Mar 25, 2015

Wednesday Mar 25, 2015 by Michael Greeley - General Partner, Foundation Medical Partners 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. Michael Greeley  is a General Partner at  Foundation Medical Partners . You can find this post, as well as additional content on his blog called  On the Flying Bridge .