

It is estimated that only 2.5% of all the water on earth is fresh and that 800 million people are facing an imminent water crisis. Furthermore, another 2.4 billion people do not have reliable access to clean water for proper sanitation. It will require at least $1 trillion to upgrade domestic water delivery infrastructure. According to the EPA, tap water in the U.S. averages about $2 per 1,000 gallons, suggesting that the price of water is likely to increase significantly.

One of the best performing environmental investments recently has been European carbon credits, established as part of the Kyoto Protocol in 1997, which are up 20% year-to-date and double the levels from January 2018. This market is estimated to be close to $40 billion in size. One credit is required for each carbon dioxide ton emitted and is trading for about 26 euros. Across Europe, 1.7 gigatons of carbon are emitted annually according to Energy Aspects data.

Additionally, there has been a flurry of investment activity in the alternative meat sector. In part reflecting concerns about the impact of livestock production which is responsible for 15% of all greenhouse gas emissions, a number of high-profile plant-based food companies are seeing dramatic market acceptance as they introduce alternatives to traditional meat products. Beyond Meat, which went public in May 2019 with a $3.8 billion valuation, is currently valued at $10.1 billion or 115x trailing revenues. The global meat market is considered to be $1.4 trillion and accounts for 29% of the water used in global agriculture but a staggering 80% of all agricultural land.

The American Lung Association attributes 7,500 deaths each year to coal pollution. While an important industry which last year provided 30% of all U.S. power (down from 45% in 2010), the coal industry only employs 50k people. By comparison, there are 260k people working in the solar industry. Given in large measure to the attractiveness of cheap natural gas, the number of coal plants have declined from 580 in 2010 to less than 240 now, according to the U.S. Energy Information Administration, perhaps suggesting that market forces may assist in reducing the cocktail of harmful pollutants due to coal.

The Centers for Disease Control and Prevention recently announced that 16 states have 153 reported cases of serious vaping-related respiratory illnesses in just the past two months. Importantly, CVS just announced a $50 million campaign to curtail teenage vaping, and five years after the company stopped selling tobacco products.

Director Oge’s work at the EPA was to ultimately create policies to reduce environmental stresses on human health. Five years ago, the Center for International Earth Science Information Network scored all countries on the ability to mitigate those stresses. Consistent with other regional data, more affluent countries further removed from the equator tended to score more favorably.

2014 Environment

In this environment, there may need to be a greater reliance on market forces and the creativity of entrepreneurs to lessen the environmental impacts on health. Unfortunately, the EPA made only 166 referrals to the Justice Department in 2018, a 30-year low and half the amount in 2012. Only 78 cases were prosecuted last year, the fewest amount in 25 years. By law, the EPA must have no fewer than 200 enforcement agents in its Criminal Investigative Unit and yet only has 164 now. Recently, the Government Accountability Office determined that the EPA’s Integrated Risk Information System unit had its research stifled, most notably its extensive formaldehyde analysis linking the chemical to cancer.

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Basking in Basque…

It is impossible to not appreciate the fierce sense of independence when traveling in the Basque Country. While I was fortunate to leave right before the brutal heat of the past month, it is clear that the somewhat tortured regional history of the last half century still influences much of the current narrative, and arguably this political history has influenced the healthcare framework now managing the 2.2 million residents of this beautiful but complicated region.

basque-map

For the nearly four decades since the end of the Spanish Civil War in 1939 until the establishment of the Spanish Constitution in 1978, this region was a set of quite independently governed territories which suffered through considerable political turmoil. The Constitution provided for a much greater degree of home rule and autonomy but was overshadowed by the rise of the Euskadi Ta Askatasuna (ETA) separatist group. While the ETA was formed in 1959, the period between 1968 – 2010 saw significant terrorist activity with nearly 1,000 political killings. Since the permanent cease fire in 2011, the Basque Country has enjoyed relative stability and prosperity; GDP per capita is 33% greater than the rest of Spain and 40% above the average for the European Union.

Arguably the history of this region was most poignantly captured by Pablo Picasso’s Guernica masterpiece which famously portrayed the German bombing of that town in 1937.

PicassoGuernica

With political stability came a concerted effort by the government to address what was increasingly becoming the next crisis – chronic disease for an aging population. Healthcare expenditures in Spain are approximately 10% of GDP and rising. In 2010, the government issued the “Strategy to Tackle the Challenge of Chronicity in Basque Country,” and while a mouthful, this manifesto reflected an effort to create a more effective and responsive healthcare infrastructure. Echoing the region’s history of independence, what emerged was a centralized set of operating principles but with significant flexibility to empower frontline healthcare workers.

