It is always nice to ring the bell when a great person joins our investment team – this time we get to ring the bell twice.
Venture capital firms simply do not need to hire a lot of people. While we will make at least several dozen investment decisions together over the course of a fund, we might only make a handful of hiring decisions. Each addition to the team is important and well-considered with an extensive interview process and a long courtship. Notwithstanding that, recruiting Uma Veerappan and Kelly Scherrer were easy decisions and are two more important pieces to the puzzle.
Uma is well-known to the Flare Capital team. While earning her MBA from the University of Chicago Booth School of Business last year, she was a Flare Scholar in the great Class of 2021. She did terrific work on a number of projects, including the closing of our investment in Elektra Health. As soon as we first met Uma, we knew she was special. Her passion for healthcare and deep understanding of this sector’s many complexities and nuances were immediately evident. While in business school, Uma both worked with a few healthcare technology start-ups and held roles at two venture firms.
Earlier in Uma’s career, she was a Strategy Consultant at EY with a particular focus on launching next-generation products at the intersection of healthcare and technology. Specific areas of interest included applications of artificial intelligence and surgical skills assessment. Prior to her time at EY, she was a Fulbright Teaching Grantee in South Korea. She is not just steeped in the healthcare technology sector and worldly but is whip smart having been recognized as a Woodruff Dean’s Achievement Scholar at Emory University, where she earned her BA in Economics and Educational Studies. I am certain we have a lot to learn from Uma.
And we may have hit the lottery twice this summer when Kelly Scherrer joined the firm as Controller, further strengthening the “back of house.” Given the volatility and general decline in economic conditions, coupled with having raised our third fund, it is even more important now that we double down on our ability to carefully monitor and support our portfolio companies. Kelly’s impact has been immediate and profound, leveraging her work both at RSM and PwC where she focused primarily on tax compliance for hedge funds, venture capital, and private equity firms. In an environment where financings will be harder and close attention to underlying financial and operating performance of our portfolio companies is critical, Kelly meaningfully advances the cause for the firm. And she is also super smart, having earned her B.S.B.A. with concentrations in Finance and Accounting from Northeastern University’s D’Amore McKim School of Business.
Quick update on our Flare Scholars program and Flare Scholar Ventures (FSV), which is our commitment to invest a portion of our new fund in the pre-seed rounds of Flare Scholar sponsored projects. With 254 Flare Scholars, who are young brilliant passionate emerging healthcare technology entrepreneurs, we now have 13 FSV companies, exceeding our initial goal – and a handful of those companies have already graduated by raising proper seed or Series A rounds. We could not be more impressed with the quality of all our Flare Scholars, but particularly the exceptional Class of 2022. The progress of the FSV program is inspirational as we continue to on-board the next generation of great healthcare technology entrepreneurs.
We will look to recruit the Class of 2023 Flare Scholars this fall and remain committed to the FSV program as we begin to invest out of the new fund shortly. Capital will always follow great talent and in this market, it will be great talent that wins.
And please join us for our next quarterly Expert Roundtable Series webinar on September 27, 2022 at noon EST. The topic is “Fundraising in a Turbulent Capital Market.”
Last week’s $3.9 billion acquisition of One Medical (NASDAQ: ONEM) by Amazon triggered significant hyperventilating about the transformative and immediate impact of this transaction on the healthcare industry. Interestingly, Amazon’s market capitalization increased 1.4% or $18.3 billion on the day of the announcement, paying for the purchase a few times over. Undoubtedly there could be exciting near-term benefits for the 750k ONEM members as their Amazon Prime accounts are linked to their ONEM memberships, facilitating targeted Whole Food and Amazon Pharmacy coupons. But what might we expect to see over time is a provocative debate with powerful implications for how each of us manage the arch of our healthcare journeys.
Important Disclosure: Flare Capital was a significant investor in Iora Health and had a board seat. Iora Health was acquired by ONEM in September 2021 for approximately $2.1 billion and is an important part of the ONEM story going forward. Amazon now has an important foothold in the Medicare market. This is not meant to be a victory lap as the stars of the Iora Health story were squarely the management team, particularly the founding CEO, Rushika Fernandopulle. And while Rushika may have been the lead actor, the supporting cast numbering in the several dozens and too many to list here played a critical role in that company’s extraordinary success (raised nearly $350 million, sold for $2.1 billion).
Indeed, it does appear that Amazon is methodically stitching together a series of assets that over the next few years will better reveal the scope of its healthcare strategy. With significant fanfare, the January 2018 the formation of the healthcare consortium Haven with Berkshire Hathaway and J.P. Morgan was one of the first markers placed by Amazon in healthcare. While ultimately unsuccessful, this was followed up quickly with the June 2018 acquisition of PillPack for $750 million, which became the cornerstone of Amazon Pharmacy. The enthusiastic press coverage earlier this year about the expansion of Amazon Care to 20 cities was particularly notable. Easily overlooked were all of the important healthcare hires made by Amazon over the last five years, each one received with a quizzical look at the time but now look prescient and coming into better focus.
And running in the background are the numerous other Amazon initiatives such as Alexa and Ring doorbells which have rapidly proliferated robust, intelligent, and all-seeing (all-knowing) sensors in and around millions of homes and other healthcare settings.
The industrial logic of this transaction looks very compelling – at least in the abstract. In the ongoing effort to improve outcomes while lowering costs, the healthcare industry is shifting sites of care from high-cost acute settings to lower cost post-acute settings (i.e., the home). Overlay the “consumerization of healthcare” trend, greater awareness of the role that social determinants play in one’s health, the move to value-based care models, and the heavier cost burdens placed on employers further amplifying their voice in healthcare purchase decisions, Amazon’s decision to acquire a leading, branded primary care platform with 188 practices in 25 major markets with a particular focus on the employer customer (ONEM has more than 8k corporate clients) is fairly straight forward. The creation of Haven, while considered a failed experiment by many, tipped Amazon’s hand years ago.
Now let’s dream a little. According to U.S. Department of Health and Human Service estimates, the total per capita lifetime health spending (in 2016 dollars) is $414k; if healthcare spend increases 3% greater than overall inflation (quite likely), that number would be $2.3 million. Much of the arm wrestling in the market today is over who will manage that spend on behalf of patients/members/consumers. Through that lens, Amazon’s desire to determine how those dollars are spent is quite obvious. Given all of its assets – purchase and behavior data, sensors, analytics, cloud infrastructure, etc – Amazon’s understanding of each of us is unrivaled. The company’s ability to engage, activate, communicate, inform, incentivize, and provide products and services is staggering. Amazon’s potential to change behaviors, overtly and subtly, is enormous. It is not hard to see this collection of assets being a platform for a risk-based, value-based care model at some point. Amazon Health Insurance?
So, what can go wrong? Plenty. First, healthcare is hard and expensive. One can easily envision consumers being anxious with the aggregation of all these data within one entity. Notwithstanding the guardrails provided by HIPAA, Amazon has raised numerous privacy concerns in the past. Just last week it was revealed that Amazon shared Ring doorbell surveillance data to eleven law enforcement agencies without prior consent. That same day Amazon offered concessions to European Union regulators in an antitrust case alleging that the company was using non-public information from retailers on the platform to compete against them.
One dimension not getting as much attention in all of the excitement with this transaction is the specifics of the deal. Clearly, as the economy has turned, valuations have been compressed over the last six months. While the $18 per share price is a ~75% premium to the prior day share price, it is nearly 40% below the 52-week high of $30.18 per share and well below the all-time high of ~$60 per share hit in February 2021 when ONEM’s market value was approximately $12 billion. Analysts peg the purchase price to be 3.6x and 2.8x 2022 and 2023 projected revenues, respectively. Pretty sobering multiples given the investor euphoria of the last two years.
