How and Why Family Offices Should Consider Healthcare Venture Investments
Written by Spring DigitalDx Venture Fellow Adam Aguilera
Introduction
Within the past few years, family offices have increasingly ventured into alternative assets as a means of generating superior returns and diversifying their portfolios. As family offices of all types have begun to more thoroughly explore this space they have realized that there are multiple options to deploy capital. Additionally, many family offices are more thoroughly assessing how these private investments can maximize the social impact they are generating. For most family offices, it can be difficult to navigate these options without adequate expertise in-house to assess which of the many opportunities that come across their desks should be pursued.
One particularly compelling area, even pre-COVID, lies in the portion of the digital health space focused on innovative diagnostics. As family offices continue to prioritize the impact of private investments, they should take a close look at this segment of the healthcare ecosystem. The most prudent type of exposure comes through investing in funds targeting this space. While family offices have demonstrated an increased interest in pursuing direct venture investments, they are often at a disadvantage when assessing the science behind novel diagnostic technologies and the growth of personalized medicine. As a result, many family offices should focus on providing capital as Limited Partners (LPs) to venture firms focused on the future of medicine and digital health as a means of optimizing for increased returns and social impact.
Power of Indirect Investments
One does not need to look further than the current challenges we are living through due to the COVID pandemic to understand why indirect investments are a safer way for family offices to preserve capital, principally in sectors with knowledge-related barriers to entry. The uncertainty around COVID testing, serological testing, and the vaccine timeline is hard enough for scientists and medical professionals to understand, let alone those without any background in medicine and pathology. Additionally, the ease with which sophisticated investors can be duped was highlighted in the hype surrounding the growth of Theranos. Aside from considerations unique to healthcare investing, the earlier one goes into the venture capital spectrum, the more likely it is for challenges to arise. As compared with more de-risked investments in mature companies, the risk-return profile for venture investments, along with founder assessments and dilution considerations, requires a different approach for deal diligence and, ultimately, execution.
Accordingly, family offices looking to directly invest in these promising startups must have the requisite industry knowledge and technical valuation skills. Familiarity with market terms, cap table resets, financial modeling under high degrees of uncertainty are just the basics of venture capital investing that may necessitate external advisors or new in-house hires. This required expertise indicates that fund investments are the most prudent way of allocating capital to this rapidly growing investment vertical. According to a UBS Research Report, 57% of 360 family offices that were surveyed, indicated they were making venture investments (either directly or through funds). To participate prudently in this space through direct startup investments, family offices should focus on deploying capital in the sector(s) that align with their primary operating businesses. However, only an estimated 6.3% and 1.6% of the family offices surveyed in the UBS report have operating businesses in technology or in healthcare/social assistance (see chart below). Unsurprisingly, more than half of these surveyed family offices come from more traditional sectors, including real estate, manufacturing, or finance/insurance. This does not mean that the vast majority of family offices should automatically turn away from any potential investments that are not in their wheelhouse, they should simply access them through a specialized venture fund.
Primary Industry of Family Office Operating Business
In addition to being able to leverage the expertise of sector-focused investors, indirect investing also has other notable benefits. Given how competitive the venture capital world can be, it is not surprising that direct access to the most compelling deals can be a serious obstacle. Even in the best case scenario where one knows the vertical and consensus can be garnered to make an investment, sometimes, there simply is not enough room for a family office to fit directly on the cap table. As cited by a CIO at a single family office in the same UBS report, “We like direct investing, but we have not been able to deploy bigger dollars there. It is easier at a fund level to commit bigger sums.” While there is a desire to cut out fees that come from investing in a fund, the reality is that indirect investments are still a more efficient means of accessing deals that many investors realize. Some of the funds that family offices can access benefit from proprietary deal flow. This can come from the fund’s reputation or investing track record and is one of the key reasons that serving as an LP can prove to be especially fruitful. There is also reason to believe that this exclusivity might accelerate in the healthcare investing space given the current economic climate. Digital health investors will deploy capital into new investments more cautiously during a recession while they simultaneously take action to support their existing portfolio companies. With that in mind, expect to see a convergence of capital to a smaller set of deals which could ultimately lead to increased competition for the best deals. Furthermore, if we examine the pooled returns across a large set of US venture capital firms by vintage year from 2000–2016, we see an average of 11.73%. This pales in comparison to the average pooled return of 18.01% from 2007–2011, the period during and immediately preceding the financial crisis of 2007–2008. This trend in conjunction with the aforementioned selectivity in digital health points even more strongly to the consideration of investing in the space despite the current economic climate.
