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Healthcare venture investing: How to succeed in a white-hot market

Healthcare venture investing: How to succeed in a white-hot market


While the world suffered through the COVID-19 pandemic, the U.S. healthcare venture market exploded in 2020 and the first half of 2021.

A growing number of healthcare corporate venture investors expanded their activities apace to realize financial opportunities, support their corporate strategies and spur innovation throughout their organizations.


As a follow-up to our previous surveys of venture investors in health systems and other healthcare companies, we conducted a third survey this year to understand the forces driving today’s rapidly expanding market for healthcare venture investments and its impact on corporate investing strategies. Key findings of our research are described here. (For lists of survey respondents and health system and other strategic venture investors, see appendixes A, B, and C in the PDF for this article.)


TREND DETAILS AND DRIVERS

From 2019 to 2020, according to Silicon Valley Bank, U.S. healthcare venture capital fundraising for healthcare companies grew 57% to almost $7 billion, U.S. venture investments grew 55% to $44 billion, and global exit values, including both IPOs and private M&A transactions, grew 54% to over $140 billion. Both the number and size of funds grew substantially, fueled by the success of healthcare ventures in the public market. According to Silicon Valley Bank, post-IPO performance of new healthcare companies in 2020 was +104% for 2018 ventures, +98% for 2019 ventures and +85% for ventures launched in 2020.


At the top end, large private capital funds, hedge funds and leveraged buyout (LBO) companies are aggressively penetrating healthcare venture financing, especially in C and later financing rounds. A prime example is Tiger Global, a New York-based private-capital powerhouse, which raised $3.75B for its 12th venture fund in 2020 and $6.65B for its 13th fund in the first quarter of 2021. Tiger Global has grown into a major player in healthcare and life sciences investing. After participating in only five healthcare deals in 2019, the company participated in eight deals worth a little more than $1 billion in 2020 and was lead investor in three high-profile financings (Oscar Health, Olive and Spring Health). In the first seven months of 2021, Tiger Global participated in 22 healthcare deals worth almost $3 billion and was lead investor in 13 of them. Sixteen of these were C or later rounds, with an average financing value of $175 million.


The emergence of large players like Tiger Global, Andreessen Horowitz, Clayton, Dubilier & Rice and Sequoia Capital in healthcare has created more exit channels for founders and early-stage investors. IPOs continue to be an important exit route across all segments, but increased availability of private capital has made private M&A deals more competitive with IPOs. Traditional strategic acquirers like pharma companies, which generally avoided competing with IPOs, are being forced to acquire biopharma ventures earlier at higher valuations in private deals in order to preempt these financial investors. In addition to IPOs and private capital transactions, special purpose acquisition companies (SPACs) are emerging as another important exit path for healthcare ventures. Although SPACS can be risky, they accounted for almost half the digital health IPOs in the first half of 2021, and Rock Health expects them to make up most if not all the digital health IPOs for the remainder of the year.


INCREASED FOCUS ON DIGITAL HEALTH

These trends are increasing valuations of healthcare ventures significantly, as was especially evident in digital health in the first half of 2021. Digital health is not the largest healthcare segment — biopharma is substantially larger. But digital health quickly became the fastest-growing segment, growing 90% from 2019 to 2020 to $14.68 billion, and then adding another $14.78 billion in just the first half of 2021, according to Rock Health.


The pandemic was a major catalyst for this growth. As one survey respondent said, the pandemic advanced the telehealth market by a decade by fostering patient acceptance and convincing clinicians that virtual care can be effective. In addition to stimulating the development of new digital technologies, the pandemic:

  • Accelerated the shift of care into the home, enabled by advancements in virtual care and remote monitoring

  • Increased adoption of tech-enabled solutions, like the vaunted “digital front door”

  • Increased collaboration between operations and investment professionals in health systems

  • Prompted many health systems to expand their value-based “risk” contracting, which proved less risky than their fee-for-service business during the pandemic

Driven by these disruptive trends, capital for digital health ventures is flooding down from later to earlier stages of investment and increasing valuations across the board. The exhibit below, from Rock Health, shows this trend clearly.



