Go to the end of the earth, and when you get there, turn left and go another few hundred miles and you will be at the Maldives, an independent Muslim country of ~550k people nearly 500 miles off the southern coast of India. Straddling the equator and comprised of 26 atolls covering 35k square miles, the Maldives is the smallest of all Asian countries and is considered the world’s most geographically dispersed. And it faces a host of profound existential threats.
Being so remote does not insulate the Maldives from global issues. The two most obvious and troubling today involve the Covid pandemic and global warming – both issues exported from the rest of the world. Most immediate are public health risks, exacerbated by an inadequate healthcare infrastructure and caused by diseases brought in by tourists.
Early on in the pandemic, the Maldives was considered one of the world’s most active “Covid hot spots” registering the highest number of infections per million people, according to an analysis by Bloomberg. Fortunately, the total number of fatalities was quite modest with just over 300 to date, but it underscores the ever-present exposure to global health crises, especially for a country so dependent on tourism.
Perhaps reflecting a cultural ambivalence or concerns with raising anxiety among tourists, the public health messaging around Covid risks was effectively invisible. Tucked into the corner of the airport terminal was one lonely sign extolling the merits of responsible behavior. Vaccination requirements were waived years ago.
Notwithstanding that, the country has made meaningful progress on other key healthcare benchmarks. Average life expectancy now stands at 72 years, up from 46 years in 1978. Infant mortality is at 1.2%, a marked improvement from 12.7% in 1977.
Far more disturbing are the implications of global warming and rising sea levels. While some may argue over the intensity or cause or solutions to global warming (or even if it exists at all), for a country with average elevation of 4 feet, 11 inches above sea level those debates are secondary. The highest point in the country is 7 feet, 10 inches.
Anxiety spiked recently with the news that the Thwaites Glacier, affectionately known as the Doomsday Glacier, was facing collapse which would increase global sea levels by an estimated two feet. The Thwaites is 75 miles wide and sits as a dam to “upstream” water flows from the Antarctic; its collapse risks unleashing a cascade of other glacier collapses. Sadly, what happens in the Antarctic, does not stay in the Antarctic.
Even geopolitical issues risk intruding on this idyllic place. While remote and not easily reached, the large number of Russian tourists was notable, notwithstanding a sad and lonely Aeroflot check-in desk. It is hard given what the world is witnessing with Russian aggression toward its neighbors to contemplate what those travelers think while on vacation. But even in such moments, there were examples of exceptional grace. Svetlana, the Maître d’ at one of the finer restaurants, greeted each guest with elegance undoubtedly while thinking of family members left behind in the now destroyed Ukrainian city of Kherson…
Yesterday just over 25k people died of starvation. The causes that contribute to that tragedy are numerous, and while the problems are often intractable, possible solutions to address this calamity are being developed in disparate settings such as the laboratory, in the capital markets, in restructuring the supply chains, and with fiscal and tax policies.
Many of our pedestrian concerns have likely been eclipsed by the ongoing devastation in Ukraine and the catastrophic earthquakes in Turkey and Syria. Hunger and issues of access to adequate food supplies stare us in the face constantly now. A recent United Nations report titled “State of Food Security and Nutrition in the World” concluded that 2.3 billion people in 2021 faced moderate or severe difficulty in obtaining food, well before these two emerging crises. It is believed that nearly 830 million people struggle with hunger today.
Obviously, the Ukrainian war drove dramatic food price inflation starting a year ago. In addition to supply chain disruptions, there was the dramatic spike in fertilizer prices given that Russia and Belarus account for 35% of global potash and nitrogen production, a critical component of fertilizer. Up until this year, the global agricultural sector experienced dramatic increases in productivity over the last several decades due to the abundance of hydrocarbons used for fuels and fertilizers. That is at risk of reversing.
As impactful, the spike in food export restrictions has significantly reduced the amount of food trade, which in addition to limiting food availability, also exacerbates food price inflation in countries facing scarcity. The world’s poorest countries tend to be net importers of food products and are most directly exposed to food price inflation. This dynamic has also led to food hoarding in certain countries as a way to moderate domestic inflation and limit social unrest. Globally, the stock-to-use ratio for wheat and corn is estimated to be 29% according to the United Nations Food and Agriculture Organization. China is holding 50% of the world’s wheat stockpile, significantly increasing wheat import at the outset of the pandemic; the U.S. only holds 6%.
It is estimated that 60% of all food production is accounted for by five countries: China, the U.S., India, Brazil, and Argentina. While Ukraine is only the seventh largest wheat producer, it still represents approximately 10% of all annual production, which is not reliably available to the rest of the world. Together with Russia, both countries together account for 28% of all wheat produced, according to an analysis by McKinsey.
These issues have conspired to create an estimated wheat and corn deficit of 15 – 20 million metric tons in 2022, which may increase to 23 – 40 million in 2023 per McKinsey. The high end of this range would be enough food for 250 million people.
Setting aside the scourge of starvation, the urgency to develop alternative sources of food production is also linked to broader issues of national security and social unrest in malnourished hot spots around the world. The Defense Advanced Research Projects Agency (DARPA) has launched the “Cornucopia” initiative to develop a new framework for future food production systems that are more equitable, accessible, and lower cost. At the core of this effort is the goal of utilizing microbes which could create secondary food production systems thereby reducing geopolitical risks. It is estimated that the U.S. military is deployed in 80% of global crises, much of them related to food security.
Particularly disturbing was a recent Bank of America analysis which concluded that humans are utilizing natural resources 1.7x faster than the earth can recover; this is expected to reach 2.0x by 2030. Only 29% of the earth’s surface is land, of which 71% is considered habitable or just under 41 million square miles. It is estimated that 46% of all habitable land is used for agriculture, and 77% of that is for livestock, implying that livestock occupy 14.3 million square miles. According to the United Nations Food and Agriculture Organization, one-third of the earth’s soil has already been compromised, underscoring the urgency for innovative approaches to food production.
Further challenging the world’s ability to produce food is the burden pests impose in critical regions of the world. A recent study by the Center for Agriculture and Bioscience calculated the total financial costs in Africa due to invasive pests and plants to be $3.5 trillion. Many of these losses are due to the labor required to weed fields to ensure that appropriate crops can survive.
Shamefully, it is believed that upwards of 30% of all food production is wasted, either during the production process or “downstream” at the point of consumption, according to a McKinsey Sustainability study. This equates to 1.3 billion tons of food; some analysts conclude that amount would satisfy nearly 2 billion people annually. Over a third of this wastage is perfectly fit for consumption.
Americans alone waste 119 billion pounds of food according to Feeding America, which is 40% of all food. This is equivalent to 130 billion meals and costs $408 billion. The American Journal of Agricultural Economics concluded that each family in the U.S. spends $1,900 on wasted food each year. The non-profit ReFED, which studies food waste issues, estimates that 7% of all wasted food is simply due to confusion over expiration dates on labels.
Feeding America estimates that there are 50 million people in the U.S. who struggle with food security. To address this, the Biden Administration recently announced a goal to eliminate hunger in the country by 2030. In addition to $8 billion in private charitable contributions, the Supplemental Nutrition Assistance Program provided $119 billion in food stamps to 41 million Americans last year.
Solutions to hunger are complex, expensive, and inherently co-dependent on each other. Obviously, a more progressive tax framework on the production of foods that damage the environment or are not productive sources of protein may shift resources to more efficient sources. It is estimated that there is a 10x factor between the most and least efficient sources of protein, which accounts for much of the innovation in lessening the dependency on livestock.
