Underwriting banks and leveraged loan investors are struggling to analyse the impact of technological disruption on the business models underpinning private equity buyouts, as they try to dodge bullets by avoiding lending to companies that could be rendered obsolete by the ‘Amazon effect’.
KKR-owned U.S. retail giant Toys ‘R’ Us sent shock-waves through the market when it filed for Chapter 11 bankruptcy protection in September, citing the “unrelenting competition from e-commerce” as key to its predicament.
“Technology is undoubtedly a threat to traditional business models: this is definitely a topic discussed in every credit committee. The first question everyone asks is: ’What’s Amazon doing?’” said Simona Maellare, global co-head of financial sponsors coverage at UBS.
Banks are becoming more wary about underwriting deals and may offer lower leverage levels to companies in sectors that are facing disruption going forward. With very little protection in covenant-lite leveraged loan agreements, investors are focusing on careful credit selection to pick winners.
The spectre of technological disruption has haunted junk-rated lending for years. Many investors are still scarred by losses caused by the demise of yellow pages publishers including the U.K.’s Hibu, formerly known as Yell, which had to be restructured after its business model was overtaken by the internet.
Sectors such as retail and services are already feeling the effects of disruption, which is fuelling a sense of urgency to understand where technology will hit next, and perhaps more importantly when, as the pace of change accelerates.
“Barely a day goes by now without Amazon seemingly creating a new vertical,” said Gabriel Caillaux, co-head of EMEA at General Atlantic at the SuperInvestor conference in Amsterdam last month. “We now focus half our time on defending against, and being an aggressor with, digitisation.”
Thomas von Koch, CEO of Swedish private equity firm EQT, went further: “The storm is coming. If you think the change is happening quickly now, you haven’t seen nothing yet.”
PICK A WINNER
In mid-November, Swedish alarms and security company Verisure issued €1.835 billion of new loans and bonds. The company’s business model is based on smart alarms that alert its personal security team to intrusions, and also offers camera technology that allows clients to monitor their property remotely from a smartphone.
The deal coincided with Amazon rolling out a ‘key’ product, which includes a cloud-connected camera and Amazon-compatible smart lock, which let customers open their homes remotely to one of the company’s delivery drivers while watching on their smartphone.
Some investors questioned whether Amazon or another Silicon Valley giant could eventually compete with Verisure by utilising their data and technological expertise to offer an extremely competitive and possibly cheaper product.
Other investors agreed that Verisure was vulnerable, but thought that change was unlikely to happen within the seven-year life of the loans, and piled into the deal.
The question of when and how – not if – technological disruption will hit a sector is increasingly preoccupying lenders, who are keeping a close eye on recent carnage in the U.S. bricks-and-mortar retail industry while anticipating bigger transformative changes in the auto industry and beyond.
“The most fundamental industries are being disrupted,” says Harel Beit-On, founder at Viola Growth in Israel. “The ‘sharing economy’ will happen within the investment period of the funds being raised now – sharing cars as opposed to owning them, for example.”
McKinsey estimates that adoption of ‘global mobility services’ – companies such as Uber – by even just 30 percent of low-mileage urban car users could have an economic impact of up to US$2.5 trillion globally by 2025.
Given the record piles of cash that the private equity community has raised in the past year alone, technological disruption raises serious questions about how these funds, and the debt financing their acquisitions, will perform during their seven to 10-year lifetimes.
“A lot of investors haven’t seen a downturn. Add the leverage they’re now getting and they think they’re invincible,” Caillaux added. “There isn’t a single business that won’t have its model and P&L affected by digitisation.”
Although private equity is aiming to capitalise on disruption and add value by digitising more traditional businesses, its ability to adapt could be curbed by the level of debt that it piles on companies.
KKR’s 2005 buyout saddled Toys ‘R’ Us with over US$5 billion of debt, leaving the retailer paying US$400 million a year in interest expenses alone, which limited its ability to reinvigorate its digital offering, despite being aware of its importance.
According to the McKinsey Global Institute, digital leaders in a sector improve their profit margins three times more quickly than average. The institute is also forecasting that European GDP could grow a further €2.5 trillion through digitisation by 2025.
Simon Patterson, managing director at tech-focused U.S. private equity firm Silver Lake, said that technology alone will not change a company. “It’s how you use technology within an existing business model that’s important,” he said.
Dealing with the ‘Amazon effect’ requires investing in businesses with a strong digital platform or plans to build one, or investing in companies that provide software and services to the disruptors, the co-president of a large U.S. private equity firm said.
As technological advances, including the development of artificial intelligence, accelerate rapidly, investors may be wise not to underestimate the time it takes for companies such as Verisure to feel the full effects of competition.
“What was taking five to seven years is now taking three to five years and less,” said Elias Korosis, Partner at Hermes GPE.
By Max Bower
(Editing by Tessa Walsh)
Photo courtesy of Reuters/Mike Segar