Notwithstanding that this transaction may fundamentally reset valuation multiples, this likely will trigger a wave of additional M&A activity, particularly among smaller private healthcare companies. As liquidity is leaving the system making follow-on financings harder and more expensive, many companies will simply choose to merge or sell. And as is so often the case, the premium multiple tends to go to the companies that transact early in the correction cycle.
Having said all that, this is terrifically validating for the thesis that technology will transform the business of healthcare. It is exciting to contemplate the potential role “Big Tech” can play in this sector. Over the last 24 months, there have been nearly 1,500 digital health financings; many of those companies have built interesting but narrow point solutions with arguably muted impacts on cost, quality, and outcomes. Amazon’s healthcare strategy points to the profound implications of a broader integrated consumer-centric model.
Interestingly, McKinsey’s “profit pool” analysis continues to rank the healthcare services and technology sector as one of the most attractive in all of healthcare. The firm estimated that this sector generated $50 billion of EBITDA in 2019 and that it will increase to $68 billion by 2025. Specifically, McKinsey argues that this 8.2% CAGR is powered by advances in data and analytics, as more effective population health management, revenue cycle management, patient engagement, and virtual care models proliferate. Through this lens, it certainly appears that Amazon is targeting a compelling entry point into healthcare.
The scale of Amazon is astounding. Last year the company generated $469.8 billion in revenues. It has over two million small and medium-sized businesses on the platform. Given concerns over regulatory exposure, the company recently took steps to reduce its private label operations, which while only about 1% of total sales, includes a staggering 243k SKUs across 45 house brands. Here’s to hoping that the ONEM members do not get lost in this maze and that Amazon can actually have a meaningful impact on their well-being.
You know it is bad out there when the best performing financial asset in 2Q22 was the Russian ruble which appreciated 48.6% – the next closest investment was orange juice which was up 18.2%. Even the Kazakhstani tenge far outpaced the S&P 500 and Nasdaq Composite indices, generating a return of 0.1% versus –16.5% and -22.5%, respectively. On real terms, this has been one of the worst starts of any year for the S&P 500 since 1872. With a myriad of issues swirling around us – inflation, war in Ukraine, China geo-economic tensions, domestic political paralysis, climate concerns, racial inequities – it is a wonder that the U.S. equity markets have not suffered more greatly. J.P. Morgan is even teasing at perhaps a strong 2H22 in the capital markets.
Not to diminish at all the numerous problems confronting policy makers, the inflation concerns are real (obviously) and insidious, compromising basic economic decision making. When looked at historically below, just how extraordinary this new investment climate is becoming is starkly apparent. There is an entire generation (maybe two) of investors who have never experienced this before, much less a public market correction of this magnitude. To confuse matters further, June’s strong jobs report with 372k new jobs created (well ahead of analyst expectations) is hard to reconcile with the 1Q22 GDP decline of 1.6% heightened concerns that the U.S. economy may be stumbling to the feared “two-quarter GDP decline” definition for recession.
An interesting corner of the market to look for signals of this recalibration is the venture capital investment activity. Pitchbook and the National Venture Capital Association recently published a flash 1H22 analysis which showed a significant decline in investment activity in 2Q22 but a marked increase in the number of deals. In 1H22 there was $144.2 billion invested in 9,421 deals which implies an annual rate of $288.4 billion and 18,842 deals, as compared to $341.5 billion and 17,637 deals in 2021. This would be a 15.6% reduction in the annual amount invested yet a 6.8% increase in the number of companies.
A deeper review of the 2Q22 data highlights the dramatic reduction in average round size: in 2021 average round size was $19.4 million; in 1Q22 it was $19.0 million; but in 2Q22 it collapsed to $12.9 million. A critical question is the mix between new investment activity versus follow-on investments in existing portfolio companies. While Pitchbook estimated that only 5% of 1Q22 financings were “down rounds,” the expectation is that it spiked in 2Q22 and is likely to eclipse the 10-15% levels seen over the past decade or so.
Very clearly venture investors have tightened the reins. While there continued to be strong interest in early-stage private companies, investors appear to be providing shorter runways, likely focusing more intently on near-term milestones. And while averages can easily mask other trends, there is no doubt that late-stage crossover funds have dramatically pulled back, perhaps given the relative attractiveness of fallen public stocks or yet again with the realization that they may have strayed into a part of the market which is not their strength. A small sampling of what just occurred can be found when looking at the crushing rise and fall in the fintech sector, as valuation multiples collapsed by well more than 50%.
By definition everything that priced over the last two years was overvalued when looked at through today’s lens. The Chief Investment Officer of Bridgewater, a leading global hedge fund, recently observed that more than 40% of all public companies are reliant on raising additional capital which will be very tricky in this environment when liquidity is being taken out of system. Coincidentally, 43% of S&P 500 companies provided negative guidance in 2Q22 with FactSet reducing EPS estimates for the index by 1.1%, the greatest decline since 2Q20. According to Renaissance Capital, only 21 U.S. companies completed an IPO in 2Q22, raising a paltry $2.1 billion, a level not seen since the depths of Great Recession in 2Q09; the median IPO raised only $22 million. Furthermore, 2Q22 IPO performance has been abysmal – the worst quarter in history in fact – with the Renaissance IPO ETF down 32.5%.
The secondary market may offer another avenue for investor liquidity – and there are some fascinating signals emerging there. Forge Global, which operates a private stock marketplace, has seen a reversal in Indications of Interest (“IOI”) between buyers and sellers over the last six months which is putting pressure on valuations. In 4Q21, 58% of all companies traded at a premium to their last round’s valuation yet in 1Q22 that declined to 24%.
Interestingly, this is against a backdrop of a significant decline in M&A activity. Globally through 1H22 M&A activity decreased by 21% with a 28% decline in U.S. activity alone. The decline appears to be even more pronounced for venture-backed companies. Through 1H22, the M&A volume was $48.8 billion with 831 exits, which when annualized ($97.6 billion, 1,662 deals) compares poorly to the staggering $777.4 billion and 1,880 exits in 2021. This would be the lowest annual M&A volume since 2016.
One possible silver lining that may provide lifelines to many private companies is the amount of capital being raised by venture capital firms. Year-to-date U.S. venture firms raised $121.5 billion across 415 funds, which is an unrivaled pace unseen in any year prior. According to Preqin, the venture capital industry added $43.1 billion in dry powder in 2Q22 on top of the $478.5 billion already amassed, suggesting many venture partnerships will be having the ever-present “sunk cost” debate to either continue supporting existing, possibly struggling companies, or look for new opportunities.
One resilient bright spot on the venture landscape had been the healthcare technology sector but even that may be changing. Rock Health, the leading research firm that covers the digital health sector, just published its 2Q22 investment activity report showing a marked decline in both dollars invested and number of companies ($4.1 billion and 141 companies). Through 1H22, there has been $10.3 billion invested in 329 companies suggesting the sector is now on pace to see between $16 – $20 billion invested in approximately 600 companies, which while below 2021, would place this year comfortably in second place well ahead of any year prior. Investment activity in June 2022 was $1.45 billion suggesting a $17.4 billion pace. Notably, the average deal size in 2Q22 was $28.1 million which likely indicates increased caution as round sizes decline.
The average round size is directly influenced by the size of the later stage rounds, which is where there has been a significant pullback. For instance, Series C average round size in 2021 was $90 million; it was $81 million in 1Q22 and is now $70 million through 1H22, suggesting that the 2Q22 average round size was considerably smaller than that. This is a critical metric to monitor as many successful digital health companies require a few hundred million dollars of invested capital to achieve scale and/or liquidity.
