New Financial Models: Alibaba’s Micro Loan Business

Yesterday, I wrote about a Marc Andreesen interview/Tweetstorm that called for disruption of financial products through better technology. One of the examples he gave was the use of big data tools and social networks to provide enhanced consumer credit scores. This is an important idea, something we have been hearing about for a few years. Banks know enough about their customers through their own data stores, as well as a few online data sources, that they can create credit profiles that are a world better than traditional metrics like FICO.

In my post, I suggested that other companies were doing something similar with credit for businesses. I was thinking of Alibaba. I have been taking a close look at that company’s financial filings lately, and I stumbled on this interesting tidbit. It turns out that Alibaba has a side business in micro loans to merchants who sell products on Alibaba’s websites.

For a variety of reasons, small business credit in China is severely constrained. China’s financial markets are still highly regulated and not that mature. As a result, a very large percentage of credit ends up going to only the largest firms. Another problem is that there are few robust credit reporting companies in China. There is no obvious analog to Dun & Bradsheet. So while banks in the US are using data tools to supplement existing credit reports, Alibaba is essentially creating something new in virgin territory.

From their filings:

“Using transactional and behavioral data from sellers on our retail and wholesale marketplaces, we have developed a proprietary credit assessment model through which we evaluate our borrowers’ ability to service loans, assign credit scores to each borrower, pre-approve credit limits and extend loans.”

That’s a pretty good description of the process, probably the clearest piece of prose you can find in an SEC filing.

This is interesting for a few reasons. First, I do not know of any companies in the US that are trying this, please let me know in the comments who is. Consumer lending appears to be a market poised for change, but we have a pretty robust commercial credit market, and the opportunity for disruption may be much smaller there. There are a few companies I know that are starting to track private companies (like Mattermark and CB Insights), but I do not believe either of them have hard financial data yet.

Second, Alibaba appears to be doing this rather well. From other  parts of their filings, it is clear that their predicative model on creditworthiness is pretty robust. True, they still have defaults, but the defaults hew pretty closely to what they forecast each quarter.

Alibaba does have a few advantages here. In addition to providing e-commerce marketplaces for the people they are lending money to, crucially, they also control the payment system behind that. So they know their borrowers’ cash flow status in real-time.

My initial reaction to this was a sense that Alibaba is something special, a unique case. Then it occurred to me, that what we are seeing is a reshaping of finance. The idea of what constitutes a ‘bank’ or ‘lender’ can easily change. Imagine Facebook taking everything it knows about you and assigning you a credit score? Or Google aggregating search traffic to identify promising borrowers. And for that matter, why not Wal-Mart or Target. Anyone with enough data that they can gauge the risk of non-payment. Not that far-fetched. There is a lot of potential for disruption.


 

Adding to the “Entire Thing”

In an interview with Bloomberg Businessweek today, Marc Andreessen issued another clarion call for change. If software is going to eat the world, then when it comes to the finance industry “We can reinvent the entire thing.” As some of my past posts should make clear, I feel pretty strongly the same way. You can’t look at the finance industry today and claim things work the way they should. Certainly no one working in the trenches feels that way. For an industry that is supposedly the epitome of ruthless cutthroat capitalism, there are huge pockets of inefficiency. To be clear, I’m not making some moral claim, and I am not asking anyone to occupy anything. We can discuss the societal benefits of finance someplace else. Instead, I am arguing that most of the financial industry could do its job much more efficiently. And those changes are going to get forced on the industry one way or another.

In the Andreessen interview, he cites several good examples of how technology is going to change finance. He mentions the use of big data tools to assess credit scores for consumers. That caught my eye, because I am writing another note about a company that is doing something similar to gauge the creditworthiness of businesses.

My one complaint about the interview is that he does not go far enough. There are so many areas of the industry that need or are open to change. Things like Bitcoin and credit scores are a good start, but the title says the “Entire Thing”. I think that is the right sentiment, and want to add a few more to the list.

In my past notes, I have looked a lot at possible changes to equity research – the business of financial analysis for investors. This is a small field, but one which can still drive a lot of business, if done right. A complementary area that is also adrift are institutional sales forces, the people who take orders from big investors. Talk to most salespeople today and they are a glum group. There is a sense that their role is going to be entirely automated, or entirely dis-intermediated. Certainly, a lot of their work could be done by software or a low-cost offshore replacements. That is a reflection of management challenges, not their abilities.  What company does not need salespeople? The salesforce has a huge role to play, but not when they are burdened under incredibly weak software systems. I do not know of a single bank or large brokerage that uses CRM software in a constructive way. Alright, maybe one or two, but no one has developed a really good CRM tool for this kind of sales force. If I were to start a company today, it would be based on the idea of building a ‘social’ graph of Wall Street investors and hooking into this problem. I think there are a couple of companies nibbling around this, but so far no one has  quite nailed it. (The irony is that the one company that could do this, but has not, is Bloomberg, the publisher of the aforementioned interview, and likely among the top companies to get disrupted should Andreessen’s predictions prove true.)

