Funding for new technologies and products-the research and development expenditures that drive medical advancement-comes primarily from venture capitalists. Venture capital investors, contrary to public perception, are not swashbuckling gnomes from Zurich but portfolio managers, funded with capital from leading corporate and public pension funds as well as college and foundation endowment funds. The attraction of medical venture capital is all about historical and prospective returns, not social and community needs.
For two decades the venture capital community has served as a "gatekeeper" for the development of healthcare investment. The medical-care community, by contrast, has served as the customer for product innovations and improvements.
Failure to understand the closed world of medical venture capital and its impact on future industry development threatens senior managers' capacity to discharge their most critical functions of strategic planning and capital allocation.
Healthcare products and services are among the most technology-driven, knowledge-based sectors of our economy. The ongoing "creative destruction" process, to improve quality and reduce cost, is unrelenting. The small percentage of research and development embedded in the budgets of most provider organizations distorts the "off-balance-sheet" investment that venture capitalists make on providers' behalf. Providers have viewed themselves not as principals in medical research and development but as customers for the results. Yet attractive returns have consistently led money managers to allocate more funds for medical research and development. Many of today's leading names in healthcare services and technology were yesterday's venture-funded start-ups.
Executives at hospitals and health systems have long wrestled with whether provider capital should be exposed to risk and the opportunity to fund medical innovation. Surplus capital on a hospital balance sheet has been viewed as "temporary funds" until it is spent on new building projects or equipment. Financial assets have been deployed in "savings," or fixed-income, instruments rather than in "investment," or equity, portfolios. Risk-free fixed-income investments offer the certainty of returns and a comfort to rating agencies-albeit at a steep cost in opportunities to providers.
Depending on nonmedical investors to fund healthcare research and development was perhaps the first application of provider-community "outsourcing." Venture capitalists used their money, expertise and staff to cultivate new innovations. Early on, venture capitalists funded healthcare ownership consolidations and emerging reimbursement plays, such as HMO conversions and physician practice management companies. The institutional investor reaped substantial returns when these venture-backed companies sold initial public offerings, which provided market liquidity and capital gains. The venture capital funds reloaded their coffers with fresh capital supplied by satisfied investors. Recognizing tomorrow's medical needs and requirements has proved to be a lucrative business proposition.
Healthcare venture capitalists see new fields of investment opportunities, which promise to transform tomorrow's medical landscape. Major themes coalesce around applications of e-health, or high technology and other fields, rather than geo-health, or traditional bricks and mortar, such as new hospitals. The four dominant investment groups include outsourcing, risk management and underwriting, technological connections and patient education. Venture capitalists target opportunities that have potential "big company" possibilities. In just a few short years, the public market capitalization of emerging e-health companies already exceeds that of all geo-based publicly owned health service companies. This "leapfrog" in aggregate value has as much to do with expected performance as it does with 1998's $45 billion, or 40%, decline in the value of common stocks in the healthcare service sector because of the federal Balanced Budget Act of 1997 and other forces.
Change is coming. Academic gurus have long said the psychology underlying investor motivation is either fear or greed. Fear is the principal motivator of healthcare industry executives. Some healthcare systems' investment funds are configured in equity portfolios to augment operating income, which in turn is viewed as uncertain and endangered. Hospitals and health systems are even investing in venture capital opportunities, attracted by good returns and the system-planning insights offered.
High-visibility e-health IPOs, such as that of Healtheon Corp. (which is set to complete its deal to buy WebMD this week) and drkoop.com were funded as venture capital companies in part by United Health Group (Healtheon) and what is now Adventist Health System (drkoop.com). Their investment motivation was both financial and strategic. To compete in medical risk management, United needed to improve the electronic connections among its partners while accessing better and faster consumer information. Healtheon's business plan has a global model of Web-based connections. Likewise, Adventist Health advocated patient empowerment through education. Better-educated consumers make better customers. Rating agencies, moreover, were not offended by the bulge in Adventist's investment portfolio.
Product life cycles and emerging treatment protocols will be cut short as a function of applied medical technologies, causing providers' capital investment and allocations to become more precarious. To determine the impact of new innovations, senior executives must spend more time on research and development. Understanding where smart money is placing bets will entail a dialogue between customer and developer. Innovations are emerging from traditional sources but also from computer-based sources such as Massachusetts Institute of Technology and IBM laboratories, neither of which is affiliated with a hospital or medical school.
Hockey player Wayne Gretsky shared his winning philosophy of "skating to where the puck is going, not where it is." If they are to lead effectively, our healthcare leaders need the same strategic discipline and insight. Meeting and talking with research and development architects-also known as venture capitalists-is becoming an essential career move. Grasping the strategic implications of today's "works in progress" may benefit the endowment fund as much as the operating bottom line.