Bolus of Capital…Hard to Swallow?

It has been exactly seven years to the week that the American Recovery and Reinvestment Act was signed into law, committing the federal government to invest $787 billion (later “bumped” up to $831 billion) across a range of economic stimulus measures. Nearly $150 billion was directed toward healthcare, of which $36 billion was budgeted as cash outlays for Medicare and Medicaid incentives to deploy health information technologies; as of January 2015, $29 billion of that had been deployed. What has been the impact from all of that investment?

Arguably, as has been shown over many generations, the period after significant government investment in critical infrastructure (railroads, highway systems, airports, broadband), profound waves of innovative products and services were unleashed. Now that EMR penetration is nearly ubiquitous, a number of new value-added solutions are being introduced to drive greater utility from this significant infrastructure investment. In fact, we are already entering a comprehensive upgrade and replacement cycle of early EMR deployments, a sign of market maturation.

Stepped up investment and regulatory reforms have contributed to business model innovation as well as creative partnerships and acquisitions between technology vendors and healthcare companies in every corner of the healthcare industry. The recently announced acquisition of Truven Health Analytics by IBM for $2.6 billion is enormously validating. Another example of the forces of change at work would be the accelerating consolidation of Managed Care companies, which is generating significant pressure on drug discovery and distribution companies, leading to fascinating PBM consolidation. The ripples spread far and wide.

This is not lost on many entrepreneurs who seek to exploit this recently installed digital infrastructure. Attendance last year at the Healthcare Information and Management Systems Society (HIMMS) annual conference was 43,129, which was up meaningfully from the 35,065 attendees just two years before (interestingly, last year 44% identified themselves as being from a “Provider” and 31% declared that they were from the “C-Suite”). A more powerful barometer of healthcare technology’s importance is the amount of venture capital invested in the sector. The three most commonly cited sources tabulated a 2015 range from $4.3 – $5.8 billion:

  • Rock Health – $4.3 billion which was essentially flat from 2014
  • StartUp Health – $5.8 billion which was a decrease from the $7.0 billion in 2014
  • CB Insights – $5.8 billion (see below)

Digital Health Funding

At a time when there are 500 million primary care visits each year, and yet across all telehealth providers there might just be 2 million telehealth interactions, the role of technology is only just beginning to be felt. According to Berg Insights, only 5 million people globally are monitored remotely and yet there are over 7.3 billion of us (United Nations Department of Economic and Social Affairs – July 2015). Furthermore, technology companies from outside of healthcare are getting in on the action, with a no more intriguing case study than that being of Uber and Lyft entering the medical logistics space (Medicaid spends around $3 billion per year on third-party transport services). The potential for technology in healthcare continues to be very seductive.

A number of investment themes seem to be emerging from the 2015 funding data which should inform what we might expect to see over the next few years, so in no particular order, below is a list of some of the specific areas of investor interest.

  • More dynamic and flexible EHR products which will aggregate, analyze and present disparate data generated across numerous devices and platforms, often gathered in non-medical settings – arguably V2.0 which will get at issues of interoperability
  • Greater transparency as to the cost, pricing and availability of healthcare services and products
  • More effective search and navigation tools as the consumer strives for greater healthcare data access and understanding, and then better outcomes
  • Greater emphasis on wellness
  • Better tools around medication management and adherence (interestingly, less than 2% of hospitals are thought to engage with patients via text messaging)
  • Impact of less expensive genetic sequencing and multiplexing those data with other data for more precise diagnostics

But as exciting as all of that sounds, there are also concerns on the horizon. The general economic backdrop has clearly – and materially – changed. In early January 2016, S&P 500 earnings were forecasted to increase 0.8% this quarter; 45 days later that same indicator has been revised downward to a decrease of 5.3%. That is a significant re-set. Shockingly, Walmart today announced its first annual sales decline since 1980 – 35 years ago – with uninspiring guidance for 2016.

Additionally, regulators seem to be directing more scrutiny at healthcare technology solutions increasing the clinical burden to prove outcomes and efficacy. Not lost on anyone has been the harsh light pointed at Theranos, and less brightly on Lumosity, which paid a $2 million fine to settle FTC claims of deceptive advertising linked to boasts of “brain training” (this does not include the $50 million judgement, suspended because it would bankrupt the company).

