Marshall E. Jackson Jr., Stephen W. Bernstein, and Krist Werling, McDermott Will & Emery09.25.23
The economy’s downturn in the second half of 2022 created powerful headwinds in the digital health investment space, taking an industry that was thought to be radically reshaping healthcare during the pandemic and bringing expectations back down to earth.
Total funding for digital health startups came in at $15.3 billion in 2022, about half the size of investments seen in 2021 in this space. Not only was total investment down, but the number and size of deals also declined from 2021 to 2022, according to an analysis from Rock Health. Those trends continue, with Rock Health’s recent analysis predicting that 2023 will be the lowest funding year since 2019, based on H1 2023 activities.
Despite this shift, there are still opportunities for digital health deals in 2023, provided the technology can show measurable value and investors are willing to be creative about deal structure. There are several trends to watch as digital health companies and investors continue to adapt to market challenges.
As 2023 progresses, the most sought-after digital health solutions are likely to be those that focus on two goals: assisting hospitals and physician practices with solving longstanding problems, such as achieving greater interoperability of electronic health record systems, creating efficiencies in supply chain management and assisting with staffing management; and those that hold promise for innovation, such as value-based care.
With such a broad umbrella and so much potential to drive efficiency (and with it, dollars), digital health can often look good on the surface but fail to pan out. With this new funding landscape, a digital health company must be able to demonstrate that it can produce a concrete return on investment to either patients, providers, partners, or payers—but ideally to all four. In order to spur investment in the current environment, the technology must have measurable value almost immediately by reducing costs, increasing access, or creating a specific measurable value for a stakeholder in the system.
While pandemic investment was often driven by revenue growth and a company’s path to profitability, today’s investors are seeking a robust customer base, recurring revenue, and products that can quickly scale. Investors are also wondering how this technology can reduce burdens on the healthcare system and provide measurable value.
Private equity-backed physician practices are seeking digital health solutions that can help them create efficiencies and synthesize data more effectively to improve care while lowering costs, thus maximizing revenue in a short period of time so they can look more attractive to potential buyers, including household names that have acquired smaller digital health organizations for their portfolios.
Payers and retailers are also seeking digital health solutions as they find ways to reach members and consumers while improving care and lowering costs.
For example, Washington state, Nevada, and Connecticut have all enacted new health privacy laws that focus on the ways in which companies handle non-Health Insurance Portability and Accountability Act (HIPAA)-related consumer health data. This type of state-based legislation is likely to have a wide-reaching impact on healthcare companies, data processors, advertisers, and mobile app providers, and inspire similar efforts in other states. Similarly, at the federal level, CMS introduced a Request for Information from healthcare providers and other stakeholders on the use of remote monitoring, remote cognitive behavioral therapy, and other digital therapeutic models in exploring the strength of clinical evidence for local Medicare coverage of remote physiologic monitoring and remote therapeutic monitoring services for non-implantable medical devices. The FDA, meanwhile, is proposing new rules for modifications to artificial intelligence/machine learning-enabled device software.
These examples highlight the rapidly evolving nature of the digital health regulatory landscape and the importance of staying abreast of these developments beyond the period of due diligence. While regulatory complexity certainly creates a barrier to entry, it can also be an opportunity for investors who know the landscape.
Additionally, minority growth equity and other types of structured transactions allow both pies to essentially table the issue of valuation during a down market. Lower valuations are also driving an increase in continuation fund activity, which allows investors to keep a portfolio company in the fund until it can be sold for a higher valuation.
For 2023, smaller deals may be easier to close. For deals below $50 million in EBITDA, financing has been available, though it has typically taken multiple lenders to fund a deal. However, beyond the $50 million threshold, financing has been difficult to find, especially from banks in the syndicated market. As investors wait for the debt markets to open up, there is a growing backlog of deals that are prepped and ready to go when economic conditions improve. In the meantime, the key to successful dealmaking in digital health for most of 2023 is likely to be creativity, whether through continuation funds or minority deals.
Digital health technology has the potential to become the glue needed in a fragmented healthcare system. Despite the challenges, there are deals available for digital health solutions that address burdens and inefficiencies in the healthcare system and can produce a strong return on investment.
Marshall E. Jackson Jr. is a partner in the Washington, D.C., office of McDermott Will & Emery and co-leads the firm’s Digital Health Practice. He focuses his practice on transactional and regulatory counseling for clients in the healthcare industry, as well as advises clients on the legal, regulatory, and compliance aspects of digital health.
Stephen W. Bernstein is a partner in the Boston office of McDermott Will & Emery and the Partner-in-Charge of Health Practice Operations. He specializes in e-health, big data, data engineering, deployment of digital health solutions and health-related matters affected by the Health Insurance Portability and Accountability Act.
Krist Werling is a partner in the Chicago office of McDermott Will & Emery and is a co-leads the firm’s Private Equity Practice Group. He represents private equity and strategic investors in various transactional matters in the healthcare and life science industries.
Total funding for digital health startups came in at $15.3 billion in 2022, about half the size of investments seen in 2021 in this space. Not only was total investment down, but the number and size of deals also declined from 2021 to 2022, according to an analysis from Rock Health. Those trends continue, with Rock Health’s recent analysis predicting that 2023 will be the lowest funding year since 2019, based on H1 2023 activities.
Despite this shift, there are still opportunities for digital health deals in 2023, provided the technology can show measurable value and investors are willing to be creative about deal structure. There are several trends to watch as digital health companies and investors continue to adapt to market challenges.
