June 2019

A Closer Look

Big Tech Under Scrutiny

In Brief

• Technology innovation over the past few decades has transformed the way people interact, purchase goods, run their businesses, and search for information. Growth in companies tied to these trends has outpaced the overall economy, in turn helping U.S. equity markets outperform on a global scale.

• Recently, backlash has grown due to concerns over data privacy, content inaccuracy, income inequality and other societal issues, as well as antitrust worries.

• While some of these threats are overplayed in the media, we think increased regulatory scrutiny has the potential to limit growth and weigh on valuations in the medium-term — though risk of regulation varies by company.

• Bessemer mandates retain overweight positioning to the technology sector, but portfolio managers have reduced the active weight of various investments in part due to regulatory risk, valuations, and maturing business models.

Holly MacDonaldChief Investment Strategist

Barbara SterneInvestment Strategist

Beacons of American capitalism or compromised business models posing threats to privacy? Engines of growth amid lackluster macroeconomic momentum or a prime cause of increasing income inequality? Dangerous monopolies or the United States’ best chance to compete with China?

The exponential growth of “Big Tech” in the U.S. over the past decade can be viewed through many lenses, certainly positive though more nebulous of late. In this piece, we use the term “Big Tech” to refer to the major technology-related companies, including Apple, Amazon, Facebook, Google, and Microsoft. A sampling of Wall Street Journal headlines just from June highlights the fever pitch of sentiment and the importance of having a clear investment case for the U.S. tech companies:

• Google’s Enemies Gear Up to Make Antitrust Case

• Justice Department Is Preparing Antitrust Investigation of Google

• Rare Bipartisan Ground Emerges Over Big Tech Worries

• Tech Giants Google, Facebook and Amazon Intensify Antitrust Debate

• Why Free is Too High a Price for Facebook and Google

Bessemer portfolios have benefited from overweight exposure to the tech sector and to several of these companies in recent years. In light of recent developments, we want to provide our clients with an update on our views. Specifically, in this A Closer Look, we explore the rise of large U.S. technology-related companies and recent challenges to their business models. We also offer thoughts on potential regulations and the investment implications of Big Tech’s marketplace dominance.

2 Bessemer Trust A Closer Look

The Conundrum of the Growth of Big Tech

A revolution in the data economy helped fuel the rise of large technology companies, some of which have seen tremendous share price appreciation and now have trillion-dollar market caps (Exhibit 1). The business models of the five most valuable listed companies in the world are data-driven: Amazon, Apple, Google, Facebook, and Microsoft. Many technology companies provide direct consumer benefit by addressing unique user needs; in the process, they attract more users — which improves the value of their service, a phenomenon referred to as a network effect. In particular, the growth of Facebook and Google was fueled by their ability to offer free services in exchange for data while also relying on advertising revenue. In some cases, these companies then relied on user data to improve returns on investment.

The novelty of these business models, as well as strong execution, led to considerable growth over the past five years, a period in which overall U.S. economic growth has been somewhat lackluster. Revenue for this group of companies has grown roughly 15%–20% annually on average while U.S. economic growth has averaged just 2.6%. Strong business results have translated to long-term equity outperformance, though recent stock performance

Big Tech Under Scrutiny

has been more mixed. As Exhibit 1 shows, these companies have outpaced the overall S&P significantly over the past five years, with collective average share price appreciation of over 200% relative to the S&P 500 increase of approximately 50%. (Note that this outperformance was largely driven by Amazon.) However, over the past year, both Facebook and Google have underperformed the S&P 500. A more nuanced point is that the rally in the tech space has also contributed to the outperformance of U.S. equities more broadly. For example, versus European markets, of which technology comprises only around 10%, the S&P 500 is relatively tech-heavy at about 22%. (Note the communications services sector, which includes Facebook and Google, is 10%. Separately, Amazon resides in the consumer discretionary sector.) For context, this is still below the 33% of the overall index that the tech sector reached prior to the dot-com bubble in 1999.

The self-reinforcing network characteristics of these business models, often referred to as feedback loops, have led to market dominance and barriers to entry for new competitors. As a result, these have often been great companies to own. Consider a handful of statistics suggestive of market dominance:

• Almost 40% of U.S online retail is conducted through Amazon (Exhibit 2).

