Gambling on change (David A. Jones, Jr.)

Article published January 31, 2011

Five big systems buy into a venture capital fund to try to reap profits from the transformation of healthcare

By Melanie Evans

Five major health systems have put up to $50 million behind their faith that executives can pick the winners as emerging companies vie for business during the sweeping regulatory and market changes expected under healthcare reform.

Health systems in Tennessee, Michigan and Iowa said last week they had formed a healthcare venture capital fund with the investment and consulting company the Heritage Group. Behind the fund are Rock Morphis and David McClellan, who founded Heritage in Nashville’s closely knit and entrepreneurial healthcare market more than two decades ago (March 5, 2007, p. 30).

Not surprisingly, for-profit hospital giants headquartered in Nashville or nearby are among the fund’s early investors. Community Health Systems, Franklin, Tenn.; LifePoint Hospitals, Brentwood, Tenn.; and Vanguard Health Systems, Nashville, are three of the five health systems named as Heritage fund partners.

The two other investors are Trinity Health, a large Catholic system based in Novi, Mich., and Iowa Health System, based in Des Moines, which owns 10 hospitals and manages another 13 across Iowa.

Entry into the Heritage fund requires an investment of at least $1 million, but each of the five health systems agreed to commit up to $10 million. The fund has raised at least $78 million since mid-January and will seek up to $200 million, according to a notice filed with the Securities and Exchange Commission.

Iowa Health and Trinity Health reviewed the fund as they would any other investment, executives for the not-for-profit systems said. An investment committee on Iowa Health’s governing board approved the investment from the system’s portfolio, President and CEO William Leaver said. Trinity ran the deal past an investment consultant, said James Bosscher, chief investment officer at Trinity Health. The $10 million accounts for one-third of the venture capital in Trinity’s two investment portfolios, which total $7.8 billion.

The fund promises more than a potential financial return, the investors said. The systems expect to gain exposure to new technology and be able influence product development. “This is a very experienced group of people with a lot of expertise,” said Wayne Smith, president and CEO of Community Health Systems, which owns or leases 125 hospitals in 29 states.

Venture capital investment—with its promise of higher returns, but the certainty of greater risk—is limited among not-for-profit hospitals.

Investment manager Commonfund reported 4% of alternative investments in portfolios of 85 not-for-profit hospitals and systems surveyed last year was venture capital. Alternatives accounted for 15% of the survey’s combined $76.8 billion in assets of all kinds. Venture capital investments were most often found in portfolios of systems with at least $1 billion in annual revenue.

Less common are health system-backed funds that target financing for healthcare entrepreneurs, such as the Heritage fund. “I would say it’s unusual,” said Susan McDermott, senior vice president and chief investment officer for the Stratford Advisory Group, a Chicago-based investment consulting firm, which vetted the fund for one of its investors.

The nation’s largest Catholic health system, St. Louis-based Ascension Health, launched a $125 million venture capital fund in 2001 and partnered with three other Catholic systems to create a second $200 million fund. Kaiser Permanente, based in Oakland, Calif., operates a venture arm that has backed more than two dozen companies since it was founded in the late 1990s. Partners HealthCare System created its own venture pool four years ago to finance entrepreneurs within the Boston-based system.

Heritage Group founder Morphis said through a spokesman that efforts to slow healthcare spending among providers led the financiers to launch the fund. Indeed, the managers have touted the far-reaching healthcare law to promote the fund.

“The Patient Protection and Affordability Act passed by Congress last year contemplates and encourages innovation in numerous ways,” the fund’s Web page says, and investors consider health systems “the real-world laboratory for developing solutions in a rapidly changing operating environment.”

Heritage spokesman David Jarrard said Morphis and McClellan were not available for interviews during fundraising.

The Affordable Care Act, enacted last March, includes significant insurance expansion and regulatory oversight and some alternative reimbursement models for hospitals and physicians that will be tested in coming years.

The Partners Innovation Fund, which was financed by Boston’s Massachusetts General Hospital and Brigham and Women’s Hospital, joins with outside venture capitalists to back technology or products developed by Partners HealthCare. Bob Creeden, the managing partner of the fund, said outside investors have been slightly more hesitant since the healthcare law, which has raised concerns that reimbursement may change under the law.

But the change that accompanies the law also creates a potentially favorable market for the startups and upstarts that draw venture capital.

Established companies struggle to adapt to major demographic shifts, such as the wave of retiring baby boomers, technological evolution or significant regulatory changes, said Michael Roberts, executive director of the Arthur Rock Center for Entrepreneurship at Harvard University.

“The reason for that is that existing incumbents in any industry have a very developed and entrenched set of practices and investments that have all been carefully designed to give them an advantage in the existing environment or the status quo,” Roberts said.

“We know from lots of experience that these incumbent players have a hard time changing those practices and making dramatic new investment that cuts against their existing strategy. Almost by definition, if they’re incumbents and they’ve been around for a while, the things they’re doing are reinforced because they worked,” he said.

More opportunity

The nation’s fractured and inefficient health system is ripe for innovation, said David Jones Jr., the chairman and managing director of Chrysalis Ventures, a Louisville, Ky.-based venture capital firm with $400 million under management.

For venture capitalists, new regulation under the Affordable Care Act offers further opportunity, said Jones, who founded Chrysalis, which invests in healthcare and technology, more than 15 years.

“Change is a certain outcome of the law,” said Jones, who stepped down in August after roughly five years as chairman of Humana, the insurer his father founded. “Change is good, for us. We cannot win in a world of stasis.”

Jones said the risky nature of venture capital requires funds to have diverse enough investments to offset those that fail. “You have to have enough at bats to get what you’re looking for in your overall average return,” he said.

Trinity Health’s Bosscher said Heritage fund investments will target health information technology.

Healthcare has lagged behind other industries in use of information technology, and Congress included roughly $27 billion to promote use of electronic health records in the 2009 law to boost the economy, the American Recovery and Reinvestment Act. Federal officials awarded the first incentive payments in January.

Bosscher said the system will gain greater exposure to new technology as a limited partner, rather than a passive investor with an asset manager. Partners sit on the Heritage fund investment committee to review companies that seek funding. Bosscher said Trinity, which owns 33 hospitals and manages another 14, will vet products or software and will learn more as other partners do the same. “That’s where, to me, the real value is,” he said.

The Heritage fund will finance early- and growth-stage companies—those either testing products or just introducing them. Those areas are where Bosscher said investors have the most to gain. Managers will also seek out entrepreneurs to develop what the Heritage Group describes as “purpose built” companies to tackle issues identified by investors.

Separately, the Heritage Group announced funding in mid-January for a newly created Nashville-based company, Precedent Health, to develop and manage provider networks, such as accountable-care groups. Morphis was named as Precedent Health’s chairman.

Ascension Health’s venture funds target expanding or more mature medical device, information technology and service companies. Kaiser invests in all development stages.

William Carpenter III, chairman and CEO of LifePoint Hospitals, which owns or leases 47 hospitals, said the pooled fund allows hospital operators to combine resources for a better opportunity to produce meaningful innovation.

Iowa Health’s Leaver said health systems face pressure from the reform law and commercial insurers to improve quality and efficiency, and entrepreneurs may be best-suited to supply some needed expertise in technology or other services. “We have to recognize there’s an independent company … that can fill those voids more effectively and more efficiently than we can, and probably more quickly than we can,” he said.