Of particular interest to track will be the return expectations associated with the $10 – $12 billion invested over the past 24 months in healthcare technology. Venture investors look to generate at least 4 – 6x return from any given investment, ideally meaningfully more if possible. The CB Insights data suggest that approximately 1,600 companies were funded over the past two years, implying that they are expected to collectively create between $50 – $60 billion of value over the next few years. At a 2 – 4x multiple of forward revenue (there has been significant multiple compression over the past few months), generating $15 – $17.5 billion of incremental revenue in the near to medium term by these companies may seem like a stretch but attainable, although many will fail along the way. Obviously this math is crude but directionally highlights the potential for investor disappointment.

It also underscores how hard it is to successfully scale a healthcare technology company and the need to be very thoughtful about operating milestones, capital efficient product development roadmaps and effective “go-to-market” commercialization strategies. Obsession to growth to support lofty valuations appears to have led to a series of significant management lapses now unfolding at Zenefits. In 2014, revenues were estimated to be $20 million with a $100 million target for 2015, which is well ahead of the $70 million estimated to have actually been achieved. Another high flier is Oscar Insurance which expanded to California this year. According to Covered California, the state’s insurance exchange, Oscar only acquired 2,000 new members or 0.1% of the 1.57 million people who purchased on that exchange.

This issue of “capital absorption” plays itself out time and again in the investment world. Sectors get hot, too much capital floods in which drives down returns, with tears soon to follow. Undoubtedly the broader venture capital market is cooling. The unicorn phenomenon looks perilously under siege. Ironically, just when SEC regulations no longer force companies to go public when above a certain shareholder count, and with the JOBS Act of 2012 now firmly in place, being public appears to be less interesting to many companies, certainly given recent stock market volatility. Of the 142 biotech IPOs in the last three years, 74% of those companies are trading at levels below the IPO price (median decline is 35%). Case in point, LinkedIn saw nearly 50% of its market capitalization erased two weeks ago when reporting disappointing guidance.

Against a back drop of more and more “pulled IPO’s” we are starting to see pre-emptive lay-offs at venture-backed companies as they brace themselves for more hostile capital markets. While Sound Cloud is not a healthcare technology company, investors were shocked to see that the company was issued a “going concern” opinion by its auditors last week, and this after having raised $80 million at a $700 million valuation a little over a year ago – and Sounds Cloud has 175 million subscribers. This will not be an isolated phenomenon.

Gallows humor occasionally likens venture capital investing to philanthropy, particularly in times when losses are widespread. So as an interesting point of comparison, the Top 50 benefactors donated $7 billion in 2015 to charitable causes (nearly 20% more than was invested in healthcare technology companies); this was down quite sharply from the $10.2 billion gifted in 2014, according to a recent Chronicle of Philanthropy study. Notably, since 2000, the “Tech 50” donated a total of $33 billion which is a pittance when compared to the “Finance 50” who crushed it with $82 billion in donations over the past 15 years. Must be all those evil hedge fund managers – certainly not the VC’s.

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Narrow Networks – Work in Progress

As the healthcare industry continues to re-orient itself around more personalized therapies and services to match the specific needs, expectations and means of any given individual, one area that has witnessed dramatic product innovation involves the bundling of providers into specific networks that consumers can access through their insurance plans. The proliferation of “narrow networks” has been nothing short of extraordinary with 2,930 such plans being offered now, over 1,000 of which were introduced just in 2015 alone according to a recent McKinsey study. In fact, over 90% of all Americans had the choice to purchase either a broad or narrow network insurance product in 2015, up from 86% in 2014. Undoubtedly as insurers sort through the losses from insurance exchange products, we are likely to see a rationalization in the number of networks.

Narrow networks contain a greatly reduced number of providers and in-network facilities than traditional networks, often leading to significant decreases in premiums. Narrow networks are an attempt to return more negotiating leverage back to payers, much of which was lost in the face of provider consolidation over the last dozen years. In 2014, 70% of all exchange plans sold were narrow networks and they were on average 17% cheaper per McKinsey.

