Hospitals discover their inner venture capitalist

When Cedars-Sinai Health System launched a program last year to help young companies get off the ground, it received 500 applications for 11 spots.

The Los Angeles-based academic medical center, which is partnering with Techstars, an organization that provides guidance to startups, saw mentoring entrepreneurs as part of its community benefit mission and also as a way to keep pace with the wave of innovation that's transforming healthcare delivery—much of it driven by consumer demand.

“We're seeing more and more expectations that technology can really uplift people's lives in healthcare,” said Omkar Kulkarni, who directs the accelerator program. “Health systems like Cedars-Sinai are learning how to speed up.

”A good portion of the new investments in digital health over the past two years have come from end users of the technology. The number of health systems setting up their own venture capital arms has exploded, with hospital groups seeking both commercial success and the possibility of discovering technologies that will help solve their business problems.

The health systems going down this path have moved well beyond passive investment. They are becoming incubators and accelerators, guiding young companies and entrepreneurs through the healthcare regulatory and commercial maze. “They're investing more and more, and at an earlier stage than ever before,” said Unity Stoakes, president and co-founder of StartUp Health, which invests in and coaches digital-health hopefuls. “It reminds us of 1995 Internet when Netscape first IPO'ed.

It's unclear where things are going; it's unclear who the leaders will be.” Venture investing in digital health, like its information-technology and biotechnology cousins, will have a boom and bust cycle. This year's shaky start in the financial markets could cause some to pull back. Shares of companies like Teladoc and Castlight Health have plummeted since their initial public offering prices, creating unease among investors who fear the current wave may be a bubble.

Some analysts are already predicting venture-stage companies will raise less money this year than they did in earlier financing rounds. “There's going to be a reset of expectations across the board,” said David Francis, an analyst at RBC Capital Markets.

Investment appears to have hit a plateau. A total of 618 investors participated in digital-health financing rounds in 2015, according to a report from StartUp Health, up from 611 in 2014 and just 355 in 2012. Total investments stood at $6 billion in 2015, down from $7 billion the prior year but rebounding by posting $1.8 billion in the first quarter of this year. Recent investors represent a more diverse group than in previous years though, with funds coming not only from venture capital firms, but also corporate venture funds, according to the report. Well-heeled giants like General Electric Co. and Google are getting involved. The two firms made 10 and nine publicly disclosed investments in 2015, respectively.

Corporate venture arms also were prolific dealmakers. Twenty percent of the most active investors over the past five years—those funding at least 10 digital-health deals since 2011—were corporate or strategic funds.

The activity comes at a time when healthcare is under external pressure to innovate. Forced to compete on price, quality and service, these slick startups aim to change the way health systems do business.

But there's a hitch. Some healthcare leaders are frustrated because many of the new technologies come from entrepreneurs who don't really understand healthcare's need to maintain continuity of care while changing. “The biggest difference between the way a CIO views healthcare and someone from Silicon Valley does is transformation,” said Bill Russell, chief information officer at St. Joseph Health, an Irvine, Calif.-based system with hospitals in three states. “I don't think we need to disrupt healthcare; I think we need to transform healthcare.” St. Joseph doesn't operate a traditional venture fund, but runs as many as two dozen pilots. “As much as our money is helpful, the partnership is what people really covet,” Russell said.

In addition to being a living laboratory, those partnerships can open doors for young companies, especially those that are new to healthcare. Western Digital, a large employer in St. Joseph's Irvine market, approached the system last year, because it wanted a digital-health tool for its millennial workforce. Three months later, St. Joseph, with its technology partner Hart, launched a custom-built platform that gave Western Digital employees access to their medical records, laboratory results, discharge instructions and other health information. “With that in the rearview mirror, we're now getting ready to scale the entire platform,” Russell said.The new era of consumerism was evident in the applications that Cedars-Sinai and Techstars received from its inaugural class. Frequent themes included senior care and aging in place, pain management, price transparency and how to offer the same services at a lower cost.

Having the Cedars-Sinai stamp of approval is really important to companies as they go out and approach investors,” said Matt Kozlov, managing director of Techstars Healthcare Accelerator. The program also connects entrepreneurs to the people who will be making purchasing decisions about their products, allowing them to make changes and improvements. Some large health systems, Ascension and Kaiser Permanente, for instance, have been investing in startups for a long time. But in the past two years, smaller systems have jumped into the fray. “There's been some degree of success, and success draws imitators,” said Josh Kaye, a partner at law firm DLA Piper.

Falls Church, Va.-based Inova Health System in February became one of the latest players, when it started a $100 million venture fund focused on personalized medicine. Other systems that have recently established venture funds include Renton, Wash.-based Providence Health & Services, which set up its $150 million fund in 2014, and Cedars-Sinai, which partnered with Long Beach, Calif.-based MemorialCare Health System to create Summation Health Ventures in 2014.Even the American Medical Association earlier this year invested $15 million in a Silicon Valley innovation company called Health2047. Its mission: to help physicians test, develop and commercialize their technology ideas.

Providence's venture fund, which is staffed by seven investment professionals, has made seven investments since its 2014 launch, according to Aaron Martin, senior vice president of strategy and innovation. It also has an in-house software development team that works with entrepreneurs who want to use Providence as a proving ground; as many as 20 different technologies are being piloted at any one time.In addition to taking a financial stake in a technology company, health systems also can set other preferential terms, such as asking for exclusivity in piloting the product. “You wouldn't necessarily want this technology used in the competitor hospital down the street,” DLA Piper's Kaye said.

Dignity Health has emerged as an important incubator for young companies—not surprising, given its location in and around Silicon Valley. The San Francisco-based system has an open innovation program it refers to as “Run, Run, Jump,” which guides three to five startups at a time through the commercialization process.“It's modeled after kids' swimming classes,” said Rich Roth, Dignity's chief strategic innovation officer. Many startups get stuck in the pilot phase with one or two hospitals, and “it doesn't really go anywhere,” he added. The system's program is currently focused on improving care coordination and chronic-disease management, and viewing the patient as a consumer.

Dignity also has a separate investment arm. The terms of its investments can vary widely, including revenue-sharing agreements, co-development deals and traditional equity stakes. When evaluating young hopefuls, “We only invest if we're a customer and we can scale it,” Roth said.

Venture investing, whether in IT, biotechnology or now, healthcare, has its own cycle. Whether health systems and other companies will remain in the space through the inevitable booms and busts remains to be seen. “The question will be the staying power of those strategies,” said Steve Kraus, a partner at Bessemer Venture Partners. “I see them retreating in downturns.”

Ascension Health is one system that hasn't retreated, making it one of the longest-term investors in healthcare technology. Its venture fund recently marked its 15-year anniversary, and now has $550 million under management. Its focus, however, has changed in recent years. While its first two funds were weighted heavily toward medical devices, its most recent fund is focused on information technology.

“When we got started, there was a natural skepticism about what we were doing,” said Matt Hermann, senior managing director at Ascension Ventures. Some people thought Ascension would be better off building new technologies itself, or investing those funds in capital expenditures. “In many ways, the market has started to move in our direction,” he said.