Understanding Disruptions

The rise in venture capital funding in the last decade has made the word disruption quite common. We hear a lot that the incumbents are getting disrupted. In this essay, we'll have a closer look at where is the disruption happening, why is it happening, what are the emerging trends, and what does it imply for investors.

The disruptions are led by various initiatives such as innovation in products, business models, and/or customer experience. Disruption is good for society overall because it tends to produce better outcomes – economically and socially (with some exceptions which also course correct). Disruption leads to inefficient businesses and business models disappear slowly. It manifests in various forms and stages such as slower customer growth, loss in market share, declining revenue, and talent attrition.

Where is disruption happening?

Not all inefficiencies are worth removing if it does not justify the cost, time, and effort. Restricting our discussion to inefficiencies in businesses, active investment management has helped to target some of these inefficiencies because it justifies the capital required - both monetary and human. Disruptions are targeted either directly or indirectly. For e.g. targeting lending businesses directly or ad market indirectly by creating social media platforms after these platforms have enough engagement on its platform.

Private capital investment is a good example of capitalism in its best form, where capital flows to the assets which deserve more. Although one can debate on capital allocation which sometimes is affected by biased human decisions, I believe, overall, it does a good job. With the rise in venture capital and private equity investment in the last decade, the disruption phenomenon has been accelerated. Various factors can be attributed to this increased pace-

1) Time to innovation is shortened - The earlier timeline to scale businesses was long enough for incumbents to react and respond strategically. However, enormous capital behind a new startup has accelerated the innovation, customer adoption, and R&D efforts. This gives lesser time to incumbents to safeguard their interests.

2) The number of threats has increased – the number of startups founded and getting funded has increased drastically, leading to heightened competitive intensity.

3) Accelerated changes on the demand side – customer behaviors and demands are changing rapidly. Availability of capital is partly to be responsible along with increased customer awareness and ease of information availability.

Three trends are clear when it comes to disruption.

1) Targeted disruption - To get the most of out the capital invested and to increase the chance of success while backing an early-stage company, investors are willing to fund companies that target specific parts of the value chain. These parts are those that:

• Commands the largest profit pool. Thus even a small market share gain will translate into a large profit potential
• Can allow new entrants to build competitive advantages. Thus the profit accrued can be protected for a longer period.
• If possible, will not be commoditized in the near future. Thus, the new entrant can build a brand and commands some pricing power.

2) Unbundling followed by bundling. Entrants own a part of the value chain (unbundled point solution), achieve scale, and then subsidize its entry into adjacent parts of the value chain, slowly bundling solutions to capture higher LTV. This makes it difficult for incumbents to compete that are operating in just one part of the value chain. E.g. e-commerce giants that have won the distribution game can easily get into the production business by negotiating bulk discounts on contract manufacturing. E.g. Account Payables and Spend Management (cards/softwares) are point solutions but aim to capture the B2B payments market eventually.

3) Incumbents are getting squeezed to own and operate capital-intensive parts of the value chain and the profit pool of that part is also reducing with time because the other parts of the value chain have started putting pricing pressure. A few sectors have started looking more like agriculture, where the upstream players (farmers) are getting squeezed. Below are few examples:

• Food delivery businesses started with the objective to increase the reach of the restaurants and help them serve more customers, helping the restaurants to earn more by removing the constraints of limited retail space. Once the distribution problem is solved, the required network density is achieved, and the customers are hooked onto the platform, the food delivery companies started squeezing the commissions that they used to earlier pay. Moreover, they also started eating into the business of the manufacturers (here restaurants) by operating cloud kitchens.
• Fintech firms have been reducing the incumbents (banks) to just manufacturing financial products because banks are the best at it and that is because of their scale and large customer deposits. Distribution (payments, cards) are more handled by the fintech firms. Similarly, customer services are controlled by the fintech firms because they are the best in these activities.

Post our discussion about the disruptions and trends emerging out of these disruptions, I would like to end the essay by bringing up an important question and it will be great to hear some views on the same. Amidst these rapid disruptions and fast pace changes in customers’ expectations, can we hold our investments in companies for 20+ years? Can a company keep increasing or maintaining its moat? What if the moat continues to exist but the castle is no longer important?