The Basque Health Service is called Osakidetza (established in 1984) and is the public entity that organizes the 13 integrated health organizations and employs the 12,400 providers in region. Central to these initiatives is to encourage much greater care coordination, as well as use of in-home health and telehealth services. Analysts have compared this system to the Canadian healthcare system and have observed that most Medicaid programs in the U.S. do not have these levels of innovation and autonomy.

There were two other fascinating observations from the Basque Country. To the east, the Catalonia region also struggled with self-determination and how best to govern within the borders of Spain. While the Basque Country often suffered through violent unrest over those many decades, the Catalans were relatively content through that period, that is until the past few years when there has been significant separatist unrest. Recall the horrific Barcelona terrorist attacks in the summer 2017.

It was also quite surprising to learn that, while there are only 2.2 million residents in the Basque Country, the diaspora is vast. It is estimated that between 2.5 – 5.0 million Basques live in Chile alone. The largest cluster of Basques in the U.S. is in Boise, Idaho where the Basque Museum and Cultural Center is located. I never did learn why Boise.

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Flare Capital Lands #1 Draft Choice…

If a venture capital firm is like a baseball team, we may have just used the first pick in the draft to grab a terrific utility player with extraordinary range: he can hit for power, field anything that is hit to him, and is an all-around great teammate. Please welcome Ian Chiang to Flare Capital Partners.

On the heels of announcing a new dedicated healthcare technology fund, we are thrilled to announce that Ian Chiang has joined the firm as a Principal. Ian has been committed to the transformation of the “business of healthcare” over the course of his impressive career. Most recently, he served as a Senior Vice President and a founding member of CareAllies, Cigna’s family of multi-payer provider services, population health management, and home-based care businesses. All super relevant to our investment focus.

I first met Ian over six years ago just as he was launching his healthcare start-up, XcelDx, and remember being incredibly struck by his depth and humility. XcelDx ultimately partnered with Scanwell Health, a smartphone-enabled diagnostics company, a company he still advises. This experience led him to CareAllies, where he was responsible for developing new technology-enabled services, evolving existing solution and service lines, and providing on-going product management across CareAllies’ businesses.

Ian also spent five years at McKinsey & Company advising healthcare clients globally, as well as two years at Becton, Dickinson & Company, where he led new product development. And he is super smart, having earned his Bachelor of Science degree in biological engineering from Cornell University, where he graduated with honors and was a Cornell Presidential Research Scholar. As if that was not enough, he also holds an MBA from Harvard Business School.

It is pretty clear to all of us that Ian will be a lightning rod for great entrepreneurs and that he has a terrific network among executives at some of the leading healthcare companies in the world, but what really got me was our shared (tragic) love for the New York Mets. Did you happen to see what they did late Friday night?!? Bottom of the ninth and they scored four runs to win on a walk-off single by Conforto. Simply Amazin’. And guess who texted me right after? Ian “Syndergaard” Chiang!

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Health Tech: What’s Not To Like?

There were a number of very exciting developments in the healthcare technology sector this past quarter. After a relatively modest investment pace in 1Q19 of $1.0 billion, nearly $3.2 billion was invested in 119 companies in 2Q19 according to Rock Health data, suggesting that the investment pace this year may be slightly ahead of last year’s record high of $8.2 billion. This level of activity reflects what continues to be an extraordinary market opportunity as the “business of healthcare” is transformed. Industry dynamics today demand innovative business models and novel technologies that will leverage advanced analytics and mobility to enable value-based healthcare. The overarching pressures for better outcomes at lower costs will create important and valuable new companies.

Furthermore, the adoption of healthcare technology solutions is accelerating. Many companies launched earlier this decade can now point to measurable impact on outcomes and costs. Companies more often than not are able to claim real attribution for the successes of their products and services; that is, they are able to calculate an ROI with actual data. Repeatable business models are now better understood (product development timelines, successful “go-to-market” strategies, etc.) and more predictable. What this really means is that entrepreneurs are able to consistently build big businesses. The sector is reaching an important threshold level of maturity and investors are recognizing that.

1H19 Healthtech

In addition to the level of investment activity, there were a number of other strategic developments and announcements in the healthcare technology sector this past quarter. Investors eagerly anticipated the very notable IPOs of Livongo, Health Catalyst and Phreesia (all priced in July 2019) and were excited about the building backlog of other IPO candidates. While there were only a dozen significant M&A transactions, some of them were potentially transformative such as Dassault System’s $5.8 billion purchase of Medidata, UnitedHealth Group’s acquisition of PatientsLikeMe, and Best Buy’s acquisition of Critical Signal Technologies. There were also a number of smaller acquisitions, but nonetheless very notable, such as Apple’s acquisition of Tueo Health, which speaks to the attractiveness of the sector from non-healthcare companies.