Exhibit 1: Big Tech Share Price Performance and Market Cap Increase

Key Takeaway: Large U.S. technology-related firms have outperformed the overall market over the last five years, leading to substantial growth in their market capitalizations.

Big Tech Share Price Performance Big Tech Market Cap Increase

As of June 20, 2019. Data reflects stock price. Google represents parent company Alphabet.

Source: Bloomberg

As of June 25 of respective year.

Source: Bloomberg

0

200

400

600

800

1,000

1,200

FacebookGoogleAppleAmazonMicrosoft

2014 2019

$ BillionsIndexed to 100

(100)

0

100

200

300

400

500

600

20192018201720162015

Facebook MicrosoftGoogle S&P 500

Amazon Apple

3June 2019

Big Tech Under Scrutiny

• Over 70% of all internet traffic goes through Google or Facebook-owned sites.

• More than 75% of mobile social traffic resides on Facebook.

• Google hosts over 90% of the search engine market (though nearly half of U.S. internet product searches start on Amazon).

• Google and Facebook account for approximately 60% of digital ad sales.

The beauty of these business models is also one of the reasons that tech companies are now attracting greater scrutiny. Policymakers, competitors, and regulators have raised concerns regarding the large tech firms that fit in four general categories: data privacy, accuracy and policing of content, income inequality and other societal ills, and antitrust challenges. We tackle each in turn in the sections that follow.

How Much Data Is Too Much Data?

While data collection and analysis have driven financial value for many companies and the U.S. economy, they have also created additional

downside risks and complications related to data privacy and security. Some might point to the outrage surrounding Facebook’s Cambridge Analytica scandal in early 2018 as a turning point for Big Tech. During this incident, it was revealed that Cambridge Analytica harvested the data of millions of Facebook users’ profiles without their full knowledge or consent for political advertising objectives. This scandal publicly exposed the sheer scale of data that is accessible to Big Tech companies. It is likely that users, and even sometimes the companies themselves, did not fully foresee the implications of this business model.

An emerging group of journalists and politicians has suggested consumers should actually be paid for their data, with the idea that free access to internet platforms is not cheap enough to compensate consumers for sharing so much about their lives. For example, two senators from both sides of the aisle, Mark Warner (D-Va.) and Josh Hawley (R-Mo.), have sponsored a bill that would require companies with over 100 million users to disclose the value of their data and would allow users to request the deletion of the data that companies collect on them.

Exhibit 2: Big Tech Share of Digital Revenue and Online Retail

Key Takeaway: Google and Facebook represent roughly 60% of U.S. digital ad sales while almost 40% of U.S. online retail is conducted through Amazon.

Share of U.S. Net Digital Revenue Share of U.S. Retail Online Sales

As of 2019, as estimated by Goldman Sachs.

Source: eMarketer, Goldman Sachs Global Investment Research

Home DepotAppleWalmartEbayAmazonMicrosoftAmazonFacebookGoogle

37%

6%

38%

Share of ALLU.S. Retail Sales

5%5% 4%2%

22%

9%

4%

4 Bessemer Trust A Closer Look

to use social media to organize and promote terrorism and violent extremism.” New laws and regulations have popped up across the world that hold platforms accountable if they cannot expeditiously remove violent and hateful conduct.

Income Inequality and Other Social Challenges

We believe that a less tangible driver of negative sentiment around large tech companies relates to a broader populist move in the country, and indeed around the globe. Lately, we have seen a shift in how politicians talk about Big Tech; rather than examples of the strength of the U.S. economy and sources of national pride, many politicians now tie them to automation of jobs/displacement of labor and corporate greed, both resulting in income inequality.

The backlash against Big Tech was evident in the controversy surrounding Amazon’s plan to build a second headquarters in Long Island City. The passions of New York residents and politicians were so inflamed that Amazon canceled its proposal. Amazon had planned a $2.5 billion investment with 25,000 Amazon jobs (plus additional jobs in construction and other support businesses) that was projected to generate $27 billion in additional state and city tax revenue over 25 years. The plan called for $3 billion to be returned to Amazon in tax credits, with a net $24 billion still flowing to the state and city, but populist rhetoric framed the Amazon deal as the equivalent of a massive taxpayer handout. The speed with which the deal collapsed with little concrete debate made it clear how far the pendulum has swung against the company in certain parts of the country.

