VCs Healthcare Tendencies Toward Devices, Away from Services (Alan Ying)

PEHub
Posted on: January 25th, 2011

Healthcare has always been an area of focus in venture capital. In particular, over the last several years, healthcare IT has received a lot of public attention. The recent J.P. Morgan Healthcare Conference in San Francisco– focusing on public companies – offers a timely snapshot to compare the healthcare interests of public markets versus venture capitalists.

Interest level in device and equipment companies is significantly higher from VCs than from public markets, and the interest level in healthcare companies is significantly lower by VCs than the public markets. Negative sentiment has recently surrounded the device industry and new regulations and backlash on costs have dampened enthusiasm around the business models and efficacy (perceived long-term financial and clinical impact) of medical devices. The public markets have apparently adjusted their interest, focusing more on healthcare services.

The VC industry, however, is still focused on medical devices. Perhaps VCs know something public markets do not. Or perhaps human nature has made VCs slow to change embedded investment styles. Or maybe industry fund structure is the explanation.

The flipside of this device disparity is the relatively high interest in healthcare services companies by the public markets compared to VCs. One possible explanation is that the public markets expect industry upheaval to impact the earnings of healthcare services companies more immediately than companies in other sectors. Whatever the actual reasons for this disparity, investment returns will eventually determine whether the VCs or public markets are focused on the right areas.

Healthcare IT, however, has not attracted substantial investor interest.

For example, one of the most anticipated keynotes at the J.P. Morgan event was “Innovation Opportunities for the Health IT Market.” In the 29-year history of the conference, this was the first session ever on healthcare IT, and it featured a high-energy panel including John Doerr of KPCB, Eric Schmidt of Google, and two of the most senior healthcare IT leaders in the federal government, Todd Park and Aneesh Chopra.

At one point Doerr asked the packed audience how many were active healthcare IT investors – and over 1/3 of those present raised their hands. This is particularly surprising given the nearly negligible public or private investment activity in the segment.

Of the many possible explanations for this disparity, I’ll mention one that I refer to as the “Elephant Gun in the Rain Forest Problem” with venture capital and healthcare IT.

Average VC fund size has increased at a CAGR of 7.25% over the last 20 years, faster than both U.S. GDP (4.7%) and national healthcare expenditures (6.7%). Assuming similar numbers of companies per fund, larger absolute exit proceeds per company are required to achieve satisfactory returns.

Because of this trend, healthcare investors have become like hunters on the African safari, stalking fewer “big game” deals with bigger “elephant gun”-sized investment minimums and exit requirements. One reason that this has been possible is that certain segments of healthcare – the pharma market, for example, at a CAGR of 10.1% – have expanded even faster than VC fund size.

Healthcare IT, however, is less like the African safari and more like the Amazon rain forest – a dense ecosystem filled with a huge number of small animals. The market isn’t suited to produce elephant-sized absolute returns – it is suited to have a high volume of smaller companies that produce more frequent and smaller returns than device or biotech.

Thus, you get the problem of the elephant gun in the rain forest: firms and funds are structured for fewer and larger investments to yield large absolute returns in markets like devices and biotech, but the healthcare IT market is suited for more numerous investments that yield high relative returns but relatively small absolute returns.

Alan Ying is a Houston-based Venture Partner with Chrysalis Ventures. Chrysalis manages one of Mid-America’s largest funds for early-stage and growth investments with approximately $400 million under management. Since 1993, the firm has invested in over 65 companies, primarily in the healthcare and technology sectors. With headquarters in Louisville, Kentucky, Chrysalis has offices in Cleveland, Pittsburgh, Ann Arbor and Houston. Contact Alan here.