- Sector Lead, Health Care
Australia & NZ, Institutional
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Because history has a way of rhyming rather than repeating, we believe it wise to learn what we can from patterns that emerge. The cyclical volatility in financial markets over the past three years and ongoing macro headwinds offer investors valuable opportunities for reflection. Given our area of focus, one of the most interesting lessons has been the opportunity to objectively assess the durability, relative to peers, of health care companies that recently entered public markets. The high volume of initial public offerings (IPOs) and special purpose acquisition companies (SPACs) in 2020 and 2021 resulted in a large private-to-public cohort. Some companies in that cohort have held up well, while others are far below their value at IPO. While macro challenges account for some of this divergence, fundamentals have, in our view, driven the bifurcation to a far greater degree.
For this paper, we analyzed 48 non-biotech health care companies (those encompassing services, software, and medical technology) that entered the public market between January 2018 and December 2023. We describe what we mean by “durable” and “nondurable” and share examples of characteristics that we used to distinguish companies on that basis. Finally, we show the results of a framework analysis we created to help our team evaluate the durability of companies in this cohort.
While we would never make investment decisions on this basis alone, we believe the exercise is instructive. As of 31 March, the aggregate enterprise value (EV) of nondurable companies we analyzed was down 97%, representing US$92 billion in lost value. This environment has highlighted the divergence between durable and nondurable enterprises and presents an opportunity for private equity investors to stress test their investment criteria and refine their process. A hypothetical investment in our durable “index” at IPO would have returned 18x an investment in the nondurables segment. Public investors who participate in IPO offerings or trade in high-growth names, which are often sensitive to similar macro factors, may also find this useful. We believe the delineations we present here may also be instructive for late-stage leadership teams who want to ensure their company remains durable once entering the public market.
Our process: The durability test
For the purposes of this exercise, we analyzed all non-biotech health care start-ups1 that went public between January 2018 and December 2023 and reached an enterprise value of US$1.5 billion (Figure 1, at the end of this paper). We excluded corporate spinouts and lower-growth private equity platforms and divided companies into three categories:
- Durable: Companies that reached an EV of at least US$1.5 billion at IPO and/or after going public and retained that value as of 31 March 2024.
- Nondurable: Companies that temporarily attained a public market EV of US$1.5 billion but that were worth less than US$375 million as of 31 March 2024.
- Inconclusive: Companies whose EV post IPO ranged from US$375 million to US$1.5 billion as of 31 March 2024.
Characteristics of durable health care start-ups
This project began with a simple thought exercise: If we could turn back the clock to mid-2021 and knew a market crash was imminent, would we be able to identify late-stage private health care companies that would retain their value? What traits would we look for? Are there leading indicators of fragility we should avoid? Today, with the benefit of hindsight, here are the top five characteristics that we found to make companies in this cohort durable.
First mover and/or technology breakthrough
Typically, health care start-ups exiting at more than US$1.5 billion must create enormous value in a compressed period. This is extremely challenging to do unless a company is creating a new market or delivering significant improvements over current standards, particularly in health care, where friction points tend to accrue lasting advantages to incumbents. Every durable company in our study was either at the vanguard of a nascent subsector or represented a major technology-based improvement. In contrast, nondurable companies we analyzed tended to innovate around a business model or transitory trend.
Example: One sequencing company made a major technological breakthrough using a novel approach to molecular analysis. Although operating in a competitive sector with multiple entrenched incumbents, the company’s unique modality elevated it above “fast-follower status” and enabled a much smaller form factor (increasing location flexibility), lower price (democratizing sequencing), and real-time data (improving workflows). This innovation, protected by a fortress of intellectual property, has driven durable growth.
Wide moat
Moats, long seen as synonymous with durability, are often misjudged, and overestimating the frequency of winner-takes-all markets was a common fallacy during the latest bubble. The five sources of moat — switching costs, intellectual property (IP)/brand assets, network effects, cost advantages, and efficient scale — are relatively rare. Start-ups often pitch innovation as a moat and are surprised when commodification occurs more quickly than expected. The durable start-ups we examined did not fall for this trap, and instead had created wide moats to protect their market share.
Example: One medical device company exemplifies how a moat can be grown and maintained over time. At launch, the company had IP protection around its novel calcium-modification mechanism. Although several of the company’s patents were invalidated post IPO, by then it had established a strong brand and enjoyed a high switching cost (in the form of surgeons’ widespread familiarity with and adoption of the company’s products), which helps protect its moat. In comparison, a diagnostics company believed its broad test panel and data repository represented a competitive advantage; however, as sequencing costs continued to drop following a reverse Moore’s Law trend, those “unique” assets held by the company quickly became table stakes and the company’s offering became commoditized.
