Capital Rotation…

In a period of negligible interest rates, which was just reaffirmed for at least another month or two, investors are desperately looking for returns and many continue to find it in healthcare. According to the National Venture Capital Association, VC’s invested $17.5 billion in 2Q15 across all sectors; this was a quarterly high-water mark going all the way back to 4Q00 (almost 15 years ago). Of course, much of this was invested in late-stage break-out companies (Uber, Zenefits, etc), which arguably skews some of the data, but directionally it is quite clear that large institutional investors have piled into VC quite late in the cycle – never a good thing. Some troubling undercurrents are starting to emerge when one looks closer at the data.

Over $3.2 billion or nearly 20% of the dollars invested this past quarter was in healthcare, which is clearly understated as it does not

the surge in healthcare technology investment (software businesses). According to StartUp Health, there was another $1.7 billion invested in “digital health” companies in 2Q15. Approximately $2.3 billion was invested in 126 biotech companies which is meaningfully more than the $1.7 billion invested in 1Q15. In fact, three of the top ten VC financings this past quarter were for biotech companies which raised an aggregate of $620 million. The medtech and healthcare services sectors, on the other hand, continue to play relatively small roles in the overall healthcare investment activity.

Why is this? Broadly speaking there are three factors to account for this rotation: (i) the re-invention of the “business of healthcare” is well underway which requires a whole set of innovative new software solutions as we go from a transaction-based system to one predicated on outcomes; (ii) the hyper-valued flurry of successful biotech IPO’s in 2014 through the first part of 2015 attracted significant public investor attention and capital given the promising advances in gene therapy and immune-oncology treatments; and (iii) all of this is juxtaposed to the still hostile regulatory, reimbursement and development timeline dynamics in the medtech sector. It is expected that another one billion people will join us in the next ten years contributing to a doubling of global healthcare spending so the long-term continues to be promising.

Because of the significant public market volatility this summer (which was unlike anything we have seen since 2008) due to China’s acknowledgment of slower growth and an expected period of interest rate normalization, it does appear that the euphoria in biotech in the first half of the year drew in many investors who now must feel somewhat scorned given…

  • The NASDAQ biotech index, which had been up 580% from March 2009 to July 2015, is now off nearly 20% from its summer high, having surrendered over $150 billion of market capitalization
  • Hilary Clinton tweeted how “outrageous” price gouging is for therapeutics (which knocked another 5% off the NASDAQ biotech index earlier this week)
  • 90% of biotech stocks in the Russell 3000 traded down in August 2015
  • In more than half of all biotech mergers this year, the stock of the acquirer dropped
  • According to Silicon Valley Bank, 40% of all biotech IPO’s in 2014 were for companies that had yet to complete Phase I studies (that is public VC, my friends)
  • There were 84 biotech IPO’s in 2014, but the pace has slowed materially with only 37 year-to-date (there were only 11 in 2011)

An important catalyst to this activity has been the role of healthcare crossover funds which were often significant large investors in the final private mezzanine rounds for many of these now public companies. Notably of the 26 venture-backed IPO’s in 2Q15, 20 of them were healthcare companies, many of them featuring large crossover funds on their cap tables. The question this raises is how these investors will behave when the IPO and M&A markets for venture-backed companies slow, which it inevitably will.

How is this playing out in Europe? This past quarter 52 healthcare companies raised nearly $510 million in venture capital, which is down over 13% from the year-ago second quarter. Through the first half of 2015, healthcare investment activity is down nearly 15% from 1H14 according to Dow Jones VentureSource data. The European market has always been smaller than the U.S. – in healthcare, about one-sixth the size – but appear to have pulled back sooner in Europe than in the U.S.

There were some extraordinary milestones achieved in the healthcare technology sector in the first half of 2015, perhaps none more notable than the tremendous FitBit IPO and the $500 million private financing for Zenefits. StartUp Health estimates that globally there are over 7,600 “digital health” companies which underscores both the global nature of these healthcare issues and the enormity of the opportunity (and unfortunately that barriers-to-entry have all but collapsed leading to too many companies). According to StartUp Health, 551 companies raised $6.9 billion in 2014 which would suggest that the 2015 pace is tracking behind that of 2014.

There were two other “funding” announcements this summer which nicely puts the venture capital data in perspective.

  • The House of Representatives voted 344-77 in favor of additional federal funding over the next five years for medical research at the National Institutes of Health by $8.75 billion which is approximately five quarters of venture funding. This bill also attempts to accelerate the approval of new therapeutics and devices by the FDA.
  • The other number which surprisingly did not get as much attention was the $6.5 billion paid by biotechs and device companies in 2014 to providers for consulting, research and promotional speeches. The Sunshine Act, which was part of the 2010 Affordable Care Act, required the disclosure of these payments. Of this total, $404 million was for “food, beverage, travel and lodging” or just under how much VC’s invested in medtech companies in 1Q15. They gotta eat (and drink and party)…