Product releases such as Alexa Skills for healthcare or the Centers for Medicare and Medicaid Services expanding access of telehealth services for Medicare Advantage members deepen the narrative that healthcare technologies will continue to be a core part of delivering care in non-traditional settings. Additionally, the Food and Drug Administration announced a streamlined regulatory framework with its “Digital Health Software Precertification Program” which underscored the sector’s importance.

Against a backdrop of extraordinary overall venture capital liquidity in 2Q19, and with the very well-received IPOs of Livongo and Health Catalyst two weeks ago, a fair question is to look closer at investor liquidity in the healthcare technology sector. Rock Health (disclosure: Flare Capital is an investor in Rock Health’s seed fund) analyzed in detail the $36.3 billion private capital invested in the 1,274 digital health companies that they track since 2011, concluding that $29.4 billion is still “at work.” There are 23 companies which have raised over $7.9 billion that are both mature and likely IPO candidates, suggesting significant potential liquidity for this sector. Importantly, only $1.5 billion was invested in companies that were shut down, which is a relatively modest capital loss ratio given the typical risk profile of venture capital investments (of course, some of the $4.1 billion of M&A activity is likely quite underwhelming).

 

1H19 Health Liquidity

Arguably, healthcare is one of the cornerstones of any impact investment strategy. Recent public equity investor attention has become quite fixated on the “socially responsible” impact sector. Notably, in 1H19 those funds experienced record inflows of $8.4 billion according to Morningstar adding to the roster of public equity healthcare investors. In all of 2018, there was $5.4 billion invested in these funds, bringing the five-year total to $35 billion. Hopefully, healthcare technology will continue to be a sector where one can “do good and do well” at the same time.

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Let the Good Times Roll – 2Q19 In Review…

Accelerating out of 2Q19, both the S&P 500 and Nasdaq indices hit all-time highs, trading at close to 19.8x trailing earnings. Last week the U.S. Bureau of Economic Analysis announced that GDP increased 2.1% for the quarter, and while a marked decline from the prior quarter, it was still a reasonably compelling figure. Interestingly, consumer spending which accounts for approximately 70% of the activity, increased 2.9% in the quarter (although credit card delinquencies are up 22% since 2015). Macroeconomic Advisors estimated that revenues for the S&P 500 companies grew 2.6% in 2Q19, while FactSet estimated that earnings declined 1.9% year-over-year (first time in recent memory), perhaps suggesting that operating costs have increased markedly over the past few months.

 

2Q19 GDP

Source: Axios

Against this narrative, the National Venture Capital Association and Pitchbook released their 2Q19 report with screaming headlines about investor liquidity. Quite simply, it was a tremendous quarter with $138.3 billion of exit value created (via either IPOs or M&A transactions), nearly half of which was due to the Uber IPO alone. Year-to-date exit value totaled $188.5 billion, more than any prior year, suggesting broad-based activity and a robust environment. And there will be even more to come: CB Insights is tracking 362 “unicorns” globally, 18 of which are valued in excess of $10 billion each. These mature private companies will seek investor liquidity at some point in the near future.

For the entire quarter, there were 2,338 financings which raised $31.5 billion, keeping the venture capital industry on pace to once again exceed $100 billion in annual investment activity. While the number of investments has been relatively constant since late 2012, the advent of “mega deals” (in excess of $100 million round sizes) has dramatically increased the amount of capital invested. Year-to-date there have been 123 “mega deals” which, while only 2.5% of all financings, accounted for nearly 45% of the capital invested.

 

2Q19 VC Activity

The amount of seed and angel activity continued to meaningfully decline in the quarter, registering $1.7 billion across 1,001 deals. The median age of those companies at the time of these financings was slightly over three years old, suggesting that the amount of “pre-seed” activity is high and now an important part of how many entrepreneurs are funding their businesses. In part due to the proliferation of accelerators and incubators, entrepreneurs are able raise very modest amounts of capital to accomplish a handful of initial milestones. The average size of these financings was $1.7 million at a median pre-money valuation of $7.6 million.

Early stage activity (Series A and B rounds) remained relatively constant with $8.9 billion invested in 754 deals (average size of $11.8 million). The median valuation was $30.0 million. Late stage financings (Series C and D rounds) continued to account for much of the activity with $20.9 billion invested in 583 deals (average size of $35.8 million). It is these rounds when there starts to be significant separation in terms of amount of capital invested and valuations, particularly for those companies that are scaling quickly. Series C median valuation in 2Q19 was $115 million, while Series D companies commanded a median valuation of $418 million. Over 70% of the capital of the Late stage financings was invested in “mega deals” yet were only 17% of the companies. To underscore the separation at these Late stage rounds, the 25th percentile companies were valued at $140 million on average, while 75th percentile companies were valued at $1.08 billion (as compared to $702 million in all of 2018).