Conversely, incentives and subsidies can be introduced that shift resources to novel more effective means of protein production. In mid-2022 the World Bank announced plans for $30 billion in assistance for programs linked to food and nutrition security. The Inflation Reduction Act earmarked $22 billion for Agriculture Department programs in regenerative or climate-friendly agricultural techniques.
Arguably and cruelly ironic, the U.S. food production industry has contributed to a domestic health crisis. It is estimated that 58% of all calories consumed now are from ultra-processed foods with modest nutritional value. Furthermore, nearly 100 million Americans have diabetes (11% of the population) or are pre-diabetic. Sadly, the Center for Disease Control and Prevention recently published a study of children in the U.S., highlighting that 50% consume only one vegetable each day. This is to say nothing of the knock-on environmental impacts given that 37% of all greenhouse gases emanate from the farming industry and that excess nitrogen from fertilizer is devasting to many inland waterways.
Issues surrounding food production and distribution have not gone unnoticed by the venture capital community. According to Pitchbook, $10.6 billion was invested in 988 companies in 2022, and while down 13.2% and 10.2% from 2021, respectively, last year was the second strongest year on record and represents relatively healthy activity given overall market volatility. Median pre-money valuation in the “agtech” sector was an attractive $15.3 million while median round size was a modest $3.3 million. Notably, exit activity was only $2.2 billion across 38 deals, perhaps suggesting the category is still quite immature. In light of that, $2.5 billion was committed to launch the Food, Nutrition and Health Investor Coalition in September 2022 to support private investment to address issues of hunger. Crunchbase estimated that $2.5 billion was invested in 2022 in start-ups to address just food waste issues.
These investments point to longer-term innovations that might be expected to have an impact over the next few decades. Introduced with much fanfare and investor enthusiasm, the synthetic biology sector brought to market a range of plant-based meat products. Many of the fast-food chains rolled out meals based on products from Beyond Meat and Impossible Foods, causing the stock prices to soar. This past year saw dramatic declines in share prices for companies in the alternative meat category (Beyond Meat has declined 65% over past twelve months) as supermarket sales of these products declined by ~15% in 2022, according to Information Resources Inc.
Upside Foods, formerly known as Memphis Meats, uses synthetic biology to produce chicken; it is chicken cells but just not from poultry. These lab-grown meats sidestep ethical issues around the treatment of live animals and are considered more environmentally friendly. While today’s price per pound is not yet competitive with real chicken (in 2022 the price per pound was $7.70 as compared to $4.30 for real chicken), it is expected that vat-grown meats at scale should be more in line with real chicken. Certainly hope so as we race toward 100 pounds per person consumed in the U.S.
In addition to products that provide more efficient sources of protein, there are solutions which take on the supply chain waste issues and utilize existing foods that may not be palatable or “ugly.” Misfits Market uses misshaped foods that would otherwise be disposed of. Novel technologies are being developed to make fresh foods last longer, allowing them to travel greater distances in the supply chain, which tend to be distinct and separate from general supply chains. Shorter supply chains for food tend to create less waste but that is often not practical. The producers of beef, pork and poultry are highly consolidated (and centralized and industrialized), with the top four in each category controlling 85%, 70%, and 54% market shares, respectively. It is believed that 60% of all mammals are now livestock.
Alternatives to traditional farming will require time and patient capital to develop, and quite likely substantial government support, if not outright intervention. The advisory firm Green Street calculated that average annual return for U.S. farmland to be 11.2% over the past 25-years through 3Q21 (likely only more valuable over the past year) as compared to just 9.6% return from the S&P 500 Index over the same period – and without the volatility of the public markets. In 2021, the average acre of U.S. farmland was valued at $3,380. Traditional approaches continue to be good long-term investments.
The phenomenon of vertical farming may effectively shorten supply chains as fruits and vegetables are grown in indoor controlled conditions, utilizing automation and AI to optimize production yields. Bowery Farming is an emerging leader in this category, which according to Grand View Research saw $4.3 billion in sales in 2021, growing at nearly 26% per year through 2030. Of the more than 400k plant varieties, 30k are thought to be edible, even though humans only consume roughly 200 plant types. Plenty to work with.
Interestingly, insects represent another source of plentiful protein and while most of the investment so far has focused on insects as food for livestock and pets, there is a growing appetite to feed insects to humans. Notably, Ynsect has already raised $370 million to develop food ingredients made from insects, claiming that such an approach requires 100x less land and 25% less water for equivalent meat production. Rabobank estimates that by 2030 10-20k tons of insects will be processed for human consumption.
According to the Proceedings of the National Academy of Sciences, there are 2.5 million ants for each human, implying that there are 20 quadrillion ants on the earth. Almost enough to lose your appetite…
Just over three months ago, along with our terrific partners at the Hospital for Special Surgery (HSS), we announced the formation of a new company called RightMove Health, which has as its goal to make high quality, patient-focused virtual musculoskeletal (MSK) physical therapy (PT) available to all Americans. HSS is hands down the preeminent leading academic medical center specializing in MSK health.
And like at the Academy Awards there simply are too many people at HSS to acknowledge but clearly a few need to be recognized for having built an extraordinary collection of physical therapy assets and for visionary thinking to partner to build a leading independent company serving the nearly 12 million people who annually utilize physical therapists: Lou Shapiro (CEO @ HSS), Bryan Kelly (incoming CEO @ HSS), Amy Fahrenkopf (President, HSS Health and SVP @ HSS), and David King (Interim Executive and Founding Team member @ RightMove).
Perhaps even more exciting, last week we announced the addition of a rock star CEO, my good friend Marcus Osborne, who is known to many from his extraordinary work for over 14 years at Walmart, most recently serving as SVP Walmart Health. There is not a corner of healthcare or an innovative solution that Marcus has not considered or purchased. And a tip of the hat to the team at Oxeon, led by Patrick Sullivan, who ran an exceptional recruiting process. Importantly, Marcus joins Employee #1, David Lim, who is an exceptional founding Chief Clinical and Medical Operations Officer, having among many accomplishments been on the founding team at Quartet Health. This is a band of rock stars…
There are a few powerful industry trends facing the over 590k professionals in the PT field in the United States (Bureau of Labor Statistics counts ~225k actual physical therapists), and like many other recent developments in healthcare, these trends are framed by the pandemic. Obviously, the explosion in telehealth services has been transformative in the PT industry and is a significant tailwind for RightMove. It is estimated that telehealth visits increased 38x in the immediate aftermath of the pandemic. According to a recent McKinsey study, 55% of patients expressed greater satisfaction with virtual versus in-person visits.
Second, advances in healthcare technology have improved patient engagement and facilitated more personalized care plans. This development has directly informed the third significant trend in PT, which is the drive to provide more in-home services, in part due to the rapidly aging population.
Staff burn-out and pressures to provide more flexible, accommodative work environments for providers coupled with profound improvements in virtual reality and AI have recast the patient-provider experience and account for the other two industry trends. Against this backdrop, the market forces seem to have converged to marry the field’s highest regarded, most effective, and clinically validate PT protocols developed at HSS with outstanding entrepreneurial talent to scale a disruptive approach to address what has been an often poorly managed care pathway, rife with underwhelming outcomes and significant waste.
It is thought that Hippocrates may have been one of the first practitioners of PT as far back as 460 BC. Much has changed since then. IBIS World estimates the PT market to be nearly $47 billion in size, serviced by nearly 38k clinics. Across all professionals in the PT field, average earnings total $75k annually, although sadly, there is quite a wide disparity by gender and geography. Bureau of Labor Statistics data show the mean salary specifically for physical therapists is ~$93k.