The mix by stage of financing is informative as well. Over the last five years, Series A financings accounted for ~25% of all financings, Series B was 15-17%, Series C was 8-10%, and Series D or later was another 8-10% (the balance included seeds, bridge rounds, and other equity financings). While this has remained relatively consistent, the “graduation rate” (the ability to raise a subsequent round) will be closely watched as capital becomes scarcer and more expensive. Notwithstanding the decline in 1H22 M&A activity to 16 transactions per month (versus 23 per month in 2021), one would expect to see a significant increase in private-to-private M&A activity in 2H22 as companies fail to hit value-creating milestones, perhaps implying a lower prevalence of later stage rounds.
Rock Health has also analyzed investor type concluding that 70% of investors in digital health companies in 1H22 are repeat (presumably more expert) investors, which had been consistently 55-60% in prior years. If this trend holds, one might expect to see relatively less capital available to healthcare technology companies as more casual, generalist investors focus elsewhere. Notably, the number of investors by round per company in 1H22 was 2.3 as compared to 1.7-1.8 in prior years, suggesting that entrepreneurs are building larger investor syndicates with greater financial capacity.
The atmospherics around this sector is somewhat confounding. The promise of healthcare technology solutions has never been more evident, yet the public markets have been unforgiving over the last handful of months. The median revenue valuation multiples for the SVB Leerink Digital Health index (21 companies) for 2022 and 2023 are 2.9x and 2.4x, respectively (the average multiples are greater at 5.5x and 4.4x), yet the companies in the index in aggregate are projecting a relatively robust 25.3% revenue growth (2021-2023) with an average 2022 projected gross margin of 61.0%. Since the index’s peak in mid-February 2021, it has declined 64%.
The regulatory situation is also running at crosscurrents. There is significant support for greater data liquidity, interoperability, and transparency, yet in a post-Roe world, there has never been greater anxiety about the misuse (abuse) of intensely private information around reproductive rights.
One issue that has concerned healthcare technology entrepreneurs over the last three years has been access to great talent. In light of an historically low unemployment rate of 3.6%, there does seem to be an emerging group of available and talented labor. The website layoffs.fyi has been tracking the number of laid off start-up employees, and with the implosion of the crypto, fintech, and “proptech” (real estate) sectors, there has been a spike in the number of people suddenly available to join other hot start-ups. According to the Bureau of Labor Statistics, the unemployment rate in the healthcare and social assistance sector is 2.4%, so this may actually be a silver lining for digital health companies.
Nationally there are 2,632 landfills and 72 incinerators which handle much of the 250 million tons of trash produced in the United States each year. It is estimated that each of us generate nearly 4.4 pounds of garbage every day. Globally, the Organization of Economic Cooperation and Development calculates that 2.6 trillion pounds of trash are produced annually. In light of this most pressing problem, last week’s Supreme Court decision to sharply curtail the Environmental Protection Agency’s (EPA) authority to oversee power plants was particularly troublesome.
Obviously, the wellbeing of a given population is impacted by numerous factors. Most directly, the advances in therapeutics and medical technologies can have profound and almost immediate impacts. Improvements in general living conditions, including environmental, have a significant and perhaps less obvious influence on overall health. The promise of digital health innovation to inform, engage, activate users can also be quite dramatic, although may be limited when damaging environmental conditions persist. It is the confluence of all of these advances, supported by thoughtful responsive regulatory frameworks, that will lead to improved outcomes for all. Unfortunately, poor environmental conditions can overwhelm all of the other beneficial activities to improve health.
The EPA has been responsible for the implementation of the Clean Air Act for fifty years. This act to regulate fixed sources of air pollution reflected an emerging belief that public health was directly and profoundly impacted by environmental conditions, and that the infrastructure to manage issues such as waste was often sited in near or in disadvantaged communities, further exacerbating poor public health conditions. It is striking – and shameful – that 80% of the incinerators in this country are in “environmental justice communities;” that is, more than 25% of the residents as either low-income or minority. The Biden administration recently launched the “Justice40” initiative to ensure that at least 40% of the benefits of federal cleanup programs accrue to the disadvantaged communities.
To many observers, the east coast is often referred to as the “tailpipe of the country” given prevailing winds and the relative density of the waste handling infrastructure. Naturally, one would expect that air quality is particularly poor in urban areas and where heavy manufacturing industry is more prevalent. A recent University of Chicago study found that the difference between geographies with the best and worst air quality likely translates into 1.7 years of life expectancy. The researchers further concluded that 92% of Americans live in a region with either periodic or chronic unsafe air conditions, while the World Health Organization now estimates that 97.3% of the global population lives in unsafe zones. Ecoprog estimates that the amount of waste incinerated will increase by 48% between 2018 – 2028.
The distribution of landfills across the country looks eerily similar to the air quality map above. It is not surprising that the locations of landfills would be near/in major population centers given convenience and cost considerations. Undoubtedly decades ago at the time of original permitting, the dramatic public health risks were not properly weighted in that calculus. It is estimated today that the United States has approximately 62 years of remaining landfill capacity, suggesting that this situation will remain in place for some time. Landfills have been linked to the production of greenhouse gases and are known sources of dangerous toxins.
The framework for site permitting, zoning and tax policies for the waste handling industry arguably contribute to structural disadvantages and health inequities low-income and minority communities confront every day. And these issues become self-reinforcing as property values become more depressed with the increased presence of polluting industries, further exacerbating environmental health inequities. While slightly dated, the overall Environmental Quality Index by county (below) maps closely to the location of incinerators and landfills.
While not a direct overlay, the map of the life expectancy by county developed by the Centers for Disease Control and Prevention certainly correlates to many regions of the country when considering the public health impact of waste disposal. Climate change, a direct result of waste management, also indirectly effects life expectancy either with more intense, longer lasting heat waves, or flooding and droughts. Many disadvantaged communities are particularly vulnerable to extreme weather events and often lack robust public health infrastructure to respond appropriately. The World Health Organization recently determined that 250k more people will die globally each year between 2030 – 2050 simply as a result of climate change.
According to the Financial Times, approximately half of the world’s population lives in cities and while cities only occupy 2% of the land mass, they account for 70% of all waste produced and 80% of all energy consumed. A New York Times survey determined that 12% of the world’s population lives in “wealthy countries” yet produced over 50% of air pollution since the end of the Industrial Revolution. While the pollution issue is systemic and global, there are identifiable geographies that if remedied could have an outsized impact on overall wellbeing.
The investment community is broadly focused on two main vectors to address this issue: clean technology investments and a concerted effort to build social determinants of health (SDoH) companies. Pitchbook estimates that there are more than 1,000 clean technology companies which have raised $150 billion over the last decade. BloombergNEF identified $53.7 billion invested in clean technology start-ups just in 2021 with another $755 billion invested in major waste infrastructure projects such as energy storage, renewable energy, nuclear, electrified transportation, and sustainable materials. Pitchbook identified 369 clean tech investments year-to-date 2022. Much of this investment activity has been fostered by institutional interest in Environmental, Social and Governance (ESG) strategies, an often misunderstood segment of the investment landscape (although according to Morningstar, over $2.7 trillion is now held in ESG-focused funds). Yesterday, the European Central Bank announced that it would start to “tilt” its corporate bond holdings to companies that excel on climate matters.
The other vector that is focused on issues concerning public health involves the broader SDoH investment strategy, quite popular among healthcare venture capitalists now. A recent analysis in the Annals of Internal Medicine suggested effective SDoH management could reduce inpatient admissions by 11% and ER visits by 4%. According to Population Health Management, since 1985 more than 50 companies have raised $2.4 billion, which is now valued at $18.5 billion. Like ESG, SDoH is often misunderstood and is used as a catch-all for a basket of solutions that recognize one’s health is a function of a number of factors such as access to quality food, level of education, proximity to effective healthcare providers, etc. Oftentimes, these social determinants can be overwhelmed by poor environmental conditions.
