“Fastest Turtle” — Healthcare Investing and the U.S. Economy…

Given the investment horizons for venture capitalists, we do not necessarily try to time public markets when making new investments – although they obviously influence pre-money valuations, particularly for later rounds. Greater concerns revolve around portfolio companies’ ability to access capital on reasonable terms, and that the general macroeconomic environment is conducive to strong revenue growth. Notwithstanding the confusing economic signals that abound today, conditions continue to be supportive for new company creation, particularly in the healthcare tech sector.

Call it the “fastest turtle.” The U.S. economy continues to be one of the most robust and attractive markets in the global economy, despite the fact that 4Q 2014 GDP growth was recently revised downward to 2.2% from initial estimates of 2.6%, which is significantly down from 3Q 2014 growth of 5.0%. Arguably the dramatic decline in the price of oil has yet to be fully reflected in consumer spending although consumer sentiment has meaningfully improved over the past year, bolstered in large measure by the relatively low unemployment rate of 5.5%.

The current environment is complicated and quite confusing, though. There remain significant and disturbing geopolitical risks: Russia’s aggressive and blatant expansionist activities in Ukraine and elsewhere; the barbaric and senseless behavior of ISIS; and the looming Greek debt crisis. On top of such factors, given high European unemployment and all of the attendant social unrest that is causing, there is the need for the European Central Bank to take steps toward quantitative easing. All of these risks will obviously impact domestic economic activity.

There now is the specter of rising interest rates in mid-2015. After a nearly 6-year period with targeted fed rates between 0.0% – 0.25%, Fed Chairwoman Janet Yellen recently signaled that rates may rise to be 2.5% by year-end 2016. This is particularly notable given that the Fed’s balance sheet now stands at approximately $4.5 trillion as compared to $1.0 trillion in 2008. Arguably, since 2000, the U.S. economy has experienced steadily declining interest rates (as well as two difficult bear markets), which has now sparked another emerging concern: the under-funded status of corporate pension funds. Pension fund managers are in the business of matching their assets and liabilities, which has been particularly difficult over the past decade as fixed income yields are effectively zero. With the dramatic improvements in healthcare, pensioners are living longer, often outstripping their assets to cover healthcare costs. Estimates are that domestic pension funds are underfunded to the tune of $800 billion, which is comparable to the size of the infamous TARP (Troubled Asset Recovery Program) of the Great Recession.

Broader equity valuations are also cause for increasing concern. Investor sentiment has quite clearly moved from positive to neutral this past quarter, even in the face of consensus analyst GDP growth for 2015 between 2.5% – 3.0%. Currently the S&P 500 index trades at 17.5x trailing earnings which is well below “bubble territory” of 25x witnessed in 2000, yet the NASDAQ has just eclipsed 5000 and other public equity indices are regularly setting all-time records. The U.S. stock market trades at 155% of GDP, comparable to 2007 levels. Arguably private equity valuations for break-out companies have never been higher, causing consternation among many later-stage private investors.

Healthcare Environment

Broadly, there are a handful of powerful and disruptive themes evident in the healthcare technology marketplace today: (i) the shift to risk from fee-for-service (aka “volume to value” whereby providers are assuming more of the responsibility for clinical outcomes at lower costs); (ii) tiered and innovative new healthcare delivery models; (iii) the role of the patient as a consumer of healthcare services; (iv) the demand for mobile-based 24/7 solutions; and (iv) novel “diagnostics” that include many different variables, not just DNA or protein biomarkers but possibly even your FICO score or zip code. And there are many other themes – each one potentially creating exciting and valuable new companies.

The Agency for Healthcare Research and Quality recently reported that 1% of all patients account for 22% of all hospital costs, which calculates to nearly $98,000 of annual costs incurred per patient in this 1%. Notwithstanding that Medicare spending “only” grew at 3.4% in 2013, important initiatives across the entire healthcare ecosystem are being adopted to drive down costs and improve efficacy. This environment continues to hold great promise for new and valuable healthcare businesses focused on technology infrastructure to be created over the next decade.