Notwithstanding those issues, the PT field has developed a deeply committed and talented labor force, which is fortunate given MSK issues are estimated to account for one-sixth of all healthcare spend annually, costing approximately $600 billion per year. Physical therapists are the first line of care for MSK issues, and when handled properly, PT can reduce the incidence of certain unnecessary and frightfully expensive MSK surgical procedures. This is exacerbated in a fee-for-service framework, so more effective PT triage solutions facilitate the move to value-based care MSK clinical models.
The RightMove offering is centered around “expert physical therapists” who will provide live triage and virtual PT covering 90+ MSK conditions. The company will build upon HSS’s vast PT experience and data collected over decades; annually HSS conducts ~330k in-person and ~100k virtual PT visits. The product offering is anchored in three modules: virtual triage (45-minute live comprehensive exam); virtual PT sessions; and “digital engagement” with curated expert content, personalized dashboard, and asynchronous chat capabilities.
Over time, it is expected, like many virtual care providers, that RightMove will develop into a “hybrid” model that likely will include an expert network of in-person physical therapists (“powered by HSS”), which will be particularly impactful for larger risk-bearing provider and employer clients. All of these capabilities have RightMove on the path to becoming a value-based PT platform to take on risk in pay-for-performance, pay-for-quality arrangements.
The power of the co-creation model that our firm, Flare Capital Partners, has utilized successfully is to co-invest with a leading strategic partner at the outset, often times one of our investors, to stand up a novel offering that while solving an immediate need of our strategic partner, can develop into a wider industry utility. This model requires that the new company be able to quickly recruit world class executive talent – RightMove just checked that box – and importantly, that other great co-investors join the ride once the company has launched. RightMove recently received additional capital from two outstanding firms: Frist Cressy Ventures and Greycroft. Another box checked.
It is not a “stretch” to say that Marcus and David made the right moves to join. I am only hoping that they create an offering that makes it easier for me to touch my toes. Oh, and I still want to finish a marathon in under four hours – is there anything for that?
Obviously, the problems addressed by healthcare technology did not just get cut in half. So, what accounts for the rather dramatic decline in venture investment in digital health from $29.3 billion in 2021 to $15.3 billion in 2022, according to recently published Rock Health data. There has likely never been a more complicated and confounding time to be investing in healthcare than now. Against a backdrop of daunting macroeconomic issues, the problems confronting the healthcare industry requiring innovative solutions continue unabated.
This past week we learned that the U.S. has hit the debt ceiling of $31.4 trillion. The Wall Street Journal’s year-end survey of leading economists peg the likelihood of a recession in 2023 at 61% with a meager 0.2% annual GDP growth rate; fortunately, inflation is expected drop to 3.1% by the end of 2023. GDP growth over the past 12 months was only 1.4% while employment has increased by 3.0%, strongly indicating a rather dramatic decline in worker productivity, which is a leading indicator of recessions. Bank of America now forecasts a 1.1% decrease in GDP in 2023, which would be one of the mildest recessions in decades. Ominously, though, Deutsche Bank expects default rates on high yield bonds to be 5.6% in 2023 and a frightening 11.3% in 2024 – near historic highs.
Paramount to all of this is liquidity and fund flows to determine whether investors are seeking exposure to risk-based assets. Sharp declines in monetary growth inevitably lead to dramatic declines in asset values. Data from the Investment Company Institute over the past few years show significant equity mutual funds outflows, largely accounting for the dramatic reset in equity prices.
As healthcare technology investors gameplan for 2023, it is informative to look at prior sector corrections, none more notable than the bursting of the Dot Com bubble over 20 years ago. According to an analysis by SVB Securities, its Digital Health Index declined by just under 70% since peaking in February 2020 (nearly 700 days ago) tracking very closely to the trading activity of the NASDAQ Index from March 2000 to Spring 2002. The NASDAQ Index touched bottom almost 950 days after peaking in March 2002 suggesting, if the trend holds, that the digital health sector will mostly trade sideways through 2023. Underscoring the reset in valuations, the median twelve month forward revenue multiple for the SVB Digital Health Index declined from 15.0x to approximately 3.0x during this timeframe.
Public markets were not the only markets impacted. With an increase in relative liquidity and sophistication of the secondary markets, a more robust trading environment for securities in private companies has emerged. An analysis by Forge Global highlights the dramatic correction in valuations just over the past year, with median pricing declining by ~50% of the prior round of financing. With the shock of the pandemic in early 2020, this discount was only about 20%, recovering to be ~10% premium in 2021.
Interestingly, an early readout of overall venture capital investment activity from Pitchbook for 2022 totaled $238.3 billion as compared to $344.7 billion in 2021, a rather dramatic pullback of new investment activity undoubtedly impacting follow-on rounds for venture-backed companies. Analysts estimated that there are now 2.5 sellers for every buyer for private shares, a modest improvement from 4:1 six months ago but nowhere near the balanced 1:1 in 2021. Fortunately, the healthcare sector has been relatively resilient in the secondary markets.
Other barometers as to the health of the financing markets are the IPO market and M&A activity. Overall, exit activity of venture-backed companies was nothing short of abysmal in 2022. According to Pitchbook data, there was $71.4 billion of exit activity across 1,208 transactions in 2022 versus a staggering $753.2 billion and 1,925 transactions in 2021 (average deal sizes of $59 million and $391 million, respectively). This past year looks to be the weakest IPO year since 1990, according to Axios, with a mere $8 billion in proceeds across 74 IPOs.
Data: Dealogic; Chart: Axios Visuals
Indicative of the general lack of liquidity in the market, 70 special purpose acquisition companies (“SPAC”) have shut down just since last month, more than the total number of shutdowns in the market’s history, according to SPAC Research. These 70 SPAC sponsors are estimated to have lost $600 million. In total, there are still approximately 400 SPACs holding about $100 billion still sitting on the sidelines. Notably, Chinese companies that went public in the U.S. in 2021 only raised $536 million, which is down 96% from 2021.
Notwithstanding the many financing headwinds, the resilience of the healthcare technology sector should be supported by the continued migration of patients/members into value-based, digital-first solutions. As the pandemic morphs into an endemic, there is an expectation of increased hospital utilization, an increase in previously deferred elective procedures, and a relatively supportive reimbursement environment including for telehealth and other virtual services. Telehealth visits seemed to have settled at 14% – 17% of all visits, up from ~1% pre-Covid. The role of the consumer will continue to be important, underscoring the need for better, more effective engagement and care management platforms.
While the 2022 downdraft in digital health funding mirrors investor concerns more broadly, given the enormous market opportunity to transform the business of healthcare, this past year still recorded the second most active year ever. In fact, the 4Q22 investment pace of $2.7 billion was more than 20% ahead of 3Q22 activity of $2.2 billion, pointing to continued sector strength, but also that the “new normal” will likely be annual investment activity between $10 – $15 billion. Entrepreneurs will need to recalibrate to this new reality – capital will be less plentiful and likely more expensive.
What does that practically mean? Average round size collapsed to $26.7 million down from $39.7 million in 2021. Of course, averages can be misleading. According to Rock Health, there were only 35 financings greater than $100 million (“mega rounds”) while there were 88 and 43 in 2021 and 2020, respectively. Those 88 companies in 2021 consumed 56% of all invested capital that year, while mega rounds represented only 39% in 2022. In addition to fewer mega rounds, there was significant compression in round size for both Series B and C financings according to analysis prepared by my firm, Flare Capital (my thanks to my colleague, Parth Desai). The implications of smaller round sizes will require companies to operate with greater capital efficiency and/or focus on more modest milestones with each financing given the shorter runways.