After the Great Depression more than 80 years ago, the federal government graded every neighborhood in several hundred cities to help inform real estate investment and subsidy decisions. This “redlining” legacy has contributed profoundly to structural disadvantages suffered by the most vulnerable – often the poor and minority – populations across the country. The relationship between these policies and the waste treatment infrastructure is clear and tragically will perpetuate many of these health inequities. A recent analysis by Deloitte concluded that disparate health outcomes will likely cost the U.S. healthcare system $1.0 trillion annually, tripling the costs today and consuming 12.5% of all healthcare spend.
Istanbul literally is both in Europe and Asia which underscores just how complicated the neighborhood around Turkey is. To its south is Syria and Iraq; to the east is Iran; to the north across the Black Sea is Russia and Ukraine with Europe to the west. Almost 100 years to the month, the Greek, Armenian, and French armies were expelled from the country, and the current Republican political system was established, bringing to a close the Ottoman monarchy rule of over 620 years. Current events made my recent trip to this most extraordinary country even more confounding.
It was somewhat unsettling to see massive tankers navigate the narrow Bosporus strait, which bisects Istanbul, on their way to/from the Black Sea and the Ukrainian war zone. Because of the Montreaux Convention, which effectively affords Turkey significant control over which military vessels can access the Black Sea (civilian vessels are granted “complete freedom” during peacetime), global attention is now directed to this important waterway as the west wrestles with how to best assist Ukraine and secure safe passage of its agricultural products to the rest of the world.
With 84.7 million people, Turkey ranks as the 18th most populous country with nearly three-fourths of the population being ethnic Turks and another 20% of Kurdish descent. While a secular country, it is estimated that more than 80% of Turks adhere to Islamic faith. Importantly, Turkey is a member of North Atlantic Treaty Organization (NATO) but its application to join the European Union, which was submitted initially in 2005, has stalled with an uncertain outcome. While the reasons for this are numerous, the significant purges that followed a failed coup in 2016 have been unsettling for many EU members. All of this is further exacerbated by the recurring political and often bloody unrest by members of the Kurdish population seeking independence.
Turkey has also created friction recently with many of its NATO colleagues, offering significant resistance to the admission of Finland and Sweden to this military alliance. Just last week, President Erdogan rejected trilateral talks with those two countries given his stated concerns over their support of the Kurds, whom he considers terrorists. Oh, and in May, President Erdogan stated that he no longer recognizes the current president of Greece given a dispute over the procurement of U.S. jet fighters.
To make matters worse, there will be Turkish national elections sometime in the next twelve months and after nearly two decades of rule, there now appears to be a credible opposition coalition forming to President Erdogan. The Republican People’s Party (CHP) has successfully consolidated a number of the smaller opposition parties and last year won a series of important municipal elections in Istanbul and Ankara (capital city). The wildcard in these forthcoming elections will be the Kurdish Democratic Party (HDP) which secured 12% of the popular vote in the last election and is currently not affiliated with either the ruling party (Justice and Development Party) and or the CHP.
The economic situation is quite perilous now. According to a recent Financial Times analysis, the Turkish economy is estimated to be $790 billion but is struggling with extraordinary inflation, which was 73.5% in May 2022 – the highest in the G20. Quite troubling, food inflation is running at nearly 100% which will undoubtedly generate social turmoil. The Turkish lira declined by 44% in 2021 and is down another 22% year-to-date. GDP growth in 2021 was greater than 11% but has collapsed to be just 1.2% in 1Q22. In response, President Erdogan quixotically decided to lower the interest rate on deposits which is now only 16%.
On top of all of this, Turkey is confronted with an unprecedented refugee crisis which has placed inconceivable demands on its public health infrastructure. It is estimated that there are at least 3.8 million refugees in country which equates to about 4.5% of the population. As a point of comparison, the most recent analysis by the Center for Immigration Studies estimates that there are 11.35 million illegal immigrants in the U.S. which is approximately 3.4% of the U.S. population.
This is a staggering burden on a country that provides free access to basic healthcare and educational services, notwithstanding that it is believed that over 98% of these refugees reside in camps and temporary housing. In fact, many of these refugees participate in the Refugee Medical Assistance short-term health insurance program. Given who Turkey’s neighbors are, it is unlikely that the flow of refugees will diminish as two of the top three countries (Syria, Afghanistan) that account for the most refugees are in relatively close proximity.
Turkey has a universal healthcare system and spends approximately 6.3% of GDP on healthcare services. While this compares unfavorably to the average 38-member Organisation for Economic Co-operation and Development (OECD) of 9.3%, this is believed to be due primarily to the relative youth of the population which is on average 32.4 years old. Over 75% of healthcare expenditures are covered by public sector funding. Unfortunately, average life expectancy is 78.6 years which is quite a bit below the European Union average of 81 years. As with many emerging economies, obesity and air pollution are significant public health concerns; it is believed that 29.5% of the Turkish population is obese. Medical tourism is a big business in Turkey, generating over $1 billion in revenues over 662k patients (2019 estimates), a majority of which is attributed to plastic surgery.
Fortunately, after a particularly brutal winter for Covid infections, Turkey has seen a dramatic reduction in cases, in large measure due to very effective vaccination efforts and notwithstanding the notable absence of masking. It is estimated that 88.6% of the population has received at least two doses. Sadly though, total deaths attributed to Covid now number 99k.
While reliable data are hard to come by, the Turkish venture capital community appears relatively robust and experiencing somewhat of a renaissance. According to Tracxn, there are currently 5,767 start-ups and 103 venture capital firms (either local firms or international firms with a presence in country). There was a significant spike in 2020 annual investment activity to $383 million (0.25% of U.S.), which was nearly a tripling from 2019’s pace. Notwithstanding a recent significant staff reduction, some notable Turkish unicorns include Getir, an omnipresent yellow and purple clad instant delivery service, which has raised nearly $770 million and is now valued close to $12 billion.
As exciting as the local innovation scene appears to be, it is quite clear that the pressing geopolitical issues are likely to set the economic agenda for the foreseeable future. President Erdogan just announced an initiative to construct 100k homes in northern Syria to “induce” one million of the refugees to head home. The Victory Party, a fringe ultra-nationalist political movement, is pressing to forcibly remove all refugees. As toxic as the political discourse in the U.S. is today, it may be worse in Turkey making it hard to envision a smooth path forward before many of these fundamental issues are resolved.
Sadly, it was very disappointing to see Eclipse, Roman Abramovich’s 533-foot long super yacht, in the Gocek harbor, which served as a stark reminder of the country’s deeply problematic human rights record (Syria, Azerbaijan, etc.) and its frustrating straddle to appease Russian leadership in its unjustified war with Ukraine.
This is going to be huge, right? CB Insights says that the metaverse will be a $1 trillion market by 2030, just over a mere seven years from now. It is the buzzword of the day, right up there with crypto, EVs, and NFTs (both two words, actually). Unfortunately, all of those buzzwords seem to have run right into the cold hard reality of the real world after the last few months so what might we expect for the metaverse, in particular, how might it reveal itself in healthcare.
It still is not entirely clear that people are yet actively looking for the metaverse. According to a recent Axios analysis, 60% of the respondents could not describe what it is and nearly 90% of all respondents were either indifferent or scared by the metaverse with only 7% excited. Only 22% of Gen Z’ers (less than 25 years old) were excited about the future of the metaverse.
