2022 observations thus far
A top-down look at shifting market dynamics in the venture asset class
Hey there! I’m Jordan Pascasio, Investor at Next Ventures.
Every month I write a piece encompassing whole person health. If you would like to receive it directly in your inbox, subscribe now.
A special thank you to Kendall Drake, Emre Karatas, Amee Kapadia, Lance Dietz, Hannah McQuaid, Ian Rountree and Julian Eison for all the ideation and contributions to this piece.
With all the anecdotal sentiment floating around regarding market shifts at various stages of VC, I wanted to take a top-down look at this past quarter’s market developments, which saw a decrease in both overall and health & wellness venture investment activity compared to the preceding four quarters.
While macro factors have been responsible for a good portion of recent volatility, micro factors are shifting as well, driven by shifting consumer behavior as the pandemic unwinds. As it relates to secular themes within my investment thesis (and to switch things up a bit), I tapped some of my favorite investors at other shops to get a flavor for the opportunities and shifts they’re seeing across focus areas such as healthcare, biotech, fitness & wellness and insurtech. I’ve also included some industry expert color around the current M&A and IPO environment given waning exit activity. I’m excited to share these sound bites a bit later in the piece.
Before jumping into broader market analysis, I will note a few things for clarity. As an investor in Seed and Series A opportunities, I am underwriting risk for where the market will be in 5-10 years, rendering current public market volatility immaterial as it relates to a prospective investment’s long-term potential. Venture is a long-term bet on innovation and on the idiosyncrasies of a founding team, and studies have shown that indexed venture returns are uncorrelated with public equities. And yet, being cognizant of how upstream market noise affects downstream developments within private markets helps to provide proactive considerations around price discrimination (and thus portfolio construction) within new investment opportunities or growth and liquidity recommendations for existing portfolio companies. Said another way, I believe that isolated decisions made within an investment period can be affected by market shifts occurring at that particular time. Aspects such as portfolio entry economics or board decision making require keen market awareness across market cycles and can collectively help (or hurt) a fund’s ability to meet target net returns.
Macro narrative
📈 Propagation of volatility
Let’s start from the very top and work our way down. The macroeconomic headwinds that markets faced to start the year stemmed from an overhang of two conflating themes in 2021 - (1) fiscal relief (stimulus checks) and (2) a tightening labor market that accelerated wage growth, ultimately leading to too much money chasing too few goods, or inflation. The Fed was arguably too slow to course correct via rate hikes during the year, sticking to a recent change in policy around inflation and being sensitive to the objectively negative burden of the pandemic at the lower end of the income spectrum.
Hawkish Fed speak finally came in late-November when Fed meeting minutes revealed that they could raise rates “sooner than participants currently anticipated”. The October CPI print (released on 11/10/21) was likely a large factor, coming in at 6.2% (+15% MoM). For context, CPI started the year (Jan ‘21) at 1.4%. The fear of a rising rate environment to control inflation sent shock waves through high-growth names as investors placed greater value on margins and less on cash flows further out in the future. As this sentiment carried through into 2022, high-growth public SaaS and Fintech names traded down by 30-50% from 52-wk highs, prompting companies like Chime to delay their planned IPO in mid-February. A week later (2/24/22), the Eastern European crisis emerged, disrupting commodity flows and further exacerbating inflationary pressures.
While private market valuations tend to lag those in public markets, corrections in Late-stage valuations were potentially accelerated by the increasing number of crossover funds that could look at public holdings and private opportunities side by side. As these subjective price setters became more discriminatory around pricing, we saw Late-stage names re-price significantly this past quarter and an exodus of said crossover funds out of the asset class.
While Early-stage opportunities are well insulated from near-term macro shocks, one can’t deny the general frothiness seen in Series A and Series B deals last year in which many companies raised at exorbitant multiples. The compression seen in Late-stage valuations makes it all the more difficult for these Early-stage companies to grow into bloated valuations and to ultimately generate a meaningful step-up upon their next round of financing. This dynamic is certainly factoring into the investor skittishness and the empirical evidence around Series A and Series B opportunities being repriced marginally lower (fig. 2) and investment pace slowing (fig. 4).
I can say that demand for Seed deals through Q1 remained strong with term sheets getting done at valuation levels equal to or higher than what we witnessed in 2021. Demand for the asset class is undoubtedly benefiting from dry powder tailwinds produced by the institutionalization of Seed capital and the rise of emerging managers. Regarding the latter, Preqin recorded 214 first-time venture capital funds securing a total of $18B in the first ten months of 2021. As such, it’s not surprising that Seed opportunities were the only asset class to expand, in both aggregate deal volume and count, in Q1 as the overhang of capital is deployed.