As of year-end 2013 nearly 190 million people in the U.S. (or ~60% of the population) were covered by private health insurance. Due to Obamacare, more than 10 million new members enrolled taking the uninsured rate down to 12.4% in 4Q 2014. Consumer out-of-pocket spending (co-payments, deductibles, services not covered) was $339 billion or approximately 12% of the national healthcare spending in 2013. Clearly the growing role of the patient as a consumer is a powerful force as healthcare models are transformed.

Other pressures are increasingly evident such as the fact that over 257,000 doctors incurred 1% Meaningful Use penalties for failure to comply. As financial incentives become more apparent, expect changes in behavior and increased adoption of new solutions. According to Healthcare Growth Partners (HGP), nearly $1 of every $4 spent in hospitals was spent on overhead. HGP further observed that the U.S. ranks #46 out of 48 countries in healthcare efficiency, just one rank behind Iran.  As greater transparency of actual costs incurred becomes more evident, expect increased investment in healthcare IT infrastructure to better manage new risks and revenue streams.

The Federal Health IT Strategic Plan 2015 – 2020 calls for five broad initiatives to be implemented over the next five years: (i) expanded adoption of health IT across the ecosystem; (ii) advanced and more secure interoperability; (iii) strengthened healthcare delivery systems; (iv) programs to promote greater wellness; and (v) continued investment in research and innovation. Novel solutions will be developed across each of these activities that will result in new company-building investment opportunities.

Analysts estimate that nearly $7 billion of private capital was invested in healthcare IT companies in 2014, nearly double the amount invested in 2013. Of this total, approximately $4 billion was invested in early-stage and growth companies; in fact the top six financings in 2014 raised over $1 billion collectively. Some 376 healthcare technology companies raised capital in 2014, although there were only 7 IPOs, in part a reflection of the sharp decline in some of the public healthcare technology stocks in 4Q 2014. Importantly, according to Rock Health, there were 95 M&A healthcare technology transactions with an aggregate disclosed transaction value of $20 billion. This underscores the encouraging evidence of investor liquidity through increased M&A activity. In particular, there was a strong acquisition focus on population health and care coordination companies; other categories such as consumer digital health and EMR vendors appeared to lag somewhat.

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Bet the Jockey…Bet the Horse…and Bet the Track

Earlier this month we announced a new investment in Iora Health, a fascinating company run by an extraordinary entrepreneur transforming an enormous sector of the healthcare economy – primary care. Rushika Fernandopulle (CEO and co-founder) is fundamentally re-architecting how many of us will buy and consume primary care and in so doing, he has created a passionate mission-driven culture throughout the company.

A fundamental premise to this investment is that the US is marching toward a tiered healthcare delivery system, where brand means something and the price of services provided actually corresponds to services received. Providers are no longer being asked to manage just facilities but rather populations, and in so doing, will quickly see the wisdom of investing in wellness and preventive measures to lower overall costs. Healthcare is moving – erratically some might argue – from a B2B transaction model to a B2C model. Some analysts speculate that within five years as many as 100 million Americans may be purchasing healthcare coverage on exchanges, which would place Iora in a fascinating market vortex.

Consistent with this trend, the Department of Health and Human Services (HHS) recently suggested that more than 30% of all Medicare payments by 2016 will be value versus volume based. Furthermore, HHS set a goal that this should be 90% by 2018, creating a great environment for disruptive value-based payment models like Iora’s. In 2014 Medicare fee-for-service payments totaled $362 billion – almost $1 billion each and every day.

Recently the Centers for Medicare and Medicaid Services (CMS) made a series of announcements that underscore its commitment to fundamental healthcare transformation. The most notable one involved the CMS Innovation Center commitment of $840 million to the “Transforming Clinical Practice Initiative” which will encourage 150,000 providers to share best practices. CMS also announced that healthcare costs rose only 3.6% in 2013 in the U.S. to $2.9 trillion, marking the fifth consecutive year of spending increases below 4.0%. Arguably insurance cost-sharing initiatives like expanded deductibles and the proliferation of innovative healthcare technologies are beginning to have an impact on overall healthcare spend. Notwithstanding that relatively good news, many analysts expect the rate of healthcare spend to increase in 2014 and 2015 by as much as 5.6% and 4.9%, respectively, as more than nine million additional Americans gain coverage. Overall healthcare’s share of the U.S. GDP was 17.2% in 2012.