Institutional sales forces and equity research are nice side shows. And really, the equity market is small potatoes. Do you really want to make big changes the Entire Thing? Then the place to look is the bond market, which is valued at something like $30 Trillion in the US alone. Despite its size and importance, the bond market is about as inefficient as a market can get. There is no central exchange, no floor to ring a bell on, no easy way to keep track of prices. Everything is a negotiated sale on imperfect information. It has festered this way for years because of a variety of conflicted interests and massive inertia. Everyone knows it has to change, but few people want to say it. That is starting to change. Last month, the world’s biggest investor Black Rock issued a white paper calling for reform[PDF] of the corporate bond market. They suggest a number of technical changes to bond market practices, but I think some good software could extend the changes much further. As with much of finance, there are all sorts of regulatory hurdles, and it is hard to see a five person start-up going against that, but then again maybe what the world needs is to see an attractive alternative.  I have tried to avoid using the word ‘disrupt’ in this piece, it gets overused, but I think it applies to the potential for change here.

Like I said, that Bloomberg interview is a good start, but there’s a lot more that can be done.

 

A few thoughts on splitting up companies

After the big news this morning about HP splitting in two pieces, I wanted to put in my two cents. I have followed HP for a long time, but have not been close to it for years. So I have a lot of opinions about HP, its future, its management team, its winding strategic path and its pattern of M&A, but I will avoid those for today’s post. Instead, I just want to cover the idea of splitting a company in two.

Divestitures and spin-offs are something that the Street loves. Corporate Finance classes teach the idea of focused companies, it is as close to a religious principle as you can find in MBA 101. And as Joel Grenblatt points out in his great investment book, investing in spin-offs are usually a great investment strategy.  The idea is to let investors pick their risks. If you want a low-growth, high dividend company you will soon be able to buy one piece of HP (HP Inc.), but if you prefer higher risk, faster growth companies, you will soon be able to buy the other piece (HP Enterprise). This widens the scope of investors who can participate, capturing both growth and value investors. And not for nothing, it is generally easier to model, follow and conduct checks on smaller companies, which means it is easier for the analysts to do their work.

But what makes sense to the Street often conflicts directly with the reality of running a company. Put simply, splitting a company is hard. Let’s just say this is a subject with which I am a little familiar. There are so many fine points that have to be considered – from large things like who owns the brand and who owns the patent portfolio, to the small things like who gets which office furniture.  Done poorly, it can wreck both the parent and spin-off.  But doing it well, requires a huge spend on lawyers and consultants and accountants, not to mention employee distraction time.

When HP first suggested doing something like this a few years back, customers revolted, as many enterprise buyers were concerned that they would not get support from both sides of the company. If you bought your servers and desktops from one business, but purchased those through a consulting contract with the other side of the company… well those things cause confusion. I think the whole computing market has shifted a lot since then, so these concerns are less pressing, but I imagine the HP salesforce is going to be one of the trickier areas to split up. Manufacturing is also going to be easy. The PC/printer side (HP Inc.) has massive scale (e.g. a top 3 Intel customer), so the other side of the business will soon lose access to that volume pricing. My favorite spin-off issue is IT. How do split the IT services of a company? Often, the way this is done is for one company to provide transitional services to the other for some period of time until the other side gets its own operations in order. The irony is that HP has for years built a business providing outsourced IT for other companies. Now one side of the business is going to get to ‘enjoy’ what its customers have endured for years.

Now it bears mentioning, that HP has done this before. Most notably with Avago their chip business, and Agilent their test and measurement business, which recently split itself again. So HP has experience at doing this. I read through some of the management presentations and analyst commentary this morning about the transaction, and I got the sense that management had clearly thought through many of these issues. I really doubt that they have a full plan, because you need to tell everyone about that, but it did sound like they have some of the key issues sorted out.

This is an old company with many large acquisitions layered on. They say it will take a year to complete the spin-off, and people who have done this sort of thing agree that is a rapid timetable. They have a lot of work to do.

Nonetheless, I suspect this is going to prove a difficult transaction. Maybe not for investors, but definitely for employees.