Absent a crystal ball, there’s really no telling how things will manifest for the rest of the year across private markets. I think the directional propagation in valuations that we’ve witnessed over the past two months will continue for another quarter or two until fair value in Late-stage and Early-stage is found. For Late-stage, keep an eye on leading indicators such as the Fed’s rate-hike decision on Wednesday (5/4 at 2pm ET), core CPI, high-growth public indices and IPO activity. For Early-stage, it will be interesting to observe if/how companies are able to grow into previously marked valuations while equity becomes more expensive. In terms of Seed, I believe the resilience within the asset class will continue given the natural insulation from macro noise and the cumulative, stage-specific dry powder that could continue to grow as capital allocators look to diversify risk amidst expectations for inflation to stay elevated for longer.
To reiterate, these takeaways serve as considerations around two core aspects from a practitioner point of view - (1) price discrimination (and thus portfolio construction) within new investment opportunities or (2) growth considerations and liquidity pathways for existing portfolio companies. For the former, these market shifts should prompt some scrutiny around fair value given the recent pullback, which presents Early-stage investors with new opportunities to build a great portfolio. For the latter, this is an opportunity to emphasize the importance of enduring business models and strong balance sheets to founders.
To close, my co-working mate and inspirational investor Ian Rountree puts it best:
💰 Liquidity Considerations
The aggregate value of VC-backed company exits surged in 2021 with public listings continuing to function as the largest driver of exit liquidity - a prevalent theme since 2018. Aggregate exit value via public listings in 2021 alone exceeded that over the previous three years combined. Private company acquisition liquidity also reached all-time highs last year. Notably, the most common stages of target companies at acquisition remain Seed and Series A.
However, as challenging market conditions brought exit activity to a screeching halt to start the year, how should we think about the viability and proportion of exits by type over the next 12-24 months? I’m not nearly qualified enough to answer this so I put together some questions and used my phone-a-friend lifeline to tap a long-time pal (since 6th grade!) who just so happens to be a subject matter expert.
IPOs have been the largest driver of exit liquidity for VC-backed startups over the past five years. Do you foresee trade sales / acquisitions comprising a larger proportion over the next few years?
We believe exits through partnering with strategic acquirers and financial sponsors will become increasingly common over the near to midterm as IPO markets remain either closed or less attractive, especially for higher growth lower profitability companies.
While IPOs historically drove VC liquidity, actual performance has been mixed; worse yet, depending on lock-up structure, many investors are presented with a choice – sell at an IPO discount or wait 3-6 months to sell and accept increasingly unpredictable market risk.
M&A outcomes on the other hand, often offer potentially higher multiples, full cash liquidity upfront or allow investors to participate in the equity upside of a better pro forma company that is also more liquid.
This matters for consumer-focused tech companies as inflation pressures margins, as financing becomes less available/attractive (Series B average $’s raised and post-money valuations are down (23%) and (12%) respectively since Q4 ’21)1, and as customer acquisition costs increase, making strategic combination partnerships that bring the benefits of scaled, efficient platforms increasingly attractive.
Will private market M&A activity lag public market M&A activity because of the relative illiquidity and current price discovery nature of Late-stage names?
We believe that private company M&A activity will lead rather than lag public company activity.
Since November, public consumer-tech companies have seen $1T+ of market cap wiped out and material multiple compression. Unfortunately, many management teams, investors, and boards remain indexed to stock prices and multiples ~40%+ higher than where many consumer companies trade today. More importantly, as the M&A market reached new highs during COVID, buyers used stock with greater frequency to offset increasing deal sizes. Current market volatility makes it difficult to agree on a deal, ownership percentage, exchange ratio, and social issues creating friction for many buyers.
Private companies face the same market environment challenges but benefit from more manageable check sizes where deals may get done with all cash or with equity components that are a smaller percentage of ownership than the large public company deals of 2020/2021. At the same time, stakeholders are often indexed to earlier, lower or are faced with investors like Tiger Global and some of its peers slashing offers in down rounds at lower valuations.2 Private company stakeholders have better had their expectations reset to a new valuation paradigm.
Thesis Narrative
⚕️ Health & Wellness Update
Health & wellness venture investment activity was down QoQ, broadly in-line with the total market. The same trickle down dynamics discussed earlier are applicable here as high-growth public equities within my coverage area continue to endure a meaningful correction that first started in Q4 ‘21.