The brilliance of the Iora model is centered around the notion that doing a number of little things right every day will have enormous downstream benefits. We are not talking about sophisticated genomic sequencing or expensive diagnostic imaging but rather simple effective care, based on a patient-centric approach. A better and more diligent focus on basic care such as improving diets (tragically, it is cheaper to eat at McDonalds than to buy a bag of apples – maybe we should more aggressively tax unhealthy foods?).

Not to be lost in the excitement around the innovative healthcare technologies flooding the market today is the fact that when you cut through it all, effective care is provided by one person helping another person sitting directly across from him/her. Rushika understands this to his core, given he is a doctor who has retained the clear sense of mission that initially drew him to medicine – and it is this force of personality that pervades the company now. Arguably, given the complexities and nuances of healthcare, successful VC-backed entrepreneurs in this sector will likely be more experienced, having ideally developed products and/or sold to healthcare customers and/or having some clinical training so they will better understand the “voice of the customer.” Entrepreneurs with such a sense of purpose make it easy to bet on the jockey.

Iora is a special company. Start-up’s that succeed tend to do two things really well: attract killer talent and have customers eager to be in business with them. The company clearly checks both of these boxes. To an individual, the senior team is tremendous – each of the employees undoubtedly could work anywhere they wanted to but are drawn to Iora by the deep sense of mission. The breadth and depth of customers – both existing and in the pipeline about to launch – is unrivaled. This horse was a sure bet.

The primary care category is enormous. And totally broken. VC’s salivate to find markets this large, so ripe to be re-invented. It is quite clear that we have entered a period where patients will act as consumers and will demand healthcare services as simple and effective as those that they receive in banking or retail. We have raised a fund to place a number of bets at this track.

This past summer my daughter and I lived in a Panamanian orphanage for a week and while there we saw a different type of primary care model. The nuns cobbled together broken weight training equipment for rudimentary physical therapy; they resuscitated an old dentist chair and basic equipment to clean the kids’ teeth. Notwithstanding the really tough conditions, these kids appeared well cared for and in quite decent shape. Obviously the nuns are mission-driven and passionate about these kids.

Quick interlude: the orphanage apparently has an international following – while we were there a KLM crew of flight attendants showed up with bags of donated clothing from Holland which is something they bring every time their flight takes them through Panama City – and which is why I now will go out of my way to fly the Royal Dutch Airlines.

Panama 2014

Second interlude: while in country, my daughter and I toured the Panama Canal – what were they thinking over a hundred years ago?!? It is over 80 kilometers long and involved removing over 200 million cubic meters of dirt (if that dirt was put on trains, the trains would circumnavigate the globe over four times). Other fun Canal facts:

  • 75,000 men worked on the project over the dozen or so years it took to build
  • 4,000 containers cross the Canal every day
  • With the expansion underway now, that number will increase to more than 13,000 containers
  • More than 14,000 tankers cross the Canal every year
  • And the person who owns the contents of the middle right container on the tanker above is furious…


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Land of the Giants…

The 4Q14 venture industry fundraising data (compiled by the National Venture Capital Association) were just released which always makes me sit up straight and take notice – it’s kind of an industry scorecard. In addition to being baffled by the fact that the amount my industry invests chronically outstrips how much we raise (see below), I am intrigued by the other forces at work as the VC industry risks behaving more like a money management business. But first the facts…

Last quarter nearly $5.6 billion was raised by 75 funds, of which 27 were “first time” funds. While the number of funds raised was 14% ahead of 3Q14, the amount of dollars raised dropped 9% from 3Q14 (as compared to 4Q13 – a year ago – the number of funds was up 17% while the dollars raised was effectively flat). For all of 2014, $29.8 billion was raised by 254 funds, which effectively returns us to 2007 levels when $30 billion was raised. This compares to nearly $48.3 billion that VC’s invested in 2014 in 4,356 deals. The “funding gap” in 2014 of $18.5 billion is unprecedented – in fact if you lay out the data for the past 30 years (which I just did), up until 2002 the amounts raised vs. invested every year basically tracked each other; six years ago a persistent and growing “funding gap” started to emerge.