The start of the 2020 presidential campaign promises to keep this in focus. One Democratic presidential candidate, Elizabeth Warren, has pledged to break up technology giants Facebook, Google, and Amazon if she is elected president. She has also proposed designating technology companies as “platform utilities,” meaning that companies could not both own a dominant marketplace platform and be a participant competing on it.

Debating the Limits of Free Speech

A downside of connecting people and enabling instant sharing of information turbocharged by algorithms programmed for user engagement is that inaccurate or dangerous content can become viral before anyone has a chance to evaluate it. And there is the more basic question of who, if anyone, should evaluate it. The issue applies both to inaccurate content (“fake news”) that has been tied to political events, such as the 2016 U.S. presidential election, and also to violent or hate-ridden content. Does the government or a regulatory body bear responsibility for policing content? Or do the companies themselves? The Supreme Court has established precedent regarding the limits of free speech. For example, yelling “fire” in a movie theater in the absence of fire is not protected speech. Further, interpretation of Section 230 of the Communications Decency Act has given internet sites broad immunity from lawsuits when platforms publish information provided by others. Under this ruling, companies are protected for moderating content. But with roughly half of U.S. Facebook users now turning to the site for news (and half of those claiming it is their only news source), yielding critical decision-making power to a team at Facebook is being called into question.

While companies have moved to set their own policies, government is taking action as well. Amid growing global concern regarding the capacity of these networks to provoke violence, foreign governments have sometimes moved to block social media platforms entirely. During the Easter terrorist attacks in Sri Lanka, for example, the government moved swiftly to shut down several social media networks, including Facebook, WhatsApp, YouTube, Instagram, and Snapchat. Indonesian authorities blocked social media during deadly protests in the recent election. India blocked access to Facebook as early as 2012 during riots related to questionable information circulating on the platform.

Outrage after a gunman used Facebook’s live streaming feature to broadcast the killing of more than 50 people in New Zealand further prompted a regulatory response as countries came together to fight online extremism. Many signed the Christchurch Call, a pledge to “bring together countries and tech companies to end the ability

Big Tech Under Scrutiny

5June 2019

A Brief History of Antitrust

American history has deep roots in resistance to powerful monopolies. Indeed, the American Revolution was ignited by anti-monopoly sentiment when the Boston Tea Party erupted in response to the East India Company’s tea monopoly in the colonies. Corporate consolidation beginning in the 19th century led to the creation of some of the biggest companies in American history, including Standard Oil, U.S. Steel, the railroads, and AT&T. In response to these companies controlling vast sectors of the U.S. economy, the “people’s lawyer,” Louis Brandeis, went after business leaders such as John D. Rockefeller and J.P. Morgan, and the government moved to break up AT&T and Standard Oil. Rather than carving up U.S. Steel and the railroads, the government created new regulations, such as the Interstate Commerce Act, and federal bodies to enforce rules on working conditions, wages, and trade practices, which resulted in the Federal Trade Commission (FTC).

Antitrust laws were designed to regulate competition and prevent monopolistic practices. The 1890 Sherman Antitrust Act prohibited anticompetitive agreements, or collusion, and conduct that limited competition. The 1914 Clayton Antitrust Act increased the government’s ability to intervene to break up large corporations.

Interpretation and ruling on these laws generally have been left to the judiciary. One-time Supreme Court nominee Robert Bork wrote “The Antitrust Paradox,” a book that frames U.S. competition policy to this day. Judges largely have defined antitrust violations by a consumer-welfare standard (i.e., whether consumers are harmed by lack of competition). Thus, the goal of antitrust enforcement in the U.S. historically has been protecting consumer welfare, not preventing excessive corporate size. This differs in Europe, where regulators often focus more on preserving healthy competition.

The last major U.S. antitrust legislation was passed in 1976, and the last government breakup of a substantial company was AT&T in 1982. Since the 1980s, antitrust regulation and enforcement have been largely behind the scenes — often preventing large mergers rather than breaking up existing companies — with the notable exception of Microsoft’s antitrust battle in the 1990s (Exhibit 3). The case preoccupied Microsoft for many years, though the company eventually avoided a breakup and settled the matter. A wave of M&A over the past 30 years has led to more industry consolidation, raising the question of whether another government antitrust push may be in the offing.