Data: Momentive; Chart: Thomas Oide/Axios
In general, it appears that the metaverse plays out between two ends of the spectrum: functional versus frivolous. Clearly, there are a number of very obvious, practical and perhaps even valuable activities enhanced by or extended into (is that the right preposition?) the metaverse, such as entertainment, education, commerce, and business gatherings. One might debate how satisfying or enduring this modality would be if 100% of our entertainment was conducted in the metaverse, but it is very conceivable that this will be an important venue for many activities once the technology is robust enough (and omnipresent, inexpensive, etc). Last October, Accenture purchased 60k Oculus Quest 2 headsets to facilitate virtual socializing among its employees.
It is not yet clear what the enduring economic models will be in the metaverse. Meta (a.k.a. Facebook) has indicated that its Horizon World metaverse platform will charge third-party developers upwards of 47.5% to transact on the platform as compared to the 15% – 30% in more traditional app stores. It will be fascinating to see how successful the “host” of the space in which to transact can extract such significant economics, which is frankly antithetical to Web3 (more on that in a moment).
Virtual real estate is big business in the metaverse. According to Parcel, the Zillow of the metaverse, 2Q22 will see $800 million of “real estate” transactions in the metaverse. A quick review of Parcel’s listings shows approximately 100k “properties” for sale, many of them having been listed for about three months. A leading virtual gaming company called Illuvium recently offered something called “Tier 5 Land Plots” for a mere 80 Ethereum (or ~$120k). In March 2022, CVS filed trademarks to sell goods and healthcare services in the metaverse while the company recently announced plans to shrink its physical store count by 900 locations – likely unrelated.
A number of announcements point to an emerging set of more frivolous use cases for the metaverse. Of course, many of the frivolous activities could well have powerful economic business models that would drive more practical use cases. Many brands (Coca Cola, Wendy’s, Chipotle) have set up a presence in the metaverse which are meant to drive awareness and engagement, and are often dressed up as gaming applications, likely directing users to more commercial activities. In addition to digital pet stores and virtual church congregations, it appears that dating and sex are a thing in the metaverse, raising real questions as to whether that is considered infidelity for those married in the real world. A notable case unfolded when a British couple divorced after the husband’s avatar was found to be having sex with another avatar in Second Life, an early incarnation of the metaverse.
Creating virtual people may lead to a similar but distinctly different use case (hopefully) when a start-up called Somnium Space develops a metaverse populated by the deceased, enabling those living in the real world to continue to engage with passed loved ones’ avatars. The blurring of life and death in the metaverse at first appears confusing, maybe even creepy, but starts to hint at potentially interesting healthcare applications.
Life in the metaverse will be complicated, certainly in the early days. Given the enormous number of stakeholders (regulators, participants, technologists, academics, etc.) with often conflicting objectives how such a decentralized and unmanaged world should evolve is far from clear. But that is one of the core tensions: many believe there should be no organizing body – by design – which will make it particularly challenging in healthcare. Other very important and complicated concerns that will need to be addressed include security, privacy, bad boorish behavior, mis/disinformation.
Arguably, there may be two dimensions that emerge to define some of the ground rules and frameworks of the healthcare metaverse: one involves the venue, and the other is time-based. Does one “go to” the metaverse or is it brought to you? Facebook and certain other technology vendors envision a world that is delivered via increasingly smaller formats: headsets, goggles, glasses, contact lenses. Wherever one looks, the metaverse will be delivered right in front of your eyes. Other wearables may complete this experience. The other approach is that one goes to the metaverse in a more immersive environment – the participant is in a room or space equipped to put you in an environment that surrounds. Perhaps this is an approach plays to the inherent strengths of hospitals and other providers with virtual waiting rooms, operating rooms/ICUs, recovery rooms – either on the main campus or in new satellite facilities.
The second issue around timeframe will be, in part, addressed by how quickly hardware costs come down and increased functionality improves. In the near to medium-term, it is quite clear that there are interesting therapeutic use cases (VR, digital therapeutics), many of which are already in early stages of commercial release. Similar tools are in active use in the classroom and operating rooms to improve outcomes.
Perhaps more provocative are possible use cases in the longer term that the metaverse may enable. The ability to exquisitely create a digital twin for synthetic clinical trials or to interrogate how one might respond to a particular therapy. Imagine being able to accelerate the digital twin’s aging process by 10x, 100x, 1,000x to see the effect of certain clinical approaches. The ability to distort linear time in the metaverse opens up fascinating other applications. The potential for advanced biometrics begins to bridge the metaverse back to the real world for more appropriate clinical decision support at the individual level. At the most recent ATA (American Telemedicine Association) conference, the phenomenon of virtual reality and digital twins was a central theme.
Notwithstanding the fanfare the metaverse is receiving in other sectors, healthcare investors seem intrigued, yet the interest is arguably quite muted. According to Rock Health data, venture capitalists invested $198 million in 11 metaverse companies in 2021; for some context, overall digital health saw $29.1 billion invested in 729 companies (less than 1% of digital health investing was in metaverse companies). In 2020 those amounts were $93 million in 8 companies. Over the last dozen years, Rock Health has identified a handful of interesting start-ups in the healthcare metaverse.
Technology in healthcare is the great democratizing force. The ability to extend world-class care to disenfranchised populations via innovative technology platforms is compelling, yet still illusive. While the metaverse may bolster this potential, the reality is likely to be quite expensive and may, in some circumstances, exacerbate issues of affordable access (not everyone can afford an Oculus). Will those in the metaverse be afforded priority access? There will be pressure (or incentives) for providers to build brand in the metaverse, but might that come at the expense of quality. Or does the metaverse offer an on-ramp for non-healthcare entities to disrupt legacy providers? All important issues to be debated.
A word on Web3, the decentralized internet paradigm that shifts economic value to the users and away from the central gatekeepers of the current internet. The Web3 hype cycle is in overdrive now, notwithstanding problematic technical performance issues and an uncertain regulatory framework – and even in light of losses in excess of $1 trillion in crypto valuation in 2022 alone ($40 billion of which was attributed just to the LUNA token/Terra USD stablecoin debacle last month).
An intriguing use case though may be to envision personal medical records and data as our own NFTs – proprietary virtual assets that each of us controls via established property rights such that we can track, trace, and monetize our own healthcare data. These novel business models start to establish fundamentally different rules around access and equality. A Flare Capital portfolio company – HealthVerity – directionally enables some of these capabilities.
Now the reality: in a recent Center of Connected Medicine survey, 80% of providers reported that less than 20% of all appointments are booked directly by patients (“self-scheduling”) due to poor implementation of those tools. Feels like the healthcare metaverse is still some years away…
Meanwhile back on (the real) earth, as part of NASA’s Artemis missions back to the moon by 2025, the German Aerospace Center will include two “identical phantoms of the female body” loaded with over 10k sensors and 34 radiation detectors to study the effect of space radiation. This starts to clearly blur the metaverse with the universe and may even have virtual dating implications. All very complicated still.
Today we announced the closing of Flare Capital’s third fund with a total of $350 million of committed capital. Typically, when our portfolio companies raise their Series C rounds, they have established product / market fit which feels quite relevant to us now. The narrative around the transformation of the business of healthcare being a source for new company creation is profoundly compelling, even more so in light of the pandemic.
This fund is quite a bit larger than our prior fund and was well-above the initial target. We are quite pleased by the reception from both our existing and new investors, which reflects a high level of interest in this extraordinary market opportunity. 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.
