Healthcare Transformation is a Marathon

The number of companies currently being founded and funded to drive the transformation of the healthcare system is staggering.  While I am known for occasional (or maybe even frequent) hyperbole, this is not a hyperbolic statement.  This comes as a surprise to no one as there is a convergence of regulatory, financial, political, and demographic factors driving this incredible rate of change and resulting innovation.  We are, after all, talking about an industry that makes up roughly 18% of GDP. The statistics are all out in the public domain and I’m not going to re-quote them here.  I will say that we measure the frenzy of activity in the HCIT/Services space by the fact that our firm regretfully declines far more searches than we have the capacity to take on.  If that is happening with our little 3.5 year-old “engine that could,” we also assume that is happening with other firms recruiting for healthcare companies backed by venture and private equity firms.  This comes as a result of lots of executive teams being required by lots of companies being backed by lots of investors. So for this edition of FWIW, I wanted to dive into two interesting trends we’re seeing with regard to investments being made in healthcare IT and service companies.  The first is the entrance of non-traditional healthcare investors and their impact on valuations across the sector. The other is the upstream movement of private equity investors toward investing in de-novo, built for purpose businesses leveraging complex business models and experienced management teams. While both of these trends are welcomed by all of us working in the space today, I thought I’d try to shed some light on why this is happening now and some of the implications that we’ve seen across a portfolio of 100+ clients and investments.

Venture capital investing in healthcare IT and services has always been an interesting space, or maybe it is better described as interesting in how it has historically not been a very interesting space.  Returns have been hard to achieve, timelines have been longer than acceptable for most VCs and the funds that have succeeded in healthcare IT investing have been a hearty few, often times with a strategic angle.  Traditional VC firms like Venrock and Bessemer have achieved VC-acceptable returns and strategic funds like HLM, Health Enterprise Partners, Sandbox, and Ascension Health Ventures have all done well. However, there are many who have quietly dissolved, unable to raise a new fund or justify mediocre returns.

Three years ago, when we formed Oxeon, we had very little reason to interact with Khosla, Greylock, Sequoia, Andreessen Horowitz and other tech-VC darlings. Today, we work with all of them in bringing talent to their healthcare portfolio companies.  They are making large and aggressive commitments to companies operating in the healthcare space, and see great promise for VC-type returns from the category. This trend is clearly reflected in the oft-published stats about the growth of VC investing in healthcare IT.

While it is great to collaborate with such accomplished investors from Boston and Menlo Park, there is a potential dark-side to this trend.  There are many reasons why VC-like returns have been hard to achieve in HCIT, most of which are not celebrated on Sand Hill Road, Winter Street, or in Cambridge.   To begin with, healthcare entrepreneurs can’t turn to generations of very wealthy and successful Facebook, Google, eBay, Apple, or Yahoo alums to serve as super angels and mentors. These seasoned execs often provide companies with credibility, lessons learned and early-stage “smart-capital,” thereby increasing the likelihood of success.   Also, it is really f’ing hard to sell software and services to hospitals, insurance companies, and large self-insured employers - unless you are EPIC, that is.  For early stage companies, sales cycles are often 18 months for relatively small enterprise software contracts and “pilots” are a frustrating norm. Without super-angels and faced with risk-averse Series A healthcare VCs, healthcare entrepreneurs have historically been left appealing to the mission/societal values of tech entrepreneurs or struggling to raise money from those risk-averse healthcare VCs who are looking for $5M run-rates.

So enter the tech-VCs interested in participating in the opportunities inherent in redefining 18% of GDP.  These investors have a lot of money to put to work and what results is a “froth” in the market, with valuations growing at a frightening rate; Castlight is everyone’s comparable. What we end up with are fancy new consumer insurance companies with values more typically held by hot software companies or high growth consumer tech businesses.