Big Tech Under Scrutiny

Exhibit 3: Antitrust Filings, 1975–2017

Key Takeaway: The number of antitrust case filings has declined since the 1970s.

As of 2017. Government totals include civil and criminal cases involving the government as a plaintiff or defendant. Data for 1975–1991 are for the 12-month period preceding June of that year. Data for 1992–2000 are for the fiscal year, and 2001 onward are for the calendar year.

Source: Barclays, Sourcebook of Criminal Justice Statistics, United States Courts

0.0

0.5

1.0

1.5

2.0

20152011200720031999199519911987198319791975

Government Cases Private Cases

Thousands

6 Bessemer Trust A Closer Look

Antitrust with a Tech Twist

A quick glance of the Big Tech market-share statistics cited on page 3 raises the question: Are these companies monopolies? Whether it is through network effects (i.e., more people want to use a good platform, which in turn drives more users) or purchases of potential competitors, the growth has been substantial as we have outlined. But what constitutes a monopoly, and what if anything should be done about U.S. tech monopolies?

In recent years, there have been efforts to revisit antitrust laws in light of the growth and power of U.S. technology companies. But with antitrust rules and policies designed for an industrial economy, there are many questions around how legislation and enforcement should be adopted for the internet age. For example, the consumer welfare standard may not be at odds with Amazon’s use of economies of scale to drive down prices. Under the consumer welfare framework, if Amazon is making prices lower and increasing choice for consumers, it is not engaging in classic anti-competitive behavior — quite the contrary, it would be viewed positively by this standard.

The past few years have seen a growing openness to the argument that concentration of power is a problem even if there is no apparent immediate cost to the consumer. Professor Lina Khan’s January 2017 Yale Law Journal paper, “Amazon’s Antitrust Paradox,” argues that prevailing antitrust “does not recognize Amazon’s ability to crush competitors by pricing goods below cost and to exploit its power in one sector to gain market share in another.” It is her view that the Amazon model amounts to “predatory pricing strategies to dominate multiple industries and choke off competition and choice.”

While there is no case precedent weaving this reasoning into law, it is worth noting that Department of Justice (DOJ) Antitrust Chief Makan Delrahim has said that despite internet services being free, they can still violate the consumer welfare standard by hurting innovation, reducing consumer choice, and lowering quality. He used the precedent of the DOJ’s case against Microsoft, where it was ruled that Microsoft violated antitrust law in limiting operating system

and web browser choices for consumers despite the fact that there was no price harm. This may be the line of reasoning the DOJ will pursue in its recently announced antitrust probe into Google. Early reports suggest that regulators may focus their investigation on Google’s search business and advertising platform, though its Android operating system could be scrutinized as well. Google has highlighted how its services benefit consumers and encourage competition, which is always “one click away,” as the company has argued. The company’s response is suggestive of a more general theme — that it would likely require a new U.S. antitrust framework to enforce many of the proposed regulations against technology companies.

Rationalizing the Regulatory Discussion

Due likely to all four of these concerns, government and related agencies have taken steps to review the growth of Big Tech (Exhibit 4). So far, U.S. lawmakers have questioned technology CEOs but have yet to pass concrete legislation at a federal level. Still, more than 25 states are now pursuing their own privacy legislation. California has already passed a comprehensive data-privacy law that gives California consumers the right to have their data deleted and to prohibit the sale of personal data to third parties. Earlier this year, the FTC set up a task force to examine competition issues in the technology marketplace. Officials have noted that previous government decisions to grant acquisitions of potential future competitors could be evaluated. As mentioned previously, at the beginning of June, there was a f lurry of headlines regarding antitrust and tech regulation, and politicians appear to be jumping on the bandwagon and proposing additional legislation.

For context, the European Union has been much more aggressive than the U.S. in terms of new legislation and fines, while China has continued to support its own tech giants. In 2018, the European Union passed General Data Protection Regulation (GDPR), which regulates the collection, usage, safeguarding, and sharing of personal data. GDPR includes breach notification, data portability, the right to be forgotten, as well as rules around consent and third-party data. France has implemented a “digital

Big Tech Under Scrutiny

7June 2019

tax,” Germany’s competition authority has restricted Facebook’s data gathering capabilities, and the list goes on. Overall, European regulation has enabled consumer data privacy rights, held platforms liable for the content they host even if they do not create it, and given power to content creators over platforms. This stronger approach is perhaps not surprising given that the firms are U.S. based and listed. In China, the tech giants Alibaba, Baidu, and Tencent have come under pressure at times when company strategy has conflicted with national policy, but in general the firms appear to be part of the national strategy to continue to rotate the economy from industrial exports to consumer-oriented, technology products.