A new model for semiconductor investing

There was an interesting post on Techcrunch this afternoon, called “The Revival of Semiconductor Investing”. The title alone touched a nerve. It states something that I would very much like to believe is true, yet fear deep down inside is not.  The author, Ilgiz Ahkmetshin, is a venture investor at SK Telecom (a South Korean operator) in their incubator. More than that, he actually crunched some data. What he showed is that even though the number of semiconductor-related venture investments has fallen sharply, in the past few years, the number of investments in new semiconductor companies has started to grow again.

This seemingly defies common “Valley wisdom”. Most VCs I know find the idea of investing in a semiconductor company deeply unattractive, if not downright laughable. Now that I am considering my next career steps, I have been watching such investment trends closely. Speak to most people in the semiconductor industry and there is a clear sense that we have entered a new age, one with little room for new, small chip companies.

For several years, I have been suggesting that there is a great need for chip start-ups, but the funding model has to change.

This is how I see the problem.

Designing hardware is much harder than designing software, and by ‘hard’ I really mean expensive. If you design a web site, the whole product can be built around the idea of iteration. The first version will not work perfectly, so plan for that, and fix it in upgrades. And upgrades on the web or in the cloud are very easy. In hardware, everything has to be right before you ship the product. And not just before you ship, but really before you even start to build it. Returns are prohibitively expensive, and hardware cannot be readily fixed on the fly or in the field. This problem is even more acute in semiconductors. First, those chips have to get designed into other things, and that means even longer preparation times. Secondly, the complexity of the semiconductor manufacturing process are hard for the human mind to grasp. The industry requires incredibly tight specifications, as you can imagine for circuits many times smaller than a human hair.

In terms of investment dollars, this has meant that the cost to go from ‘good idea’ to revenue-generating product is very large. There are several private chip companies out there that have raised north of $200 million and never shipped a product much less gotten to profitability. So if you are a venture investor, you can roll the dice on that kind of prospect or launch a photo-sharing messaging, cloud storage app which gets to revenue in hours. Not much of a choice, except there are already a lot of those apps out there, and a growing shortage in semiconductor innovation.

I have been arguing for years, that the problem is one of expectations and funds raised. Too often, chip companies were funded on the premise that they need to get to the point where they are shipping product. This has meant that companies needed to build a relatively large operation. WhatsApp did fairly well with something like 30 employees, most of whom focused on the core app and user experience. By contrast, for a chip company to get to revenue, they need to build a big operations team that can take clever designs and walk them through the all the steps needed to get manufactured. They need a large sales force. They need incredibly expensive design tools.  The list goes on, and adds up to a lot of people and a lot of expense.

It is unclear what can replace that model. I think a better approach would be to break up the whole system and allow for some abstraction. VCs should fund promising chip designers, not on the expectation that they will get the product all the way to shipment, but to proof of concept, when the investment will be handed over to a company that specializes in transforming designs into prototypes. I think there is also room for clever incubators which pool some of the more expensive elements of chip design like software tools. This sort of ecosystem may be starting to emerge, but is still far from maturity. And none of this is easy. For chip designers to merely prove a concept, they would essentially be selling IP, and the market has not been that kind to IP companies like this. At their very worst, they end up becoming companies with more lawyers than engineers.

Nonetheless, I think a new model is starting to emerge. Many design tools are now becoming available on Software as a Service (SaaS), pay-as-you-go models. There are a few companies out there that can handle many of the complexities of translating designs into shippable products.

One of the paradoxes of the modern semiconductor market is that while starting a new chip company from scratch has only gotten more expensive, the cost of building a chip have generally come down meaningfully.  I do not mean the physical costs of manufacturing, that’s a topic for a different day, but the upfront costs have come down in many areas. This is the reason that the big web companies like Google and probably Facebook, are now designing their own chips. I am working on another post which lays out the math behind Google building its own server chips, and it turns out that this is a pretty easy investment choice for them to make. Part of the reason for this has been the rise of ARM Holdings, which designs and licenses a key piece of chip IP. So in many areas, the abstraction process has already started, with a dramatic impact of chip design costs.

Now ARM designs only work for certain chip applications. There are many more areas which have little or no abstraction available, and some where it is not even possible. Nonetheless, I think there is room for a new model to emerge that would greatly reduce the upfront costs of starting a chip company.

So I am encouraged to see posts like Ahkmetshin’s with tangible proof that investments may be picking up in this space. We still have a years to go, but maybe there will be a day when Venture investments in semiconductors once again make sense.

In which, the cause of the author’s absence is revealed

Some of you may have noticed that I have not been writing as frequently over the past few months.

