Dramatic Capital Inflows Continue in 2Q17… Trouble Ahead?
In an environment of microscopic interest rates, it is particularly interesting to read the Preqin 2Q17 Quarterly Update, which exhaustively tracks all things private equity and venture capital. At the end of June 2017 there were 1,998 funds in market raising a total of $676 billion – a staggering sum – indicative of global investors desperately looking for alpha. Admittedly, SoftBank’s $100 billion Vision Fund skews the data somewhat but at the beginning of 2017, there were 1,834 managers raising $525 billion, which were already all-time highs.
In 2Q17 private equity funds raised nearly $121 billion across 206 funds; buyout funds accounted for $88 billion of the totals, which coincidentally was approximately how much was invested ($83 billion) in 1,001 buyout deals. This investment pace comfortably returns the private equity industry to levels not seen since the Great Recession nearly eight years ago.
Amidst all the distractions swirling around the Russia Probe and “Repeal and Replace,” the venture capital industry also reported startlingly strong results for 2Q17. According to the National Venture Capital Association (in partnership with PitchBook, see chart below), nearly $21.8 billion was invested in 1,958 companies across all sectors. When the first half of the year is annualized, the industry is on pace to invest over $75 billion in 7,750 companies and would mark the third year comfortably above $70 billion invested. Venture funds raised $11.4 billion in 2Q17 and may well be on pace to exceed 2016’s ten-year high of $41 billion raised. Indicative of the robust level of activity, round sizes and valuations remain somewhat elevated, while the “time to exit” also remain extended with average holding periods of just under six years for venture-backed companies.
Much of this activity reflects the “unicorn” phenomenon, which investors are anxiously watching play out. At the end of 2Q17, according to the Wall Street Journal’s “Billion Dollar Startup Club,” there were 167 unicorns. While 41 unicorns raised capital in 2Q17, only five could go public. As these companies chose to stay private longer, meaningfully larger round sizes are required, which likely accounted for the nearly doubling of financings greater than $200 million in size as compared to 2016 levels. In many unfortunate cases, unicorns may not be choosing to stay private but rather are recognizing that IPO valuations are likely to be quite a bit below the last private round’s valuation. The very public failures of companies like Theranos and Jawbone, coupled with the disappointing IPO performance of Blue Apron and Snap, have reminded investors that the exit environment is as important as the early-stage financing environment.
And it may be issues around liquidity that rattled investor confidence among Silicon Valley VCs. The “Silicon Valley Venture Capitalist Confidence Index” (such an index actually exists – it’s a 5-point scale) dropped to 3.52 from 3.83 quarter-over-quarter, underscoring anxieties about lofty late-stage valuations, a disappointing exit market, and political uncertainty.
Not to be lost “below the fold,” so to speak, was the news reported by CB Insights and PricewaterhouseCoopers that in 2Q17 for the first time ever private Asian technology companies raised about the same amount as their U.S. brethren. To highlight how significant this convergence is, the U.S. venture market was over twice the size of Asia’s in 2016.
More specifically, the healthcare technology sector continued its run of impressive strength in 2Q17, in part as a reflection of the category’s maturity and that very substantial business needs exist across the entirety of the healthcare industry. Per Rock Health, $3.5 billion was invested in 188 companies year-to-date which rivals the annual totals of more than $4 billion in each of 2014, 2015 and 2016. The average size of financing was $18.7 million which is significantly greater than any prior period when round sizes never exceeded $15 million. Notably there have been seven companies that have raised more than $100 million in a 2017 financing, another high-water mark and indicative that many healthcare technology companies are scaling rapidly.
Additional evidence of strength in the U.S. healthcare sector was a recent report from Silicon Valley Bank which highlighted that venture investors had raised approximately $5 billion year-to-date, which is on pace to be one of the most robust VC fundraising years ever.
The political landscape remains uncertain at best. The potential cuts to both Medicaid and federal insurance cost subsidies could be profound with uncertain implications on IT budgets. Fortunately, the dysfunction all of us are watching painfully play out in DC has had so far a surprisingly muted impact on the healthcare technology sector. Analysts are encouraged by the new FDA Commissioner Gottlieb’s positions on regulatory front, and in particular, the early drafts of the “Digital Health Innovation Plan” appear strongly to endorse the continued movement to value-based models. Our core investment themes remain very much intact and perhaps are even more compelling in this environment.
But in light of the emerging political imperatives, there has been some rotation of the sub-categories within the healthcare technology sector. In recent years, the consumer health information, telemedicine, and population health categories have given way to greater investor interest in consumer engagement, digital therapies, and analytics. There does seem to be evidence that the “quantified self” phenomenon now is either fully penetrated and/or consumers have lost some interest as the wearables category has attracted significantly less capital in 2017.
One other indicator of sector strength is the geographic breadth of healthcare technology innovation. Important and relevant companies are being built in many cities which historically have not attracted significant venture capital. Rock Health (see map below) estimates that year-to-date, 25 states have seen healthcare technology companies raise capital. Notwithstanding this breadth, certain states such as California, Massachusetts, and New York continue to be particularly important hubs of innovation.
Essential to a compelling investment strategy is a robust exit environment. Limited liquidity options have been a concern across all sectors for venture capitalists the last few years. PitchBook recorded 348 exits of venture-backed companies year-to-date 2017, 58 of which Rock Health noted were healthcare technology companies (which disappointingly was behind the 87 exits in 1H16). One of the hallmarks of the healthcare technology sector is both the breadth and depth of the universe of acquirers from large established enterprise technology vendors, insurance companies, and traditional business service providers to increasingly other strategic pharma and medical device companies.
Public markets have offered mixed signals as well. Notwithstanding that there have not been any healthcare technology IPOs this year, the Leerink healthcare technology/services public stock index has increased nearly 26 percent this year and went up nearly 12 percent in 2Q17 alone. The average 2017 revenue and EBITDA trading multiple for this index at the end of 2Q17 was 4.3x and 14.7x, respectively. The Leerink data demonstrated that this past quarter the payer sector traded much more favorably than the provider section – 20 percent versus 3 percent, respectively.
[This post first appeared on Michael Greeley’s blog—Eds.]