It’s Not All Bad News

All hope for tech bulls is not lost, however. There are several reasons why we would suggest not overreacting to recent and potential regulatory developments.

First, when evaluating the investment implications on these companies, it cannot be overlooked that users are getting a high utility through most of these products and services, many of which benefit the consumer with lower cost and increased choice. Amazon shoppers generally find what they are looking for at good prices and with near instantaneous delivery. Google has put information right at our fingertips and transports us to every corner of the web in mere seconds. Facebook has given us digital relationships, network connections, picture sharing, event planning, online marketplaces, and more. Are consumers ready for regulation that might extract some of the utility they are currently enjoying?

Moreover, by fortifying barriers to entry, regulation could act to reinforce the dominance of larger companies. Regulation will bring added costs, for both big players and small players. Larger companies would be better equipped and have the resources to ensure compliance while smaller companies could face an increased cost burden that could challenge their growth, profitability or even existence. Early reports indicate that smaller digital firms have been hurt in Europe, where there has been stronger legislation and greater fines post-GDPR. On the other hand, Facebook has continued to see further growth in daily and monthly active users in the region. Some businesses may be choosing to place their digital advertising spend with tech giants that have invested in the capabilities to abide by the regulations. Much as the regulation around the banking sector following the financial crisis made it more difficult for smaller and regional players to compete, a crackdown on tech may set the stage for Big Tech to get even bigger. Awareness of unintended consequences may temper the extent to which regulators push the needle.

We also believe that self-regulating may preempt a full regulatory assault. Viewing regulation as inevitable, some companies have agreed with its need and are actively trying to control the direction it goes, perhaps keeping it more rational in the process. Both Facebook and Amazon have proposed their own regulation. Apple has called for a U.S. privacy law similar to Europe’s, having positioned itself as the data-protection and privacy company. Still, others are combating regulation. Google is fighting efforts to export GDPR rules to other countries and claims its products and services increase choice and competition.

Big Tech Under Scrutiny

Exhibit 4: Timeline of Relevant Regulatory Events

Source: Bessemer Trust

1890 1914 1978 1982 1995 1996 1998 2017 2018 2019 2020+

Sherman Antitrust Law

Robert Bork’s “Antitrust Paradox”

EU Data Protection Directive

EU’s GDPR Passed

Microsoft Antitrust Battle

California Data Privacy Law into effect

Clayton Antitrust Act

AT&T Breakup

Communications Decency Act

Lina Khan’s “Amazon Antitrust Paradox”

EU ePrivacy Regulation

U.S DOJ/FTC Antitrust Probe?

8 Bessemer Trust A Closer Look

Finally, the position of U.S. technology companies on a global scale must not be forgotten. The escalating technology war with China is likely to factor in the discussions where politicians and regulators contemplate the impact of legislation and enforcement. The fact is that Chinese companies are very unlikely to be broken up, and it is advantageous for U.S. companies to be in a position to compete on a global scale. Some argue that the U.S. needs the size, resources, and capabilities of large technology companies in order to defend against hackers, terrorists, and cyber warfare. We have written on the role of technology-related tensions in the ongoing U.S.–China trade negotiations in our A Closer Look, “Beyond the Deal.”

Regulatory Impact and Investment Implications

While we have seen stocks react on the back of data or antitrust regulation headlines, the technology giants have so far largely weathered the storm. We would expect that regulation has the potential to limit growth, margins, and valuations over a medium-term time horizon. Tech companies that have benefited from the massive upside of their business models are being called upon to bear the costs to society, a phenomenon not dissimilar in many respects to appeals that oil

companies consider their impact on the environment. How well companies can manage their platforms through moments of national tension and amid various political pressures will likely be a determining factor of their future success.

That said, the companies are at varying degrees of risk from regulations (Exhibit 5). In our view, Facebook and Google are most vulnerable, followed by Amazon and Apple, with Microsoft less likely to be severely impacted by potential regulation. When it comes to the investment positions of Bessemer mandates, it is also important to consider to what degree these risks are already priced into the stocks.

