Funding for healthcare startups is a much scarcer commodity than it was during the pandemic, a fact that — along with a recent increase in mega-deals — could signal rampant consolidation on the horizon, investors said this week during the HLTH conference.
Mega-deals, or rounds worth $100 million or more, made up more than a third of all funding in the first half of the year, according to Rock Health. In addition, a number of big-ticket mergers and acquisitions, including CVS-Oak Street, Optum-Amedisys and HealthComp-Virgin Pulse suggest an appetite for strategic tie-ups.
Acquirers could take advantage of the tighter market to snap up companies they think will improve their value proposition, according to investors.
“We had this big storm. It’s sort of passed,” said Ryan Stewart, a partner at MTS Health Partners, during a Tuesday panel at the Las Vegas event. But “we’re still seeing very, very transformational deals happening.”
Investment in health startups reached record highs during the pandemic, but began to slow in 2022 in a market correction following the boom. In the third quarter of 2023, U.S. digital health startups raised $2.5 billion, the second-lowest funding quarter since the end of 2019, according to Rock Health.
High interest rates have affected venture funds’ ability to raise cash, which lowers the amount investors have on hand to pour into startups. Valuations have plummeted, and IPOs have slowed to a trickle, further decreasing the funds available to startups and making investors more cautious about deals.
Since valuations are inversely correlated with rates — which are likely to remain high for the foreseeable future — companies need to get used to the tighter market, said Robb Vorhoff, managing director and global head of healthcare at growth equity firm General Atlantic, during the panel.
“Hope is not a strategy. I would get comfortable being uncomfortable,” Vorhoff said. “Assume this environment is the status quo for the foreseeable future.”
Many companies that raised funds during the pandemic-era highs will have to raise more cash soon, investors said at HLTH. Typically, companies raise two years of capital, so they will have to come back to market this year, or in 2024 or 2025 if they found additional support.
Companies raised capital during the pandemic on “unsustainable or indefensible valuations,” Vorhoff said. “Many of these businesses are going to be coming back to the market.”
But instead of seeking out new investments, VC firms are focused more on inside rounds, where they funnel additional cash into existing portfolio companies, experts said at HLTH.
General Atlantic, which invests around $8 billion to $9 billion annually, has allocated 35% to 40% of its capital this year for existing companies, to fund growth through acquisitions or acquiring additional ownership, Vorhoff said.
Inside rounds can signal that existing investors want more ownership in a well-performing company, that they’re giving a startup more runway to grow its valuation before it raises outside capital or that they’re willing to put more capital into a poorly performing company to keep it from going under.
Inside rounds are “a little bit of kicking the can. We think that just means there’s going to be another valuation question in the not-to-distant future,” said Julie Betts Ebert, managing director of life science and healthcare at Silicon Valley Bank, during the panel. “And maybe that results in M&A that’s more like identifying positive companies that you can put together. There will also be some distressed sales.”
Employers and health insurers are particularly awash in point solutions, and are increasingly looking for more holistic offerings to handle more of their members’ needs. As a result, business is drying up for point solutions, and smaller vendors are starting to approach larger platforms about a combination, especially in the area of chronic condition management, SVB’s Ebert said.
In the next few years, “many point solutions will not be here. That has started and it’s continuing. You can’t have multiple solutions in an area when your sales market is insurers and self-insured employers,” said Cheryl Pegus, managing director of Morgan Health, in an interview. “Can this merge with something existing in the market? That’s actually smart business.”
As startups look for exits or are forced to consider a sale due to a lack of new capital in the next two years, companies have the opportunity to build their value proposition at reasonable prices, investors said.
“If there’s a partner that could, if you put the right deal together, get you out of the storm, it could turn into a great outcome,” Stewart said.
Pharmaceutical giant Merck, which has an internal growth investment fund, is thinking about how to combine its portfolio companies together to build scale and attract new customers, according to William Taranto, president and general partner of the Merck Global Health Innovation Fund.
Merck is interested in combining companies in machine learning and drug discovery with different but complementary algorithms or target identification, Taranto said during the panel.
Startups that want to avoid consolidation will have to pressure test their businesses and focus on executing on performance metrics, said Lynne Chou O’Keefe, managing partner of Define Ventures, which invests in early-stage digital health startups.
Boards are telling their companies to rein in growth and focus on profitability, and founders will have to consider elongating their cash runways by cutting costs, sticking to fewer geographic regions, narrowing down service lines and being selective about partnerships, according to Chou O’Keefe.
“I understand what founders have gone through. It was grow, grow, grow. And within an 180 degree turn, it was profitability, profitability, profitability,” said Chou O’Keefe. “It’s been hard.”