The Downsizing of Healthcare Venture Capital

by Daniela Drake

This is a great time to be a venture capitalist, or so you might think after seeing the astronomical returns that VCs have pocketed recently. But the picture might not be so rosy if your venture interests are in healthcare. Whie healthcare is the largest single industry in the US, healthcare venture capital is downsizing.

"Healthcare VC is consolidating up here in the [Silicon] Valley," said Richard Lin, MD, an associate at healthcare venture fund Three Arch Partners. Indeed several large VC funds throughout California are reported to have exited the healthcare investing business.

Others have simply made the decision to segregate the disciplines of Healthcare and Information Technologies. The most extreme example of this segregation is the high profile shake up at Brentwood Venture Capital and Institutional Venture Partners (IVP) that resulted in the formation of two new venture funds-one of which is the health care focused Palladium Venture Capital.

Behind the Drive to Specialize-Public Market Performance

The recent public market performance of healthcare stocks is part of the reason for the shift in venture fund management. Although in the early 1990s, healthcare services outperformed the S&P 500, in the latter half of this decade the services sector has been trounced. In addition, for a wide range of reasons, investors have shied away from the once hot biotech sector.

The widely disparate returns between healthcare and high tech "has led to tensions in our firms-and across the industry in general," believes Brian Atwood, a founding partner of Palladium, and formerly of Brentwood Venture Capital.

In mixed funds there is another tension -- that of competing for limited resources. The opportunity costs of every investment imply that tradeoffs have to be made. "[In a mixed fund], it was getting to be difficult to get a healthcare deal approved [given the market performance.] It was hard to justify investing in healthcare, and ultimately we have to do right by the limited partners as well," said Atwood.

Two different types of Venture

Another reason for the recent shake up is that the traditional healthcare industry is fundamentally very different from the high tech industry and requires different investor skill sets. Given the market dynamics, the long cycle times, and the level of expertise required for healthcare investing, some question the merit of mixed funds in today's economy.

Previously it made sense that venture partners had different areas of focus and expertise. Leveraging their breadth of experience, the venture partners could choose the best sectors for the fund to be in at any given time. The non-overlapping skill sets gave venture partners as a group the insight and judgment to invest in hot trends. This was the case in the 1980s with the energy sector, and in the early 1990s with retail.

Nevertheless, the premise of combining healthcare and information technology (IT) specialties "may have been flawed," posited Wilf Jaeger, founding partner of Three Arch Partners, "because partners are apt to make relatively short term economic decisions, and in the short term these sectors perform differently."

The recent break up of Brentwood Ventures and IVP has highlighted the complexity of combining healthcare and IT investing. "We realized that they were really two asset classes with two completely different dynamics." Atwood stated. "One is regulated, one is not; one has fast product times, one does not. It was harder and harder for the partners sitting across the table to add value to each other."

Another driver in the segregation of healthcare and technology investments may be that to succeed in each, an investor must adopt radically different investing styles. ""Fundamentally, our investing pace and styles differ," added Barbara Lubash, a founding partner and director in the Southern California office of Palladium. "IT investors have to respond fast to competitive opportunities, and are less sensitive to initial valuations and capital needs."

Since Internet startups funded by successful VC's can quickly become multi-billion dollar companies, this may indeed be the intelligent approach to Internet investing. Since the dynamics of these markets are so different, Lubash suggested, "It would be death for health care investors to follow the same approach."

Investing in a complex industry

Creating healthcare-focused venture funds may, in fact, be the best way to deal with the growing size and complexity of the healthcare industry. In order to get a handle on this large and complicated industry, venture investors break healthcare down into four sectors: Biotech, Devices, Services, and eHealth/IT.

Given the size and complexity of healthcare and its individual sectors, it is increasingly difficult to have expertise in all four areas. "In fact it is hard to be an expert in two," agreed Lin of Three Arch.

A specialty fund that has several professionals with healthcare backgrounds can have both the breadth of perspectives needed to understand the landscape of the industry, as well as the depth of experience required to make the best investment decisions.

These healthcare venture funds can offer the entrepreneur something else: industry specific know-how. In this increasingly competitive marketplace, this type of expertise is vital for start-ups to achieve and maintain a competitive advantage.

Others disagree. Kleiner Perkins, Mayfield, and Draper Fisher Jurvetson are well known mixed funds with strong health care expertise represented at the partner level.

Warren Packard, a director at Draper Fisher Jurvetson, is the only partner in the fund with formal healthcare background. As an early stage investor, Draper Fisher Jurvetson also finds that it is able to give strong support to its healthcare investments despite the fund's main focus on IT. "At the beginning it is all the same stuff-how do I start a company? Best practices, generic support," said Packard. "Later, it is the industry specific stuff. Then we can go in for a second, strategic round."

Historical Sector Performance

The historical performance of the healthcare services industry continues to color the institutional investor's approach to healthcare investing. This in turn affects the flow of venture capital. Although the public market is not the sole measure of an outstanding opportunity, it does influence the investors' comfort with any given investment.

Medical devices and biotech firms' big IPO window in 1996 and 1997 brought eventual disappointment to many investors. "Many firms went out too early and failed to meet investor expectations," said Lin. "With the memory of pummeled firms, investors are now demanding less risk."

