Healthy Outlook for Health Services

In every industry, venture investors look for companies in growing markets with business models that deliver better services at a lower cost than established players. Perhaps nowhere but in health services, however, do those criteria seem easier to meet.

On the growth side, U.S. health care spending is projected to rise about 6% a year between 2009 and 2019, according to the Department of Health & Human Services. Over the same period, health care’s share of the total economy will grow from 17.6% to more than 19 percent.

As for the efficiency side, there’s clearly ample room for savings and quality improvement. Currently, the United States spends more per person on health care than any other industrialized nation, according to indices compiled by the Organization for Economic Cooperation and Development, with no evidence that the additional expenditure results in a measurably healthier population.

That economic reality—combined with increasing government and private sector pressure on health care providers to reduce costs—has many venture investors with a long-term track record in health services sounding particularly optimistic about the sector. With a large pool of active acquirers and healthy valuations for attractive targets, they’re also seeing potential for a greater share of venture-scale returns.

“Right now represents a very interesting time,” says Koleman Karleski, a managing director at Chrysalis Ventures who specializes in health care. “The combination of demographic trends in the country, which are driving dramatically higher health care costs, and the recent regulatory changes are resulting in pretty tectonic shifts in the health care system.”

At Chrysalis, Karleski says that investments have historically been relatively evenly divided between health care and technology. Over the past couple of years, however, he says the firm has leaned more heavily into health care services and expects to do so more. A key driver, he says, is the increasing pace at which health care payers, providers and pharmaceutical companies are remaking themselves on the heels of health care reform. That trend has opened up opportunities for innovative, technology-driven companies.

Even so, it’s not as if health care services makes many venture firms’ lists of most popular sectors. Despite its massive share of GDP, the sector hasn’t historically accounted for a large portion of U.S. venture investment.

In 2010, health care services venture deals totaled about $1.25 billion, or less than 6% of overall venture investment, according to the MoneyTree Report by the National Venture Capital Association and PricewaterhouseCoopers, based on Thomson Reuters data. The numbers look somewhat larger when one factors in health care IT startups with a service component, but it’s still a comparatively small slice of the venture pie, as health care services over the past five years have consistently accounted for less than 10% of venture investments.

Healthy Exit Climate

But exit opportunities may motivate VCs to take a closer look.

This year has been a record-breaking one for health care services in the M&A sector, with worldwide acquisition activity, predominantly from the United States, topping $64.1 billion as of the end of the October, according to Thomson Reuters (publisher of VCJ). That’s on pace to outdo the previous record of $53.7 billion set in 2007.

Granted, most of the billion-dollar-and-above deals involve purchases of publicly traded companies, led by pharmacy benefits manager Express Scripts’ planned $29 billion purchase of rival Medco, as well as Cigna Corp.’s $3.9 billion acquisition of benefits provider HealthSpring. But in recent years, a number of sizeable deals have taken place involving VC-backed companies, giving investors reason to believe it will pick up further.

“For a while, during the recession and during the advent of Obamacare, you had a markedly decreased amount of deal activity,” says Craig Frances, a physician and managing director at Summit Partners. “That has picked up a lot. You’re seeing a tremendous amount of activity from the health insurance companies. They’re now aggressively acquiring companies they think will add long term value.”

One example is Inspiris, a Brentwood, Tenn.-based provider of case management for eldercare services that raised about $30 million over more than a decade. The company sold to UnitedHealth in March for an undisclosed sum. Carter McNabb, a partner at River Cities Capital, which invested in a later stage round, says the return was about 5x.

Investors also did well with HealthMedia, an Ann Arbor, Mich.-based provider of Web-based wellness and disease prevention services that sold to Johnson & Johnson a couple of years ago. Though the purchase price was not disclosed, Karelski says it went for about 18 times cash flow, enough to generate a sizeable return for backers, including Chrysalis, Arboretum Ventures and Avalon Investments.

As for deals with disclosed prices, among the largest was Baltimore-based Bravo Health, a provider of health care services to the elderly, which sold to HealthSpring last year for $545 million. Bravo previously raised $157 million from more than 10 firms, according to Thomson Reuters.

Generally, exit multiples for health care services deals are more predictable than other sectors, says River Cities’ McNabb. It’s not an area where having a well-known brand can compensate for a track record of losses. Rather, deals are driven by a hard look at the balance sheet and income statement, with business valued on a multiple of cash flow or EBITDA.

That makes sense, McNabb says, since most health care services companies are really execution plays without much in the way of intellectual property or other barriers to entry. That’s one reason the sector has been particularly attractive to growth investors, such as Summit and River Cities, whose strategy lies in identifying companies with superior execution in regional markets and funding their expansion.