Another benefit of indirect investing comes from the preservation of a higher level of anonymity as an LP versus being a direct investor. Many family offices understandably prefer to not be highly visible given the publicity and large number of inbound requests. Confidentiality and privacy will only continue to grow in importance given the increased risk of cyber threats. Investing through a fund means that there is no need to be the face behind the capital that is provided. This can insulate the family office from scrutiny or demands from entrepreneurs while ensuring that they can still participate in the potential upside from a venture investment.
Exerting Influence as a Limited Partner
While privacy and anonymity may be important to many family offices, many do still want to have some level of influence on the investments they are making, particularly in regards to the early-stage companies that they are backing. As younger members of the family begin to exercise more control over their respective family offices, there is an increased desire to think deeply about the impact associated with their investments along with a desire to be a more active part of generating that impact. Millennials are generally not satisfied deploying capital passively and that has led a larger number of family offices to consider direct investments. Whether that means taking a board seat or having the ear of a founder, there are multiple ways to exert some level of influence through one’s early-stage investments. However, serving as an LP and having control are not necessarily mutually exclusive options.
One alternative that has become common is to co-invest with the partners of the fund that a family office has already committed capital to. In the later-stage world of growth or traditional private equity, 43% of funds now allow for co-investing through sidecar vehicles and this trend should become more popular for earlier-stage investing as well. There are many different ways that this co-investment can be structured, but what’s important to note is that this serves as a means of increasing exposure to a specific portfolio company in a more secure way than through a standard direct investment. When coupled with the aforementioned benefits resulting from proprietary deal flow, co-investing allows a family office to gain experience in an unfamiliar space while tagging along with an experienced capital provider that can open the doors to opportunities that they would likely never see through direct investing.
Another benefit of investing alongside a fund is that a family office can have some level of access to the research and due diligence completed by investors at the venture firm. Since access to professional due diligence can be an issue in assessing potential direct investments, this provides support that may not usually be available to a family office. Should a company not end up being funded by the venture partners, the family office still has some resources to assess direct investments due to their relationship as an LP. Perhaps the most appealing approach is a hybrid model, where family offices are able to assist in the sourcing and deal origination while potentially also participating in the preparation of due diligence. Either way, it is clear that multiple options exist when a family office has their relationship with a venture capital firm solidified as an LP.
One frequently cited concern for family offices that are considering providing capital as an LP is the fee structure. However, the venture firms that generally have the leverage to charge higher management fees and alter the carry structure are often the most prominent ones that are fully invested and more general in focus. The growth of the venture investing space has recently allowed for smaller, emerging funds, such as DigitalDx Ventures, a venture firm focused on diagnostics powered by artificial intelligence, to generate success. These smaller funds are more specialized and more accessible to family offices, not only on a financial basis because capital commitments are of reasonable size, but also from a supply and demand perspective since it is more feasible to get into a newer fund. Additionally, smaller funds tend to outperform larger ones as cited by one of Preqin’s data sets that looks at average pooled returns across hundreds of funds from 1969–2015. (see chart below). And in the diagnostic healthcare space, it certainly makes most sense to look for a specialized team that can capitalize on an ever-growing opportunity set.
Obviously, not all venture firms will be successful, so it is imperative for a family office to do their diligence when looking at these newer venture capital firms. Ultimately, it is oftentimes more comprehensible for a family office to assess the team and track record of a venture firm than a highly technical, science-based startup. As mentioned previously, the competitive and time-consuming nature of targeting the right startups for investment is something that challenges seasoned venture investors, let alone family offices that may not have adequate experience. De-risking this process requires a very high level of deal flow and an internal team that can devote sufficient time and expertise to monitor and assist earlier stage companies with their growth. Even if an internal team can be sourced, it may still be difficult for a family office to staff and retain this team over the longer term. These reasons demonstrate the benefit of indirect investments, especially in the healthcare space.
