October 8, 2019
Platform or network businesses take many forms and defy neat segmentation, but what we can confidently say is, in aggregate, leading network businesses have delivered immense value. In fact, one study suggests 70% of the value created in the Tech sector since the 1970’s has been driven by successful iterations of network-based business models. Fairlight defines network companies as those with plug-and-play platforms which allow participants to connect, interact with each other and create and exchange valuable information, products and services. Volumes moving through these networks develop a virtuous cycle that drives user adoption and customer willingness to pay, which in turn, leads to scale economies when profit margins improve with expanding sales volume.
Look beyond the FAANGs
Facebook, Amazon, Apple, Netflix and Google (often referred to as the FAANGs) are the most widely discussed platform businesses due to their size, powerful brands and ubiquitous presence in most global equity portfolios. However, there is a cohort of lesser known niche network businesses which offer similarly attractive economics whilst arguably demonstrating superior durability. To this end, the Fairlight portfolio holds platforms providing services as diverse as contributory databases for the insurance industry, vehicle scrappage auctions, credit reporting services, heavy equipment disposal services, used vehicle retailing portals and financial benchmarking services. In fact, these niche network businesses currently account for more than 30% of the Fund’s assets.
Although scarcely appearing in the media, these smaller platform businesses are nonetheless incredibly impressive enterprises. Whilst the average age of the better-known FAANG cohort is 22 years, the network businesses that Fairlight holds have an average age of 44 years, with the oldest dating to 1929. This longevity corroborates the idea of their durability and perhaps highlights our holding’s reduced susceptibility to technological change.
Beware of multi-tenanting
There is however, one key weakness which tends to present in network businesses generally - a phenomenon best described as ‘multi-tenanting’, or the tendency to use more than one service provider simultaneously. It is more difficult to lock out competition from new entrants when the members of your network can use competing networks without penalty. For example, it is free to list a product on both eBay and Etsy, so many customers choose to use both without extra cost. The defenses against multi-tenanting generally lie in the strength of the brand, the mission critical nature of the product and the scale benefits that are derived from being the market leader.
An example of a network company protected from multi-tenanting is Fairlight investee company Verisk, owner of a contributory database serving the property and casualty insurance market in the US. Insurers send Verisk approximately 3.5 billion individual records of transactions annually, such as insurance premiums collected or losses incurred and Verisk maintains a database of over 19 billion statistical records, which it cleanses and sells back to the insurers to help them prevent fraud and understand their liability.
In this instance, the data contributions by insurance companies to a trusted independent service provider for the overall benefit of the industry creates a unique, almost irreplaceable, network effect. There is no credible competitor to this service as replicating the database with similar accuracy is near impossible, and the cost of opting out of the service for insurers is enormous – essentially the client could no longer accurately price the risk of insurance without the data insights provided by Verisk.
The Fairlight View
As with Verisk, the general attributes we look for in network companies can be defined as:
· Commanding a #1 or close #2 market position
· Superior technology and/or supporting infrastructure
· Customer data that increases in value over time
Approximately 60% of the network companies Fairlight holds have nil to light multi-tenanting which results in strong pricing power, wide margins and attractive return on invested capital (ROIC), calculated as after-tax operating profit divided by invested capital (working capital plus fixed assets). Our network holdings have a median ROIC approaching 50%. Where our network companies currently generate lower returns, they are generally investing heavily in a first mover advantage which we believe will scale over time.