Digital health investments in series D and later rounds have soared, but the average size of A, B, and C rounds has also increased, with A series financings having increased more than 40% in the first half of 2021. These valuation trends suggest we may be approaching a situation similar to the late “dotcom” era. One experienced investor believes that high valuations are allowing ventures with subpar performance to last longer than they should, and that some portfolios are getting “long in the tooth” and unlikely to yield good returns. Another investor mentioned “zombie portfolios” full of “walking dead” companies.


Not everyone agrees, however. Two investors – one strategic and one financial – think higher prices in A and B rounds are justified because digital health companies are more mature, with more serial entrepreneurs than in the past. And Nickolas Mark, managing director and partner of Intermountain Ventures in Salt Lake City, said, “More dollars flowing into digital health equates to more innovation, which is good for each of us individually, as well as the communities we serve.”


NEED FOR NEW STRATEGIES

Increases in valuations are forcing investors to adopt new strategies, and respondents identified several changes they were making to adapt. Pete Tedesco, a managing partner at Health Enterprise Partners in New York, said his firm was doubling down on areas where they have intense convictions: “When you know you’re going to have to pay a market-clearing price, you need to stick to your strategy and add value.” Another investor said that high valuations had pushed his fund into earlier-stage investments to avoid over-paying.


Increased competition is also affecting investor strategies. More firms are establishing healthcare platforms and hiring experienced investors to build healthcare portfolios. Many firms – even early-stage angel investors – are specializing in certain healthcare segments (e.g., digital health). Other investors are merging to create larger firms that can compete with private capital and LBO players for later round financings (e.g., the merger of Cambia and Mosaic to form Echo Health Ventures). And underlying all these strategic moves is the imperative for diversification, which drives collaboration among venture investors. There is probably no industry where “coopetition” is more pervasive today than healthcare venture investing. As prices and competition heat up, risks grow.


Although in our 2018 report we heralded the opportunities of venture investing by health systems, we are now raising the yellow caution flag. In addition to the specter of the Federal Reserve tightening the money supply to stave off inflation, there is too much capital chasing too few smart deals, according to Scott Powder, president of Advocate Aurora Enterprises in northern Illinois. “Unless you have already built a strong venture infrastructure, the risk of direct investment may be too great,” Powder said.


KEY SURVEY FINDINGS: RISING NUMBERS AND SHIFTING PRIORITIES

The number of health systems with venture investing programs grew from 69 in our 2018 survey to more than100 in this year’s survey, and we identified more than 40 other healthcare corporations with active healthcare corporate venture investing programs, as shown in Appendix A, below. About half these investors have defined investment funds; the remainder invest off their balance sheets. In addition to the growing number of strategic players and growing size of funds, respondents noted they are making more investments, with a larger average size of deals, and have had more exits in 2020 and 2021.


Reflecting this growth, one experienced investor reported their fund governing boards shifted from quarterly calls to calls every six weeks to keep pace with the increased deal flow. Several strategic investors also noted that growth of the healthcare venture market has made ventures more central to their corporate strategies. New companies and partnerships are becoming meaningful businesses for health systems, and for this reason they are commanding more C-suite attention than in the past. As one experienced venture manager put it, “Our company is increasingly aware, asking more questions, and taking them more seriously.” In our sample, we identified five distinct types of strategic venture investors, as detailed in the sidebar that immediately follows this article.


KEY SUCCESS FACTORS IN 2021

Given the white-hot market for healthcare ventures, key behavioral success factors have inevitably changed from three years ago. Our findings pointed to four critical success factors that should guide strategic investors today.


1 Be clear about strategic goals. The starting point for any investment strategy is deciding what you want to accomplish. Strategic goals articulated in our interviews included the following:

  • Learning about new technologies to provide a window on trends. Scott Powder of Advocate Aurora Enterprises emphasized investing in strategically aligned venture capital funds rather than direct company investments because, in his view, “You don’t have to invest capital directly in early-stage companies to get this knowledge.” But as long as you keep investments small, this may be a reasonable approach.