An important dimension to our story, and that we believe is an asset for our entrepreneurs, is the composition of our investor base. A significant amount of the capital is provided by strategic investors representing leading provider systems, national and regional payors, healthcare retailers, device companies, lab operators, and pharma companies. Our portfolio companies have sold several hundred million dollars of products and services to these investors. The majority of the capital comes from sophisticated endowments, family offices, sovereign wealth funds, and other financial institutions, many of which have been active co-investors in our portfolio companies. The diversity of our limited partners underscores the broad appeal of the sector and the potential to build significant new companies.
When we started the firm in 2014, over $4.5 billion was invested in healthcare technology companies; in 2019, when we raised our prior fund, $8.1 billion was invested. Arguably, in part due to the pandemic exposing such significant issues, nearly $29.1 billion was invested in the sector in 2021. Notwithstanding that the 1Q22 amount of $6.0 billion suggests a more moderate investment pace for 2022, this year will also see an extraordinary level of activity, likely to be ~60% greater than 2020, which was the second strongest year for digital health investing. A decade ago, healthcare technology was less than 5% of all venture capital activity; now it is trending to be ~10% of all venture investments.
And the adoption of healthcare technology solutions is accelerating. Many companies launched over the last five to ten years 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. Robust and scalable business models exist and are now better understood (product development timelines, successful “go-to-market” strategies, revenue models, etc). The sector is reaching an important threshold level of maturity.
While this is an important milestone for Flare Capital, we will continue to be heads down assisting our entrepreneur partners to build important and valuable healthcare technology companies. Even in light of recent public stock volatility and troubling geopolitical issues, the next few years promise to be terrific vintage years for healthcare technology investors. We are excited to play a small role in this sector’s future successes.
It is quite easy to see that general economic conditions are deteriorating; it is considerably harder to know what to do given the many confounding signals. The employment data are nothing short of extraordinary. Over 431k jobs were added last month alone, driving the unemployment rate to 3.6% – essentially returning to pre-pandemic levels with last week registering the lowest weekly unemployment claims in the last 54 years. Wages increased 5.6% year-over-year through March, which while tracking below the scourge of inflation, was certainly a robust pace. Annual corporate profit growth in 2021 increased 35% according to Barron’s. An early April survey of 72 leading economists by Bloomberg concluded that the U.S. economy will expand 3.3% in 2022, 2.2% in 2023 and 2.0% in 2024, respectively.
And yet nearly every asset class was down significantly in 1Q22, other than Commodities which increased on average over 25% in the quarter according to Bloomberg data, with the S&P Energy Index up 37.7%. The S&P 500 and NASDAQ indices were down 4.6% and 9.1%, respectively, while U.S. government bonds lost 5.6%, again in the face of rising inflation. Most acutely, the SVB Leerink Digital Health index was down 76% since its February 2021 high. The S&P Biotech index lost nearly 48% over a similar time frame, erasing the gains achieved since the start of the pandemic. Most ominously, with the Federal Reserve signaling that it will raise rates more aggressively, the yield curve inverted last week with short-term rates greater than long-term rates; such an inversion has predicted five of the last six recessions. Of the economists surveyed by Bloomberg (above), the consensus was a 27.5% chance of a recession in the next 12 months.
Data: FactSet; Chart: Baidi Wang/Axios
In the face of an aggressive tightening monetary policy (to say nothing of a heart-wrenching war in Ukraine), interesting signals of investor sentiment are already revealing themselves in 1Q22 venture funding data. Pitchbook and the National Venture Capital Association just released a flash review of 1Q22 which showed overall U.S. venture investment activity was $70.7 billion, which is the lowest quarterly level since 4Q20. As a point of comparison, investment activity for all of 2021 was $330 billion. Notably, prior to 2013 there had never been a full year that even came close to $70 billion so the pace is still relatively strong but a marked deceleration from recent activity (4Q21 was $88.2 billion). Notwithstanding that slowdown, there were still more than 100 “mega rounds” (greater than $100 million) and little evidence that the corporate venture investment pace pulled back, which one might have expected in the face of market volatility.
Global venture investment activity also has slowed dramatically, dropping 19% from 4Q21 levels to $143.9 billion (8,835 deals), according to CB Insights data. Somewhat confounding, the number of unicorns globally reached another high with 1,070, supported by over 350 “mega rounds” which accounted for 51% of the quarterly investment activity. While there may be signs of nervousness at the earliest stages of investing, it does appear that VCs are fortifying the emerging winners with significant rounds of financing.
The canary in the coal mine this past quarter was the activity in the broader equity capital markets. Overall issuance in 1Q22 was $32.5 billion which was the lowest quarterly level since 1Q09. This past quarter declined nearly 90% year-over-year, led by a stark decline in IPO activity which registered a mere $2.1 billion (a decline of 95% year-over-year). Only 18 companies managed to go public in 1Q22. Furthermore, the Renaissance IPO Index traded down 23.9% in 1Q22.
Special Purpose Acquisition Company (“SPAC”) activity was particularly dismal. Of the approximately 725 active SPACs, only 12 announced an acquisition in 1Q22 with another 17 having completed a pending acquisition. After an extraordinary 2021 when 613 SPACs were created, greater SEC scrutiny and poor post de-SPAC trading (once the acquisition has closed) have greatly reduced the attractiveness of this financing alternative. CB Insights reports that the median SPAC deal size was cut in half in 1Q22. The SVB Leerink Digital Health SPAC index (only 14 companies) is off 48.9% since “de-SPACing” through 1Q22. Many of the cross-over investors (hedge funds, mutual funds, etc.) dance between late-stage private rounds and public companies now trading at dramatically reduced valuations.
Notwithstanding the profound trends powering the healthcare technology sector such as the need to reduce costs, improve clinical outcomes, and engage/activate the patient/member/consumer, this sector was not insulated from the 1Q22 volatility. The SVB Leerink Digital Health Index shed nearly $88 billion of market value as forward 12-month revenue multiples reset from February 2021 highs of 15.6x to 5.0x.
Quite clearly, the investment pace in 2021 of $29.1 billion across 736 healthcare technology companies was a high-water mark, likely not to be eclipsed. According to a recent Rock Health report, the level of investment in this sector in 1Q22 was $6.0 billion across 183 companies, suggesting an annual pace equivalent to the number of companies but likely a ~20% reduction in the dollars invested when compared to 2021. Average round size in 1Q22 was $32.8 million which also was a marked decline from the $39.5 million for all of 2021. In 4Q21, $7.3 billion was invested so the quarterly pace is moderating. Also worth watching is the monthly investment activity: January, February, and March saw $3.0 billion, $1.4 billion, and $1.6 billion invested, respectively, perhaps suggesting an even more modest pace for the remainder of 2022.
None of this should suggest the sector is “unhealthy.” Quite the contrary: 1Q22 investment pace matched the activity for all of 2017 and rivaled the annual pace for both 2018 and 2019. The pandemic, as tragic as it has been for so many, is a massive accelerant for technology adoption across every corner of the healthcare system. Arguably, the public healthcare technology stocks have been uniquely exposed to investor uncertainty surrounding surges of the Covid variants and the concomitant uncertain impact on medical costs, particularly for many of the value-based care companies. Overall, the SVB Leerink Digital Health Index is trading at 4.2x and 20.2x 2022 revenues and EBITDA, respectively, with an aggregate market capitalization of $206.2 billion at the end of 1Q22. The pure-play digital health cohort within that basket of companies trades at 6.8x and 26.4x 2022 revenues and EBITDA, respectively. Still very healthy.
Today’s entrepreneurs are launching and scaling companies that will be talked about for years, likely decades. Notably, the list below (not complete) provides a sampling of the healthcare technology unicorns, many of which were started within the past half dozen years. The ability to generate compelling venture returns is, in part, due to the ability to build big companies. Given the massive size of the healthcare markets, it certainly suggests that there will be many more companies added to this roster.
