Coronavirus: Why investors' love affair with tech is over

29 April 2020

By John Colley

Warren Buffet once said “only when the tide goes out will we see who has been swimming naked”.

The global pandemic has precipitated a plummet in demand and investment akin to the dot.com bubble bursting at the turn of the century. The tide is well-and-truly out now and we can now see that those companies who have been telling investors for years they are a tech business are in fact nothing of the sort.

Ride-hailing apps Uber, Grab, Ola and Didi Chuxing; office-sharing business WeWork and even Airbnb are in dire trouble with the real tech companies like Facebook, Google and Amazon now circling them as the rich take advantage of the weakened. An example being Amazon using its cash mountain to take a reported 16 per cent stake in distressed UK takeaway delivery business Deliveroo.

While many claim to be a technology business, in effect they are following the dynamics of the taxi industry, office rental industry, and hotels and accommodation booking sector. The claim to be a technology business was always more related to investor valuations being higher for tech start-ups as optimistic funders looked for the next Facebook.

For any of these ‘naked’ tech firms to survive the pandemic is dependent on how much cash they have. Wework will struggle to survive a year without further investment, the ride-hailing apps are quite well funded but may also find this to be a very difficult year.

While, the secretive Airbnb has recently been raising money at a very high cost, which suggests investors see a significant risk to the business and therefore cash is limited. Current investors are not keen to invest further, while its proposed listing for 2020 is now unlikely for several years.

New investments will be curtailed and banks will be particularly cautious about increasing lending, while businesses with high levels of borrowings will have a problem. In many industries demand has collapsed, with customers failing to pay their bills and suppliers not being paid. And though workforces are being laid off and paid by the Government, most other costs continue.  

The consequence is that business borrowing has to increase. Those who already have high debt levels will struggle to survive, whereas those with cash have much better prospects. Despite Government pressure banks will not be keen to increase their exposure to those with high debt.

Take Airbnb, viewed by many as lower risk, it was funded by private equity for $1 billion at double digit interest rates plus a share of equity. A week later it issued another $1 billion at 7.5 per cent, which ranked higher for security. Governments are pressuring banks to lend but the banks know who will be holding the baby when collapses arrive. 

Investors in the ‘naked’ tech firms have been hoping for the same network effects - where more suppliers to a platform attracts more customers, which in turn attracts more suppliers and so on - that have seen Facebook and Amazon be the winners that take all.

It is difficult to see the network effects in businesses such as Oyo and WeWork. Even with taxi ride-hailing apps, all taxi firms now have an app and network effects are quite limited, once an acceptable degree of customer responsiveness has been achieved. Similarly, long-term price competition is difficult as 80 per cent of the business costs relate to driver wages.

Will WeWork and Uber survive the pandemic?

In all these areas it is relatively easy for competitors to enter the market and compete. Customer switching costs are also very low. The cost of switching for a customer is literally moving from one app to another. Prices and arrival times can readily be compared and almost instantly. For accommodation booking sites they are all accessed in the same way now via an app, and it is very easy to compare accommodation availability and costs.

Hence all these markets are going to remain very competitive in the long term, which means low margins and low returns. It is no surprise the share prices of ride-hailing businesses have halved. In these industries technology is no longer a competitive advantage as almost all the competitors now have similar technology. The technology is simply infrastructure.

The collapse of stockmarkets also means the appetite for new listings will dissipate for a number of years. A lot of people have just lost a lot of money and with all the IPOs for this year cancelled they are battening down hatches. They won’t be back next year either. In turn, this suggests that there will be difficulty in exiting investments for venture capital and if there is no exit route to make money, then why invest?

Private equity is believed to have around $2.5 trillion in ‘dry powder’, ie available cash. It can prop up some of the businesses in which it holds investments, or acquire companies that will be available at much lower future valuations. But one suspects private equity will save the most promising businesses and allow the others to fall into the hands of creditors, while gearing up to buy up firms with great potential but stricken by the pandemic.

There is evidence that they are surveying ‘wounded’ business in their hunt for value. But now that these ‘naked’ tech firms have been exposed for the low margin, high debt enterprises they are it is doubtful they will be on private equity’s shopping list.

Cash will be in much shorter supply and venture capital investors will also have to choose more carefully where to invest. Clearly the Deliveroo backers are not willing to find additional investment, forcing its part-sale to Amazon and many other developing businesses may well find that cash is curtailed.

Instead, expect huge consolidation with successful tech firms entering new markets through cheap acquisitions, especially as competition authorities are now preferring business survival over competition.

The biggest loser in all of this pandemic crash is SoftBank, which invests through its $100 billion Vision Fund into technology stocks, investing around $30 billion in ride-hailing companies, and $20 billion in WeWork. It also has significant investments in hotel chain Oyo.

Investors in SoftBank were encouraged by its huge initial success with Chinese online marketplace Alibaba, but one hypothesis is that Softbank’s investment strategy is little more than luck. Initially very lucky and then unlucky; a predictable result as performance regresses back to the mean if no additional skill is involved.

It is critical to be able to differentiate between technology businesses with strong network effects that creates an industry, and firms where technology simply facilitates access to traditional industries. Once all the competitors have similar technology then where is the advantage?

Softbank and its ‘naked’ tech firms are now realising the answer.

 

John Colley is Professor of Practice in Strategy and Leadership and teaches Mergers and Acquisitions on the Executive MBAExecutive MBA (London) and Distance Learning MBA. He also lectures on Strategic Thinking on the Full-time MBA.

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