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Platform power

Platform power

11-04-2017 | Research
Surging connectivity is powering a new business model: the platform company. Platform companies, such as Uber, Airbnb and Alibaba, facilitate commercial or social interaction between interested parties that faced high costs of finding each other in an unconnected world. What are these companies’ investment merits and what are the risks investors should keep an eye on?
  • Steef  Bergakker
    Steef
    Bergakker
    Senior Portfolio Manager

Speed read

  • Platform companies have yielded very good investment returns
  • Investors should develop a deep understanding of the nature of network effects
  • Envelopment is a strategic risk that should be monitored
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Over the last few years, we have witnessed the meteoric rise of new businesses such as Airbnb, Uber and Alibaba, which have been able to build a global presence in just a few years. A common feature of these upstarts is that they operate as a mediator between value creators and value consumers that would not, or to a much lesser extent, have interacted without the platform.

Platform companies dominate in terms of market capitalization

The virtual nature of the networks and meeting places means that it is much easier to grow these businesses than businesses that employ physical assets. The world's five largest companies in terms of market capitalization today, i.e. Apple, Alphabet, Microsoft, Amazon and Facebook, are all platform companies and have become household names in a very short time.

Platforms are not a modern invention. Real physical platforms like bank branches, airports or restaurants and bars have been around for quite some time. Physical market places, which go back to early civilization, can perhaps be considered the archetype of the platform business model.

What distinguishes modern platform companies from archetypal platform companies is the evolutionary leap forward in business reach made possible by the exponential increase in connectivity of the last 15 to 20 years. Modern information and communication technologies have turbo-charged the old platform business model and expanded its reach from mainly local to truly global. Commercial and social interaction that was impossible or prohibitively expensive in the past can now take place almost instantly and at very low cost. This has proven to be a huge game changer.

The monetization challenge

Platforms can generate a lot of economic value for their users. However, capturing a part of that economic value can be challenging for platform operators. An important part of the economic value created by the platform operator is the reduction of search costs. However, once a potential consumer and producer have found each other, there can be an incentive to go off platform, negotiate a private deal and avoid having to pay a commission to the platform operator. This is especially a problem for platforms that connect service providers with service consumers where often substantial sums of money are involved and the likelihood of repeat transactions is low.

In principle, platform operators can try to monetize by charging a transaction fee, charging for access, for enhanced access (e.g. premium articles on online newspapers) or for enhanced curation (e.g. vetting services for online dating services).

An additional monetization possibility is analyzing, leveraging and selling the data that platform traffic generates. This can potentially represent huge commercial value, but is fraught with privacy issues.

The market is characterized by some very large companies that completely overshadow the rest. This is a manifestation of increasing returns caused by the network effect that tends to lead to winner-takes-most/all outcomes.

Which markets are susceptible to platform disruption?

Platform companies have already invaded many markets and increasingly start-ups adopt a platform business model. Where we can expect platforms to pop up next? In their book ‘Platform Revolution’ Choudary, Parker and Van Alstyne list four characteristics that make markets susceptible to platform disruption: information intensiveness, non-scalable gatekeepers, high level of fragmentation and large information asymmetries. Industries that tick many of the boxes are education, energy, finance, healthcare, labor services, logistics, and transportation.

Platform companies have generated extraordinary returns. Most of them have massively outperformed both the S&P500 and MSCI All Countries World Index over one, three and five years. This can largely be attributed to network effects, as a source of growth and competitive advantage. Once increasing returns from network effects kick in, growth becomes self-sustaining and requires very little capital. As a result, returns on invested capital improve and economic value creation soars.

In markets with winner-takes-most/all characteristics, growth is only limited by the market’s size. As the network’s size grows, scale advantages grow as well, raising entry barriers and extending the competitive advantage period while further compounding profitability. Finally, as users become ever more embedded in the network, switching costs tend to rise as well, adding to the competitive advantage.

Investors need to understand the nature of network effects

The main task for investors is to develop an understanding of the nature of the network effect in combination with the cost of multi-homing and switching costs for users. In addition, careful examination of the monetization and governance model a company employs, is required to get a full understanding of the strengths and weaknesses of platform companies.

Once a platform has reached critical size, it becomes very difficult to dislodge, provided company management doesn't slip up too badly. Investors can usually look forward to a long period of value creation. Two risks should be monitored, however. One is the introduction of Schumpeterian improvements in functionality by competing platforms. While this does happen from time to time, it seems a fairly remote risk as a platform’s main functionality is finding a match, which, by definition, a successful platform already does.

The second is the risk of envelopment by another platform. This means that one platform provider moves into another one's market, combining its own functionality with the target's, to form a multi-platform bundle. This is possible if there is significant overlapping in user bases and/or there are significant economies of scope. Envelopment is a risk investors should be aware of.

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