That said, I remain extremely bullish on the Seed and Early-stage opportunities within our thesis. On the clinical side, I am excited by all the incredibly talented teams that are leveraging technology to deliver better (and more equitable) health outcomes, to lower costs, and/or to enable providers. On the prevention side, the sheer amount of inspiring teams that are building nascent, upstream fitness & wellness solutions that will result in more favorable downstream healthcare utilization and cost is amazing to see. We remain confident that the combination of these two foundational pillars will help increase health literacy and drive the communal shift toward a healthier future.
…Okay, drum roll please 🥁
Without further ado, here’s what industry investors had to say about the recent past and near future based on a set of provided prompts:
Virtue recently published a great piece on the importance of innovation that drives provider-enablement. What are some of your favorite use cases or opportunity areas for this theme within digital health?
Companies that embrace a provider-focused approach to innovation will accelerate our transition towards new healthcare business models with lower costs and better outcomes across a number of different themes (e.g., financial, operational, data interoperability). Across Revenue Cycle Management (RCM), companies are leveraging AI to make coding and chart reviews more efficient. Companies are utilizing technology to help providers triage patients to the right care setting and improve the logistics of getting care into the home. Although still in the early days of data interoperability, we're seeing companies improve event notification, e-prescribing, and patient record retrieval so providers have the right information at the right time. Providers want solutions that fit into their daily workflows and make it easier for them to do their jobs. This is increasingly important in a world where 75% of all physicians are now employed by a hospital or corporate interest.
Thoughts on virtual-first care eventually needing to establish in-person locations or partnerships to achieve a duality of care?
I'm particularly excited to see how virtual-first care companies work with health systems (representing $1.3T in total spend) to help them adapt to a rapidly changing world following COVID. Rising expenses, lackluster volume recovery, supply chain issues, and reduction in Public Health Emergency (PHE) funding have hurt hospital’s operating margins (4% lower than pre-pandemic). Virtual-first care delivery companies can help health systems thrive in a consumer-centric world in both fee-for-service (FFS) and value-based care (VBC), whether that's connecting MSK patients to ambulatory surgery centers (ASCs) for hip/knee surgeries or coordinating cardiac CTs for patients with suspected coronary artery disease (CAD).
You recently published a piece that explores how you are re-framing the biotech industry as "TechBio". What is driving this shift in nomenclature?
The shift in nomenclature from "biotech" to "TechBio" reverses the emphasis from bio to tech. TechBio companies are focused on engineering biology. Instead of identifying specific biological pathways or tracing the activity of a single gene, the TechBio mindset involves taking a systems engineering approach to biology—using computational tools and conducting rapid experiments both on the computer and in the wet-lab to generate data that you can then analyze to discover how to modulate the complex biology we don't fully understand. Many people think of TechBio platforms as the goose that lays the golden eggs whereas traditional biotech has been concerned with the golden eggs themselves.
There are a couple factors driving this shift. One is the the advancement in tech— from AI breakthroughs to high throughput processing. Perhaps less obvious, another major driving factor lies within founders themselves. TechBio is founder-led, meaning the companies are started and operated by PhDs, engineers, and researchers often straight from university labs. They retain more ownership, generally have "tech"-forward investors lead their early rounds, and tend to prioritize interdisciplinary teams. This has freed TechBio from the usual biotech model of venture incubation by large biotech firms. It's a really exciting time for founders because more people are realizing they don't need 20 years of pharma experience before they can start a company. This new model is allowing TechBio to accelerate quicker and we're seeing really innovative approaches for understanding and subsequently engineering biology. It's clear the industry is starting to think outside of the box and I strongly believe this shift is going to be instrumental in getting to precision medicine and solving enigmatic diseases quicker.
Food-as-medicine has been an emerging theme as of late. Can you walk us through the efficacy of nutrition prescriptions and why you think it's taken so long to come to light?
We all know that what you eat effects how you feel so it has really shocked me that we're only just starting to map specific diets to disease prevention and treatment. Cancer is a great example of a complex disease that is significantly impacted by nutrition. At its core, cancer is a genetic and metabolic disease but we've historically treated it as a genetic disease given most therapeutics target specific oncogenes that are associated with tumor growth. The trick is, there are also several complex metabolic pathways (ex: Pi3K) that cancer and other diseases exploit to progress. By understanding these, we can map precise nutritional profiles and thus diet to improved disease outcomes, something several companies are starting to tackle (Faeth Therapeutics, Filtricine, and Season Health). This can be by strictly restricting certain nutrients (ex: sugars or amino acids), enriching a diet with nutrients (ex: specific vitamins or minerals), or a combination of the two.
