Back in 2020, just as it looked like the entire world came to a stop from the pandemic, many of us thought that the capital markets would suffer greatly. After all, investors look for stability, strong economic activity, and consumer confidence to allocate capital. If there’s market uncertainty, business or consumer lack of confidence, or any type of shock to the system, they usually pull back. Along the way, the opposite happened after the pandemic! Investment activity picked up significantly in the second half of 2020 after a few slow months following the lock-downs. Not only did the investment activity picked up, but also it set records over the next 18-24 months. The level of investment by private and public investors reached record levels, the exit markets soared. IPOs and M&A markets showed significant activities and capital gains flowed to investors, both public and private. In the private markets, VC distributions to their LPs hit record levels and as a result, those Limited Partners (LP) allocated a bigger portion of their portfolios to this asset class. It all seemed like a dream! The pandemic seemed to have the opposite effect to what everyone expected. What could explain all of this?
When it became obvious that the deadly virus was forcing lock-downs and significantly slower economic activity, the governments and central banks responded with unprecedented level of stimulus. As you recall, the federal government passed legislation to send checks to individuals and created programs to help businesses. The Fed cut interest rates to zero and provided significant liquidity into the economy. Suddenly, investors and consumers had a lot of money to spend. Businesses that catered to the digital economy greatly benefited. Zoom, telehealth companies, e-commerce companies, and more. Public market indices soared and investment levels in private market investment levels reached record levels in 2021. It looked like it was all kitties and puppies and investors and entrepreneurs could not miss! One of the byproducts of this euphoric era was the private market valuations. In VC, companies raised capital at record valuations and often at never seen multiples to their revenues or even if pre-revenue, the valuations reflected a level of optimism about their future prospects. This led to a ballooning of the Net Asset Values (NAV) for VC companies over time.
What has followed since then is the type of unexpected turn of events that has had a lasting chilling impact on the private market investments. Following a run-up in inflation, the Fed raised interest rates in rapid fire succession and the cost of capital increased dramatically. Suddenly, risk assets such as early stage companies had to compete with safer assets that were offering returns in the 5-7% annual range, rather than 0%! LPs not only could get nice returns on lower risk assets, they faced lower distributions from their VC investments due to a slow IP and M&A market. Why did the IPO and M&A markets slow down so much? Well, when sanity returned to the markets following a period of euphoria with cheap money flowing in all directions, investors now had to be more disciplined in their evaluation of companies since money was more expensive now. Suddenly, companies that had previously been valued at astronomic levels did not look as attractive. Their fundamentals such as revenue growth, customer traction, technology maturity, etc did not support the previous valuations. But the companies that had raised at those high valuations were clinging to those valuations and wanted to be acquired, go public, or raise money again at those levels. This mismatch of what the investors were now valuing those companies at and what those companies were asking led to slow activity in the M&A and IPO markets.
The result of all of this was lower distributions for the LPs. What happens when the LPs are not getting the expected distributions back from their investments? They stop writing more checks to that asset class. This has resulted in lower fundraising by VC funds and lower investment levels by them into companies. While the investment levels have still been high by historic standards, they have been lower than the 2020-2021 levels and valuations have been far lower. This has meant a much tighter funding environment for entrepreneurs. Those who were coming back to raise again had to agree to valuations more in line with their fundamentals. As a result, the percentage of companies raising flat or down rounds increased significantly. For those companies raising their first priced round, the valuations are much more in line with historic benchmarks and with their fundamentals. While this is a good development long-term, it has made fundraising more difficult in all fronts: funds are having a hard time raising money from the LPs due to low distribution levels and entrepreneurs are having a hard time raising money from VCs because they have less dry powder and are much more cautious about writing checks and the valuation levels they invest at.
Digital health and its branch, health AI, has not been immune to any of these trends. Digital health is about Telehealth, remote monitoring, remote chronic disease management, automation, and more and all of that was in line with the themes that attracted large amounts of capital in the 2020-2021 period. That meant high levels of investment at high valuations, the exact recipe for later problems! While investment levels are significantly down from those days, they are still at respectable levels given the level of dry powder that was available to VCs from their high fundraising levels in that time. That dry powder, however, has been dwindling down and unless the exit markets perk up, it can spell trouble for digital health companies that are raising capital. The valuation story is an interesting one. Given the story that I’ve been telling in this post, you would expect that the valuations would have cratered over the last couple of years. Oddly, that has not been the case. The reason is not entirely clear but there are a few possible explanations. First, many companies have delayed raising new priced rounds to grow into their valuations. They’ve done this by cutting their burn rates, raising unpriced rounds (e.g., bridge loans,) and cutting their growth targets. Another explanation is that many of the rounds are being done at significantly lower valuations but those are not being disclosed. The percentage of funding rounds that are being done without a public disclosure of the valuations is way up! The same is happening in the M&A market. Digital health companies are exiting to other digital health companies, corporate buyers, or PEs without disclosing the price. This often indicates a low sales prices that is best not publicized!
With the new administration pursuing a different regulatory regime, new fiscal policy, and the proposed tariffs, there is uncertainty and volatility in the public markets. The private markets are also showing caution so far in 2025 as the investors try to figure out what all of this will mean for the re-opening of the IPO window or the M&A landscape. The fact that inflation has proven more sticky than expected can mean that the Fed will keep the interest rates at higher level for longer. This will mean lower liquidity and higher cost of capital, not a recipe for asset price appreciation or more deals. If all of this indeed will result in a continuing slow exit markets, we can expect the investment levels and valuations to remain subdued for the near future. If you’re an entrepreneur or an investor, this is the time to focus on business fundamentals, product development, setting realistic growth targets for your stakeholders, and wait for your moment.