One noteworthy example of that is Heartport, the Silicon Valley medical device company whose product allows surgeons to perform a wide range of minimally invasive cardiac surgeries, often obviating the need for more risky open-heart procedures. This promising concept, backed by the prestigious Kleiner Perkins Caulfield and Byers, has taken a beating in the public markets with a recent stock price low of $1.80 in July 1999 from a high of over $40 shortly after the IPO in 1996.

In services, Physician Practice Management Companies (PPMCs), once thought of as the panacea to physician practice pattern variation and ballooning physician practice overhead, have, as a class, also performed poorly on the public markets. These rollups have typically been a thin margin business. The proposition: if you could get scale then you might be able to get a halfway decent return.

"We did not invest in PPMC's because we did not see them addressing any [unmet clinical] needs. Although there were potential economies of scale and purchasing efficiencies, these were never quite enough to make businesses-and ultimately the public markets came to a similar conclusion," reported Jaeger of Three Arch.

The one bright spot in this story has been healthcare IT. As a class these companies have performed well against the other sectors of the healthcare services industry, according to a recently published McKinsey & Company study. Despite high profile management difficulties at the recently merged McKesson HBOC, one of the largest companies in this sector, the recent market performance of healthcare IT has perhaps been the single most important driver of the half-way decent track record of healthcare services in general.

Healthcare Trends

As in many industries, the advent of Internet Technologies has redirected interest in all healthcare sectors. "In fact," said Jaeger, "it is becoming increasingly rare to see any company without some Internet strategy. Many are using the Internet as their primary lever." A year and a half ago eHealth strategies were virtually non-existent.

The Internet, however, does not account for all of the healthcare plans that are floating around out there. While most healthcare VCs agree that they are seeing a lot of ehealth plans from a new crop of Internet entrepreneurs, they are also seeing a wide range of more traditional opportunities.

Even within the services sector, the deals represent a robust array of offerings from such things as traditional home health care and practice rollups to the more innovative Internet-based disease management strategies.

At least two well-known venture funds, Domain and Alta, remain strong in Biotech, according to Jaeger. "Alta is saying that Biotech is out of favor and the valuations are low and that this is a great time to invest."

Filtering the Flow

Sorting through this flood of opportunities, VCs are seeking out companies with solid fundamentals focused on unmet clinical needs and what many of the investors called 'structural opportunities.' "We ask, 'Does this service or product meet an unmet need? Does it add value?'" said Lin.

Draper Fisher Jurvetson is remaining "opportunistic" with respect to healthcare. "We are not looking at devices, services or biotech unless it is breathtakingly revolutionary," says Packard of DFJ. "We are focusing more in the IT space."

Another mixed fund, the Walden Group of Venture Capital Fund, with $1.2 billion to invest, is not aggressively investing in healthcare. Nevertheless, they are not willing to sit it out entirely. Aware of the wide-ranging returns across the healthcare sectors, they are taking a hedged approach. "It is a case by case thing," said Jonathon Wang, Investment Manager at the Walden Group. "We are looking at returns across the sectors, looking for ways to capture value in any sector."

The Chosen Ones

Although there are many wide-ranging investment opportunities in healthcare, "The buzz right now is the Internet and these palm pilot devices," said Lin. In fact, the valley heavyweights have invested in two competing palm pilot technologies: iScribe (Kleiner Perkins Caulfield and Byers), and ePocrates. (Draper Fisher Jurvetson, Three Arch, and Interwest.) Both of these tools promise to bring information technology to the physician at the bedside, potentially one of the most revolutionary tools in altering physician practice and prescribing patterns.

The combined focus on Business-to-Business and structural opportunities has led to Three Arch Partners' bet on Medchannel, a start-up focused on revamping the supply chain in healthcare services. Similarly, Crosspoint Venture Partners has backed Cogent, in Southern California, that provides services and products to HMO's and provider systems.

Large international funds have another interesting option: transferring technologies overseas. In fact, the Walden Group, with a strong presence in Asia, opened up Asia Renal Care, based in Hong Kong. The enterprise has grown from, "Zero to 16 centers operating in four countries in the last two years," said Wang. "We were able to leverage the best practices in kidney dialysis and transfer them to Asia. The growth opportunities are enormous."

Despite the public interest in and awareness of high profile content plays, such as Dr. Koop and WebMD, these ventures are less interesting to many healthcare VC's.

"We have not done any of these deals," said Jaeger of Three Arch Partners. "Although the Internet is an extraordinary source of information and we believe that it serves a need-it is difficult to distinguish between these businesses. Ultimately they are marketing and consumer driven-and that is not our power alley."

The Future

The current snapshot of health care investing, like the industry itself, remains complex. Healthcare investors have to believe that the imbalances in the returns in healthcare and IT are transient. "All of us [healthcare partners] remember when the tables were turned," said Atwood, reflecting on the public market performance in the early 1990's.

There is one thing upon which all of the investors are agreed: The Internet is here to stay. The issue remains the same in healthcare as in all other industries: what is creating value?

Venture capitalists that are focusing on healthcare are certain that there are remarkable opportunities for value-creation now and in the years to come. Lin of Three Arch summed it up this way, "Everybody talks about the adoption rate for technologies. But ultimately there is a 100% adoption in healthcare because everybody gets sick. The demographics are too compelling to ignore."