Shifting from Biotech

The combination of demographic trends in the country, which are driving dramatically higher health care costs, and the recent regulatory changes are resulting in pretty tectonic shifts in the health care system.

Koleman KarleskiManaging DirectorChrysalis Ventures

Stepped-up interest in health services comes amid a difficult period for traditional life science investors, who are grappling with a shuttered IPO window and increasingly cumbersome FDA approval process.

In recent months, several VC firms have either scaled back, spun out, or moved to shutter life sciences investment activities. The list includes Scale Venture Partners, which does not plan to make new investments in the space, as well as Morgenthaler Ventures and Advanced Technology Ventures, which are planning to spin out their respective health care teams to a combined fund focused on the sector.

“There are a number of investors that are doing less in the FDA-regulated areas,” says Barbara Lubash, a managing director at health care investor Versant Ventures. Given the long exit horizons and funding challenges biotech and medical device investors currently face, it’s logical more will look to parlay their expertise into health care services and IT.

That said, health care services is too small a portion of the venture investment pie to ascribe much significance to quarterly funding fluctuations, Lubash says. She advises that it would be premature to draw conclusions about industry trends from the third quarter MoneyTree Report, which showed health care services investments up 200% over the second quarter, with $152 million going into 11 deals. Over the same period, investment in pharmaceutical and medical device startups fell.

Public markets also seem to show some favor to health services plays. Unlike the biotechnology sector, where VCs in the last several years have faced a chilly IPO environment, health services and IT companies have had reasonably good access to public markets.

One of the best outcomes in recent years was IPC, a provider of acute care specialist services for hospital patients whose shares have nearly tripled in value since its 2008 IPO. Accretive Health, a provider of revenue management services for hospitals, also did well, raising $120 million in its May 2010 IPO and seeing its stock double in subsequent months to a market valuation of about $2.5 billion. Another less impressive performance came from Epocrates, a provider of handheld computer systems for physicians that went public this spring, raised about $85 million, and has since seen its stock price fall in half.

What’s Getting Funded Now

Looking ahead, health services VCs are pursuing a strategy similar to past quarters, seeking entrepreneurs with proven operational expertise who use technology to give themselves an edge over established competition.

“It’s not about the bleeding edge of IT,” Lubash says. “It is about applying existing, well understood and well developed technology to health care.”

Certainly that description applies to the most popular business models for health services venture investment, which include companies in the telemedicine, homecare and personalized medicine spaces. None could be categorized as pure technology plays, yet virtually all rely on health care providers adopting some new technologies or equipment.

On the telemedicine front, at least three companies have raised venture rounds this year. The list includes one Chrysalis investment: Pittsburgh-based Foundation Radiology, a provider of remote radiology services for community hospitals and other customers. The company raised a $1.6 million round in May, bringing total funding since 2009 to $21 million, according to Thomson Reuters.

Another remote service provider is St. Louis-based Advanced ICU Care, which raised an $8 million round in September to target an even larger segment: intensive care units of community hospitals, where it deploys technology for monitoring critically ill patients and consulting with remote physicians specialized in intensive care cases. The company has raised $18 million to date from such backers as Arboretum Ventures, Catalyst Capital Management, Trident Capital and Versant Ventures.

The largest funding recipient, meanwhile, is TelaDoc, a provider of telehealth medical consultations. The Dallas-based company has raised $38.4 million to date, including $18.6 million in August from backers, including Cardinal Partners, HLM Venture Partners, Kleiner Perkins Caufield & Byers, New Capital Partners and Trident Capital.

Personalized medicine deals are also getting traction. One example is Chronicity, a provider of clinical services for people with chronic conditions, which has raised $23 million in the past five years. The Addison, Texas-based company runs a network of treatment centers for patients with chronic fatigue syndrome and other ailments.

Grand Rapids, Mich.-based Intervention Insights, meanwhile, offers services to assist community oncologists in developing personalized treatments for patients. The company, backed by The Charter Group, Chrysalis and Beringea, analyzes the genetics of cancerous tissue to determine which chemotherapy drugs will most likely be effective for a particular patient.

VCs and growth funds are also investing in services for providing health care in the home, through companies such as CareCentrix, a Summit-backed provider of benefits management for home health care services.

As for gadgets, investors are also still open to companies offering equipment tailored for health care users. Eve Kurtin, senior advisor at VantagePoint Capital Partners, says she was drawn to Phreesia, a developer of tablets for patient check-in, because its technology offers doctors a cleaner replacement for paper forms on clipboards. At the same time, its gadgets aren’t too sleek for their own good.

“It’s similar but uglier than an iPad,” she says. “That way no one walks away with it.”

Joanna Glasner can be reached at She tweets at @jglasner.