Funding Gap 2014

So either these lines will converge rapidly – that is VC’s simply shut off the investment spigot (which is easier than raising materially larger funds – more on that below) or there is a more profound evolution of the early stage capital marketplace. In an environment of basically free money and zero interest rates, Limited Partners are increasingly looking to the VC asset class to drive investment returns. Cambridge Associates just released its “Endowments Quarterly – Third Quarter 2014” report where the average US Endowment and Foundation universe in 3Q14 returned -1.3% (yes, negative 1.3%). Those with top quartile overall performance had the greatest PE/VC allocation which was 12.8% of all assets managed and generated 17.4% return for the 12 months through 3Q14. Notably the bottom quartile performers had only 2.4% PE/VC exposure. Notably – again – the US PE/VC index one-year return performance was 24.4% for the 12 months through 3Q14.

We know that capital follows returns but arguably something equally important is also occurring, and that is the dramatic rise of the secondary market. According to intermediary Setter Capital, total secondary volume in 2014 was $49.3 billion – an increase of 37% from 2013. As greater liquidity comes to this part of the capital markets, Limited Partners in VC funds increasingly have credible alternatives to sell a VC fund commitment, perhaps making it more of a “trading asset” or at least, create the appearance (illusion?) that these commitments are no longer 10+ years in duration. The Setter report observes that there are increasingly very large buyers coming into the market buying positions in a wide array of private investment vehicles such as real estate, PE, venture, hedge and infrastructure funds. In 2014 there were 1,270 transactions in the secondary market.

But neither of the above observations accounts for the entire “funding gap” – clearly the investment data are capturing non-VC investors. This is in part the “Uber phenomenon” where a venture-backed company raises billions of dollars and it all gets lumped into the venture category (last month, Uber raised ~$1.8 billion from the Qatar Investment Authority, Goldman Sachs, Baidu, assorted hedge funds). Clearly non-VC investors are looking for greater returns and have come down market to find them – either investing directly into portfolio companies or into venture funds – which in turns drives up the investment activity and pace (and valuations for break-out companies).

And as always there were some fascinating nuggets buried in the detailed fundraising data which serves to better clarify what may be really going on underneath the headlines…

  • Of the 75 funds raised in 4Q14, the Top Five took home $2.3 billion or 41% of all dollars raised…the Top Ten scoped up $3.3 billion or 59%
  • While the average fund size was $74 million, the median was a paltry $14.7 million…think about that long and hard
  • So naturally I looked at the other end of the list – the Bottom Ten funds raised totaled $8.8 million or 0.15% of all dollars raised – not a typo
  • One new fund was listed as having raised $40,000 – really?
  • Of the 75 funds raised, 50 of them were less than $100 million in size – but it gets better
  • 27 funds were less than $10 million in size
  • Over the course of 2014, there were 96 first-time funds raised (of the 254 total new funds) – those first-time funds totaled $3 billion – so 10% of all dollars raised in 2014 was by nearly 40% of the funds (the largest first-time fund was Presidio Partners at $140 million – congrats)

Lost in all the news about domestic VC fundraising, two other important geographies were making their own noise. The State Council of China announced this month plans to establish a $6.5 billion fund to provide seed capital for start-up’s. According to Zero2IPO Capital, a PE investor in China, the estimated the size of China’s venture capital industry was $6.8 billion in the first half of 2014, so this is a potentially a big deal in China. And not to be left out, buried further in the announcement, China’s Insurance Regulatory Commission made clear that it would allow insurance companies to now invest in venture funds. And on the other side of the world, the Israel Venture Capital Research Center released its own 2014 data which showed that $914 million had been raised, which was an increase of 68% over 2013 levels. The largest Israeli fund was raised by Carmel Ventures at $194 million.


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Silver Lining Behind the Drop in Black Gold…

Instead of developing a warmed over list of “Top 10 Predictions for 2015,” this upcoming year may be most colored by the implications of the collapse of oil prices around the world. We will see the obvious and direct benefit to the US consumer (November retail sales were up a surprising 0.7%) as the price of oil continues to decline, now down well over 40% since June 2014. But hopefully we should also see profound improvements in other areas of the global economy. Of course businesses and geographies (like Texas) which are directly benefited by the high price of oil will suffer; notably while the energy sector only makes up 9% of the S&P 500, this sector accounts for nearly 30% of the total capital expenditures for this index – clearly there will be far reaching ripple effects across other sectors as these investment budgets are slashed.