There was a dramatic spike in valuations at the outset of the pandemic as investors embraced novel technologies as the healthcare system was forced to be virtual, intelligent, predictive, and real-time nearly overnight. Interestingly, pre-money valuations held up remarkably well in light of recent volatility in the public markets. There was evidence of softness in Series B rounds but valuations for most stages were either flat or up slightly over prior years, with notable strength in the Seed stage rounds.
While admittedly somewhat nonsensical, adding the average round sizes from Seed through Series C rounds in 2022 (total of $104.6 million) compares favorably to the average Series C pre-money valuation of $421.6 million (or 5x post-money valuation to capital raised). In 2019, prior to the onset of digital health investor euphoria, on average $77.4 million was raised to reach Series C stage (or 2.2x post-money valuation to capital raised). One should expect a more measured capital appreciation dynamic going forward with less liquidity sloshing through the market.
As a cohort, healthcare technology unicorns (Flare Capital tracks 86 of them) saw significant valuation compression in 2022, consistent with the overall public equity markets, declining in aggregate value to $281 billion from $416 billion in 2021. While valuations of privately held unicorn shares tend to reset slower than comparable public stocks (that might be changing – slowly – with greater liquidity in the secondary markets – see above), one should expect further reduction in valuations in 2023 as those companies come back to market to raise additional capital. This will be great theater as many of those companies still require significant capital to reach breakeven and will find capital availability much more limited and with potentially onerous terms. Also expect extensions of prior rounds with significant existing investor support to be quite prevalent.
According to analysis by Refinitiv, overall healthcare and life science M&A declined from $505 billion in 2021 to $329 billion in 2022. Arguably, a few hundred healthcare companies will be coming to market to raise capital in 2023; not all of them will be successful. This will undoubtedly generate a spike in private-to-private M&A activity which may reverse the trend in 2022. Specifically, exit activity in the healthcare technology sector saw a dramatic reduction in 2022 to a miniscule $2.2 billion according to SVB Securities. It is a safe bet that this will increase meaningfully in 2023.
But no need to be so dour. A reading of the Center for Medicare and Medicaid Innovation (“CMMI”) 2022 Report to Congress (someone had to) is energizing as a healthcare technology investor. There is no shortage of innovative models and solutions demanded by the market, coupled with a sophisticated and talented entrepreneurial community set on transforming healthcare. Over the past two years, CMMI has tested 32 novel payment and service delivery models that touch 41.5 million lives and 314k providers; eight models have already shown significant cost savings or meaningfully improved quality of care.
As more of these initiatives and the few hundred digital health companies launched in the past five years show impact with data and can claim attribution, there should be adequate capital available to fund future growth. And maybe even tap into the nearly $300 billion of venture capital raised (according to Pitchbook) but yet to be invested sitting on the sidelines waiting to jump in.
Me: “Describe the most powerful, potentially disruptive technology to transform the business of healthcare.”
ChatGPT: “Me.”
What to many may look like a typo, ChatGPT is one of the most rapidly adopted technologies to capture the imaginations of the “Technorati.” It took a mere five days for ChatGPT to reach one million users. Three days ago, the Wall Street Journal broke news of talks that OpenAI, the non-profit artificial intelligence research laboratory which developed ChatGPT, is considering a secondary share tender offer for at least $300 million at a $29 billion valuation. This would nearly double the vauation from a financing completed in 2021. Microsoft invested $1 billion in 2019 and is a cornerstone strategic partner with OpenAI, which was founded by Sam Altman and Elon Musk in 2015.
So, what is it? The GPT stands for Generative Pre-trained Transformer and is a natural language processor model. Most chatbots are considered “stateless;” that is, each session starts from the beginning, there is no inherent continuity in the engagement. Not Generative AI which puts forth the “best guess” on what word comes next in the sequence based on the training and is not deterministic. In a sense, it has an ability to “remember” and can pick up where it left off creating a more persistent persona. ChatGPT is not overtly a search engine but can indirectly and powerfully inform and teach. Natural language tools such as ChatGPT inevitably will replace awkward existing graphical user interfaces (GUIs) to create more effective human – computer interactions.
These foundation models are trained on extraordinarily large data sets. ChatGPT was trained on GPT-3.5, which is one of the largest training sets of data available yet only reflects content up to the end of 2021. Generative AI tools are considered relatively easy to create as they are built on existing foundation models, which analysts suspect will become somewhat commoditized over time. Recognizing the logarithmic scale of the chart below underscores the dramatic and recent explosion in the size of these models. Megatron-Turing NLG has 530 billion parameters and is the largest monolithic transformer in the English language.
There are important implications to this approach, which is very compute power intensive and requires an extraordinary amount of training data. Analysts estimate that ChatGPT is burning up to $4 million per day and that each interaction costs between $0.01-$0.02. Setting aside the myriad of eristic issues involving plagiarism, mistakes (“hallucinations”), biases, etc – more on that shortly – one of the most immediate implications is a profound disruption to Google’s search business. The New York Times recently reported that ChatGPT is “Code Red” within Google, which has enjoyed a near-20-year hammerlock as the internet’s front door. Expect to see ChatGPT be front and center in Microsoft’s Bing search engine.
Google made waves last summer with its LaMDA (Language Model for Dialogue Applications) when a Google engineer claimed it to be sentient. While later shown to be somewhat hyperbolic, it clearly showed that significant progress had been made in developing more robust chatbot solutions. Not to be left behind, Meta developed Galactica, its version of a chatbot, but unfortunately was quickly removed due to issues around accuracy and biases (seems to be a chronic Meta condition).
These initiatives are important for the healthcare industry to monitor. It is expected that quite quickly a platform will emerge that will be robust enough, accurate enough to reliably transform healthcare applications. The irony is that this novel technology is about to disrupt a whole set of recently deployed novel healthcare technologies. The generative AI category has certainly attracted enough investor attention. Venture capitalists have invested over $1.37 billion in approximately 78 companies in 2022, according to Pitchbook. A recent New York Times analysis estimated that there are already more than 450 generative AI start-ups.
Healthcare investors have backed literally hundreds of virtual care models with a provider at the center – doesn’t this platform go right to the heart of those business models? There will be a litany of obvious use cases: training, content for patients, symptom checkers, second opinions, etc that lend themselves readily to these generative models. Translating medical jargon to plain language will improve patients’ understanding and likely adherence to courses of treatment. In addition to the tremendous time savings, the reduction in friction for the patient will be immeasurable.
Notwithstanding the promise, there still remain significant concerns. Most troublesome are the incidents of “hallucinations” whereby ChatGPT with great confidence may provide an answer that is simply wrong, manufactured, or lacks appropriate nuance. The apparent fluency and ease of ChatGPT obfuscates the lines between fact and fiction. ChatGPT is not allowed at the Q&A website, Slack Overflow, which is used by software developers given concerns about accuracy.
Perhaps understandable given how nascent the technology is, there are other concerns involving unintended biases. Today there is no obvious revenue model for ChatGPT so under an onslaught of investor pressure, should we brace ourselves for a world of sponsored medical content and/or disinformation? Absolutely. Will we see “brought to you by…” embedded in much of the generated content? Should there be concerns that ChatGPT may amplify the loudest, most boorish voices? Of course. Like with Google and Meta, until the underlying algorithms are fully revealed, how the content is created may amuse but the implications will not be fully understood. The temptation to misuse such a powerful platform is real and imminent.
