Where angels have already trod

Hitherto a largely angel investor and venture capital-dominated sector, there is an increasing role for private equity to play within the social media industry, writes GMT partner Natalie Tydeman.

Despite mutterings of a ‘bubble’ and high levels of market volatility, M&A and IPO activity in the social media sector is on course for a record year in 2012.

A combination of factors, among them Google-like levels of penetration and increasing consumer engagement, are enabling social media companies to develop the revenue streams necessary to attract significant investor interest. With social media advertising expected to reach $8.3 billion globally by 2015 – up from $2.1 billion in 2010 – and other, proven monetisation models that leverage Facebook’s success, social media revenues are set to grow strongly over the next few years.

But who is actually making money in this space?

To date, social media has largely been venture capital-funded. While VC backers have in some cases seen home runs, not every business can be a Zynga or a Groupon, and most of us will never hear the names of the many Social Media start-ups which fail to make it. A number of non-traditional funds have come into companies like Facebook at later stages of investment, buying small secondary stakes from employees and angels at very high valuations, with minimal or no governance rights, anticipating a quick exit via IPO.

Clearly neither of these investment structures follow the traditional private equity model, where investors typically look to take significant stakes with high levels of influence. Yet these businesses demonstrate a number of the characteristics that appeal to traditional private equity investors: strong growth fundamentals and cash flows, large and diversified user bases, opportunities to consolidate and to leverage their platform globally; and for the “winners” there is a clear exit route through a trade sale or IPO.

So how can private equity fit into the social media investment ecosystem? Firstly, given the accelerated lifecycle of many social media companies, private equity investors need to identify and track companies early, in order to be well positioned to invest at the transition from “venture” to “growth”, where the company’s product and business model are proven, but additional cash and skills are needed to expand globally, consolidate the market and so on, or where early investors are seeking liquidity.

Secondly, private equity investors need to be skilled at identifying challenges as well as opportunities and pricing both growth and risk in a sector where the public and private valuation metrics applied to hyper-growth companies are frequently obscure.   Valuations for the high potential companies at these inflection points are unlikely to be cheap, yet the sector faces a number of inherent challenges: there are still significant issues surrounding barriers to entry; audiences can be quick to move on when a portal loses its lustre, or a better service comes along (let’s not forget MySpace and Friends Reunited); costs of customer acquisition are increasing; and there are questions about sustainability of business models.

Thirdly, private equity companies do not have the hit driven model of a VC and need to invest with a view to low loss ratios. How does an investor get comfortable with this in the social media sector? Naturally, there is a prerequisite for strong revenue traction and a clear road to profitability, and a loyal customer base is essential. Other sources of competitive advantage are also key, such as first-mover advantage, a large and established network, and – importantly – proprietary content. Social Media companies should also demonstrate multiple clear growth avenues and they need visionary management with the ability to drive these growth opportunities and respond quickly in a rapidly changing marketplace.

But lastly, history dictates that if you’re looking for a fair valuation, you generally have to look below the radar and beyond the obvious. Knowing the market inside out is therefore imperative, allowing a private equity investor to explore the broader infrastructure and look at the supporting ecosystem of businesses that feed off the Social Media space.

For private equity firms looking to maximise these opportunities, the ability to work collaboratively with management teams is essential. And, in this fast-moving sector above all, deep market knowledge and the associated ability to spot the right opportunities, price risk and growth, and bring strategic value-add are the key to success.

Natalie Tydeman is a partner at technology media and telecoms-focused private equity firm GMT Communications Partners.