Arguably the dramatic decline in the price of oil contributed to the increased volatility of public equities we saw during the 4Q14. But it was not only public equity valuations which were whipsawed; fixed income securities, particularly high yield bonds, were impacted by the price drop as investors now appear to be re-assessing how appropriately risk is being priced in the capital markets. The high yield market, which is particularly exposed to turmoil in the oil patch, should now see a spike in corporate defaults. All of this may directly impact the cost of capital, that is, make it more expensive and/or harder for companies to raise capital on terms as favorable as we have seen the past 12 -24 months (the end of “free money?”).

But the greatest impact will be felt in the global geopolitical realm. Notwithstanding numerous countervailing and at times conflicting forces which this price drop has unleashed, the undeniable budget pressures that have been foisted upon the economies of many of the bad acting regimes (Iran, Iraq, Russia, Venezuela come to mind) should lead to profound changes. As Tom Friedman of the New York Times recently pointed out, on the heels of significant oil price declines from 1986 – 1999, we saw the Soviet Union fall apart, more progressive leadership change in Iran (still far to go), and broader recognition of Israel in certain Arab states.

Today we may be seeing emerging evidence of similar potential transitions. Cuba has normalized relationships with the US now that “big brother” Venezuela is effectively bankrupt (oil is 96% of Venezuela’s export revenue). There is widening speculation of imminent political turmoil in Russia and Iran, with continuing turmoil in Libya, Nigeria and Algeria, to name just a few. While these transitions can be marked with much pain and suffering, the long term benefits when politically corrupt oil tyrants collapse are dramatic. Interestingly, according to the World Bank, nearly 12% of the world’s population resides in war zones; those same geographies account for 9% of global oil production yet only 3% of global GDP and less than 1% of the global equity market capitalization. Having significant oil does not necessarily translate into robust economies.

Far too much collective time and energy of our world leaders is dedicated to navigating crises created by regimes propped up by high-priced oil. Idealistically one might dream that, after certain regime changes, those same leaders would be able to focus more of their time on other pressing problems involving healthcare, the environment, education, and wealth inequities or invest more deliberately in critical infrastructure. If nothing else unreasonably high priced oil diverts capital away from arguably more productive uses like developing solutions for those problems confronting us all.



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Sun Also Rises – Twice….

Somewhere Over the Atlantic in Row 32: When you fly across nine time zones you see a lot of odd sun rises. If I did the math right I saw two of them in less than the 15 hours since my initial departure a few days ago.

I spent this past weekend in Abu Dhabi at the Formula One Grand Prix, which it turns out was the season finale and was to determine the overall winner for 2014 (spoiler alert – Lewis Hamilton won the race and had the most points overall). Thanks to my good friends at Mubadala (the leading investment and development company established by the Government of Abu Dhabi to support the emirate’s long-term economic diversification), I spent two days immersed in a series of discussions around the investment climate here – oh, and I also saw a car race.

Abu Dhabi 2014 - 3

It is fascinating to see a region come of age so quickly, so profoundly. When I was last here almost six months ago I toured an extraordinary new hospital being developed by Mubadala in partnership with the Cleveland Clinic – on this visit I was able to once again walk through the facility which is to open in the first half of 2015. This hospital, which sits on 23 acres and has 4.5 million square feet, will service a wide range of complex and critical care cases – arguably the most sophisticated healthcare facility in the entire Middle East. The five Centers of Excellence (Heart and Vascular, Eye, Neurological, Digestive Disease, Respiratory) anchor the activities of the hospital. There will be over 2,000 “Caregivers” servicing the nearly 400 beds when the hospital opens. Given my jet lag I was easily able to get a photo of the sun rising over the hospital, which I thought was particularly propitious.