Today’s news should explain that. I have been a little busy.

When I write, I tend to write about things that I have observed firsthand, and unfortunately for my writing (considerably more fortunate for my other aspects) there has been little that I have observed firsthand this year that I could share. I cannot really discuss any of the details of the transaction, but suffice it to say it would make for an interesting book…

Now that the deal has been announced, I should be able to write more freely about things I see. So I hope that I will resume my intended pace of 500 words a day. Come to think of it, I now have an awful lot of free time on my hands, and probably nothing but free time in a few months. So stay tuned, and stay in touch.

 

The Changing Structure of Financing Companies

A few weeks back, I read a post on Mark Suster’s Blog Both Sides of the Table called “The Changing Structure of the VC Industry”. It evoked a very strong response in me and I have been struggling since then to put my thoughts on his post on paper.

Put simply, I agree with many of his conclusions. The piece is one of the most thought-out, best researched pieces I have seen on Venture investing in some time (including this one). His basic premise is that even though everyone bemoans the decline in venture investing, the numbers actually paint a different picture. Professional Venture investors are not being overrun by Angels, nor is there a wholesale decline in the number of VCs out there. Instead, he argues, the boundaries are blurring (my word) between investment stages. Large VCs are increasing their late stage investing. Many old shops are closing down, but their numbers are being more than offset by new funds emerging. This is almost a changing of the guard as we transition from Web 1.0 successes and failures to Web 2.0’s new crop of hits.

Suster seems to draw two conclusions from his data. First, that the VC industry is undergoing transition but remains fundamentally healthy. He makes a very good case for this, and I agree with it. However, he closes his piece with the idea that the public funds who have been dabbling in VC (mutual and hedge funds) will eventually exit the market and go back to doing what they do best, namely trading public stocks. Admittedly, this is a side argument for his piece, but it got me thinking.

He argues that the traditional divisions among VC funds is blurring with the staging of funds changing as their sizes grow. It occurred to me that the public funds are no different. We hear similar comments from time to time in the public fund universe as well.

I think this blurring will continue, and we will see a steady shift to a new structure for the whole capital raising industry.

The distinction between and a public and a private company is entirely arbitrary. It is an artifact of habit and adaptation to regulation, but there is no ‘natural’ reason to draw the line where we do. Set aside the regulatory regime for a moment. Instead of thinking about public versus private, we should view companies on a spectrum, with companies changing their capital structure as the number of investors grow. As the company grows, it will need to attract more capital and that will mean more investors.  This in turn will dictate more mature corporate structures.

Today, there is so much focus on the IPO and getting ready to go public. I argue elsewhere (constantly) that there is too much of a disconnect between the way that private companies prepare for their IPO and what their life is like once they are public. If we were starting from scratch today, we would have a more gradual transition. Each step in the fund-raising process should be preparing companies for being more mature. Instead, of slowly aging, the system today treats companies like they are caterpillars that enter a cocoon and emerge at IPO as a butterfly (or ugly moth).  As if these were two wholly different stages of life.

I think the changes in the venture industry will be mirrored in the public markets as well. I think more mutual funds will enter late-stage private financing rounds. As Suster (and others) note, the returns in growth investing are increasingly going to private investors. So it makes sense that the money managers of the world will follow Sutton’s Law and go where the money is.

Obviously, we are not there yet, but you can see the pieces starting to fall into place. The crowdfunding ‘movement’ is likely to grow, and seems set to provide the regulatory bridge between public and private investors.

This will be a change not only for venture investors, but for the whole financing business.

Mobile Gaming’s Giant Treadmill

I find that I have been having the same conversation about mobile gaming repeatedly, with a number of different people. Usually, that’s a signal that I should publish something. Ben Thompson’s post the other day about Buzz Feed was close enough to my subject that I wanted to respond, and just as I went to publish this piece I noticed there is something related on Techcrunch (I have not read the TC post yet, but you should go ahead and click, they need the pageviews more than I do).

Mobile Gaming seems to be the great success story of the Appconomy. There have been something like a dozen game-related IPOs in the past few years, probably double that if you count the China companies. There have also been a large number of nine-digit exits.

Yet for some reason, the mobile gaming industry does not feel like a growth industry. As I posted a couple weeks back, Independent developers are re-considering their career choices. And if you look at the major, public game companies it is hard to find clear signs of mobile wealth. Having spent a few days last week in the Valley, I get the sense that VCs are making few new mobile gaming investments. They are supporting their existing portfolio companies, but there does not seem to be a lot of appetite for new gaming investments.