Much of the transformation of the “business of healthcare” is driven by fundamental payment model reform. This has created significant revenue opportunities for many technology vendors, which are selling enabling solutions to manage these new risks and revenue streams. Goldman Sachs tracks 15 public healthcare technology companies and recently reported that, as a group, those companies saw 12.4% and 17.9% revenue and EBITDA growth, respectively, in 2015. Expectations for 2016 continue to be strong with estimated growth for both revenues and EBITDA in the “mid-teens” percent. It is this transformation that is driving such significant VC interest as well. According to CB Insights, over $5.8 billion was invested in 903 “digital health” companies in 2015.

Given the breadth and depth of this wave of transformation, it is unlikely that recent economic volatility should materially impact 2016 growth estimates, even in light of the recent announcement from the Institute of Supply Management that its index decreased from 55.8% to 53.5% over the last month; weakness in this barometer has been highly predictive of a recession. Further bad news was released last week as domestic industrial production declined 0.4% in January. All of this has caused the S&P 500 and NASDAQ indexes to trade down by 6% and nearly 13%, respectively year-to-date. Clearly there will continue to be significant and, at times, painful reduction of valuation multiples.

Unfortunately for many consumers, there has been significant confusion and anger around narrow network design and what services are included. Ultimately consumers, and increasingly regulators, are worried about a decline in the quality of these networks as many of them tend to exclude the branded, high-cost providers. In fact, the National Association of Insurance Commissioners recently announced the development of “network adequacy” models and are actually encouraging payers to go in the other direction and broaden networks. The map below highlights the patchwork nature of how narrow networks have proliferated across the US. One possible explanation for this dispersion seems to be that in states with a high prevalence of HMO’s, there tends to be a greater percentage of narrow networks.


The Massachusetts Group Insurance Commission (GIC) recently observed that consumers lack basic understanding of choice and quality when purchasing health insurance, and advocated for greater plan design transparency; that is, clearly explain the trade-off between the cost and quality of the providers included in each network. Surprisingly, the GIC found that consumers are quite loyal even to low-quality providers underscoring the difficulties of getting consumers to switch health providers. Interestingly, in one study, when consumers were offered a three-month “premium holiday” only 12% switched plans; the most significant item cited was loyalty to primary care providers.

Notwithstanding the level of activity, there are still a number of important issues that need to be addressed around narrow networks:

• Fundamentally, do narrow networks actually drive better outcomes at lower costs?
• What is the impact on access to care?
• How best to judge adequacy of the network?
• Do narrow networks unintentionally allow for discriminatory practices?
• What are the appropriate measurement standards?
• Best approaches to communicate, promote and educate consumers/members?
• And significantly, are the regulatory frameworks adequate and/or appropriate for narrow networks?

The Center of Health Insurance Reform has put forth a regulatory model that sets forth a floor on consumer protection to drive adequate transparency and oversight, which underscores the considerable debate around how best to govern these networks. At the end of 2015, California regulators imposed fines on Blue Shield of California and Anthem Blue Cross because their provider directories were inadequate. A recent Harvard study found that almost 15% of health plans sold on the exchanges lacked providers in at least one specialty – that is an extraordinary number.

So why is this all of this important to a healthcare tech VC? Many of the exciting start-up’s we see today have solutions that can be used to help create, manage, evaluate narrow networks. Through better (big) data collection and analytics, there will be greater transparency and the ability to assess impact and effectiveness. Creating more compelling care pathways and care coordination platforms is at the heart of many of these solutions. More effective use of specialists should lower downstream medical costs. Might we even get to a point where consumers could create their own “synthetic” narrow networks by piecing together their own set of providers. Arguably the advent of narrow networks is another version of population health management as specific consumer groups coalesce around a specific set of providers and services.


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Comings and Goings…

Yesterday Oxfam released its annual study of inequality around the world which showed that there are actually 62 people who possess as much wealth as the 3.5 billion people in the bottom half of world’s income scale. Five years ago that number was 388 people. And all of this is against a back drop where the global economy has more than doubled over the past 30 years reaching approximately $78 trillion in size. Interestingly, the top 1% is expected to control more wealth than the remaining 99% by the end of 2016.

And in related news, earlier this week the National Venture Capital Association (NVCA) released its own study of “inequality” – I mean the 4Q15 fundraising statistics which showed that 46 funds totaling $5.0 billion were raised, bringing the annual total for 2015 to $28.2 billion. Quite clearly the fundraising pace over the second half of 2015 markedly slowed from the first half of the year. Notwithstanding that, 2015 was still meaningfully ahead of the 10-year trailing average of $23.4 billion, although it was modestly below the 2014 total of $31.1 billion.