Abu Dhabi 2014 - 1

Healthcare is a big deal in the United Arab Emirates. The level of activity and investment in the region is significant and many US companies are finding a receptive marketplace there. The Cleveland Clinic has brought significant expertise to Abu Dhabi with its particular healthcare delivery models. The 72 critical care rooms have the most sophisticated equipment available but it is obviously much more than that – the attention to training and operating protocols, even the care to the most mundane of tasks, is quite apparent as evidenced by the signs throughout (see below). Interestingly, and maybe because of heightened awareness due to Ebola or an obsession with really clean hands, the cover story in this weekend’s Gulf News was “Modern Hand Dryers Spread More Germs” – true (cover) story!

Abu Dhabi 2014 - 2

Much of the local investment capital actually flows out of the region as petro-dollars are diversified into other assets and geographies. The amount of new private equity funds focused on the Middle East and North Africa raised year-to-date 2014 is around $2.0 billion (according to Thomson Reuters) versus $1.2 billion for all of 2013, which is an encouraging development but is notably well below the $8.4 billion raised in 2008. Interestingly the private equity investment pace in region is quite modest as year-to-date only 38 deals totaling $428 million have closed versus 71 deals valued at over $1.0 billion in 2013, making Mubadala’s commitment even more notable.

While stuck in a taxi with a defense industry expat I learned that Abu Dhabi has built one of the most impressive fighter jet fleets in the region. Evidently they have 76 of the most advanced F-16’s available – they used to have 80 but 4 recently crashed during training exercises, which at $90 million per plane, nearly rivals the total investment made in the region this year. Unfortunately there is not much of a return on those four investments.


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Barbell or Lollipop?

A great barometer as to the health of the venture capital industry is the quarterly fundraising data which the National Venture Capital Association, in conjunction with Thomson Reuters, released recently. The 3Q14 data suggest that the annualized fundraising pace should come in around $32 billion for the year; this past quarter 60 funds were raised totaling $6.1 billion. The amount raised through three quarters of 2014 ($23.8 billion) already surpasses the amount raised in all of 2013 and will edge right up to the mark set in 2006, the last year the industry raised more than $30 billion. Great sign, right? Closer scrutiny of the data raises some troublesome trends.

In aggregate the VC industry manages $193 billion per the 2014 National Venture Capital Association Yearbook across 874 firms employing 5,891 people (that seems light to me). Interestingly California-based firms manage $94 billion of that amount (or 49%) while Massachusetts firms account for $33 billion (or 17%). The top five states (CA, MA, NY, CT, IL) manage 72% of all venture capital dollars; interestingly those same five states captured 76% of venture dollars invested in 3Q14. Some other notable data points:

  • The dollars raised in 3Q14 was a 21% decrease from the amount raised in the prior quarter. The number of funds declined by a larger amount – 26%. Maybe because it was the summer months?
  • Of the 60 funds raised in 3Q14, 36 were follow-on funds and 24 were from first-time fund managers – quite an important dynamic as it suggests new managers are able to raise capital and that the VC industry can “innovate” with new talent and/or investment strategies.
  • Unfortunately those new funds tended to be quite small; the largest new fund raised was $150 million (congrats, Providence Ventures). In fact 88% of capital committed in 3Q14 went to existing managers leaving the 24 first-time funds to fight over the remaining 12%, implying the new funds were ~$30 million in size on average.
  • Overall the average fund size was $102 million, while the median was only $24.5 million – ouch.
  •  The largest fund raised this past quarter was ~$1.0 billion – J.P Morgan’s Digital Growth Fund II.
  • The top five funds raised 48% of the capital. The top ten raised $4.3 billion or 71% of the capital.
  • Only 16 of the 60 funds raised were larger than $100 million.
  • There were 32 funds raised that were less than $25 million in size, 23 of those were less than $10 million.
  • One poor soul raised a $0.01 million fund.

According to Prequin’s “Fund Manager Profiles 2014 Q1” analysis, 9% of venture firms have raised at least 6 funds, 11% have raised between 4 – 5 funds, 36% have raised between 2 – 3 funds, while 44% of the industry is still with just one fund. This underscores the ability of the industry to rejuvenate itself with many new small funds but it is also really hard to break through and create an enduring venture franchise. Many industry observers have taken to calling this a “barbell” industry structure suggesting stability on either end of the continuum but that may actually be quite elusive. Maybe it looks more like a lollipop – scratch and crawl up the stick to get to the fat and sweet part of the market?