Facebook is at risk given both its dominance in social networking and digital advertising in addition to the focus on data privacy, especially given the company’s track record for privacy violations. The utter size of its social network, especially after acquiring Instagram and WhatsApp, makes Facebook the main social networking player. All four areas of concern we have outlined above apply to Facebook.

Facebook’s recent business model pivots both toward cryptocurrency and away from public posts, shifting the burden of content moderation toward encrypted private messages, were likely motivated in part by regulatory

Big Tech Under Scrutiny

Exhibit 5: Companies at Varying Degrees of Risk from Potential Regulation

Size of company icon represents risk of potential regulation.

Source: Bessemer Trust

Data Privacy Monopoly

Content Moderation Societal Ills

9June 2019

scrutiny. After its investigation into the Cambridge Analytica scandal, the FTC is now looking into Facebook’s broader monopolistic practices and whether it is hurting competition. While Facebook grows at roughly 20%, it trades at an attractive 20x price-to-earnings, suggesting that regulatory risk is likely priced into its valuation in the view of Bessemer portfolio managers.

Google, Amazon, and Apple have been accused of developing monopolistic positions in their respective industries and have faced criticism for limiting competition, yet their services remain largely popular with consumers. Google’s control of internet search and high market share in digital advertising and mobile operating systems make it a monopolistic target with multiple exposure points. Google has already been subject to fines under GDPR, and now the DOJ is poised to examine Google’s business practices.

Amazon currently accounts for roughly 40% of U.S. online retail sales (Exhibit 2). Yet the company’s focus on consumer benefit with low prices and increased choice makes it slightly less at risk given that regulation would likely require a change in the consumer welfare standard. Additionally, Amazon offers small businesses a bigger and more effective platform to advertise and reach customers, which propels their growth and helps boost competition.

Apple’s business model is much less at risk on the data privacy side given its strong focus on privacy management. However, the company has come under some fire for its App Store monopoly. Some argue that Apple is utilizing its consumer privacy focus to foster anti-competitive behavior in restricting other competing apps. The company is currently facing a lawsuit that alleges the App Store drives up prices for the consumer, a potentially dangerous proposition in light of the consumer welfare standard. In our view, it is likely Apple will settle or pay a fine. However, in a worst-case scenario for the company, it could be forced to change its App Store business model, an action that could negatively impact a key source of company profits.

Finally, Microsoft appears less at risk relative to some of the other technology giants given its business-to-business model in addition to its diverse revenue streams.

Bessemer Positioning

We will closely monitor evolving developments on the regulatory front as well as responses from management teams to evaluate how companies navigate a changing landscape. We are watching to see which companies, if any, receive a CID, or civil investigative demand, which is a subpoena that requires the company to submit internal documents. A CID does not mean that action will be taken against the company — only that it is more likely. Reports have indicated that CIDs could be issued within the next few months.

Even if there is no eventual regulatory action, scrutiny could be costly and has the potential to distract management. The uncertainty could weigh on multiples. History shows that a company’s involvement in an antitrust lawsuit can cap its valuation — at least in the near-term. AT&T in 1974, Microsoft in 1998, and IBM in 1969 are three examples where valuations fell and sales growth slowed during a period of regulatory scrutiny. However, just because additional regulatory challenges have surfaced, Big Tech companies are not necessarily doomed — there is a very real possibility that these companies emerge in stronger positions in the years to come. The Big Tech companies still have some of the best business models investors have seen in recent history with management teams that have successfully navigated challenging situations before.

Bessemer portfolios are currently overweight the technology sector. An all-equity portfolio is overweight both Amazon and Microsoft, underweight Apple, and closer to the benchmark weight in Google and Facebook. Portfolio managers have taken actions to limit position sizes where they see regulatory risk, but they have also opportunistically taken advantage of overdone weakness to purchase companies with compelling long-term trajectories at attractive prices.

A special thanks to colleagues on Bessemer’s portfolio management teams, including Jeff Rutledge, Alex Christie, John Hall, Michael Morrisroe, Michael Tobin, and Andrea Tulcin.

Big Tech Under Scrutiny

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Big Tech Under Scrutiny