Arguably, academic and medical societies need to mobilize. While the clinical adoption at the bedside may be either generational or limited initially, patients will certainly reach for ChatGPT much like they have for Dr. Google for the past 20 years. A number of Flare Capital portfolio companies which operate in and around the AI sector have seen significant market interest but more limited near-term commercial traction, underscoring that broad scale adoption has been more challenging (selling technology in healthcare is hard – plan accordingly). That may well be about to change. One of our more recent early-stage portfolio companies building that future is BirchAI, which envisions documentation consistently better than the average human by 2025 (graphic credit to BirchAI, Sequoia Capital).
Outstanding healthcare is ultimately a human-to-human interaction, the more complicated the condition, the more skilled the provider needs to be. But what are the implications if the care for more mild or chronic conditions can be augmented (or even replaced) with a platform as empathetic, as informed as a human and yet available 24/7? Arguably many behavioral health conditions could be managed by a platform that freely communicates with patients and learns over time how best to inform, engage, activate. Does this not start to meaningful address issues of access? Is this one of the onramps to more personalized care? Just saying…I mean, just chatting.
None of this was written by ChatGPT…or was it?
Me: “Write one paragraph that describes the healthcare technology sector in 2023”
ChatGPT: “It is difficult for me to accurately predict the state of the healthcare technology sector in 2023, as my knowledge was cut off in 2021 and I do not have access to updated information. However, based on trends and developments in the field up until 2021, it is likely that the healthcare technology sector will continue to grow and evolve rapidly in the coming years. This may include the development and adoption of new technologies such as artificial intelligence, virtual reality, and telemedicine, which can help improve the efficiency and effectiveness of healthcare delivery. There may also be an increased focus on the use of data and analytics to drive decision making and improve patient outcomes. Additionally, there may be ongoing efforts to integrate technology into various aspects of the healthcare system, such as electronic health records and medical devices, in order to streamline processes and improve communication between healthcare providers.”
Having spent three energizing yet exhausting days in Israel this past week, one struggles to neatly put the experience in a simple elegant context. Like many countries today, there is extraordinary and somewhat confounding political confusion. There are significant anxieties due to volatile economic conditions. And all of this against a public healthcare crisis that simply will not abate. Maybe one word to capture the zeitgeist of the moment is unrelenting.
Undoubtedly, Israel resides in a neighborhood fraught with conflict, although there are encouraging signs of geopolitical advancements anchored by the Abraham Accords. This framework seeks to (more) normalize relations with the United Arab Emirates (UAE), Bahrain, Morocco and Sudan, with other Arab countries expected to join the fold over the next few years. Since the initial signing, over 500k Israelis have traveled to the UAE in the past two years and there has been an estimated $192 million in trade deals according to an analysis by The Jewish Chronicle. The Israeli Minister of Defense can already point to $791 million in defense exports to the participating countries. Even with this progress, it was fascinating to watch the Morocco – France FIFA World Cup semi-final match at Ben Gurion Airport with several hundred highly partisan Israeli fans on Wednesday night.
But the current political discourse is solely locked now on the rise of the ultranationalist party in the emerging Netanyahu-led Likud party’s coalition, which won the national elections held last month to form the 37th government of Israel, and just this past week secured a 10-day extension to form the new government. Many of my conversations centered on this phenomenon which will likely see the further expansion of settlements, stiffened resistance to Palestinian statehood, and the possible dismantling of judicial oversight. The Knesset, which is the legislature of Israel, has 120 seats and will likely be made up of 12 political parties, each of which secured enough votes to be included – there are another 43 parties which will not have a seat in the Knesset). Unrelenting political chaos.
Interestingly, the public health response to Covid has been nothing short of impressive. When most other countries struggled to manage variant surges (see below at the challenged U.S. responses), Israelis deftly managed to limit the spread of the disease and suffered a modest, yet still tragic, loss of just under 12k lives with a total of 4.75 million cases. By comparison, the U.S. to date has experienced an estimated 1.1 million deaths and 99.6 million reported cases, effectively 3x the fatality rate seen in Israel.
The entrepreneurs I met in the healthcare technology sector were remarkable and unrelentingly enthusiastic and determined. According to Tracxn, there are 867 healthcare technology start-ups in Israel now, underscoring the well-deserved reputation as the “Start-Up Nation,” which was first coined in 2009 to account for the extraordinary Israeli entrepreneurial culture. According to Calcalist, there are 9,484 start-ups in Israel now and approximately half of them have revenues below $10 million. Just under 10% of all Israeli start-ups are in the healthcare technology sector.
One of the wonderful hallmarks, among many, of Israeli healthcare technology entrepreneurs that I witnessed on each of my prior visits (March 2011, June 2014, December 2016) is the unrelenting obsession to solve intractable healthcare problems, often with a very disciplined product-first approach. Obviously, their engineering bona fides are beyond dispute, which colors how many founders view the market opportunities. Given much of the risk healthcare technology investors take is around product / market fit, the promise of deeper collaboration with Israeli founders is to help refine the specific near-term commercial opportunities that have real budgets.
As is the case in most venture capital markets around the world, the Israeli venture investment activity cooled significantly in 2022, tracking to be an estimated $15 billion, well below the 2021 highwater mark of nearly $26 billion. Notwithstanding that, the Israeli venture investment per capita ranks #2 globally as of mid-2022, behind only Singapore, with $506/person invested as compared to Singapore and the U.S. (#3) with $695 and $357, respectively.
The relatively strong exit environment in 2021 with close to $24 billion of exits across 262 deals continues to drive exciting venture capital fund formation. According to the Tel Aviv Stock Exchange, there were 94 IPOs in 2021 which raised nearly $13 billion. While many markets struggled to see new venture funds raised, Israeli-based funds saw a 71% increase over 2021 in the amount of capital raised, reaching €2.9 billion across 28 funds through November 2022. Tracxn estimates that there are 126 accelerators and incubators in Israel to complement the local venture capital industry.
The level of activity is remarkable when one considers the relatively short and challenged history of the capital markets in Israel. It was not much more than 40 years ago when the Israeli economy was in the midst of an absolute desperate financial crisis, triggering a massive Economic Stabilization Plan in 1983 (the 1984 inflation rate was over 370%).
Structural reform and privatization initiatives over the past twenty years have created one of the most robust regional economies with benign inflation and a GDP per capita in 2021 of $51.4k (compared to $69.3k in the U.S. and $23.6k in Saudi Arabia). Israeli unemployment rate as of October 2022 was 4.1%. The total market capitalization of the 549 publicly traded Israeli companies is $216 billion. It is estimated that now 25% of all European IPOs are in Israel and there are significant capital inflows into the market. The push for dual listings has further diversified the investor base of many companies and afforded greater liquidity. Unrelenting capital market successes.
My sincere thanks to Phyllis Gotlib, Flare Capital’s amazing Executive Partner (who spends much of her time in Israel), the entire team at Arkin Holdings (particularly Nir Arkin, Nadav Shimoni – excited about our partnership), the inspirational team at The Peres Center for Peace and Innovation (particularly my friend Chemi Peres), the hardworking team at Google for Startups Israel (what a terrific facility), the tireless8400 Network of leading healthcare technology executives (great breakfast conversation), and the dozen hot start-up founding teams I had the great privilege to hear from (apologies for my unrelenting jet lag).
In 2019, before the pandemic, the U.S. Census Department estimated that 611k people were treated at hospitals every day. In mid-January 2022, at the absolute height of the Omicron surge, there were ~150k daily hospital in-patient admissions recorded due to Covid. As there are 6,093 hospitals in the United States with approximately 921k staffed hospital beds, it is understandable how battered the healthcare delivery system was during that surge. In addition to the pressures to dramatically lower hospital operating costs, it became clear that innovative new care models had to quickly evolve in response.