There is the litany of usual suspects as to why this may be occurring: rising interest rates, China deceleration, lack of sustainable and compelling IPO activity, and general economic conditions. Standard & Poor recently announced that the outlook is worsening for 17% of the companies rated by S&P as compared to only 6% which are improving; this is the largest spread since the Great Recession. But undeniably the venture capital industry also has an “absorption” issue; that is, only so much capital can be deployed productively given the industry structure, especially in the face of inconsistent liquidity.

As of the end of 2014, the NVCA counted 1,206 Existing Funds managed by 635 Active Firms. The total assets under management (AUM) at that time was estimated to be $156 billion, of which $85 billion was managed in California, $20 billion in both New York and Massachusetts, with only $3 billion in Texas. The high water mark for AUM was $289 billion in 2006 which implies that the industry was nearly cut in half over the course of the Great Recession, plus or minus. And yet, given that contraction, there are hundreds of firms chasing after innovative market opportunities which often leads to far too many competitors in small niche, but emerging, marketplaces.

To underscore this dichotomy, some interesting jewels are buried in the 4Q15 fundraising data:

  • Of the 46 funds raised, 20 were deemed “first time” managers which raised $424 million (or under 9% of the total)
  • The average size fund raised was $109 million, although the median (a better barometer) was only $23 million
  • The largest first time fund was $90 million
  • The largest fund raised (Tiger Global) was $2.5 billion or 28x larger than the largest first timer
  • The Top Five funds raised $3.7 billion (or 73% of the total)
  • The Top Ten funds raised $4.3 billion (or 86% of the total)
  • Fifteen funds raised less than $10 million
  • The smallest fund, maybe in recorded history, was DunRobin Ventures weighing in at $50,000

And now for the rest of the story…

Unlike the amount of capital raised in 2015, the annual amount invested by VC’s increased significantly to total $58.8 billion. Interestingly 4Q15 saw $11.3 billion invested in 962 companies, which were both modestly down from 3Q15 levels, and in fact, the amount invested was the lowest in the past six quarters. There was significant investor enthusiasm directed at “tech-enabled” business models in the financial services, healthcare and consumer sectors, potentially suggesting that those companies may have an easier time raising follow-on capital once the unit economics are proven. The phenomenon of “mega” venture rounds continued in spite of a weak IPO market in the second half of 2015 as there were 74 of them in 2015.

Blog Jan 2016

The “funding gap” continued to widen which may be more of a reflection of definitional challenges as the boundaries blur between true early-stage venture capital investing and mutual and hedge funds investing “down market” in large mezzanine rounds of venture-backed companies, which would skew the aggregate funding data. In any event, this gap is troublesome should the amount invested decrease precipitously fast, leaving many companies stranded. Notwithstanding the possible “data integrity” complication to the analysis, there were also a number of interesting jewels in these data.

  • Software accounted for $4.5 billion (40%) of all the capital invested in 4Q15; healthcare was second with $2.4 billion (21%)
  • Overall, the average round size in Software was $12.2 million, eclipsed by the $15.3 million for Biotech but both were greater than the $7.7 million for the Media category – maybe a commentary on capital intensity?
  • Bringing up the rear was Telecom which barely registered with only $67 million invested or less than 1.0% of the amount in 4Q15
  • Cleantech saw $319 million invested in 30 companies (or $10.6 million per)
  • Nearly 19% of all capital invested in 4Q15 was in “First Time” companies although these round sizes were meaningfully smaller on average at $6.8 million – maybe suggesting a “newbie” discount?
  • Silicon Valley companies captured $4.3 billion, while New York Metro and New England saw $1.6 and $1.1 billion, respectively, invested; these three regions of the country accounted for 62% of all invested capital
  • Interestingly, the average round size for Silicon Valley companies was $16.1 million as compared to the more frugal New England round sizes of $10.3 million
  • There were 370 venture deals in California (39% of total) while only 97 (10%) and 94 (10%) in New York Metro and New England, respectively
  • The Top Ten investments were all over $100 million in size and accounted for $2.2 billion in aggregate or 19% of the total amount invested in 4Q15

So, less than 1% of all companies received 19% of all dollars invested in 4Q15. Not quite as bad as mankind writ large…but troublesome nonetheless.