We could delve back into the subject of the problems with App Stores and new app discovery, but I think there is a broader issue. Mobile gaming has become intensely competitive, and is now very much a hit-driven industry. The most immediate example of this is the decline of King Digital’s fortunes. Their stock is off sharply since the IPO. Their hit title Candy Crush seemingly came from nowhere to become a huge hit. It still throws off incredible amounts of cash, but its growth is slowing and the company has no easy way to replace those declines.

This is the central issue with gaming. Every few months some new game comes along and goes viral, generating huge downloads and revenue ramps. But eventually they fade. Candy Crush seems to have been displaced by a Kardashian game. Remember Farmville? That great Zynga hit, which eventually fell victim to Clash of Clans and Candy Crush itself.

Mobile Gaming is a treadmill. Individual games can grow quickly and last for a long time, but eventually the decline sets in. I think it may prove impossible to build a game with a long shelf life in mobile. Or at least, there will be very few games that can last a long time. This is not so terrible in itself, but it makes it very hard to build an ‘investible’ business, meaning one that can become a sustainable public company.

I think gaming companies are going to start looking a lot more like movie studios. Investment dollars will flow to management teams that can prove they can build a pipeline of games. These gaming ‘studios’ will need to adopt a portfolio approach to game development, knowing that 7 out of 10 games will fail, two will carve out niches for a period, and one will be a multi-year hit or franchise.

The problem with this is that this is not the kind of business that VCs want to invest in. See Thompson’s Stratechery post for more on why that is. For movie studios today, the truth is that movies are just a small part of the business. Any individual film is financed through a hodgepodge of sources. The studios actually outsource a lot of financing of films, and most movies probably lose money. But the studios continue to make a lot of money by selling rights to the movie to every available channel – including DVDs, cable channels, online streaming and merchandising rights. (If you want to understand more of this, I highly recommend you read “The Hollywood Economist”. That work shapes a lot of my thinking about this subject and is very revealing for those of us in Northern California seeking to understand Southern California.)

When I originally started looking at this subject, I thought that today’s mobile gaming companies would end up looking a lot like mobile gaming companies from a decade ago. Remember Jamdat? Probably not, but they were the first mobile gaming company to go public and eventually sell themselves for a healthy sum. Ten years ago, there was an initial rush to build mobile games for phones that were just starting to have color screens. This business was hijacked by the carriers who insisted on something like 50% of the economics, or more. Apple broke that model completely, and if nothing else, we should all be grateful to them for doing so.

However, the more I worked on this, the more I realized that today’s mobile gaming market, for all its problems, is much healthier. In the last go-round, mobile gaming companies ended up being largely dependent on existing media brands. There was no way to build a successful game through word of mouth or feature-phone based ‘app stores’. For a while, there were several dozen mobile gaming companies all trying to buy licenses for whatever movie was due to come out that month. If the movie was a flop, then the mobile gaming company went out of business, having bet their entire cash balance on upfront payments.

Today, mobile gaming companies are no longer stuck between the movie companies and the carriers. They still have the potential to build a hit game. And there is still a lot of room for independents to get lucky. Clash of Clans, Candy Crush and many others are immensely profitable. It is so much cheaper to launch a game today than ever before. As a result there are a lot of profitable games out there.

So while conditions are much improved from ten years ago, mobile gaming is still a cottage enterprise. To become a real industry will require some corporate structure that allows for greater scale. My guess is that companies like Pocket Gems, Kabaam and probably even Zynga, are steadily moving in this direction. These all seem to be doing fairly well now (we’ll see about Zynga), but I think that with time their business model will gradually shift. Instead of designing all their games themselves, they will become platforms for smaller developers to emerge. This is less about technology and more about licensing and clever talent-spotting.

Will the media conglomerates dominate this field too? It would seem natural that the seven studio majors could eventually dominate mobile gaming, given the overlap in content and business model. On the other hand, I think the mobile market is different enough that a few mobile studios will emerge. They will find a way to better cross-promote across their brands. This has so far been hampered by some of the iOS policies, but that is a subject for a different day, and probably not a hard and fast rule in itself. Mobile studios will find ways to make the most of what mobile has to offer and use that to their advantage.

Another way to gauge the value of this market is through the tool makers. A few weeks ago, I admitted that building developer tools did not look like a promising area, but there are still some stand-out successes in gaming. Notably Unity, they build what is probably the leading mobile gaming graphics engine out there. Given the huge number of Unity-based games out there, this company could end up becoming one of the great success stories of mobile gaming. (That being said, I have no idea what their financials look like.)

In the end, I think we still have a lot of transition and exploration ahead of us.

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