Venture Capitalists Step Up Investment in Services

As products from technology-driven start-ups increasingly fail to gain support from customers and investors, VCs are steering more of their life sciences funds towards services. The withdrawal from technology , however, is more like a fire drill than a stampede, owing to the non-proprietary nature of medical service businesses. Yet the inefficiencies in US health care beg for solutions and VCs plan to oblige--largely by proferring information systems.

• As products from technology-driven startups increasingly fail to gain support from customers and investors, VCs are steering more of their life sciences funds toward services.

• The withdrawal from technology is more like a fire drill than a stampede, owing to the non-proprietary nature of medical service businesses.

• Yet the inefficiencies in US health care beg for solutions and VCs plan to oblige. Their savviest play: capitalizing on information systems expertise to bring health care information technology up to speed.

Most venture capitalists experienced in life science investment have spent the past 18 months on the fence, uncertain whether to fund technology- or service-oriented companies. Buoyed by the strong performance of technology-driven product companies between 1990-92, VCs easily raised new funds that called for at least some investment in the life sciences. But in the first half of 1993 a series of warnings began to emerge from the marketplace—biotech clinical failures, increased regulatory scrutiny of devices, and tepid customer enthusiasm for newly introduced products—that suggested the future would be less prosperous for technology-driven companies.

During the same time period, VCs recognized that any new national health plan in the US could dramatically alter previous, successful startup strategies. A new plan would not necessarily place more pressure on product companies, but probably would shift the focus and attention paid to the value of health care.

“Last year it was difficult to determine where the health care market was headed because of the political situation,” says Neil Ryan, a general partner at Oxford Venture Corp. “Now that it is clear that change [in the system] will come from the private market, the choices are clearer.”

Same Industry, Different Focus

For Oxford, a firm that began investing in medical service companies in 1980, the transition is seamless: investment in service companies will increase while investment in technology- or science-driven product companies will become more selective. Other firms with a history of broad life science investment, such as JH Whitney, CW Group, NEA and Allstate Insurance Co., likewise have shifted their focus to the service side. Most began around the middle of ’94 when it became clear that federal government-driven health care reform was politically doomed and the capital markets were not going to sustain biotech as they had in the past.

But for less diverse VC firms, the shift toward services is not as easy. First, many do not have partners or associates experienced in services. Adding staff, always an expensive and risky task, becomes even more so when the returns on the service side don’t match technology-driven ventures. Second, new service investments have to compete with existing portfolio companies and startups in other industries. Most life science portfolios own at least a few biotech companies with high burn rates that have little leverage for a partnership or in the capital markets, regardless of their scientific merits. Given those burdens, investment in a new life science frontier at many VC firms becomes questionable.

“In a retail startup, the whole corporation usually breaks even on sales from two or three stores,” explains Chris Gabrieli, a partner with Bessemer Venture Partners. “If you hit a recession or the competition gets ahead of you in expansion markets, you still have revenue. Maybe you have to wait to expand, but you’re still breaking even.” In contrast, Gabrieli points out, biotech companies have always counted on windfall financing just to stay alive, let alone break even. Most device startups have been seeded in anticipation of a quick, windfall market that would at least lead to an acquisition. With such windfalls no longer likely and VC firms reaching deeper into their pockets to keep biotech portfolio companies alive, partners in specialties like retail and electronics are reluctant to support a new area of life science investment.

Finally, many VCs thrived in life sciences by funding technology companies based in three geographical areas—Boston, San Diego and San Francisco. Scientists could easily be recruited within or to those areas, startups could be incubated in VC offices, their patents could be prosecuted with experienced law firms, and once the companies grew, they often could be moved into lab space just vacated by a portfolio company. But the geography is more dispersed in medical service investing. Atlanta, Nashville, Tulsa and Boise become centers of operations as health care in less densely populated regions becomes better managed and improves in quality. To succeed in services, VCs don’t need a lot of capital but are required to scour the country more thoroughly, thereby losing time and missing out on more lucrative opportunities.

In spite of these drawbacks, interest in services is booming. Only a few experienced life science VCs, such as Sanderling Ventures and Health Care Investment Corp., expect to fund technology-driven companies exclusively over the next few years. The US political events of the last eight months all point to the pressing need for a change in the way health care is delivered—but with a continued limited role by government. How health care will be delivered efficiently remains uncertain, and with uncertainty comes opportunity. VCs with life science capital are willing to gamble on the opportunity because of the inherent inefficiencies of the delivery system.

Continued Consolidation

In the short term, VCs are attempting to consolidate physician group practices in selected regions and to begin carveout businesses in many areas of health care delivery. Oxford recently capitalized on both types of opportunity when it seeded a consolidation of OB/GYN group practices on the West Coast. Bessemer played a card in both types: it seeded a consolidation of primary care practices in Atlanta and funded a radiology management company in Nashville. While the radiology management company plans to have a national business, its first client is expected to be a network of physicians in upstate New York.

VCs are pursuing two strategies to consolidate physician group practices. The first is to consolidate primary care practices in order to improve their ability to provide more specialty care at the primary level; the second is to consolidate specialty care providers.