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Only 10,877 Days Left…

It is quite unsettling to now know how many days I have left. At least that is the number that the Social Security Administration’s “Life Expectancy Calculator told me. Admittedly, I was somewhat apprehensive to hit “submit” after filling out the form.

Over the last few months I have been struggling to reconcile what appears to be a societal asymmetry; that is, why do we spend so much on end of life care and spend relatively so little on wellness, prevention and other activities focused on early childhood and young adults. All of this has been brought into even sharper focus because of the recent debates on drug pricing and accusations of gouging, often for therapeutics focused on diseases associated with old age. The sound bites are plentiful: 25% of Medicare spending is incurred during the last year of life, median length of hospice care is over two weeks (and is very expensive), Medicare spends over $16,000 on someone who is 96 versus $7,500 on someone who is 70 years old, and on and on. Overall, Americans spend $8,915 each year per person on healthcare products and services, of which just over $1,000 was for drugs. The Centers for Medicare and Medicaid Services estimates that total healthcare spending for those over 85 in 2010 was $34,783. These are really big numbers when viewed across a large population.

And VC’s have noticed this phenomenon as well. According to StartUp Health data, of the $2.8 billion invested in “digital health” during the first half of 2015, over $1.3 billion of that amount was directed at technologies for the 50+ crowd. Quite consistently over the past five years roughly 50% of all healthcare technology funding has gone to solutions for older people.  While many of these technologies arguably have relevance for people of all ages, venture capital tends to follow where a lot of money is spent (or misspent) to hopefully make it more productive. And the elder population consumes a lot of healthcare resources. Interestingly, this balance may now be changing as the largest product category for venture investment in the first half of 2015 was Wellness, which secured $674 million of capital according to StartUp Health.

Undoubtedly the diagnostics sector has suffered over the last decade as technologies focused on early detection ran into extended development timelines, hostile regulatory hurdles and brutal reimbursement policies. The promise of “value-based” diagnostic pricing models continues to be elusive, which also baffles me – isn’t a couple hundred dollar test that will determine the course of very expensive treatments, and oh, flags early onset of disease, incredibly valuable?

Increasingly investors are focused on new emerging care delivery models (see Iora Health) which are powered by many of the innovative healthcare technologies being developed today. For example, 800 new palliative and hospice organizations have been launched just in the last five years bringing the number to over 5,800; these organizations provide care to over 1.5 million people. One should expect innovative new business models to emerge which will partner hospice organizations with traditional providers and payers. Better care coordination continues to be the great promise of all of these new technologies.

When I was born my parents might have been told that my life expectancy would be 66.6 years given my birthdate and race. Now, according to the Social Security Administration, my life expectancy is expected to be 82.6 years – a dramatic improvement arguably due to advances in healthcare technology, nutrition, wealth of the country, etc. Many economists now believe that these numbers are understated due to future advances we cannot even contemplate that are over the horizon. In fact a cottage industry exists to sort all this out as these calculations have significant societal, political and economic implications if they are wrong. Thus the debate around the adequacy of the Social Security Trust Fund. Since 1956, economists have looked to the QALY (“quality-adjusted life year”) index but are now focusing more on the VSL (“value of a statistical life”) paradigm to get a more precise forecast on life expectancy, and frankly, to determine how much cost we should incur as a society to extend life.

Traditionally, economists tend to calculate the value of one year of human life as the amount of economic wealth that person might create. After conducting detailed cost-benefit analyses in 2011, a number of governmental agencies came up with their own determination as to the value of a life: leading the pack was the Environment Protection Agency which concluded that one life was worth $9.1 million, while the Food and Drug Administration calculated that it was worth $7.9 million, although the Department of Transportation determined it was “only” worth $6 million. The Office of Management and Budget hedged by saying a human life was worth between $7 and $9 million.

The DoT pointed to some fascinating data to reach its conclusion. In 1987, the speed limit nationally was raised from 55 to 65 mph which evidently saved all of us collectively 125,000 hours of driving time for each incremental fatality, thus concluding that society valued one additional life for $6 million. Furthermore, the DoT goes on to argue that if the speed limit were set at 13 mph, there would be no fatalities on the road.

