“All empires become arrogant. It is their nature.” —
Two technology related observations to begin with.
Over the last few weeks, a number of clients and service providers we deal with have switched from organising video conferences on Zoom to Microsoft Teams. All of them have subscriptions to Microsoft Office and since Team’s comes free with Office, the switch is a no-brainer. This probably does not bode well for Zoom unless it builds out additional functionality to lock-in existing users.
Teams, in our experience, is not the best product but it is good enough for most intended use cases, especially for the non-tech savvy user. Additionally, its integration with Office it does have some synergies that the likes of Zoom and Slack do not provide.
Building a good enough application is not a recipe for success. When said app is also the default option, however, it does stop most users from ever trying alternatives and that can be enough to achieve success.
Free + default is a difficult moat to overcome.
Second, the unprecedented intervention by the US government threatening to ban TikTok and set a tight deadline to force a sale of its US operations to an American company, most likely Microsoft, has the potential to further strengthen one of companies probed in the Antitrust Hearings — Facebook.
TikTok is genuine threat to Facebook and its advertising engine. Breaking up TikTok by geography does not seem like a feasible solution as ultimately TikTok’s edge comes from its algorithm and it is unlikely ByteDance, the owner of the app, will transfer its ‘secret sauce’ to the buyer. We think only a sale of TikTok’s global operations, ex-China, is a viable transaction.
If Microsoft turns out to be the buyer, the ultimate beneficiary is Facebook. Microsoft has had very little, if any, success in consumer facing businesses. One only has to look at the failure that is Skype.
Some may argue that Facebook could potentially be banned in other countries as nations become increasingly inward looking. While we do not expect governments around the world to give further access to the mega-cap US tech companies, they also do not want to provoke the ire of President Trump in fear of retaliatory tariffs.
TikTok being banned in the US or broken up is good for Facebook.
The Great Firewall in China we already have an Internet for Chine served by Chinese companies, controlled explicitly or implicitly by the Communist Party.
The General Data Protection Regulations implemented by the EU in 2018 and the striking down of Privacy Shield —a flagship EU-US data flows arrangement — is also creating a “European Internet”. Europe will be served by European tech companies and only the very largest tech companies from the US, China and the rest of the world as only the largest companies can afford to comply with regulations. The best and latest innovations in Internet-based technology will only make it to Europe last, unless the innovations come out of Europe.
The most valuable and most open of networks is in the US.
The US can afford to play hardball with the likes of TikTok because it has the best and brightest of tech talent and disproportionate share of the leading Internet companies. However, with increasingly tighter immigration policies, the unpredictability of the Trump Administration and a handful of dominant players, the “American Internet” is at risk of entering a secular decline.
The European consumer is the clear loser in the near-term. In the longer-term, if innovation continues to be stifled by policymakers and dominant companies, we are all losers.
Notes on Private Debt
Something a little different this week.
We share notes from our discussions with a number of investment managers operating in the direct lending / private debt market in the US. We had the discussions to better understand direct lending space in general and the impact of COVID-19 on the direct lending market.
- Private debt, or direct lending, refers to making senior loans to small, middle-, and large-market companies made by nonbank lenders financed by long-term, locked-up capital.
- Investors demand an illiquidity premium for investing in private markets. Borrowers in private debt market must pay lenders higher rates to attract capital.
- On average, direct loans repay after three years.
- Yields on loans to smaller companies tend to be higher.
- There is a misconception amongst market participants that direct loans are covenant-lite. Cov-lite deals are uncommon in the private debt markets. Rather, terms tend to be much stricter.
- Because of these greater protections, direct lenders are able to recover more capital than can traditional lenders. As the economic crisis continues to unfold, direct lenders expect to achieve higher recovery rates for their loans than those achieved for senior secured loans issued by banks and other traditional lenders.
- Most mid-sized borrowers in private markets are owned by private equity companies. If a borrower starts to underperform, both the lender and the private equity manager are motivated to resolve the issue. Private equity managers can provide a capital infusion; lenders can defer interest payments or amend the terms of the loan.
- The most vulnerable loans are those made to borrowers in the energy sector. The sector is estimated represent less than 3 per cent of total private debt lending market. In contrast energy makes up around 12 per cent of Search iShares iBoxx $ High Yield Corporate Bond ETF.
- Private market lender held a guarded view of the energy sector even before the pandemic. Nonetheless, it is worth noting that not all companies in the energy sector are equally affected: Oil storage companies, for instance, are much less disrupted than oil and gas exploration businesses.
- Almost a third of direct loans are concentrated in the consumer discretionary sector and more than two-thirds of these loans are in the high-risk of default category due to the impact COVID-19 has had on consumer facing businesses such as restaurants, cinemas, gyms, etc.
- The lowest risk loans are in the technology sector and very few managers are seeing of wide-scale defaults in the sector. More than 10 per cent of direct loans are estimated to have been made to technology businesses.
- Overall, more than a third of borrower in the direct loan market are expected to default or require restructuring of loans in the coming 12 months. While a quarter of high yield and senior secured loans are expected to default or require restructuring in the coming 12 months.
- Direct loans, however, more than make up for the higher default rise through higher rates. The expected returns of direct loans are higher than those expected on senior secured and high yields even after adjusting for the illiquidity premium.
- The Federal Reserve’s policies bring in credit spreads but do not solve for insolvency. Senior secured loan and high yield ETFs should be avoided until there is greater evidence of an economic recovery being underway.
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.