Warburg, Pincus Ventures recently started a company that has consolidated primary care practices in Philadelphia, Dayton and Chicago. These cities and the practices were chosen because of three factors: managed care penetration in each of the markets was high, as was the insured population, and most of the patients in the practices were relatively healthy. As a result, the VCs found the economics compelling enough for the company to offer a capitated, full-risk integrated delivery network that could be competitive with a managed care group like US Healthcare Inc.

The group practices consolidated by Warburg were motivated by their desire not to lose more patients to MCOs, while continuing to practice medicine with a degree of autonomy. The same holds true for Morgan Health Groupin Atlanta, seeded by Bessemer. Bessemer’s Gabrieli describes the process as unionizing without owning, unlike the Phycor Inc. model that purchases large group practices. Explains Gabrieli, “Until about 1991, the changes in the fee-for-service system didn’t really affect the average doctor. There may have been some additional overhead and utilization review, but for most it was business as usual. Now when physicians see the Harvard Community Health Plan move their entire OB/GYN practice from one group to another, they understand the system is changing. For the first time, some doctors are actually losing income.”

Can Physicians Remain Independent?

To correct the income slide, doctors are more receptive to consolidations like those of Bessemer, which assist in management and delivery of care, as well as create a marketing channel for its members, but follow less uniform guidelines of care. “Hospitals essentially let the outpatient business walk away from them,” says Gabrieli. “Physicians don’t want to make the same mistake now.” In addition to developing a more robust outpatient business, Morgan Health aims to help physicians reduce costs, combine facilities and provide more timely specialty service to patients. For example, instead of making a walk-in patient wait a weekend or several days to see a urologist or radiologist, the Morgan Health promises specialty care within a day. More overtime is required, but many doctors are prepared to accept the overtime to retain their autonomy.

Driving the change in the work schedule is the tacit acknowledgment by physicians that buyers of their services now have more power. But that doesn’t mean that physicians are powerless, argues Oxford’s Ryan. “The distinction is how the physician perceives his future,” he says. “The hospital seeks to fill beds. The payer seeks to balance capitation. But physicians want to practice medicine. The top 75 oncologists in the country don’t want to be owned by an HMO.” At Oxford, physicians’ desire for independence will result in the recruitment of respected physicians, not just doctors with large practices. The first consolidations were in OB/GYN, where costs vary widely, but Oxford plans to consolidate practices in other specialties over the next few years.

How Much of a Business?

While physician consolidations and carveout options appeal to many VCs, others caution that such strategies may have a limited shelf life. Carveouts, for example, seek to provide lower cost, more efficient service to payers, employers and MCOs on a capitated basis in a system in which prices remain high due to the lingering influence of fee-for-service reimbursement.

A carveout such as management of radiology services would allow payers to work with fewer hospitals in a defined region. Instead of 50 radiologists in a market of 500,000 patients, the number could be reduced to 25.

The carveouts of OB/GYN practices seeded by Oxford and The Mayfield Fund promise to deliver quality care at a lower cost than prevailing rates in a defined region. Aggressive carveouts in asthma patients, worker’s compensation-reimbursed rehabilitation programs, and home health care promise to cut costs by closer management of the biggest users in the system.

But because all the carveouts are centered around reducing costs in the existing system, many VCs question where carveouts can go once price equilibrium is established through competition in the marketplace. Most state worker’s comp laws now allow employees to go directly to the hospital for treatment of a broken leg. The hospital bill may amount to $1,000; a carveout business can surely halve the cost, but how long will the business last once the surviving MCOs and integrated delivery networks establish a market price for the treatment? Similarly, the national average of the cost to deliver a baby is $2,500; in California, it’s $1,300.

“I’m not sold on carveouts,” says Paul Queally, a general partner with The Sprout Group. “The smart HMOs already have the numbers [on how to provide local cost-efficient service] in house. It may make sense in some parts of the country where there are undermanaged segments, but I don’t see HMOs or large providers letting go of the business.”

Part of the enthusiasm for carveouts, say VCs, is that the system is in such disarray and plan administrators are so spooked, they’ll enter into any agreement to keep their companies alive. But over the long term, if all health care in the US is delivered, as expected, by an estimated 70-300 large providers, carveout businesses inevitably will be absorbed by the larger providers. For VCs, the right carveouts in the right markets present decent short-term opportunities for an acquisition exit—but little or no chance for long-term business.

“Carveouts and disease management are very popular now,” adds another VC. “But when you get down to the economics, they really don’t make a lot of sense. A lot of experienced venture capitalists may end up losing their shirts by picking the wrong specialty or region.”

Chasing Health Care’s Microsoft

Over the long term, the choices for VCs are clear. Nearly all have identified the need—and the opportunity—to provide the health care system with open architecture, client/server software systems. The big question is how. Explains Chuck Hartman, managing general partner at the CW Group, “Everyone acknowledges that if you can manage your own data you have a competitive advantage. Right now, there’s a good amount of financial data and software in areas like cost containment and reimbursement; development of clinical data and electronic patient record systems is coming along. But the clinical data [and systems] are completely different from the financial data. And how to integrate both just doesn’t exist now.”

