Two professional memories from the past two decades come to mind as I look to the horizon and try to see where this industry is headed, as all healthcare investors must do.
The first memory is of the constant refrain I heard from healthcare executives in Nashville, Tennessee, as I was learning the ropes of the healthcare venture investment industry. That refrain? “The healthcare industry is very fragmented.”
That description was an attempt to explain how convoluted the industry is and why it operates the way it does. And that refrain worked, as over time I rationalized the unconventional workings of healthcare. As we all know, healthcare is just different.
The other memory has nothing to do with healthcare. It is a memory from my early days as a programmer. Before I switched to all-Apple technology, I programmed on the Microsoft Windows operating system. And after a while, the computers would start to run really poorly. There was no good explanation. Over time, they would crawl. And when that happened, I’d have to run the “Disk Defragmenter.” And voila, the computers would run like they should again.
I never put those two memories together until very recently, while recording the 25th episode of the Health:Further podcast with my partner, Vic Gatto. We were producing themes for the industry based on the first 24 episodes of the podcast, and the theme we landed on was “Insolvency is driving defragmentation.”
I began to see that the old payer-provider paradigm — and the assumption that healthcare is fragmented — was being crushed by inflation and its contributing factors, COVID-19 and workforce turbulence.
| Private healthcare investing falls | |
| Stage of private investment | Change from Q2 2022 to Q2 2023 |
| Series A | (50%) |
| Series B | (47%) |
| Series C | (54%) |
| Series D | (69%) |
The inflation rate in the United States rose to 3.7% from 1.4% over the 36-month period from September 2020 to September 2023. That rate increase might be considered reasonable, except for June of 2022, when the inflation rate hit 9.1%. The pandemic was initially behind the swings in inflation, but since then, it’s been the Federal Reserve’s tight monetary policy.
COVID-19 must be mentioned because it stressed the healthcare system’s operations and workforce, destabilizing it in a way from which it still has not recovered.
A NEW PAYER-PROVIDER PARADIGM
U.S. healthcare had, for decades, a reasonably balanced power dynamic between payers and providers, allowing for healthy negotiations on rates that enabled both types of organizations to profitably run their businesses. That is no longer the case. Health systems have so much profit pressure from inflation, labor challenges and lack of pricing control that engaging in negotiations with payers is leading most organizations to an inevitable operating loss.
Conversely, payers built strong balance sheets during the pandemic and are aggressively running the payvider playbook, building out sister companies to develop value-based care for when a hospital isn’t the center of a patient’s experience. Health systems have consequently fallen into four new buckets:
- Those that have health plans and can run the payvider playbook
- For-profits that have scale, solid operations and strength in their markets
- Non-profits that have scale and, therefore, have time to work on the balance sheet to offset the difficult payer mix
- Everyone else
The two big strategic plays in the new paradigm are: The integration of payers and providers as closed-loop businesses, and M&A to get the right scale, payer mix and labor stability to continue a viable fee-for-service model. Everything else is secondary. These two plays are reducing the fragmentation that healthcare veterans are so used to. The industry will lower the cost of care because, finally, the pressures of inflation and rising interest rates are forcing the free-market players to lower operating expenses.
WHO IS AT RISK
There are specific types of providers and locations that are at risk. Disruption is a destructive force. When disruption is created by a competitive market actor, usually all customers get the benefit of the new market actor’s services even if their previous service provider goes out of business. When bricks-and-mortar booksellers were undercut by Amazon, there was no danger that customers couldn’t get a book. But when the disruptive force is the economy itself, customers may be left without an alternative as incumbents go out of business, and no service provider is ready to fill the gap.
Economically strong communities will see an improvement in the care received as a result of disruption, while economically challenged communities are more likely to see a deterioration of access to care.
Defragmentation will produce a healthcare industry that runs more efficiently, but likely less equitably. In this new landscape, innovation will likely be in favor of payers. The venture capital industry has already seen massive compression over the past two years as a result of the rise of the federal funds rate, with healthcare investment falling sharply (see exhibit above right). Overlay this difficult capital environment with a lack of bandwidth on the provider side, and it becomes a difficult time for innovation.
Perhaps this point is best illustrated by the experiences of Olive AI and Main Street Health. Olive AI raised almost $900 million for its work to modernize healthcare but was shutdown and sold for parts on Nov. 1. This was an amazing implosion of a company backed by some of the best venture capitalists (VC) in the business. One of those VCs, General Catalyst, appears to have learned from the experience and wants to buy a health system.
Conversely, Main Street Health announced recently that it had raised $315 million from investor Oak HC/FT and a consortium of companies, notably large Medicare Advantage payers as well as some undisclosed health systems. The clear driver of growth here is the payer ecosystem.
The good news is that Main Street Health is focused on rural communities, so it may fill in gaps where defragmentation results in the closure of hospitals.
SUMMARY
Thirteen years is a long time to have interest rates near zero. It is long enough for an entire generation to not know anything different. To have the run of zero interest rates end in the manner it did has turned out to be the disruption that finally broke healthcare. The new healthcare industry will be less fragmented, more integrated and, yes, more value-based-care-driven.