While many providers have piloted hospital-at-home (“H@H”) programs, often at sub-scale levels, market forces now make it quite clear that a robust tech-enabled H@H company could be successful. Last month the formation of Inbound Health, a partnership between Allina Health and Flare Capital, was announced with a $20 million Series A. To Allina’s great credit, at the pandemic’s outset its executive team developed a H@H program that has now managed over 4,400 admissions. This program replaced facility-based observation, both for acute and skilled nursing episodes. These cases covered patients across more than 180 diagnosis-related group (“DRG”) codes. In fact, nearly 60% of the episodes since May 2020 are for non-Covid cases.
Inbound Health provides both the technology infrastructure and analytical capabilities, in addition to the care model, virtual workforce, supply chain, payment models, and a local staff presence as a turnkey solution for other providers to launch H@H programs. The Inbound Health service offers a flexible workforce solution, utilizing employed and contracted labor. Specifically, this program includes physician visits, 24-hour monitoring, nursing services, diagnostics, and drug dispensing, whenever necessary. There are two principal value components to the Inbound Health offering: (i) historic Allina data shows a dramatic reduction in length of stay versus inpatient episodes; and (ii) enables customers to own another dimension of the care continuum.
Inbound Health has developed a fully aligned payment model with its customers, charging a modest fee at the outset to enable the company to start to capture patient data. As the data set is enriched, the reduction in length of stay and significant cost benefits will become readily apparent, facilitating attractive reimbursement models from payers. Ultimately, Inbound Health will be able to identify certain at-risk populations who would be appropriate for H@H offerings in advance.
Over the past 30 years, hospital expenses have increased nearly 5-fold and yet overall in-patient hospital admissions have remained relatively constant at around 35+/- million each year. This is clearly untenable and will require that much of that care must be provided in community-based settings, outside of the hospital’s four walls. The situation is further exacerbated by the acute hospital labor shortage. Long-term care facilities are also struggling to provide adequate staffing, encouraging even more of these cases to be handled in home settings.
In November 2020, the Centers for Medicare & Medicaid Services (“CMS”) launched the Acute Hospital Care at Home program, which granted waivers to meet certain reimbursement requirements (i.e., 24/7 onsite nursing care, etc) to a total of 114 systems covering 256 hospitals in 37 states. Patients are only to be admitted from emergency rooms or discharged from inpatient beds, often in lieu of being admitted to skilled nursing facilities (“SNF”). In 2019, the national annual average discharge rate was approximately 33 patients per bed, of which 5% were assumed to be H@H eligible per a pre-Covid Milliman analysis. This would imply that ~825k Fee for Service (“FFS”) and Medicare enrollees are appropriate for H@H programs each year.
The benefits of H@H programs are numerous. Outcomes arguably are superior to inpatient stays with many providers reporting approximately 20% reductions in mortality. Patients often prefer to be cared for in their homes and tend to show significant improvement in familiar surroundings. In fact, H@H patients are 3x less likely to be readmitted within 30 days. And patients appear grateful for such care models; Inbound Health has lifetime net promoter scores 86+.
Importantly, the potential cost savings are dramatic: early trial work at Johns Hopkins demonstrated 32% cost savings while an American Hospital Association 2019 study concluded that home hospital patients realized a 38% cost savings when compared to in-hospital care. At a time when rural hospitals are closing and many communities are struggling to provide inpatient care, H@H programs will serve to augment those losses at lower costs.
Against those benefits, there are concerns with H@H programs which must be managed carefully. The implementation can be complex as supplies and staff need to be coordinated very carefully. In-home environments need to be assessed, and whenever necessary, improved to accommodate such clinical services. Patient acquisition can be complicated as demand can be inconsistent given the novelty of such an approach. Certain patients will remain convinced that the highest quality care can only be provided in a hospital (notwithstanding the risk of infection, inconvenience, etc.). H@H providers need to maintain a minimum level of patient volume to ensure that the program can be profitable given the associated overheads required. Additionally, there are possible novel legal exposures to H@H providers associated with non-medical factors involving supply chain issues, logistics, and managing third-party providers.
Arguably the greatest concern involves the enduring payment model. In general, there are two approaches to structuring H@H payment models: top-down versus bottom-up. The top-down approach involves a Medicare payment of approximately $17.5k to the hospital per episode of care based on the acute inpatient prospective payment system. The bottom-up payment approach looks to rates paid to home-based care providers, which are consistently lower, and tend to total approximately $10.5k per episode. Most of this difference is due to larger acute DRG payments in the top-down approach and SNF avoidance.
Given the uncertainty still with the longevity of the waiver program and the somewhat unsettled payment models, the CMS Innovation Center in October 2021 announced efforts to encourage beneficiaries of covered entities to seek care from organizations accountable for quality and cost, providing incentives for such organizations to adopt H@H programs. Specifically, the 2021 stimulus package earmarked an additional $400 billion for reimbursement of home and community-based care. But concerns remain among providers. A recent survey conducted by Hospital at Home User Group concluded that only one-third of respondents were likely to continue with H@H programs even in the absence of the waiver, suggesting a relatively high degree of uncertainty still in the marketplace as to the enduring economics of these programs (27% stated that they would need the waiver to remain in order to continue).
Additionally, it is expected that H@H programs will bundle additional services such as transportation, home modification, and food provision to increase the revenue per episode potential. Interestingly, a recent Modern Healthcare survey concluded that 50% of the time adequate broadband access is lacking and must be deployed. Undoubtedly, this played a role in Best Buy’s $400 million acquisition of Current Health in 2021 to provide more robust remote patient monitoring solutions.
The investment community has also recognized more broadly the compelling market opportunities in senior care revealed by the pandemic. Venture capital investment activity in 2021 spiked to well over $2 billion in nearly 40 deals, while private equity investment also increased significantly last year; both seemed to have returned in 2022 to levels seen in recent prior years, according to Pitchbook and Axios data.
Consistent with the movement to more community-based care, it is not surprising to see that the rate of home births is now at a 30-year high in the U.S. It is estimated that 1.4% of all births in 2021 were in the home, which would be the highest level since 1990. For many of the same reasons that more acute hospital services are moving to the home, rural hospital closures and limited access to obstetric services are encouraging more women to consider in-home delivery options. An analysis from the International Journal of Environmental Research and Public Health concluded that home births cost approximately $4.7k versus in-hospital delivery costs of $19k, an even more dramatic cost savings when compared to traditional H@H savings.
Technology is the great democratizing force in healthcare. World-class care can now more readily be delivered to disenfranchised populations who struggle with access and affordability. The advent of robust H@H programs like what is being delivered by Inbound Health promises superior outcomes at dramatically lower costs.
Upon the conclusion of a very tough week for U.S. consumer internet and technology stocks that saw over $550 billion of market value evaporated at Alphabet, Amazon, Apple, Meta and Microsoft (combined market value now sits at $6.64 trillion), coupled with the news of the 70% decline upon the first anniversary of the largest bitcoin ETF (Proshares Bitcoin Strategy fund), it is a good time to take stock of the healthcare technology sector. While there has also been significant volatility with healthcare technology stocks, the resilience of top line revenues has been impressive. Admittedly a rather small sampling, the Flare Capital portfolio saw 12% 3Q22 over 2Q22 aggregate revenue growth and nearly a 60% increase 3Q22 over 3Q21. Overall, revenues are tracking ahead of plan for the year, even in spite of worsening economic conditions.