It also continues to be notable that the VC industry is raising capital at a pace well below the amounts invested (see chart below). This fascinates me and probably is explained away by the non-VC investors who have piled into the market (hedge funds, mutual funds, really rich people). We are staring at the seventh consecutive  year that these lines have failed to converge.

Funding Gap Slide 3Q14

Ultimately the real barometer of the industry’s health is measured in returns, which are very complicated to assess. Arguably conditions have conspired to make this a tremendous time for venture capitalists. Powerful new platforms have emerged – such as Amazon Web Services – which can drive innovation in low-cost ways unlike ever before. There are numerous “on ramps” for entrepreneurs with incubators and platforms like Kickstarter. Corporates continue to pursue outsourcing and partnering strategies like never before. The rise and creativity of “super angels” and micro-VC’s contribute enormously to ecosystem. And start-up’s can now address global markets versus just smaller domestic markets.

One of the hallmarks of an inefficient marketplace arguably is a dispersion of returns. Thomson Reuters recently published an analysis which concluded that over the past 30 plus years the top quartile venture returns outperformed by 22.3% the bottom quartile. While returns data are problematic, and if one tortures the numbers long enough, you can get them to say anything, it does seem apparent that small funds struggle relative to peers. In February 2014 Thomson Reuters presented aggregated fund performance data by vintage year which looked at returns by fund size: after three years, funds between $0- $100 million generated 0.6% IRR versus funds $200- $350 million in size with 4.9% IRR; after 10 years it was 1.3% vs 5.3%, 15 years was 13.1% vs 27.4% and after 20 years, the difference was 18.9% vs 34.3% consistently in favor of the larger funds. Returns for funds over $500 million in size tended to outperform on an IRR basis in the near-term (probably due to later stage investments turning over more quickly which helps reported IRR’s, not necessarily return as a multiple of invested capital) but meaningfully underperformed over the long-term.

What does all this mean? The truism that the (historic) venture model really sings with ~$50 million per partner per fund across relatively small partnerships of 4 – 6 general partners may actually be the most productive model. Of course there are outliers on either side of that argument but it is nearly irrefutable that the VC industry structure is changing in profound and not yet fully understood ways.

So barbell or lollipop? Or maybe you have a different shape in mind?


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Shanghai Trip Report….

It only took a few days after I returned this weekend from China for my eyes to stop burning, and maybe the slight cough was really due to the changing seasons in Boston and not the air pollution in Shanghai (now I better understand the amenity in my hotel room – below). A small price to pay to witness the extraordinary commercial activity in what may well be the largest economy in the world sometime in the next decade. And what a fascinating time to be there – although maybe each time I go back I am at risk of thinking that that will be the most fascinating time to be there.

Gas Masks

Arguably the recently introduced reforms by Premier Li Keqiang have ushered in dramatic economic and political advancement. China has never appeared so confident, so assertive. Since late 2012 the systematic purging of corrupt corporate and government officials, undertaken to bolster the public’s confidence in the Communist Party, has led to some spectacular falls from grace. One hopes that increased economic freedoms might gradually lead to greater political freedoms (although as seen in Hong Kong these past few weeks, that does not yet appear to be the case – the October 10 China Daily editorial was titled “HK Protesters Have No Valid Grievances”). Ironically the intense focus on rooting out corruption may also be contributing to slowing economic growth as Premier Li is dependent on those same government bureaucrats to implement his economic agenda, – and many are undoubtedly quite distracted (worried) now.

Having grown up in Hong Kong I have been fascinated for many years with the dramatic ascendancy of China; in my lifetime nearly 25% of the world’s population will have “come of age” – perhaps capped off with the IPO of Alibaba last month, now one of the largest internet companies in the world. But this economic engine requires significant growth and worrying signs are now quite evident. While the official GDP growth rate target for 2014 is 7.5% (analysts worry that growth below 7.0% will cause reforms to stall out), the Chinese Academy of Social Sciences announced last week that it forecasts growth to be 7.3% this year. Storm clouds are building. Other data points – some of which were reported in the China Daily newspaper last week.