Value creation, not value capture
Every industry can increase its overall profit pool by raising prices or lowering costs. This is value creation. Value capture, on the other hand, refers to how a profit pool is divided along the value chain and among competitors. Durable companies often contribute to industry value creation.
Example: By opening new research and diagnostic opportunities through its single-cell and spatial transcriptomics platform for molecular profiling, a genomics company created additional value for customers and expanded the sequencing profit pool. In comparison, a nondurable life-science tools company has an attractive in-line mass spectrometry product but is primarily competing for market share, a more challenging proposition over the long term.
Focused execution
Durable businesses rarely deviate from their core competencies. We like the analogy of laying rail track: An attractive durable asset should lay new track at a consistent pace in the same direction of travel. Start-ups that abandon their core competencies, typically via mergers or acquisitions, often do so to disguise deteriorating fundamentals.
Example: One successful value-based health care company could have pursued several business lines post IPO. Instead, management has stuck to the playbook and focused on partnering with leading physician groups around the US to continue to execute on its mission. In contrast, a (now bankrupt) technology-enabled health plan pursued an aggressive vertical integration strategy that, while sound in concept, was pursued in an undisciplined fashion at an unrealistic pace, resulting in lower-quality care delivery and high cash burn.
Revenue quality
In general, health care companies rarely reach the pinnacle of software as a service status or the high revenue streams that come with it. However, durable companies in this sector typically have low churn, the ability to expand consumer wallet share over time, strong net revenue retention (NRR), and good revenue visibility. Revenue quality not only indicates a strong business model, but it can also help a young company buy time with investors after missing a revenue projection.
Example: One company with high-quality revenue achieves nearly 120% NRR and has a high proportion of annual revenue contracted (“baked in”) at the start of each year. Mid-year upsells and renewals may vary but the company’s year-over-year performance typically tracks its forecasts. In comparison, in the early years of launch, a high average selling price, low-volume capital equipment company carries inherent volatility because each year is a clean slate and a single delayed order of a US$2 million instrument can lead to a missed quarter. Only after the company has built a sizable install base and once recurring consumable pull-through dominates the revenue mix do such companies achieve levels of predictability necessary to smooth out quarterly volatility.
Characteristics of nondurable health care start-ups
Many of the companies that were nondurable (EV under US$375 million as of 31 March 2024) did display some of the positive characteristics above that made them seem promising, so we found it necessary to further hone our screen by identifying negative traits that signal weak long-term prospects. These traits are often idiosyncratic, (as the saying goes, “All happy families are alike; each unhappy family is unhappy in its own way”) but we believe there are some recurring themes that investors can spot and avoid.
Poor cash efficiency
Looking at cohort cash flows at the bottom of the cycle (3Q21 – 2Q22), only 18% of the durable companies in our study had annualized burn rates above US$50 million, while 84% of nondurable companies were above the threshold. Viewed another way, the durable cohort averaged a -34% trailing 12-month EBITDA margin at IPO, compared to -54% for the nondurable cohort. Lack of clarity around variable versus fixed costs and/or promised improvements that fail to materialize can cloud otherwise strong unit economics.
We observed three types of companies with protected levels of elevated cash burn:
- Start-ups with backend-heavy cash flows are high-duration assets and are, therefore, levered to cost of capital.
- High capex/fixed costs companies lean into the bull case for their business and assume upfront capital investment will translate to economies of scale in the future. Unfortunately, these start-ups are typically more sensitive to revenue slowdowns and may not have time to react before cash cushions evaporate.
- Companies where strong unit economics are always sought after but can be clouded by variable versus fixed-cost fuzziness and promised improvements that fail to materialize.
Example: Consider the plight of a now-bankrupt dental telehealth company that claimed its marketing spend would lever over time but ultimately struggled to improve its unit economics. Marketing-dollar efficiency declined as “low-hanging fruit” was picked, competition increased, and conversion rates fell as the company’s reliance on seller financing and a cheap credit environment fell apart.
High growth but subscale at IPO
On average, nondurable start-ups went public at higher year-over-year growth rates than their durable counterparts but at lower revenue levels. We attribute this difference to companies with unproven business models accelerating growth to take advantage of market exuberance. In this context, growth tends to be low quality and fueled by marketing and/or excess risk taking, as opposed to high-quality organic growth. In addition, growth from a low base in the early stages of a product launch can be difficult to forecast, creating conditions ripe for missed expectations and the microcap trap.