  • Experimenting with others’ solutions and scaling those that work in your organization. Roberta Schwartz, chief innovation officer of Houston Methodist, experiments with new technologies and scales them across the organization with minimal investment.

  • Disrupting / shaking up your existing business model? Aaron Martin, managing general partner of Providence Ventures (PV), described disruption as a major strategic goal of his company.

  • Starting a new business line. Advocate Aurora Enterprises is an example of a company that has pursued this strategy.

  • Promoting diversity, health equity & inclusion. This strategy reflects an explicit investment goal of CommonSpirit Health. Given the steep prices of ventures in today’s market, and the opportunity cost of investment professionals’ time, being clear about your strategic goals is a critical success factor, as Pete Tedesco of Health Enterprise Partners observed.

2 Design and implement an investing strategy to meet goals. When designing such a strategy, organizations should address the following key questions:

  • What is our preferred scale for venture investing? Standing up a $100 million venture fund in a highly competitive market requires a significant investment in expensive talent and other resources to support the strategy. And planning for additional capital calls will be needed; several respondents stressed the need to stick with ventures over the long run.

  • What stage of development do we want to emphasize? The range of options includes startups, early-stage companies, A rounds, B rounds and C+ rounds. In our study, we found that strategic investors were more inclined than financial investors to invest at earlier stages. (Not-for-profit health systems’ ability to participate in more expensive later rounds may be limited by access to capital.)

  • How do we choose content areas to pursue? Almost all investors interviewed emphasized the importance of limiting the areas for investing, but different funds do this in different ways. KP Ventures starts every year with a set of themes that is informed by clinical operations, according to Sam Brasch, senior managing director, and every two years they conduct a more formal proactive needs assessment. PV writes a set of area-specific white papers that stack rank investment priorities. (Last year, PV produced 14 white papers. We discussed PV’s approach to prioritizing investments in our 2018 paper.)

Intermountain Ventures (IV) has a straightforward approach for setting investment priorities – a three-step inside-out process, according to Nickolas Mark, IV’s managing director and partner:

  • The IV team engages across Intermountain Healthcare to better understand collective goals and pain points.

  • The team pairs this analysis with research around trends and emerging technologies.

  • The team synthesizes the findings into “zones of opportunity,” such as digital therapeutics or virtualizing clinical trials, which are then updated periodically.

Cedars-Sinai has developed a methodology for identifying content areas similar to PV’s approach, as discussed in our 2018 paper. According to Darren Dworkin, managing director of CS Ventures, the venture team starts the year by asking, “What problems do we need to solve?” They then analyze their own operations, and if they’re already solving the problem internally, they pass. Next, they analyze the venture world, and if someone else is solving the problem, they pass. Finally, they assess whether the venture they’re considering investing in is a game changer, or whether it’s just bells and whistles. If it’s bells and whistles, they pass.


Given these different investment strategies and the frothy market, it is not surprising that survey respondents identified a variety of content areas where they are focusing current investments. The following exhibit highlights some of these areas.


Although many of these content areas overlap, some are distinct, and perhaps unexpected. COVID-19, for example, disrupted traditional clinical trials, creating a market for decentralized trials that several new ventures are now targeting.


Regardless of content area, investment decisions in this competitive market must be underpinned with sound due diligence. Managers should be aware of where their ventures stack up in the market. As one investor said, “If the venture isn’t going to get a bronze medal at least, we’re not interested.”



3 Syndicate and collaborate. Co-investing with other financial and strategic investors has always been popular, but syndication has become even more pervasive as the market has heated up. One financial investor said that in the past, 30% to 40% of their deals were syndicated, but in the past two years, the percentage has risen to over 50%. One rationale for syndication is simple diversification: Investing $1 million in 10 deals is less risky that investing $10 million one deal. Another rationale is to leverage complementary skill sets. Strategic investors partner with financial investors for their market understanding and financial skills. Financial investors partner with strategic investors as lead users who can validate value propositions, conduct pilots and scale ventures.