  • Two of the four largest commercial banks in China cut rates to spur mortgage lending. It is quite clear that China has a real estate “issue” – year-to-date through August 2014 home sales dropped 11%. And real estate is estimated to be ~25% of the Chinese economy.
  • Related news: the Central Bank of China cut reserve rates for the second time in the last 30 days to 3.4% to spur borrowing.
  • China experienced the greatest monthly steel export boom last month (up 73% year-over-year) due to soft local demand and perhaps indicating that Chinese steel is being dumped onto the global market – watch for a US protectionist backlash.
  • Car sales in China rose at the slowest monthly pace in September over the past 19 months, increasing 2.5%, down from ~20% last year.

While I was there Barclays Research issued an analysis of state-owned companies which underscored the depth of the economic exposure the Communist Party is confronting. More than 25% of state-owned companies lost money in 2013 (as compared to 10% of private companies); the return on equity was calculated to be less than 5% for state-owned enterprises (vs 14% for private). Just to complete the thought, return on assets – also 5% for state-owned as opposed to 9% for private companies. Clearly there is a significant amount of “unproductive” capital still tied up in the Chinese economy which has led to a dramatic decline in listed equities for state-owned companies in the last 30 days (often times declines of greater than 20%).

So what I find so fascinating is watching the Chinese government manage this colossus to a more private capitalist system. This will be one of the greatest transference of asset ownership from collective to private status in the history of mankind – perhaps a little grandiose but the point still stands. Just this past week alone there were a series of developments which underscore this rapid pace of change – easy to dismiss any one of them, but when viewed collectively a clear pattern emerges.

  • The 2014 Report on Foreign Investment in China, issued by the University of International Business and Economics in Beijing (20 years ago it would have been hard to imagine that such an entity would even exist) determined that there was $118 billion of foreign direct investment in 2013 in country, of which $62 billion was in the services sector (up 14% year-over-year). There is a clear rotation away from manufacturing investment by foreigners in China.
  • German Chancellor Merkel welcomed Premier Li in Berlin last week and announced 110 new cooperation and investment agreements aggregating to $18 billion in value. In the midst of all that fanfare, four leading German “economic institutes” announced that German GDP would grow 1.2% in 2015 – which is awkward when your guest is nervous about 7.3%.
  • After Germany, Premier Li spent three days in Russia signing only 40 agreements. Obviously Russia is anxiously tilting toward China as the rest of the world shuns the Kremlin – which further bolsters China’s role as a Super Power.
  • The Chinese seem to be on a US “shopping spree” – the $2 billion acquisition of the Waldorf Hotel in New York City was announced last week. The Rhodium Group estimated that another $10 billion of acquisitions would be announced shortly.

And given my professional interest in healthcare, I focused intently on developments in that sector, which were everywhere last week.

  • It was announced last week in Beijing that foreign entities can now directly invest and operate joint venture hospitals in China, while Hong Kong and Macau based investors can own and operate hospitals outright in certain selected cities. This was confirmed with great excitement by senior hospital executives I met with while in Shanghai.
  • The local healthcare issues are significant. Cities outside of Beijing in northern China reported air quality levels 20x worse than healthy levels. In Beijing on Saturday PM 2.5 pollution particles measured over 500 micrograms per cubic meter of air – that should really be closer to single digits.
  • It was World Mental Health Day (October 10) while I was there. The China Daily reported that the 6,910 mental health specialists in Beijing were overwhelmed treating the over 50,000 patients (didn’t strike me as all that bad until I read on…). The Chinese Center for Disease Control and Prevention estimated – wait for it – that there are over 100 million people in China with mental health “problems” of which 16 million were classified as with “very worrying conditions.”
  • Ebola was referenced but seemed to be characterized as an “African issue” still (although admittedly that might be unfair just reading three days’ worth of local newspapers).
  • The China Daily reported that “Sexting Still Popular Activity in US Despite Risks” – so it is not just the Chinese that are confronting these serious health risks!
  • And lastly, this same newspaper, which was only 12 pages long, dedicated one entire page to covering the NBA, undoubtedly appealing to some of those people with mental health problems.


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