Several robust clinical trials are underway to support food as medicine and identify the correlation between nutrition and clinical outcomes. There's also a major opportunity for digital health companies to get involved with the data aspect as well as with lifestyle/patient compliance. Metabolic health company Levels is a great example of a platform that helps patients better understand their own personalized metabolic responses to foods they are eating in real time. As we start getting more clinical evidence to back up food-as-medicine claims, we're going to start seeing nutrition being pushed as a regulated therapeutic. It will be interesting to see how prescription nutrition gets treated by the FDA and by insurance companies.
What is your view on fitness innovation given shifting consumer behavior post-pandemic, and where do you think there is alpha to be found within the space long-term?
The pandemic and post-pandemic environments have solidified my view that (1) people are comfortable working out at home given the convenience and (2) appreciate high quality content delivered in personalized ways, but (3) also crave the community and interaction that come from in-person fitness/wellness experiences. Solutions that are incorporating these ‘three Cs’ – convenience, (high quality) content, and community – are really interesting to me. However, it’s not easy to do and a lot of established offerings do 1-2 of them well, leaving consumers wanting more. From a demographic perspective, I’m really interested in offerings that are ‘meeting people where they are’ by getting people moving, fueling, and recovering in super low friction ways. Joe & Anthony Vennare from Fitt Insider have profiled this as well – the basics of an active/healthy lifestyle are relatively straight forward, but there is room for solutions/platforms that can assist people here (e.g., Movr, Mighty Health, etc). Last but not least, the use of gaming, game mechanics, and game design within fitness/wellness offerings is becoming table stakes – lots of opportunity here as we’re seeing with startups like Genopets and STEP’N.
What is your outlook on VR/AR adoption and the opportunities it affords to fitness & wellness consumers?
I’m bullish on the adoption curve accelerating as potential consumers begin exploring what the metaverse means to them. Facebook/Meta has positively impacted the AR/VR opportunity with (1) Oculus Quest 2 being more affordable with improved quality, (2) a supreme focus on building metaverse experiences (hence the name change), and (3) its acquisition of Within/Supernatural (AR/VR fitness). While the install base of VR headsets limits current capacity for growth, the future upside is quite compelling given the growing interest in digital experiences and the variety of current/future use cases available: sports with StatusPRO and GymClassVR, fitness with FitXR, and health/wellness with SomosXR, for example The immersive nature of AR/VR/XR could have a meaningful impact on engagement, retention, and enjoyment of many health, wellness, and fitness experiences. Time will tell, of course, but I continue to be really intrigued by what’s happening in the space.
With increasing accessibility to real-world healthcare data, how is your fund thinking about opportunity areas that leverage this data given your affiliation with Prudential Financial and their respective product offerings?
Both as investors and as partners of Prudential, an area where we collectively spend a lot of time in is healthcare data infrastructure and how we can more digitally access (1) traditional health records in the form of EHR/ EMRs (i.e. Particle Health, Health Gorilla, Human API, etc.) and (2) alternative sources of data like SDoH, biometrics, genomics, etc. We believe data interoperability for the former still has some ways to go before realizing its full potential. However, the latter is becoming increasingly important to us as we think about more dynamically assessing risk, how carriers can differentiate on underwriting and how carriers can ultimately identify good risk in high-risk buckets. A number of insurtechs are already using alternative data sources to offer instant life insurance (no medical exams required), enabled by API connections to these alt data sources. There's still a lot of testing & learning to be done before this data can be used at scale in actuarial models to predict mortality risk but we're seeing more carriers and insurtechs adopting more digital data sources for underwriting & risk management.
What vertical-specific themes are you seeking out over the next quarter or two?
Government becoming the center of gravity in healthcare: We're spending a lot of time on the theme of healthcare expenditure shifting from commercial/employers to government (Medicare, Medicaid, ACA, etc.). From 2000 to 2020, employers' share of national healthcare expenditure declined from 24.5 % to 16.7 %. During the same period, the federal government's share has gone up from 19.3% to 36.3%. We are looking at companies riding this tailwind and enabling the navigation of Medicare, distribution of Medicare, aging at home for the Medicare/Medicaid population and more broadly speaking, digital health solutions for Medicare/Medicaid beneficiaries.
If you are building or investing in the health & wellness space, I’d love to chat! Please reach out to jordan@nextventures.com, or I can be found here.
Carta via TechCrunch (March 2022). 2021 Q4 based on November and December of 2021; 2022 Q1 based on January and February of 2022
The Information (January 2022)