Example: The single-cell/spatial genomics company mentioned above went public with nearly US$200 million of revenue that was growing at a healthy but predictable 30% to 40% annualized rate. Two other life-science tools companies in the nondurable cohort went public pre-revenue, with analysts forecasting a dubious three-year revenue compound annual growth rate of over 100%, which, unsurprisingly, failed to materialize.
Underestimating competition
Attempting to disrupt highly entrenched, high-margin incumbents is an uphill battle when a product is neither differentiated nor cheaper than the competition. Competitive analysis during the due diligence process is often rooted in the present day, but in our view, should instead be forward looking.
Example: A nondurable genomics company’s attempt to take on a multi-decade incumbent is illustrative of what can happen when start-ups try to go head to head with a similar product. The incumbent started a price war and aggressively discounted systems and reagents to protect its market leadership. This was bad news for the nondurable challenger considering that the incumbent, which enjoyed lower marginal costs, could outlast a price war, and lean on switching costs and network effects. Making matters worse, several additional competitors have appeared and are launching their own challenger systems, a reminder that compelling market openings are typically noticed by multiple parties.
Insufficiently acute pain points
Many nondurable companies provide “nice to have” rather than “need to have” products or services. While early-adopter enthusiasm often masks this flaw, it can quickly become apparent when start-ups aim for mass adoption.
Example: One manufacturer’s handheld ultrasound system is an example of a product that showed early promise but never found an ideal use case. Over time, hospitals, which are essentially budget-focused value-analysis committees, found that existing cart-based portable ultrasounds were sufficient for most applications and that handheld devices were not necessary to overcome financial or fleet-replacement-cycle hurdles. The manufacturer’s initial strategy of selling to individual physicians temporarily masked this problem, but its unsuccessful shift toward enterprise sales revealed the lack of a compelling financial and clinical ROI necessary to drive broad adoption.
Over indexing on TAM and selling on “potential”
For many health care start-ups, their total addressable market (TAM) is unclear. Several device companies that were initially thought to have niche TAMs ended up growing the market significantly. Conversely, we saw examples of life-science tools companies experiencing initial success in R&D applications but ultimately struggling to expand. There is a pattern of nondurable start-ups emphasizing a huge TAM (which is challenging to predict) and selling on potential/future business lines. While we appreciate trying to “skate to where the puck is going” (in the words of ice hockey legend Wayne Gretsky), one of the main reasons why growth investors are disappointed by buzzy health care companies is because they anticipate a rate of industry change on par with that of tech start-ups, only to discover a myriad of complex financial incentives and regulatory hurdles result in change being much more gradual and incremental than they expect. We would argue that trying to stay ahead of the puck is a more accurate maxim for late-stage health care investing.
Example: One nondurable telehealth business focused on digital triage and wellness tools for nearly a decade, but after going public it began pitching a value-based primary care narrative the drove it to acquire physical-delivery assets at an astonishing rate. Sell-side analysts acknowledged it was a “show-me story,” given lack of track record managing total cost of care, but the market temporarily valued the company on inorganic growth driven by undisciplined underwriting. Ascribing value beyond upside optionality to noncore opportunities is typically a mistake; in this case, the company could not control medical losses and entered a financing death spiral, resulting in bankruptcy.
Poor business integrity
We believe it is best to avoid investing in management teams that seem comfortable operating in regulatory gray areas. While identifying integrity concerns during diligence can be challenging, assessing a company’s adherence to ESG best practices can help. Investors should not assume that a company’s existing practices are acceptable simply because no one has challenged them thus far. Start-ups tend to fly under the radar due to their small scale and get caught when they begin to meaningfully threaten a disgruntled incumbent.
Figure 1: Private-to-public anonymized cohort
Conclusion
We conducted this analysis as an informational exercise to strengthen our process following a frenzied, volatile period in venture capital. We do not intend to make (or recommend making) investment decisions from a checklist alone. However, we have begun to incorporate these insights into our process and use a similar scorecard as a screening tool to triage investment opportunities. We will also continue to help steer portfolio companies away from nondurable pitfalls and toward the traits that we believe contribute to durability and long-term value creation in the private and public markets.
1The relative success or failure of biotech companies is highly dependent on a few specific factors, including clinical trial results and regulatory approval for drug therapies.