The pandemic obviously triggered a massive acceleration in technology adoption across the healthcare landscape which in turn let loose a wave of digital health investment activity. The healthcare system was forced to become virtual, real-time, on-demand, predictive, intelligent, distributed, empathetic, even more transparent – all capabilities ultimately enabled by novel healthcare technologies. Secondary issues have emerged such as labor force disruption and productivity which also demand robust solutions. McKinsey & Co. estimates that just the pandemic will burden the healthcare system with an additional $220 billion of costs by 2027, this to a system already struggling to be self-sustaining, much less being profitable.
Coming off a record year in 2021 of $29.2 billion invested in 736 companies according to Rock Health, the 3Q22 data show a continued slowing in the investment pace as the sector confronted more hostile economic conditions and worked to absorb the extraordinary amount invested last year. This past quarter saw $2.2 billion invested in 125 companies, which was the lowest amount invested in the past eleven quarters. This puts 2022 on pace to hit nearly $17 billion invested in over 600 companies, which would still be the second most active year yet. Unfortunately, though, this deceleration suggests that 2023 may be a relatively lean year. Interestingly, $17.6 billion was invested in 1H22 globally in digital health according to CB Insights data.
Importantly, the average deal size dropped from $39.7 million in 2021 to $27.4 million so far in 2022, indicating the relative dearth of large late-stage rounds. Much of the deal size compression occurred in the later stage rounds of financing, particularly with Series C rounds that saw median deal size of $71 million in 2021 drop to $55 million year-to-date in 2022. Rock Health tallied only six Series C financings in 3Q22 and only two rounds that were greater than $100 million.
This past quarter might well have marked the “end of the beginning” of the first phase of healthcare technology sector development. Arguably there will still need to be a few more quarters to recalibrate to this new normal when capital is no longer free and revenue growth is harder. It is informative to compare prior year rounds by series to the next year by the subsequent series (e.g., compare number of Series A rounds in 2019 to number of Series B rounds in 2020/2021) to gauge “graduation rates,” that is the proportion of companies that are able to raise subsequent rounds. One should expect a lower graduation rate as capital becomes scarcer with a concomitant increase in private-to-private combinations (and smaller round sizes as investors limit exposure and/or put struggling companies on tighter leashes).
A detailed McKinsey & Co. analysis projects that national healthcare expenditures will grow at 7.1% between 2022 – 2027, well ahead of the 4.7% forecasted general economic growth, exacerbating the acute need for greater productivity. The Association of American Medical Colleges recently estimated that there will be a shortage of 200k nurses and 50k doctors in the U.S. in three years.
As tragic as the pandemic has been for literally billions of people, this will likely be looked upon as the inflection point ushering in decades of terrific investment activity. The enormity of the market opportunity, coupled with the deeper appreciation that these value-based models do indeed create significant economic value, will welcome an exciting period of prolonged growth and investment activity when important valuable companies will be created.
McKinsey & Co. estimates that there is $1.0 trillion of improvement to be realized as the healthcare system is rearchitected to optimize limited resources, improve outcomes, and drive enhanced productivity. Bain and KLAS recently released a survey of providers to better understand investment priorities which highlighted the urgency to strengthen both infrastructure and analytics capabilities.
The strategic imperatives of the healthcare system are reflected in which sub-sectors are attracting the most capital. On-Demand Healthcare has consistently been the top funded sector until recently when Non-Clinical Workflow jumped from a distant seventh place to first in 2021. Research and Development investments captured the third slot this year.
Perhaps not at all surprising, mental health remained the top clinical indication this year with $1.7 billion invested (nearly 15% of all investments) so far this year in 53 companies, which is coming off of $4.8 billion in 2021. According to Grand View Research, the global mental health app market alone is $4.2 billion and is expected to grow at 16.5% annually to 2030. One risk is that arguably too many companies have been funded in some of these sectors, which will likely lead to painful consolidation as the sector rationalizes. The next most popular indications this year are oncology and cardiovascular followed by diabetes and “femtech.”
Notwithstanding the acute and obvious needs, this past quarter also was one of the most challenging quarters to price new investment as companies held on to legacy valuations for financings that closed in 2021. Many investors focused more on seed and early-stage opportunities where pricing was consistently in-line with historic norms and/or they focused on supporting existing portfolio companies.
Public stock market performance provides a difficult benchmark and further exacerbates the valuation debate given how poorly many of the public healthcare technology companies have traded. At the end of 3Q22, the SVB Digital Health and Heath Tech index was down 31.8% year-to-date (in September alone the index dropped 46.5%, underscoring the sector volatility) and was trading at a 3.3x estimated 2023 revenues with a total market valuation of approximately $90 billion. SVB goes on to highlight that since the index peaked in early February 2021, it has declined by 66.8%.
What will need to happen in order to see a significant recovery? In the midst of the madness last year, the SVB Digital Health index traded at 6.9x revenues in 2Q21, a far cry from where it sits now. Clearly, there will need to a be general recovery of investor sentiment and some clarity of the war in Ukraine and China – U.S. relations. Broader capital flows back into risk assets will create a rising tide. Valuation multiples will likely settle somewhere between 3.3x and 6.9x.
One might also expect an increase in “private-to-private” mergers as many companies struggle to get through this knothole. Typically, each round of financing provides 15-18 months of runway implying that many of the companies that raised in 2021 are now thinking about the next round; frankly, not a lot of time given the sales cycles in healthcare. A common critique is that too many companies have built products that are too narrow or solve a small piece of the puzzle. Oftentimes, what is built is a limited point solution, when customers require a broader, deeper set of capabilities. Expect also to see horizontal acquisitions that seek to expand into adjacent customer bases (providers + payers) or bolster distribution capabilities, especially for those companies that may not have sorted out product / market fit.
Obviously, 3Q22 was a very difficult quarter in the capital markets. Of the 115 global stock, bond ETFs, currencies, and commodity indices tracked by the Wall Street Journal, only 13 of them showed gains, paced by the not surprising 24.7% gain in the New York Mercantile Exchange Natural Gas index. Sadly, the Ukrainian hryvnia declined by 20.0%, slightly out ahead of the oxymoronic Lean Hogs index which dropped by 18.2%. The S&P 500 Health Care index dropped by “only” 5.6%.
The venture capital industry was not insulated from this turbulence which underscores a general “risk-off” investor sentiment that has settled in as inflation and interest rates both continue to rise. The level of venture investment activity in 3Q22 totaled $43.0 billion invested (a nine-quarter low) in an estimated 4,074 companies (a seven-quarter low) according to Pitchbook. While activity slowed across all stages, it was particularly acute in the later stage rounds as crossover investors walked away. Late-stage investments declined to $24.9 billion in 3Q22 from $64.7 billion in 3Q21.
Notwithstanding a collapse in exit activity in 3Q22 to $14.0 billion (in 2021, exits totaled $781.5 billion), fundraising for U.S. venture capital funds has already set a new record with $150.9 billion raised by only 593 funds through 3Q22. Notably, the average fund size raised in 2022 is $254 million, dramatically larger than the average fund size of $129 million in 2021. And 2021 was the second greatest year for fundraising with $147.2 billion raised by 1,139 funds. Fewer firms are raising larger funds.
How venture capitalists behave over the next few quarters will meaningfully influence the health of the innovation economy over the next three to five years. Undoubtedly much of the decline in venture investment activity over the past quarter was related to funds triaging existing portfolios, determining which companies merit additional financial support, developing action plans to weather the pending economic storm, and a general heightened sense of anxiety – all of which can be quite distracting. In spite of that, 3Q22 investment activity simply returned to the quarterly investment levels experienced in mid-2020, a mere two years ago.