Intersection of Social Impact and Healthcare Investing
The current pandemic has obviously increased investing interest in the healthcare space. For many family offices, this means exploring the relationship between social impact and healthcare. This should come as no surprise since data clearly shows that underprivileged communities of color have been disproportionately affected by COVID. However, it is important to note that the increased flow of capital into healthcare technology startups was already outpacing investments in many of the other traditional sectors that venture investors monitor. Between 2011 and 2019, the total amount of annual venture funding into digital health increased from just over $1B to $7.4B (see chart below). Of course, the time lag associated with calculating venture returns makes it challenging to assess the overall performance of these investments. However, this increased flow of capital over the past decade has laid the foundation to aggregate data, iterate on business models, and begin standardizing impact measurements as they relate to improved health outcomes. This foundation will prove essential as the healthcare venture ecosystem moves into the new decade with increased hopes of continuing to transform how healthcare services are rendered through the use of value-based care, preventive and personalized medicine, and cost-effective care. Furthermore, this robust groundwork indicates that healthcare venture investing is a promising area to invest in for any family office. Ultimately, there is reason to believe that this push to rethink healthcare will continue to accelerate, and impact-minded investors will look more closely at opportunities in the space by working closely with experienced investors.
Rock Health: Digital Health Funding 2011–2019
There has never been a better time for family offices with an impact mandate to look closely at the diagnostic technologies that will be a huge component of the shift to more equitable healthcare access across the globe. In the previously cited UBS Family Office Report, more than half of family office respondents indicated that healthcare investments were a sustainable investment cause that they already supported. Furthermore, of the family offices in the report that are engaged in philanthropy, 90% already give to education and health initiatives — a strong indicator that there is appetite for healthcare investments that can also generate a return while creating a positive impact.
Coming back to the impact being generated by the aforementioned venture investing firm, DigitalDx, there is a clear alignment of healthcare and social impact in the organization’s investment decisions. This is clearly demonstrated through DigitalDx’s focus on the United Nations’ 3rd Sustainable Development Goal (SDG) — ensuring healthy lives and promoting well-being at all ages. DigitalDx’s current portfolio companies are a clear example of this impact as they seek to address medical conditions collectively affecting more than two billion lives around the world. Through the funding of companies that are developing technologies that can more efficiently and economically diagnose prevalent conditions, DigitalDx is playing a key role in bolstering access to essential healthcare services. Domestically, one of the biggest issues within the healthcare ecosystem is the focus on developing the most advanced therapeutics and medical technologies, but this oftentimes overlooks the price that ultimately flows through to payers or individual consumers. Family offices should view the funding of more effective and affordable care options as an exceptional opportunity, but as previously discussed, for the vast majority of family offices, the most prudent way to begin investing in the space is through established funds with ample expertise.
Another positive aspect of healthcare investing is the ability to target diseases of particular significance for a given family office. Due to the range of potential therapeutics and diagnostics that entrepreneurs are working on, it is possible to source companies creating products or services that are tied to specific diseases or conditions. With the assistance of seasoned investors, this process of identifying and learning about healthcare startups that are specifically aligned with a family office’s area of interest is greatly facilitated. And despite the recent focus on the space, most venture investors are not simply jumping in as first timers. 62% of venture capital firms investing in digital health in 2019 were repeat investors, (see chart below) further indicating that this is as good a time as any to start deploying capital in the space as an LP.
Rock Health: Distribution of Digital Health Investors
One last point worth mentioning is the importance of targeting startups that pursue providers as their primary go-to-market avenue. This trend was very visible through the first quarter of 2020, with 63% of all funded digital health companies selling directly to providers. An impact thesis aligns with this strategy since coordination with providers is essential to gain significant market traction and maximize impact. DigitalDx’s portfolio of diagnostic startups fits well in this regard, making it a viable investor to collaborate with as an LP.
Final Thoughts
The last few years have ushered in a strong desire among venture investors to back promising ideas in the healthcare and technology space. Family offices would be well-served to partake in the funding of startups in this ever-growing sector, but are best suited to do so as indirect investors, ideally as LPs (for a thorough analysis on what to look for when assessing venture funds, see this research report). Committing capital as an LP does not necessarily mean that a family office will be unable to exert some level of control and influence. Within the health and technology space, novel diagnostic technologies and personalized medicine are specific areas that should be targeted by family offices most interested in the intersection of healthcare and social impact. For family offices truly attracted to these propositions, DigitalDx is one of a number of emerging healthcare venture investors worth taking a closer look at.