I was catching up with Marty Felsenthal who is a General Partner at HLM Ventures, a very well-known and well-regarded healthcare venture fund with a number of Strategic Limited Partners.  Like myself, Marty is getting long in the tooth having been around for a while and is notably showing gray hair.  He remembers the 90s and not just for The Macarena, Backstreet Boys and Wham but for a lot of money. In particular, new money chasing physician services and eHealth companies in two separate waves. Tech, med-device and bio-tech investors poured money into health care services and health care software, and he's of the opinion that, in general, they over-funded the sector, they funded many weak companies and then they bailed out of the sector - twice.  He’s quick to note that he can point to a number of successful investments that were made, but these new Kool-Aid drinking entrants often didn't provide value-add beyond their money and often provided advice that, in his opinion, was often not responsible or in the best interests of the Kool-Aid drinking entrepreneurs they were supposed to be helping.   Incredibly, of the 13 most recent HLM investments, 10 are already working with one of HLM's strategic limited partners and/or generating revenue from another relationship that HLM has helped facilitate. In "Trevor-speak" that means they are shortening the sales cycle and delivering the “mentorship/credibility” as referenced as being missing earlier in this article.  Proving he's not quite as unhip as he seems, he said the carnage that followed -- for many of the entrepreneurs and investors -- made the Game of Thrones seem like a children's show.  He thinks these new HCIT investors demonstrated a tendency to over-fund these businesses before the entrepreneurs knew what business they were actually in.  Marty believes that many successful businesses, healthcare or otherwise, morph between conception and scale – specifically pointing out the highly impressive (and capital efficient) work that Jonathan Bush accomplished from where Athena started to where they are today. He thinks many of these companies raised too much money before knowing how big the market they were attacking really was, before they knew if there was actually a profitable business model or before they knew if they could execute against the early-identified market.  Not only did this prove to be a bad ending for many of the investors, it was also disappointing for many of the hard-working entrepreneurs who were significantly or completely diluted by the capital.  He closed by saying he's trading in his Prius (poor man's Tesla) for a DeLorean.

So we are seeing some of this with healthcare and non-healthcare VCs fighting for deals and the resulting valuations leaving everyone scratching their heads. The bigger question is, will start-up companies lose the grit they required to accomplish enough on their meager angel funding to fight through 18 month sales cycles in order to raise venture money at the traditional levels? Further, will this “froth” in the market be justified through long sales cycles and will these high early-round valuations ultimately be a disincentive to great executives who understand that the likelihood of achieving the lofty prices is low and the probability that their equity is worth substantially more than the strike price on first day of employment is even lower.  Additionally, can the market generate VC-typical multiples and returns or will we have a bunch of tech venture investors using their own tele-depression/therapy platforms to cure themselves?  Population Health isn’t WhatsApp and SnapChat, you know what I mean?

I am personally concerned about the prospect of these HCIT companies struggling to scale at the same pace as the darlings of Sand Hill Road and the pressure it puts on the revenue organizations to justify the high prices, as I see the single hardest thing about scaling a HCIT company is bringing in great talent and fighting through sales cycles. If the valuations are crazy and ultimately serve as a disincentive for great executives and the sales cycles continue to be 18-24 months, what happens when the companies go to raise their Series B or Series C rounds? I wonder whether there will emerge a great market for “secondary VCs,” buying healthcare portfolios from tech investors, recapitalizing and executing on great ideas but with a different approach.

On the private equity side, another really interesting trend has emerged.  In many ways, as these things are often attributed, this trend might be seen to have started with Michael Cline and Accretive LLC.  A renowned private equity investor and entrepreneur, Michael and his team wrote and funded the original business plan that emerged as Accretive Health. As we know, Accretive Health had an unbelievable run from de-novo company to Initial Public Offering.  The industry watched the company grow at an astounding pace, with private-equity grade investment dollars used to attract and compensate a seasoned and accomplished leadership team who executed scale at a staggering rate. Accretive LLC went on to do the same with Accolade, Acumen and others; all companies with large, complex revenue models, risk-sharing economics, and professional-grade leadership teams.  Since that time, we’ve seen and/or had the pleasure to work with TPG in funding a relatively young Evolent Health, General Atlantic funding an effective de-novo in Alignment Health, Oak HC/FT fund XG and Candescent, and Welsh Carson support a fledgling business in naviHealth, just to name a few.