Barron’s recent Big Money poll flagged that 22% of the 107 largest U.S. investors ranked cash as the most attractive asset class today. A sense of malaise seems to have set in with public stock investors now that we have witnessed three straight quarters of negative returns for the S&P 500 index, which has not occurred since 2009.
Year-to-date the S&P 500 index is down 24.8% while the NASDAQ is down a disquieting 32.4%. Not to be outdone, Bitcoin declined 59.3% and now trades at $19,222 per token, a country mile from the nearly $70,000 reached less than a year ago. The price of a Bored Ape Yacht Club NFT has dropped 25% just this month. Interestingly, a Financial Times analysis of data compiled by Dealogic concluded that nearly 75% of the more than 400 “Covid” IPOs (companies that raised more than $100 million via a public offering between 2019 – 2021) are trading below their IPO prices and that the median return since being public is a negative 44%. Clearly, 2021 will be looked upon not so fondly as an outlier now that capital is harder to come by and no longer free.
Data: Yahoo Finance. Chart: Tory Lysik/Axios
In such an environment one might expect two developments: an increase in M&A activity and/or a spike in “zombie companies” – neither of which has yet to occur. According to Refinitiv, global M&A activity declined by 34% year-to-date to $2.8 trillion, which is the largest decline since 2009, in part exacerbated by an extraordinary level of M&A activity in 2021. According to S&P Global Market Intelligence data, 3Q22 M&A activity in the U.S. was the lowest quarterly amount since 2Q20, with just under 4,700 transactions and a total value of $255.5 billion (average deal size of ~$54 million). Transaction value dropped 58% year-over-year. The lack of robust M&A activity likely reflects increased executive suite anxiety and the dramatic spike in the cost of capital.
Goldman Sachs defines “zombie companies” as those companies which have not been able to fully service their debts for three consecutive years (interest coverage ratios of less than 1.0) and concludes that approximately 13% of U.S. companies are the walking dead. This has consistently hovered between 12% – 14% over the last decade. Admittedly, this definition includes a swath of exciting high growth technology companies leading Goldman Sachs to focus only on those publicly traded companies with stocks that have underperformed by 5% or more relative to the S&P 500 benchmark for two straight years. Through this lens the number of “zombie companies” drops to below 4%, well below what many might have suspected, but quite foreboding should there be a recession in 2023.
Speaking of the living dead, the SPAC (special purpose acquisition company) market has been slapped back to reality from a blistering pace set in 2021. In large measure due to the abysmal stock market performance of SPACs, the number of SPACs in all of 2022 may not even equal the 3Q20 level, which was just prior to the explosion of SPAC activity in 2021 when there were 613 SPAC deals. Of course, the broader story is the shuttering of the U.S. IPO market with only 22 “traditional IPOs” year-to-date 2022, according to PwC data. In 3Q22, $2.0 billion was raised by a measly five IPOs, levels not seen in years. So far this year, more than 60% of announced IPOs have been withdrawn due to market conditions.
How will this landscape impact venture investment over the next few quarters? Many venture-backed CEOs, founders, and boards are grappling with potentially painful re-sets in valuation and many likely now have less than one year of cash. Like navigating various stages of grief, companies will deploy a predictable set of strategic maneuvers: trim costs (often around the edges, often too late), explore venture debt, look to existing investors to extend the last round to preserve a legacy valuation, and maybe then explore financings with terms that optically preserve that legacy valuation. Many of these steps will not be fruitful, at least not until there has been a genuine re-pricing of the company, particularly for late-stage companies. Boards unwilling to re-price will explore M&A alternatives should the company not be able to raise capital on acceptable terms.
Arguably, while we are somewhat early in the cycle of repricing companies which raised capital at high valuations in 2021, there is already evidence of a significant impact on valuations. Late-stage company valuations have declined from close to $700 million in 2021 to $582 million year-to-date 2022. Pitchbook calculated that only 6% of financings in 1H22 were down rounds, suggesting a dramatic acceleration of down rounds in 3Q22.
In any given year, 10% – 15% of all financings are down rounds according to Pitchbook. In fact, more than 3,000 companies have closed down rounds over the past decade. The pressing question before boards now is what the path forward after a down round financing might look like. A retrospective Pitchbook analysis from 2008 – 2014 of over 1,400 companies showed that 70% of those companies went on to raise additional capital while 13% were unable to raise capital or complete an exit; the remaining companies successfully were sold obviating the need to raise more capital. The median decrease in valuation for down round financings across all stages was approximately 35% in 2021.
An increasingly important tool in the tool kit for boards to extend the cash runway is to take on venture debt, even though it may limit degrees of freedom in the future. Against a backdrop when U.S. gross national debt eclipsed $31 trillion for the first time ever earlier this month, venture debt financings have seen significant activity this year with $22.8 billion of loan volume across 1,925 financings. Average annual loan volume for venture debt over the past four years has been greater than $31 billion. In fact, average early-stage and late-stage venture debt rounds have spiked in size from $10.6 million in 2021 to $14.0 million in 2022 year-to-date, and from $17.0 million to $20.8 million, respectively. The decrease from 2019 to 2021 likely reflects the increase in equity investments in lieu of debt.
During this quarter, portfolio companies will look to lock down operating plans for 2023. As management teams and investors stare at this new reality, one would expect more moderate growth plans, anticipating expected difficulties in accessing capital on attractive terms. And while it does not feel good in the moment, scaling a business in such an environment will institute greater discipline and focus on bringing to market only what customers will readily pay for.
A critical dimension to the staffing model at Flare Capital is our deep bench of Executive Partners. These people are notable operating executives who have a record a tremendous success in scaling businesses in times of industry transformation. Our Executive Partners are visionary thought leaders, have a depth of industry expertise and insights, can see around corners, and are lightning rods for great talent. Through that lens, I am super excited to share that my great friend, Varsha Rao, has joined as our newest Executive Partner.
Varsha and I first met in 1991, a shockingly long time ago, when we both worked on Wall Street at one of the hottest emerging boutique investment banks, Wasserstein Perella. After graduating from Harvard Business School, Varsha spent time at McKinsey & Co. which set her up for a series of leadership positions in start-ups (Eve.com) and high growth companies (Gap/Old Navy, SingTel Digital Media, LivingSocial). Notably, she then served as Head of Global Operations for Airbnb before her role as Chief Operating Officer at Clover Health. Until quite recently, Varsha was the CEO of Nurx, a leading provider of women’s healthcare products and services, having navigated the successful merger of the company to Thirty Madison. She also sits on a few prominent public company boards: Callaway Golf, Viasat. Oh, and she also holds a BA in Math from the University of Pennsylvania and a BS in Economics from The Wharton School.
Not to be lost among all of her successes is that she is also a prominent angel investor with a particular interest in working with female founders and marketplace business models. Insider listed Varsha as one of the country’s top 100 angel investors, having built a broad portfolio across a number of emerging industries. Her network among Silicon Valley investors will clearly be additive to the work we do, to say nothing of the terrific insights she has already contributed with new investment opportunities and for our existing portfolio companies.
In addition to her exceptional insights into the dynamics of marketplaces, Varsha is also keenly aware of the behaviors of consumers. She will be particularly helpful with one of our investment themes involving the “retailization/consumerization” of healthcare.
Join me in welcoming Varsha to the Flare Capital team and the world of early-stage healthcare technology venture investing…
On the Flying Bridge 