Tech to Solve Long-Standing Problems, Drive Innovation
During the COVID-19 pandemic, companies pursued digital health solutions related to telemedicine and remote patient monitoring, and the rapid acceleration in the adoption of this technology sent valuations soaring. Many of these valuations were not based on creating measurable efficiencies in the healthcare system but rather on the expectation that demand for the technology would continue to grow. As pandemic restrictions have ended, patients have consistently voted with their feet and returned to physician offices. A 2021 study conducted by Rand Corporation researchers found that while patients were willing to participate in video visits, they preferred in-person care. In fact, the study found that patients were willing to pay a higher copay for an in-person visit but were more price sensitive about video visits.As 2023 progresses, the most sought-after digital health solutions are likely to be those that focus on two goals: assisting hospitals and physician practices with solving longstanding problems, such as achieving greater interoperability of electronic health record systems, creating efficiencies in supply chain management and assisting with staffing management; and those that hold promise for innovation, such as value-based care.
Evaluating a Digital Health Investment
Digital health is a fairly broad term, but it can be difficult to define and even more difficult to evaluate. Today, digital health solutions can encompass everything from software-enabled medical devices and mobile health apps to telemedicine tools. However, any type of technology used to provide or manage healthcare can be considered digital health, not just those that provide the care itself.With such a broad umbrella and so much potential to drive efficiency (and with it, dollars), digital health can often look good on the surface but fail to pan out. With this new funding landscape, a digital health company must be able to demonstrate that it can produce a concrete return on investment to either patients, providers, partners, or payers—but ideally to all four. In order to spur investment in the current environment, the technology must have measurable value almost immediately by reducing costs, increasing access, or creating a specific measurable value for a stakeholder in the system.
While pandemic investment was often driven by revenue growth and a company’s path to profitability, today’s investors are seeking a robust customer base, recurring revenue, and products that can quickly scale. Investors are also wondering how this technology can reduce burdens on the healthcare system and provide measurable value.
Eager Buyers Remain
Despite the slowdown in deals, there are still willing buyers for digital health tools that can solve problems. Over the last few years, hospitals have seen private equity firms acquire a large volume of healthcare practices, leaving hospitals looking for tools that can make them competitive in this new environment.Private equity-backed physician practices are seeking digital health solutions that can help them create efficiencies and synthesize data more effectively to improve care while lowering costs, thus maximizing revenue in a short period of time so they can look more attractive to potential buyers, including household names that have acquired smaller digital health organizations for their portfolios.
Payers and retailers are also seeking digital health solutions as they find ways to reach members and consumers while improving care and lowering costs.
Navigating the Regulatory Environment
One of the key challenges for digital health companies is the fragmented regulatory system that makes it necessary to understand the rules of the road within every state as well as across various federal regulators, such as the U.S. Food and Drug Administration (FDA), the Centers for Medicare and Medicaid Services (CMS), the Office of the National Coordinator (ONC), and the Office of the Inspector General (OIG).For example, Washington state, Nevada, and Connecticut have all enacted new health privacy laws that focus on the ways in which companies handle non-Health Insurance Portability and Accountability Act (HIPAA)-related consumer health data. This type of state-based legislation is likely to have a wide-reaching impact on healthcare companies, data processors, advertisers, and mobile app providers, and inspire similar efforts in other states. Similarly, at the federal level, CMS introduced a Request for Information from healthcare providers and other stakeholders on the use of remote monitoring, remote cognitive behavioral therapy, and other digital therapeutic models in exploring the strength of clinical evidence for local Medicare coverage of remote physiologic monitoring and remote therapeutic monitoring services for non-implantable medical devices. The FDA, meanwhile, is proposing new rules for modifications to artificial intelligence/machine learning-enabled device software.
These examples highlight the rapidly evolving nature of the digital health regulatory landscape and the importance of staying abreast of these developments beyond the period of due diligence. While regulatory complexity certainly creates a barrier to entry, it can also be an opportunity for investors who know the landscape.
Creativity Needed to Close Deals
Interest rate hikes and a tight labor market can make it tough to close digital health deals. However, for the right company, investors are willing to get creative. One trend on the rise is minority growth equity. This structure has become popular as access to debt has been restricted, with some private equity firms closing as many as half of their deals this way. Minority growth equity has advantages on both sides of the deal and increasingly founders are happy to have the input from private-equity board members and even CEOs.Additionally, minority growth equity and other types of structured transactions allow both pies to essentially table the issue of valuation during a down market. Lower valuations are also driving an increase in continuation fund activity, which allows investors to keep a portfolio company in the fund until it can be sold for a higher valuation.
For 2023, smaller deals may be easier to close. For deals below $50 million in EBITDA, financing has been available, though it has typically taken multiple lenders to fund a deal. However, beyond the $50 million threshold, financing has been difficult to find, especially from banks in the syndicated market. As investors wait for the debt markets to open up, there is a growing backlog of deals that are prepped and ready to go when economic conditions improve. In the meantime, the key to successful dealmaking in digital health for most of 2023 is likely to be creativity, whether through continuation funds or minority deals.
Digital health technology has the potential to become the glue needed in a fragmented healthcare system. Despite the challenges, there are deals available for digital health solutions that address burdens and inefficiencies in the healthcare system and can produce a strong return on investment.
Marshall E. Jackson Jr. is a partner in the Washington, D.C., office of McDermott Will & Emery and co-leads the firm’s Digital Health Practice. He focuses his practice on transactional and regulatory counseling for clients in the healthcare industry, as well as advises clients on the legal, regulatory, and compliance aspects of digital health.
Stephen W. Bernstein is a partner in the Boston office of McDermott Will & Emery and the Partner-in-Charge of Health Practice Operations. He specializes in e-health, big data, data engineering, deployment of digital health solutions and health-related matters affected by the Health Insurance Portability and Accountability Act.
Krist Werling is a partner in the Chicago office of McDermott Will & Emery and is a co-leads the firm’s Private Equity Practice Group. He represents private equity and strategic investors in various transactional matters in the healthcare and life science industries.