These are not businesses doing hundreds of millions of dollars in revenue, with predictable EBITDA - normally the sandbox of this class of private equity investor.

So what can we learn from these examples?  There are some consistent themes that are worth pointing out.

First off, these are all very complex, technology-enabled service businesses that operate in complex and mature environments.  Sharing risk on revenue cycle management, standing up health plans on behalf of hospitals, delivering care to the sickest of the sick in their homes, or taking risk on post-acute bundles are not simple “SaaS” business models. This is far different than wellness apps or cloud-based customer relationship management software. These companies are often signing multi-year, 8-figure revenue deals requiring a certain level of maturity and sophistication on the part of the leadership team. While many tech start-ups are launched by Zuckerberg-types in hoodies, the average age of a healthcare CEO for companies that last 5 years in business, is just over 40 years old.   When a CEO or CFO of a hospital system or large insurance company is going to contemplate a 5 to 7 year/$10M to $100M commitment with a new company, the CEO and leadership team must have a track record of success and a level of professional maturity that is more in line with the world these health system and payer executives live in.

Robb Vorhoff at General Atlantic is a spring chicken compared with Marty and I but he is wise beyond his years.  His venerable firm is also participating in this trend of healthcare private equity moving earlier stage into arguably riskier ventures.  In a recent conversation, Robb said “Taking earlier stage risk requires greater conviction in both the investment thesis and the quality of the team.  Alignment Healthcare represented an attractive opportunity to back a proven management team with a thesis that directly aligned with two of our top investment themes, and while the earlier stage represented greater risk, we had great confidence in the senior team’s ability to build a very special company.”

By taking capital risk off the table through large tranches of funding, private equity firms are creating welcoming environments for executives who have demonstrated the ability to operate at scale. The challenge is to find those same executives who do well at the earliest stages of a business. Take the case of an Oxeon portfolio client, a de-novo funded by a major private equity fund looking for a CEO. We identified an accomplished senior executive who had delivered great results within the health plan environment. It was his creativity, energy, passion, flexibility, and the willingness to do what was necessary that proved he would be an effective Founding CEO. Through the challenges of getting an anchor client secured, the executive repeatedly demonstrated these characteristics and proved resilient, successfully landing a massive multi-year anchor client that will launch the business on a largely unparalleled growth trajectory.  Now that the company will go from no employees, customers or revenue to hundreds of employees and hundreds of millions of dollars of revenue in almost no time, the executive team is ready to operate at this over-night scale because they have done so before.  Thus the model works by finding uniquely qualified “big-company” executives who lead from the front and can shift seamlessly from entrepreneurship to operating at scale.

The alignment of the equity models is also interesting. The incentives are structured in such a way that while the executives know they have the necessary capital to build a company, there is financial incentive to use only what is necessary ahead of a large anchor contract going live. If successful, they can end up with a handful of very large multi-year anchor contracts without the need to draw on capital.  When that happens, the executive team has an opportunity to build a big company and still own a great deal of equity, as happened with Accretive Health at the time of their IPO.

So what we are really seeing are private equity investors and non-healthcare VCs fighting for early stage companies that traditional healthcare venture capitalists have not aggressively pursued, at least historically. It is easy to think that the entrepreneur is the winner: they will get the sophistication of the private equity backers, the expertise and cache of traditional VCs, and more experienced healthcare investors will be forced to entertain deals that they have traditionally shied away from.  Even better, for the entrepreneur, all of these deals are being done at higher valuations and with more invested capital.

But with entrepreneurship at absurd levels and valuations at even more absurd levels, what eats at me is that transforming our healthcare system is a marathon, not a sprint - maybe more appropriately referred to as an Ultra Marathon. My enthusiasm in the near term is with these trends resulting in more companies being funded by great investors, creating well-capitalized homes for great executives.  At the same time, I’m concerned that we’re running a sub 7-minute mile in the 8^th mile of a 100-mile ultra marathon.  If these two great classes of investors don’t see returns that justify their participation and pull their money out of healthcare IT and services, we will be left with a ton of innovation and none of the capital necessary to transform our broken healthcare system.