Due to the essential nature of healthcare, the sector has proven itself somewhat recession-proof. Obviously, early-stage companies are exposed to the risk appetite of institutional investors and given the relative capital intensity of these business models, entrepreneurs need to be especially cautious navigating this volatility.
Investor sentiment has clearly shifted from growth at all costs to proving that profitable unit economics, much less overall profitability, are readily achievable. One might expect to see later-stage rounds creep up in size as “emerging winners” take on a more defensive posture to ensure cash runways that can carry these companies through 2023. There may well be fewer and smaller early-stage rounds as investors react to the sheer number of companies that have been launched over the last few years (competitive landscape and lack of differentiation concerns) and the deterioration of the public market valuation metrics. According to Rock Health, Series D and later rounds were $130 million in size on average. In comparison, Series A, B, and C rounds were $19 million, $36 million, and $81 million, respectively, suggesting highly successful digital health companies require ~$250+/- million of invested capital.
As venture capital partnerships huddle to assess 1Q22 portfolio company performance, where they land on state of the markets will inform whether they assume a more defensive or offensive posture. In either scenario, entrepreneurs will be well-served to be manically focused on knocking down value-creating milestones. In this environment, that list may need to be shortened to fewer milestones over the next handful of quarters until the situation becomes clearer. Like any good boxer, entrepreneurs will need to “bob and weave” carefully through this volatility.
By literally any measure the healthcare technology sector had an exceptional 2021. According to Rock Health, $29.1 billion was invested in 729 companies with an average round size of $39.9 million – all were highwater marks for the sector. There were 88 “mega rounds” (greater than $100 million) which further underscores both the attractiveness of the sector to investors and that we are in an “Anoint the Winner” phase for this category. Globally, StartUp Health identified $44 billion of investment in 990 companies.
The debate now turns toward what 2022 will look like as entrepreneurs and investors attempt to assess the impact of a rapidly deteriorating geopolitical environment and a less accommodating financing climate. The answer to this question directly informs how companies should think about growth and relevant milestones. Was 2021 an aberration or can we expect continued robust support for healthcare technology companies?
Arguably, the one of the more conservative approaches to determine how much will be invested in 2022 would be to simply look at the trailing five-year average for number of deals and average round size, and then assume that the sector immediately reverts to the mean. Such a simplistic approach would conclude that 2022 would look much more in line with pre-pandemic investment levels of $10 – $12 billion; that is, for the digital health sector, there would be just over 100 Series A financings that raise ~$12.5 million each, nearly 80 Series B rounds with an average round size of ~$30 million, etc. A trailing 10-year “look back” would suggest annual levels nearly half as much given far fewer companies and considerably smaller round sizes.
But that is not what is going to happen. Healthcare technology venture investing is now nearly 10% of all venture capital investments, up from 3-5% ten years ago. The pandemic has been a massive accelerant for technology adoption in healthcare. The strategic urgency to re-architect the healthcare system is palpable: the next two years will define the industry’s agenda for the next five years, and the next five years will define the next twenty years.
Therefore, another approach to determine what may unfold this year is to look at the companies which raised capital over the last two years and assume a “graduation rate” (that is, raise a subsequent round) consistent with the last five years (~80% of Series A companies go on to raise a Series B, ~50% of those raise a Series C, etc.) but that round sizes moderate to pre-pandemic 2019 levels but assume a consistent percentage of “mega rounds.” While 57% of the capital invested last year was in “mega rounds,” they only accounted 12% of the financings. The average size of a “mega round” was $190 million. Under these assumptions, the overall activity in 2022 could be $21 – $23 billion.
Simply annualizing preliminary year-to-date investment activity through February puts the sector on pace for $22.8 billion invested in 630 companies, perhaps due to later stage crossover investors moderating their activity.
Of course, the level of investment could be quite a bit lower should the capital markets really freeze up. One might expect to see the introduction of more onerous investment terms (increased liquidation multiples, seniority) before there is a dramatic reduction of the stated valuations. Additionally, there may simply be fewer companies financed: last year there were 729 financings in this sector, yet the five-year trailing pre-pandemic average was 400 companies. Should any of these companies stumble, expect to see a marked increase in private-to-private M&A activity. In 2021, there was on average 23 M&A transactions per month in the digital health sector according to Rock Health. Solomon Partners tallied 326 M&A transactions with an aggregate disclosed value of $152 billion inclusive of public companies. Of course, there are no shortage of companies from which to pick.
Notwithstanding all the exciting private market activity, the story is quite a bit different in the public markets, which have frowned on the healthcare technology sector these past few months. The “Anoint the Winner” phase may quickly fade into the “Prove It” phase as well-capitalized and recently public companies struggle to become cashflow positive. Investor sentiment seems to have moved from “growth at all costs” to telling a “path to profitability” story.
The public equity markets have discerned a significant difference between companies that sell technology solutions to pharma and providers, which performed relatively well in 2021, from companies focused on employers and payors. Value-based care and technology-enabled companies also struggled mightily in 2021, perhaps due to having had such a strong 2020 but also analysts have expressed concerns about the capital intensity of these models, ability to manage risk, and when these companies become profitable.
The news was even more challenged for the class of 2021 healthcare technology IPOs. Other than Doximity, all the companies underperformed the S&P 500 index, with six of them trading down by more than 20%. Since their market peaks, the public digital health, telehealth, technology-enabled primary care, and start-up health insurance companies have lost nearly $190 billion of market capitalization as of the end of January 2022, according to an analysis by A2 Strategy Group. Absent even a modest recovery, later stage investors may pause to see how the well-capitalized private companies perform over the course of the year. Additionally, many crossover investors may simply choose to invest in some of these public “fallen angels” versus continuing to pursue later stage private opportunities.
Setting aside these short-term atmospherics, venture investors are looking 5-10 years forward and see profound opportunities as the healthcare industry is re-architected. The transition to value-based care, improved data liquidity, empowerment of the healthcare consumer, more robust infrastructure, and innovation to improve labor productivity are powerful themes to drive new company creation.
And these markets are enormous. For instance, McKinsey estimates that over $265 billion of healthcare services will shift from traditional care settings to the home. That represents nearly one-quarter of all Medicare fee-for-service and Medicare Advantage spend. This is a 3-4x increase in what is being spent in the home today – and much of that capability needs to still be built and deployed. The home is one of the great frontiers to be conquered and entrepreneurs today will make that a reality.
According to U.S. Census Bureau data, over 5.4 million Americans filed applications to start companies in 2021, which was 53% greater than the pre-pandemic level of 2019. While Covid has been devastating for so many, arguably it was dramatic accelerant for innovation and entrepreneurship – either out of necessity or opportunity. Last year also witnessed the greatest level of venture capital investment in recorded history with nearly $330 billion invested in approximately 15,500 companies according to Pitchbook and National Venture Capital Association data, which once again underscored that only a small percent of all companies actually raise venture capital. Much of the anxious chatter now centers around whether we have just seen another bubble.
The economic signals are confounding, and it is near-impossible to descry a bright and obvious path forward. Gross domestic product grew 6.9% quarter-over-quarter which was up from the 2.3% in 3Q21. For the year, GDP increased 5.7% in 2021. Weekly jobless claims are trending downward and unemployment currently stands at 4.0%. Industrial output grew in 2021 at 5.5%, the highest rate since 1984. While analyst consensus expects a slight reduction in 4Q21 EPS for the S&P 500, U.S. corporates should report very strong earnings to end the year.
U.S. household net worth stood at $144.7 trillion at the end of 3Q21, according to Federal Reserve data, while total household debt was only $15.6 trillion. Coupled with a nearly 20% increase in home prices in 2021, the U.S. consumer should feel rather content notwithstanding that pesky inflation and pending interest rate increases.