Solution-finders are particularly active participants in syndications and partnerships with other investors. For a strategic investor, syndication provides assurance that they aren’t “just eating our own cooking.” (See the sidebar below for details on these different investor types.)


In the past, health systems were rarely lead investors, unless they were commercializing their own inventions. This may be changing, however. Martin of PV said the company is starting to lead more syndication, and it recently spun off Dexcare on its own, partnering with a financial lead.


4 Differentiate and integrate investing activities and operations. Venture investing and operating a healthcare enterprise are distinct businesses. Venture investing is externally focused, while managing operations is internally focused. The businesses typically operate on different timeframes. There are also potential conflicts of interest, as when operating managers pressure venture investors to invest in pet projects that are unlikely to be accretive or when venture investors pressure operating managers to implement ventures that don’t fit their needs. One financial investor observed that strategic investors can unduly constrain ventures by imposing unrealistic requirements and stretching out timelines.


Achieving symbiosis between these two businesses requires carefully designed structures and processes that differentiate them but also integrate them at just the right points. Differentiation is typically achieved by creating separate venture organizations (e.g., KP Ventures), recruiting investment professionals to staff them, defining fixed capital commitments (venture funds), setting investment goals, and developing agreed-on funding rules.


At the same time, symbiosis requires integration between investing and operations. Venture managers must develop a deep understanding of operational needs, and operating managers need to learn what venture funds are investing in and how they can help make them successful. From a timing standpoint, venture managers need to decide where they should be ahead of their systems, and where they should be in lockstep.

Effective integration is achieved through management structures and processes like the following:

  • Investment committees comprised of senior operating managers

  • “Boards” of funded businesses that integrate venture professionals and operating managers and provide sponsorship and “air cover” for the ventures

  • Disciplined venture development processes with rapid development timelines and performance goals

  • Regular reviews of venture performance, including reviewing progress in scaling ventures inside the company

KP Ventures, for example, has an oversight committee that includes KP’s executive vice president of health plan operations, its chief information and technology officer, and its national vice president for business development and innovation.

Cedars-Sinai has a similar structure called the “Selection Committee” that whittles down a list of 50 to 60 venture candidates to 10 potential investments. These are the types of structures needed to integrate investing and operating activities effectively.


BE OPTIMISTIC, BUT BE CAREFUL

Opportunities for venture investing are still significant, and healthcare companies with established venture operations and a track record of success should continue to do well. Companies considering getting into the game, however, should exercise caution. In addition to normal business risks, many ventures today are being propped up by low-cost capital that obscures problematic fundamentals. Although profitable exits have grown, they still lag invested capital. Healthcare companies whose leaders feel they want to get started in venture investing should consider lower-risk strategies than capitalizing $100 million venture funds, such as making smaller investments with syndicates of other investors.


In a crowded market, it is also important to stay focused. Most venture funds employ a handful of investment professionals (perhaps three to 10) to manage a portfolio of 10 to 25 investments. It is easy to underestimate the amount of effort required to evaluate, invest in and manage new ventures to successful exits. And experienced investment talent isn’t cheap: Corporate venture organizations must structure their compensation to compete with independent venture firms.


Finally, health systems and insurers should also take a lesson from Houston Methodist’s innovative user strategy, described in the sidebar below. Over the past few years, the market has spawned thousands of healthcare ventures, and many have the potential to create value for patients and/or providers if implemented effectively. In today’s environment, implementation is often the critical success factor. A proactive strategy that searches for and experiments with new ventures that are already in the market may pay off better with less risk than launching a dozen more.


Healthcare venture
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David G. Anderson, PhD

Senior Advisor

Boston and San Francisco 925-352-9462 dave.anderson@bdcadvisors.com


Dudley E. Morris

Senior Advisor

San Francisco and Los Angeles 312-286-4865 dudley.morris@bdcadvisors.com

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