Markets have been core to commerce since the first day humans began transacting. In the last 10 years some of the biggest tech companies that have been created have been marketplaces intermediating new and old markets. Amazon has intermediated the market between buyers and SMB sellers of goods. Uber has intermediated the market between riders and drivers. AirBNB has intermediated the market between homeowners and short-term stay guests. Rent the Runway the has intermediated the rental market for clothes. There are many more small and large examples.
These marketplace businesses come in many shapes and forms. Some are peer-to-peer (AirBNB). Some are vertically integrated and own the supply-side (Rent the Runway) and many have been so disruptive because they have pursued an asset-light approach. But what they all share in common is that they have intermediated huge markets and when they hit scale the volume of transactions they process is tremendous.
With the rise of this new breed of tech-enabled marketplaces processing huge transaction volumes a whole new business model for marketplaces is becoming possible. The business model of the insurance industry – investing float to generate returns – suddenly becomes applicable to these marketplaces at scale and the possibilities are very attractive.
At its core float is generated when a payment is made to a business or supplier before a service or good is delivered to the payee. This time-difference is called float and it is the fundamental business model of the insurance industry. For example, insurance carriers who issue home insurance often receive many years of premium payments before they receive a claim. So, in practice the carrier may receive 15 years of premium payments before that homeowner’s house burns down, is flooded or any other type of catastrophic claim.
The carrier may receive $10,000 for 15 years before a claim is made. The insurance carrier than has to pay for the full insurable amount of the house which we we’ll put at $500,000 for this example. In this case, the carrier has received $150,000 over 15 years but is required to pay $500,000 on year 15 to its client. This doesn’t seem to be a sustainable business at any level. Somehow insurance carriers have make up this $350,000 difference over the course of those 15 years. There are several ways to make up this difference, but the most powerful form is to invest this $150,000 of float over the years to generate returns to partially or completely bridge the gap.
Float has been used famously by Warren Buffet – the darling of the investing world – to build Berkshire Hathaway into an empire. Berkshire Hathaway first entered the insurance industry in the late 1960s and has continued to grow its book of business ever since. Today Berkshire Hathaway’s float is an incredible $100 billion, over 50 times what it was a generation ago.
Berkshire Hathaway has employed this float to finance and aggressive M&A campaign of purchasing distressed companies in valuable, key industries and rehabilitating them to create more enterprise value for Berkshire Hathaway. For example, Berkshire bought the undergarment company Fruit of the Loom for $835 million in 2002 after the distressed company had lost 97% of its value. Berkshire Hathaway has since turned the company into a big success. Berkshire Hathaway’s stock price has soared from $290 a share on March 17th 1980 to $309,996 per share on March 18th 2019.
Berkshire Hathaway has been the shining success example of investing float for business gain, but there have been many others that have done so successfully and the business model of investing float is applicable to the breed new tech-enabled marketplaces in a big way. AirBNB for example is a marketplace with significant float. On the AirBNB platform you can make a reservation for a home months ahead of time. But the homeowner only gets paid out the day after you check out of their home. This generates tremendous float and AirBNB quietly began using this float to great effect a few years ago.
According to Bloomberg AirBNB ex-CFO Laurence Tosi, formerly CFO investment group Blackstone, “quietly built a hedge fund within the company’s finance department. He used a portion of capital from the balance sheet to buy stocks, currencies, and fixed-income securities, mimicking the treasury fund he ran at Blackstone. The side project represented 30 percent of the company’s cash flow last year and made about $5 million a month for Airbnb, the people said.”
AirBNB quickly shutdown this internal fund when news broke of it, but by all measures it was an unparalleled success. Apple – another darling of tech – runs Braeburn Capital, an asset management firm that is allegedly the world’s largest hedge fund with its total assets under management sitting at about $270 billion.
While Braeburn is not built on investing float its another powerful example of how companies with a lot of cash, irrespective of whether its float or profit can invest this cash to generate even greater returns. But its not just marketplaces which have the opportunity to generate float. Subscription-based businesses such as consumer product businesses or even software businesses have the opportunity to invest float if the context is right.
For example, consumer product companies bought on subscription such as Dollar Shave Club, Winc or Bouqs (disclosure: Winc & Bouqs are Wavemaker portfolio companies) can charge consumers upfront for annual subscriptions and thereby generate several months of float. At the right scale inventory costs and the supply-chain will be optimized so that this float could be used to invest to generate additional returns.
Businesses investing float are essentially investing borrowed money at no fee. Any return than will be profitable. Aside from insurance industries where significant float is generated include subscription services, banks (who already actively invest float), gift cards, loyalty programs and more. An extremely important factor for determining whether the float a business generates is investable is the time period of that float. If the float period is short (5, 20, 90 days) it will be tough to invest the float in a way to generate meaningful returns. However, if the float is longer, say a year or more, than these businesses have a better foundation to invest that float.
The two majors risks of investing float for marketplace or subscription business is the risk of negative returns (losing cash) and the additional overhead costs of employing full-time finance talent to manage this investment process or the fees associated with third-parties.
Despite these risks, for marketplace and subscription businesses at the right scale investing float is a new potential business model for them to pursue that can enable them to alter their core business meaningfully. The revenue generate from float could allow these marketplaces to reduce or cut fees, or price their product differently. At scale investing float may allow whole new transaction structures and incentives structures in marketplaces and subscription businesses.