To put all of this into some context, the Centers for Disease Control and Prevention tallied the 2013 census data (most recent annual data) and reported that 2.596 million Americans died that year, which is 822 people per 100,000 inhabitants. That same year, 3.932 million Americans were born or 1,240 per 100,000 inhabitants (32.7% of which were by Cesarean if you were wondering). Obviously there are many more of us at the top of the “life funnel” which further underscores my puzzlement over the asymmetry of the healthcare spend on older people. Clearly, older people have a louder voice (unless sitting on a long flight) but like my diagnostics argument above, shouldn’t the rational investment decision be to over-investment in wellness and “beginning of life” activities like prevention and education.

Life Expectancy

So then imagine how disturbed I was to read the recently released report in the Proceedings of the National Academy of Sciences which observed a dramatic and unexpected spike in the mortality rates of middle-age white Americans, in part attributed to substance abuse and mental health issues (see chart above). So, notwithstanding all the healthcare resources committed to older Americans, their mortality rates are increasing. Analysts speculate that economic stress may account for both this elevated mortality rate as well as a decreased labor force participation rate. To further underscore this phenomenon, 10.6 of every 100,000 people aged between 45 and 54 overdosed on prescription painkillers. To put an even finer point on this, nearly 45,000 Americans died from an overdose as compared to over 35,000 in motor vehicle accidents and just over 16,000 homicides.

In 2013 the overall U.S. suicide rate was 12.6 per 100,000. Now that is an unacceptable cost.

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Expanding the Posse…

Over the course of any one fund, we will make a few dozen investment decisions together (a big deal), a couple of hundred “ordinary-course-of-business” decisions (less of a big deal), and debate thousands of other issues (many are often quickly forgotten) – but we will only make a few personnel decisions (a really big deal). So it is with great excitement that we welcome Jason Sibley as a Principal to the firm.

Jason is passionate about the transformation of healthcare first and foremost. Sure, he is super smart. And of course he has a great depth of investment experience, which is nice, but what we were all so struck by was his fascination with how the business of healthcare is being reinvented. Jason comes to us from GE Ventures, one of our most important partners, which is staffed by some of the most talented healthcare investors out there. GE Ventures enjoys a privileged relationship with GE Healthcare, which is a $20 billion business for GE and has deep customer relationships with virtually every healthcare institution around the world. GE Ventures is led by Sue Siegel, who also sits on Flare’s Industry Advisory Board and is a close friend of the firm.

But that is not all.

We are also excited to announce the Flare Scholar program, which is an initiative to add a set of young professionals from great graduate schools and important leading healthcare companies to our team. Our Scholars will be offered a court-side seat to the world of venture capital, principally assisting us in identifying great young entrepreneurial talent – people who are looking to be in the healthcare technology industry. We also expect that our Scholars will be helpful in thinking through industry trends and may even work with some of our portfolio companies.

Stay tuned for more as we expand the Flare posse…

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CO-OPs – “Innovation” Run Amok?

Innovation in healthcare is often associated with break-through scientific discoveries in the lab, which leads to profound new therapeutics and devices. This decade, however, will be characterized by innovative new business models powered by novel software and hardware platforms. Arguably these advances will have greater impact on outcomes and cost of care across large populations. At its core, there are a handful of trends driving this wave of innovation: (i) dramatic shift from acute care models to prevention and wellness; (ii) greater emphasis on point-of-care and decentralized care delivery; (iii) development of personalized, predictive and preventive solutions throughout healthcare; and, (iv) an increased role of data, adaptive learning systems and automation in every corner of the healthcare landscape. Of particular interest are technologies which create and support integrated platforms that manage and coordinate care and are location agnostic.

Central to this entire transformation is the dilemma that provider systems have historically been structured to treat the individual as an individual but are now being pushed to manage populations. In contrast to that, payors must do the reverse; that is, historically health insurance products and services were structured, priced and delivered as if each individual were the same, but now those same products need to be tailored to the individual given the obvious differences among members. Both are searching for successful models of “mass customization.” A fascinating set of conflicting industry dynamics indeed.