Certainly, VCs do. The animal spirits ran wild in 4Q21, particularly with early-stage investors (below). Of the $88.2 billion invested in 3,356 companies in 4Q21, nearly one-third of that amount was invested in early-stage companies with an average round size of $23.9 million, which is dramatically larger than any prior quarter. Entrepreneurs may be signaling the need for longer cash runways heading into a more difficult financing environment or large capital raises are a point of differentiation in the market. Or there may simply be too much early-stage capital available. Early-stage median and average pre-money valuations in 2021 were $46.2 million and $119.2 million, respectively. Late-stage median and average pre-money 2021 valuations saw eye-popping increases to $114.5 million and $775.4 million, respectively. The 6.5x step-up in average valuations from early to late stage falls in the “unrealized” bucket, which has reinforced those animal spirits.
The pattern repeated itself in the 4Q21 angel and seed stages as well. The dramatic spike in amount of venture capital invested was just as notable as the fairly significant step-down in the number of deals which started in 1Q21. This may reflect a heightened sensitivity to risk for seed investors or that valuations for seeds have simply been priced too high. The average size of seed rounds in 4Q21 was $4.6 million; the median and average pre-money valuations for seed stage companies in 2021 were $9.5 million and $18.5 million, respectively, also significantly greater than any prior year. Five years ago, those valuations were $5.0 million and $6.9 million.
Undeniably, much of this enthusiasm is driven by extraordinary, head-spinning exit activity. In 2021, there were over 1,600 exit transactions valued at $774.1 billion – levels never before achieved – and nearly 3x the record-setting level of activity in 2020. The entire decade prior to the pandemic saw a total exit value of $1.07 trillion. Global M&A activity in 2021 was $4.9 trillion, according to Pitchbook, with $2.8 trillion of that activity in the U.S. Notably, technology M&A transactions increased more than 50% in 2021. Of the total exit values in 2021, $681.5 billion was due to public offerings across 296 offerings.
The robust public equity markets have clearly supported, even encouraged, an historic IPO market. Over the last six quarters, there has been $866.1 billion in IPO value generated, as compared to $126.4 billion in acquisitions and a mere $21.9 billion via buyouts. The extraordinary special purpose acquisition company (SPAC) activity, which has since summarily ceased, somewhat obfuscates the trend as many of those SPACs have yet to “de-SPAC” and still sit as public shell companies. In 2021, 556 SPACs raised nearly $135 billion and now have a two-year fuse to acquire an asset.
In order to achieve ataraxia, here’s the rub – most public listings involve significant investor lock-ups, so remains “unrealized” for extended periods of time. According to a Cambridge Associates (CA) analysis, over 90% of the gains in 2020 were unrealized. In fact, nearly one-quarter of CA’s U.S. Venture Capital index is comprised of public stocks, and therefore, generated significant mark-ups in 2021. Problems set in when high-flying public stocks experience significant volatility. The Nasdaq composite is down nearly 16% just in the past eight weeks – 60+ Nasdaq stocks are down more than 50%.
Notwithstanding the recent disturbing trading of the Renaissance IPO index, venture capital has been the best performing private capital asset class for the past three years (although the data are lagging). According to Cambridge Associates, the horizon pooled return U.S. Venture Capital Index as of 3Q21 generated 9.6%, 44.1%, 83.7%, and 27.6% IRRs for the prior quarter, year-to-date, trailing 12 months, and last five years, respectively. This performance compares very favorably to all common public equity indices. A Pitchbook 2020 analysis concludes that U.S. venture capital generated 71.7% horizon pooled IRRs versus 30.8% for S&P 500 and 40.4% for the Russell 2000 indices. Notably, venture capital returns were consistent across varying fund sizes.
Not unexpectedly this performance drove dramatic fundraising activity by venture firms. In 2021, 730 funds raised $128.3 billion, another highwater mark (in 2020, the prior record-setting year, 733 funds raised $86.9 billion). The riches were not shared equally, though. First-time fund managers only accounted for $9.1 billion (10.5% of total) raised across 172 funds (23.4% of total). The median fund size raised in 2021 was $50.0 million, which was an increase from the $42.1 million in 2020, while the average fund sizes were $188.1 million and $156.9 million, respectively. Clearly the more established fund managers are raising ever larger funds.
All this fundraising is conducted against a broader liquidity context. According to an analysis by the Financial Times, over $12.1 trillion of equity and debt was raised in 2021 globally, of which $5.0 trillion was raised in the U.S. Refinitiv data shows that $1.44 trillion of equity was raised globally in 2021, suggesting relatively high systemic debt levels. A Pitchbook analysis of the “dry powder” overhang in venture capital estimates that $222.7 billion has been raised but not yet invested by venture capital firms in the U.S., which may be important should VCs need to weather a prolonged recession. Coincidentally, the overhang is virtually the same amount of capital as was invested in late-stage deals in 2021 ($228.5 billion).
Not to be lost in all this activity, a recently released analysis from the Massachusetts Institute of Technology (MIT) of the Paycheck Payroll Protection (PPP) Program, which was launched with great fanfare at the outset of the pandemic, concluded that only ~25% of the $800 billion program actually went to pay wages for jobs that otherwise would have been lost due to the pandemic. While a relatively modest amount was directed to venture-backed companies, the National Bureau of Economic Research estimated that the PPP program spent $169k to “protect” jobs with an average salary of $58k. MIT concluded that 72% of the funds went to households in the top 20% income bracket.
With an increasingly speculative market many analysts are cautioning investors from being overly exposed to public equities. While it is likely too early to declare a “bubble,” it is informative to review the cycle of past bubbles (below). Arguably, there have been several boomlets in a handful of sectors over the recent past due to accommodative monetary policies, unprecedented stimulus spending, and investors searching for returns. While corrections of these boomlets may be uncorrelated, they point to systemic issues of ”too much capital chasing too few quality opportunities.” The Financial Crisis Observatory at the Swiss Federal Institute of Technology, which is tasked with tracking bubbles, recently flagged that a “green-energy” bubble burst in early 2021 as those stocks have plunged 45% from their peak.
A commonality to many of the recent sector corrections is the unmasking of “technology posers;” that is, companies dressed up as high margin “SaaS-like” business models. WeWork and Compass are not really technology companies, but rather slickly packaged real estate companies. Rent the Runway and Casper are retailers, not the “closet in the cloud” or a leading “sleep economy” company as both have described themselves. Nearly 98% of Oscar’s revenues are from insurance premiums. The U.S. affiliate of FTX, FTX Gaming, is poised to release a “crypto-as-a-service” platform. As broader public equity investors come to understand the fundamental economics of these businesses, a reset in valuations is likely not far behind.
Today’s shiny penny is non-fungible tokens (NFTs). According to Chainalysis, almost $41 billion was spent on NFTs in 2021; UBS and Art Basel estimated that there was approximately $50 billion spent in the global art market. Fortune estimates that the combined value of NFTs today is $16 billion, suggesting a high level of NFT trading. It is estimated that 360k owners hold 2.7 million NFTs, although only 9% of those people account for 80% of all NFTs purchased. Adjacent to this sector, venture capitalists have invested more than $30 billion just in 2021 in crypto companies according to Pitchbook – nearly 10% of all venture activity last year.
Breaking news this week was a massive leak of Credit Suisse private bank data of 18k secretive accounts that total over $100 billion of assets, $8 billion of which was deemed “problematic.” Setting aside that many of these accounts are held by despots, fugitives, and other international criminals, it would be fascinating to see where those “investors” placed their bets.