Notably, corporate VCs are hanging in there. In 2Q19, 311 companies raised $13.0 billion in financings which a corporate investor was a member of the syndicate; that is,13% of the financings included a corporate investor yet those rounds accounted for over 41% of the investment activity, indicating that corporate investors tend to participate in later rounds.

Back to where the attention was focused this past quarter – exit activity. In addition to the more notable IPOs of Uber, Lyft, Pinterest and Zoom was the Slack IPO, which was a “direct listing” like the Spotify IPO in April 2018. Many recent enterprise technology IPOs have been priced at 25 – 30x revenues (not earnings). Notwithstanding the extraordinary IPO activity in 2Q19 ($130.8 billion), the M&A exit activity was relatively underwhelming with only $7.3 billion versus $22.6 billion in 1Q19 and $10.7 billion in the year ago quarter. In fact, year-to-date the ratio of number of new investments to exits is 12.7x. Historically, this ratio has hovered between 10.0x – 10.5x so the growing backlog of private companies is notable, especially with the number of large rounds with somewhat impatient later stage investors. Bookmark that.

 

2Q19 Exit

As this liquidity windfall is distributed back to investors, grateful limited partners are expected to recycle much of it back to venture firms in the form of new commitments, suggesting good times ahead for fundraising. Through the first half 2019, 103 funds were raised totaling $20.6 billion. In 2Q19 alone, 66 funds raised $11.0 billion but only two funds were larger than $1.0 billion. Interestingly, in 1Q19 the average and median fund size were $259 million and $103 million, respectively. At the end of 2Q19 those amounts had declined meaningfully to $202 million and $81 million, indicating a trend of much smaller fund sizes. There was an even more dramatic decline in the number of “first time” venture funds with only 10 raised through 2Q19, and they were only 2.9% of all capital raised. Yet against this backdrop, SoftBank just announced its second Vision Fund totaling $108 billion of commitments.

According to Cambridge Associates, venture returns through 1Q19 have been consistently compelling when compared to public stock indices, certainly over longer time horizons. The lack of liquidity is often pointed to as the principle reason as to why limited partners are not more aggressive venture capital investors. The narrative over the last decade has been one centered around “unrealized gains” which have been dramatic but unfortunately unrealized. In a recent Fenwick & West survey of venture terms for 215 financings in 2Q19 over 86% were “up-rounds” (the average price per share increase was 58%). It will be fascinating to see if limited partner sentiment recalibrates over the next 6 -12 months as the 2Q19 IPO liquidity is distributed.

VC Returns 1Q19

As an interesting point of comparison, the venture market in China has struggled mightily in 2Q19. Notwithstanding that the Fortune Global 500, which was released this past week, included 129 Chinese companies (first time ever that the U.S. did not lead in the medal count), the overall investment activity declined a dramatic 77% decline from 1Q19. The $9.4 billion invested across 692 companies compares unfavorably to the 2Q18 level of $41.3 billion. Quite clearly there is anxiety about trade tensions as well as relatively lofty private company valuations. Interestingly, though, China last week launched the Science and Technology Innovation Board (“STAR Market”), which is part of the Shanghai stock exchange but only for local investors. On the opening day, 25 technology companies raised $5.4 billion, with the index closing ahead 140%. Go figure.

Somewhat insulated from this is the Israeli venture capital industry which saw $3.9 billion invested in 254 companies year-to-date. In 2Q19 alone, 125 companies raised $2.3 billion, but $1.2 billion of those financings were for only 10 “mega deals” (considered greater than $50 million round size).

The Institute of International Finance recently released its quarterly survey of global debt levels that showed it to be $246.5 trillion at the end of 1Q19, which had increased by $3.0 trillion over the quarter. This unprecedented debt level is now 320% of global GDP. The situation in the U.S., while relatively in better shape, is still worrisome with $69 trillion of debt at 101% of GDP. The role this plays on the venture capital industry and fund flows is certainly worth monitoring. Quite clearly, the current environment has investors desperately looking for returns with high growth companies such as those in venture capital portfolios. As a point of comparison, Facebook, Amazon and Google grew revenues 28%, 19% and 19%, respectively, this past quarter. But are we living on borrowed time with the historic economic expansion in the U.S.?

 

Expansion
Source: Axios

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