Among a protracted and unprecedented philosophical debate about the appropriate role of government in healthcare, perhaps one of the greatest experiments in healthcare business model innovation is playing out right in front of us today – and the results are decidedly mixed. In 2011 The Patient Protection and Affordable Care Act (affectionately known as ACA) provided $6 billion in funding to launch the Consumer Oriented and Operated Plan (CO-OP) program. CO-OPs were intended to be new non-profit, consumer-oriented health insurance providers by state, offering competitive insurance products on the health insurance exchanges established by the ACA. After a series of legislative actions, the total amount of funding available was reduced to $3.4 billion, and by the beginning of 2014 when the program was officially launched, 23 CO-OPs had been established with $2.4 billion in loans.

While a few CO-OPs experienced meaningful membership demand, even in some cases exceeding first year forecasts, the Office of Inspector General published a report this past quarter which found significant shortcomings with nearly every CO-OP. Overall eight CO-OPs have already failed, putting at risk nearly $1 billion in federal loans. In fact, just this past month, a handful of CO-OPs were decertified and are winding down operations (Colorado, Kentucky come to mind – Iowa/Nebraska already liquidated earlier this year). Notwithstanding that the ACA established three funding programs (Reinsurance, Risk Corridor, and Risk Adjustment – the “Three R’s”) to shield these CO-OPs against market risk while they sorted out their pricing models in the first three years, the losses have been staggering. Unfortunately the measurement models, particularly for Risk Adjustment, are both crude and imprecise, often leading to perverse subsidies to established insurers with the best provider network discounts to emerging payors.

The technical challenges of the launch of these CO-OPs were widely reported with websites crashing, long wait times and poorly designed interfaces. The forecasted enrollment across all 23 CO-OPs by the end of 2014 was 658,000 members, far in excess of the 475,000 who actually enrolled (although New York had forecasted 31,000 members and saw 155,000 enroll, highlighting that there were pockets of notable success). Most of these CO-OPs had to compete against entrenched insurers, underscoring the power that an incumbent brand may carry over new innovative products that are introduced to a market.

Perhaps what is more disturbing is when one reviews the financial statements for each of the CO-OPs (which I did), only one CO-OP (Maine) had its first year premium income exceed claims expense, raising questions around pricing and the ability to accurately assess the health of the members enrolled. Only three of the CO-OPs projected to make money in their first year of operations; in reality, none of them did. In aggregate, the 23 CO-OPs collected first year premiums of $1.65 billion as compared to $1.88 billion in claims. Most staggering though is the $380 million of first-year administrative costs incurred by the 23 CO-OPs. In the face of these losses, the federal risk corridor funding programs, whereby health plans with less healthy populations were subsidized by plans with healthier populations, were withheld for many of the CO-OPs, which have led to a severe cash shortfall for some. Overall, the 23 CO-OPs collectively lost $375 million to enroll 475,000 members in 2014 or roughly $800 per enrolled member.

It is not just the CO-OPs that have suffered mightily as a number of private insurers have announced significant losses in their individual plan businesses. Highmark Health of Pittsburgh recently shared that it has lost $318 million through the first half of 2015. In response to this unsettled environment, there is significant evidence that many insurers will move to more narrow networks, to channel consumer access to less expensive providers. Many state insurance commissioners have confronted filings for dramatic rate increases, often times in the significant double digits.

A number of questions remain unanswered. Where do these members go when their CO-OP is decertified? Would these people have enrolled in other insurance plans even if the CO-OPs did not exist? Fundamentally – what went so wrong? It is widely believed that many of the “entrepreneurs” who took the government up on its offer to start an insurance CO-OP likely lacked the depth of understanding for how to underwrite new members and did not fully appreciate the extraordinary associated regulatory burdens, much less how to run an insurance company. It certainly appears that the absence of significant up-front equity start-up capital shifted the entire financial risk to the government as to whether this experiment was successful. What the ultimate cost to U.S. taxpayers is still not known, but it is clear that the jury is decidedly out during the early innings of this grand experiment in business model innovation. Perhaps there will be another wave of entrepreneurs who will create interesting businesses from these failed CO-OPs?

These transitions, which providers and payors are currently undergoing, coupled with regulatory reform, the aging population and tremendous cost pressures, all point to a period of unprecedented upheaval. We continue to see extraordinary talent entering this sector to build the next-generation of product and service companies. The level of activity this past quarter underscores how exciting this sector is right now.

