Defensive Monopolies

Defensive Monopolies

The other day I was talking to a startup founder in a hard tech space with the fairly common model of 1) building a complicated and hard-to-duplicate gadget, and 2) monetizing it by buying some fairly commoditized inputs and selling value-added outputs. Their immediate concern was getting the gadget to work, and finding customers, but longer-term one of their big worries was that the commoditized inputs were getting a bit less commoditized over time. A conglomerate in the space had been buying producers of said input, and their suppliers, and was slowly ratcheting up its market share. Naturally, the startup had a plan: they, too, would go full-stack, and get their own captive supply for their inputs. And, who knows, maybe that business would be more profitable than the original product, with far less execution risk.

That's a vague story, partly to protect the strategy of an interesting company and partly because it happens in industry after industry: some part of the supply chain is essential and looks commoditized, then starts to get consolidated, and other industry participants have to choose between ceding their margins and doing their own consolidation. This seems inevitable given the dynamic of commoditizing the complement: if you're not benefiting from it, someone will try to make it happen to you. Fragmented industries attract this on all sides: a restaurant has to worry about relying on Sysco for their ingredients and their landlord for space, and at the same time needs to be concerned that demand is being filtered through Doordash or Google Maps. And, perhaps in the future, they'll have to worry that their other big expense will be mediated by one company, too.

The only purely economic escape from this is an unpleasant one: selling a purely commoditized product with purely commoditized inputs. Most products have some kind of branding associated with them, but some parts of the materials industry are mostly buying a product with a freely-floating price and selling one with the same characteristics. Oil refineries, for example, don't have this precise concern given that the biggest seller of crude oil, Aramco has about 10% market share, and the biggest buyer of refined oil products, and the single biggest consumer, the US military, buys about 0.2% of the world's supply. Even for those companies, there are risks from relying on vendors who sell essential components.

If every business runs the risk that it's going to be commoditized, how does that alter behavior? For smaller companies that don't plan to scale, there's a limit to how much they can do. But there's also a limit to how much they'll suffer; a beloved family-run restaurant that pays attention to its costs can earn an excess return, and it's unlikely that their suppliers will somehow figure out that they're producing high margins and try to jack up their prices. For companies with a more scalable model, there's a bigger challenge; they generally can't sit still and just keep their existing clientele happy. An industry where companies can 10x in size is an industry where they're perfectly capable of going to zero.

This can produce some odd dynamics. It was always a little weird that Wag, a dog-walking startup, got a $300m investment from SoftBank. That investment didn't work out, but Wag competitor Rover raised slightly more and is now a public company, while Wag has had to retrench and has bought back SoftBank's stake. Miraculously, Rover's investor deck from their de-SPAC transaction highlighted the fact that they expect to increase their take rate over time, from 21.8% pre-Covid to almost 24%. (So far this year, they haven't hit those projections, though last quarter their take rate was a respectable 22.3%.) What both companies recognized was that, whatever value there was in dog-walking and dog-boarding app business, most of it would probably accrue to the winner. This is true for the usual two-sided network reasons, but for dog walking they're actually stronger. As the network gets bigger, the appeal for dog walkers skews more towards the fact that it's an enjoyable activity that can be done without special training, and that's available close to on-demand. So as the app scales, it can select for a dog walker population that's not doing a strict maximum-dollars-per-hour calculation and that is consequently more willing to lose a larger chunk of their fees to the app.

The Zillow Offers collapse (covered on The Diff here ($)) is another instance of this. Zillow's CEO called iBuying an "existential threat," and that was true on two levels:

1. If the market switched from brokers to dealers, i.e. from people who connect buyers and sellers to people who centralize the buying and selling of inventory, Zillow's addressable market shrinks. And since the company had never shied away from mentioning that housing is a multi-trillion dollar market, they'd lose the abstract addressable market story that kept the company promising even when they'd had earlier stumbles.
2. More subtly, simplifying the real estate market would reduce the value of Zillow's Zestimate. The Zestimate is an incredible feature because housing is an infrequent purchase, and if people wait roughly seven years on average between home transactions, it's hard to keep them loyal to a single intermediary. Zestimates keep people coming back, but if homeowners know that there's another estimate out there that is both more accurate and is the price at which they can get an instant all-cash offer.

iBuying wouldn't just shrink Zillow's addressable market; it would chisel away at the company's most prized asset. In that model, it would be excessively risky not to take a shot at dominating the market.

Zillow's effort did not work out, and they reached a point where the existential risk of losing iBuying was lower than the existential risk from trying to win it.

And there's an important lesson there, because over the course of their iBuying career, Zillow ended up making a number of generous offers for homes, which it wasn't able to profitably turn around. Their race for a defensive monopoly ended up giving a few sellers great deals on their homes, which transferred some wealth from Zillow shareholders to homeowners but didn't make the world worse off.