As a result, VCs envision two large markets in health care information systems over the next 5-10 years. The first lies in the evolution of the handful of flexible, open-architecture software systems that will link clinical information from autonomous providers, such as clinical labs and physician offices, to a central database. The second is the design and development of systems that measure patient outcomes and the quality of care.

The central database in an open-architecture system could be owned by a payer, an MCO or, as illustrated recently by drug company purchases of pharmacy benefit management companies, perhaps a product company.

Because several types of companies could benefit from establishing a central database, or refining an existing one, VCs anticipate high demand for novel, adaptable software that integrates and consolidates current medical-related data. They also expect that competition among medical service providers will continue to lower the price of services, whether the service is a niche like rehabilitation therapy or total package like complete managed care.

The service companies that own the most complete data—by interacting with the most comprehensive database—stand the best chance of offering the most cost-efficient price for their services. Eventually, the most cost-efficient price will result in gaining the most patients. Ten years down the road, goes the thinking, perhaps a handful of service providers will play a role in health care delivery similar to what Baby Bells play in telecommunications—all as a result of owning the best information.

The software networks already exist that can link the myriad of health care service users together; they are used commonly in the airline, banking and insurance industries. What is needed most is the vision of a large payer, MCO, or HMO network to consolidate and vertically integrate the data. Consequently, VCs foresee few design constraints in the adoption of open-architecture networks. However, the second information opportunity faces formidable design obstacles because of the qualitative measures involved: development of systems that can evaluate patient outcomes and satisfaction.

As the competition increases for every cent of the capitated dollar, more physicians and companies are working to demonstrate the quality of care and savings they provide. Right now, the demand for outcomes information remains mostly business-to-business: Advanced Technology Ventures invested in Healthshare Technologies, a company that designs software to compare the performance of hospitals in common surgical procedures. Another startup, Compass Inc., seeded by Delphi Ventures, is measuring the performance and effectiveness of psychiatric services provided to payers and HMOs.

Healthshare Technologies’ clients include MCOs, drug companies and Wall Street firms; Compass intends to market its information to other HMOs. But VCs envision the day when such outcomes information could be used by the general public. Though evaluating and comparing medical options in Consumer Reportsmay never come to pass or may be a decade away, the emergence of companies like Healthshare, Compass and Apache Medical Systems clearly indicates more third-party evaluation of services will be forthcoming. VCs expect to take incremental steps toward that effort, aiming to eventually cash in when outcomes information will be fully integrated with other clinical data.

Complicated Exits

Ideally, VCs would like to combine information companies into multi-regional or even national providers. The larger the company, the larger the takeout valuation.

But information systems in health care remain too stratified to present an immediate major opportunity for inter- or intra-portfolio mergers. Explains Jim Garvey of Allstate, “It’s possible to go into many [regional] markets and establish a customer base of major providers and users [physician groups] that would share the software. But in the best markets you end up with a $20-30 million company, $100 million at the high end. And no exit strategy.”

The problem is that regional systems tend to be customized and cannot easily adapt to the software and hardware used by large providers in other regions. Without the ability to expand quickly to cover new customers in different regions, the information provider is stuck in its region and is unlikely to go public or attract an acquirer.

Garvey suggests that one possible solution to the exit strategy problem will be for VCs to promote the development of several regional integrated systems, along with compatible disease management systems, and then combine them later. Allstate is working with a consortium of technology CEOs in the Midwest to refine the concept, but Garvey adds it is difficult to get the management of large providers and VCs to agree.

Last November, roughly one year after adopting a strategic initiative to invest a portion of its most recent $225 million fund in medical services, Kleiner Perkins Caufield & Byers accommodated management by seeding a company that will design modular, open-architecture software for managed care operating systems.

The software will be designed around existing systems used by hospitals and providers. It also will aim to capture existing data in financial software based on fee-for-service reimbursement and convert the data to an application that can manage multiple capitated agreements. Since the company will tailor its information system to fit specific customer needs, KPCB expects customers will be willing to experiment incrementally.

For example, says David Schnell, a partner at KPCB, “We expect to approach each customer and ask ‘What is your primary tool to manage risk?’ After they tell us, we should be able to explain how a modular application, or several applications, can improve their risk management.”

Eventually, contends Schnell, successful integrated networks will recognize that they can’t rely on multiple, imcompatible proprietary systems, and the integration of open architechtural modules will allow geographically dispersed regional systems to communicate with each other.

Schnell believes that only a few “breakout” systems companies will succeed in the health care information market, raising the stakes for all VCs that enter. And unlike the biotech sector, where scientific discoveries have seemingly reshaped the industry every two years, the information market will allow few VCs to play catch-up.

Because medical information is so fragmented now, the early adopters gain an advantage through information that can demonstrate successful cost containment and patient outcomes. But given the changes ahead for health care, superior information systems will be essential. VCs plan to be behind the systems that are adopted, as more and more are willing to pass on some science opportunities in favor of services.—WL