Specifically, the healthcare technology sector witnessed significant activity as 148 companies raised $1.6 billion this past quarter according to Mercom Capital Group, which is a sharp increase from the second quarter 2015 activity of $1.2 billion and 139 companies, respectively. Year-to-date over $3.5 billion was invested in the healthcare technology sector. This level of investor interest might cause one some pause as perhaps too many “me too” companies are being created.

An important barometer as to the overall state of the healthcare technology investment climate is the level of IPO and M&A activity, which was weaker than prior periods. In the third quarter 2015 there were only 2 IPOs and 57 M&A transactions, which may simply reflect the summer doldrums and volatile stock market.   Interestingly there was only $500 million of debt financings as compared to $1.6 billion in the second quarter 2015.

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Fat Lady is Clearing Her Throat…

Ouch. That was a slap in the face. I get that this past quarter included the languid summer months and that the stock market volatility was quite distracting, but the 3Q15 venture fundraising data caught many flat-footed. This past quarter saw only $4.4 billion of capital raised by 53 new funds, which is a 59% and 35% decrease from the prior quarter, respectively. And this is against a backdrop when venture capitalists invested $16.3 billion in 1,070 companies during that same quarter.

Before I point out some of the nuggets buried in the data, there were a series of fascinating announcements by three of the leading accelerators/incubators over the past few months which highlight a new phenomenon in the venture marketplace: Y Combinator, AngelList and Techstars all raised large institutional funds ($700, $400 and $150 million, respectively), proving that sitting at the turnstile of extraordinary and proprietary deal flow is a very valuable and coveted position – one that is easily “monetizable.” These developments also underscore that many large institutional investors are still clambering to invest in the earliest stages of the innovation economy (the AngelList platform will now support $400 million from China’s third-largest private equity firm, China Science & Merchants Investment Management Group, which has $12 billion under management).

One of the hallmarks of the venture capital industry over many cycles is its remarkable ability to re-invent itself. Arguably these three new funds above represent $1.25 billion of capital that otherwise would have been invested by traditional venture firms. New firms often are created by partners leaving established firms which is why the National Venture Capital Association (NVCA) so closely tracks “first time” funds. In 3Q15, 13 of the 53 funds raised were deemed “first time” funds and collectively, they raised $737 million or 17% of the total. On the face of it that is not too bad until one realizes that the largest “first time” fund was $460 million (congrats to my friends at Silversmith Capital) or nearly two-thirds of the total. Stripping out Silversmith, the average size of the remaining dozen “first time” funds was $23 million.

Other gems in the data:

  • Top 5 funds raised totaled $1.9 billion or 43% of the total
  • Top 10 funds captured $2.8 billion or 65% of the total – concentration continues unabated
  • Only 16 of the 53 funds were greater than $100 million.
  • And with great symmetry, 16 of the 53 million funds were less than $10 million in size
  • The median fund size was $39 million – the VC industry continues to be characterized by a handful of very large funds tethered to a myriad of small focused funds.
  • While California, Massachusetts and New York funds captured 81% of the total dollars raised, 19 other states housed new funds – reasonably good geographic diversity
  • My favorite nugget – the Bottom 10 funds raised $26 million or 0.6% of the total. Now that is a real slap in the face – one that leaves a mark.

The real question now is what trajectory is the VC industry on: if one were to annualize the year-to-date amount raised for one more quarter, the 2015 total raised would come in around $30 billion (which is sharply down from mid-year estimates of $40 billion). But if one were to simply annualize 3Q15 performance, the VC industry is on pace to raise only $17.5 billion. It certainly feels that, absent a more robust and predictable IPO market, the venture industry is now at risk of shrinking again as capital either sits on the sidelines or looks for non-traditional access points.

Through 3Q15 there have been only 51 venture-backed IPO’s and those have raised just over $5 billion in proceeds, which is tracking well below the 2014 amount of $9.3 billion for the full year. The M&A market year-to-date for venture-backed companies is also soft with only $40 billion of transactions versus over $80 billion for all of 2014, which was a high watermark over the last 5 years. Presumably, greater liquidity will result in an improved fundraising environment as investors see a return on all that invested capital. Hopefully that will happen before the Fat Lady hits the high notes.


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