If we assume that there's selection among CEOs for big ambitions, both because generally ambitious people are more likely to end up running companies and because CEOs who can tell a more exciting story will be able to raise more money, then the number of companies trying to build durable monopolies will usually exceed the number of available monopolies to be built. And if the side effect of this is that other companies try to build defensive monopolies in response, that exacerbates the supply-demand imbalance.

So, in the average case, you have something like Zillow, where a company ends up offering normal people a better deal than they'd otherwise get, or Uber and Lyft at the height of their discount wars. Budding monopolists have to give up something, and that can take the form of cutting prices to buy market share or offering generous M&A terms to build market share a different way.

A world with more companies chasing monopolies will end up, in the long term, being a world with more monopolies. But in the short term, it's one that operates to the benefit of the non-monopolists. Paradoxically, general worries about monopoly imply a very positive view of the talent and ethics of CEOs: that someone running a company would never exaggerate that company's odds of wiping out its competitors and doubling its margins in order to raise money or recruit talent; and that these same executives would never overestimate their own ability to execute on such a plan. In a world of abundant capital, where employment and consumption growth are still below the pre-financial crisis trend, the attempt to build monopolies turns out to be a significant redistributive force, constantly forcing companies to trade the certainty of a bad deal in the short term for the hope that they'll make it all back eventually. Some will! Most won't. And in the meantime, consumers and small business owners reap a disproportionate share of the rewards from over-optimism.

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Elsewhere

Supply Chain Disruption and Retail Membership Programs

The right mental model for the current supply chain issues is that they're partly a crisis of abundance: demand for consumer goods is high, and it turns out that ports that try to operate at 101% of capacity end up functioning at more like 90% of capacity. The impact of all this is not distributed in a totally arbitrary way: the companies that chartered their own ships, or switched some goods to air freight, have been able to stock the shelves; the ones that didn't do that have struggled. For bigger retailers, this means that 2021 is a year to trade gross margin for other benefits, and they're taking advantage. For example, Walmart made its PS5 and Xbox Series X supply available only to Walmart Plus subscribers. Getting access to scarce products during a shortage makes customers happy, but at Walmart's scale they probably can't make everyone happy; better to cater to one tier of customers (and to get more high-margin subscription dollars) than to ration products some other way.

Evergrande and Unlimited Liability

One important part of the China model is that effective authoritarian governments can tolerate more leverage than an equivalently wealthy democracy, because the government has more degrees of freedom. The US can't avert a financial crisis by ordering banks to keep lending (though the Fed has had to make a persuasive case from time to time), but China can. And in the US, limited liability means that the CEO of a collapsing real estate company can probably walk away with personal assets intact, perhaps minus some insignificant legal fees. In China, Evergrande's founder has been directed to liquidate his homes, calligraphy collection, and art in order to help the company pay bondholders. While Evergrande was too levered, it wasn't quite as levered as it looked, because the CEO's assets could be clawed back. While this probably won't be the difference between survival and failure, it does mean that the cost of a restructuring will be a bit lower than it otherwise would be—in terms of financial impact, sure, but in terms of moral hazard, too.

Alameda Goes Direct

Crypto market maker Alameda Research has borrowed $1bn through a syndicated debt deal run via DeFi rather than through traditional banks ($, FT). One of the accurate knocks against DeFi in general is that it's a way to borrow using crypto, but the purpose of the borrowing is generally to speculate in crypto. (This is less of a criticism and more of a benefit when regulation is an issue: the stablecoin ecosystem isn't a systemic issue when the loans aren't supporting non-crypto economic activity.) This is a step towards more DeFi-to-TradFi interactions, though; it's more of a standard loan than an automatic margin product—per CoinDesk, Alameda is "providing their financials – profitability, balance sheet strength – very similar to the underwriting that a bank would do if they decided to lend a large company money." It will be very interesting to see how this goes.

Off-Brand

Facebook is testing allowing advertisers to opt out of having their ads appear to people who recently saw particular kinds of potentially controversial content. One reason for this is to directly raise revenue, by getting more spending from advertisers who were holding back over reputational issues. But another good use case is to figure out just how much of Facebook's revenue is at risk from this kind of content. By giving advertisers different categories to opt out of, Facebook can start to measure the demand curves for them, which means it can get a realistic estimate of the cost/benefit of further restrictions on what kinds of content can be posted and what kinds will be allowed to spread.

State-sponsored VC

Patient Capital, the UK's state-sponsored £2.5bn VC fund, has hired a team of investors to allocate more than £50m each year ($, The Times). Hiring for this role is difficult: there's strong adverse selection effects for poor capital allocators because the best wouldn't leave the private sector for reduced upside. Part of the purpose of the fund is to retain influence rather than maximize cash returns, which creates another layer of complicated selection problems: since the best companies sometimes take a while to display momentum, the better the portfolio ends up being the more it will relatively underperform early in its life. In one sense a government-backed fund means the simplicity of a single LP, but in another sense there are 67 million LPs who will only pay attention to the fund's performance during an election year.

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