Initially published on Thursday 17 November 2016

Long driven by venture capital (VC), the rapid growth of the digital sector is now seeing a new kid on the block: the corporate. Old economy "bricks and mortar" firms are increasingly eager to harness the opportunities presented by the new economy and have started to enter the digital technology bazaar.

The digital sector's rapid growth has predominantly been backed by venture capital firms' deep pockets, with financing for VC-backed companies soaring from $50bn in 2013 to $130bn in 2015.

However, old economy firms are catching on to the sector's potential, beefing up their innovation teams and investing directly in VC funds, launching their own venture divisions, or buying up stakes in digital firms.

Digital is a growing component of the tech sector, which is on track for a record-breaking 2016 in terms of mergers and acquisitions. The global tech M&A market topped $475.4bn in the first three quarters of 2016, exceeding the previous high of $446.1bn for the same period in 2015, according to Dealogic.

The US remained the dominant acquisitive force, although Asia is seeking to aggressively expand internationally, exemplified by the high-profile purchase of UK-based chip designer ARM Holdings by Japan's telecoms and internet firm SoftBank.

However, in contrast to VC firms, traditional corporates are often still unnerved by the difficulty of accurately valuing digital firms, says Jean-Baptiste Natali, Managing Director Digital in BNP Paribas CIB's EMEA corporate finance department.

Jean-Baptiste Natali, Managing Director Digital in BNP Paribas CIB's EMEA corporate finance department
How do you define digital and what trends do you see in digital in terms of capital raising and M&A deals?
Digital is everything related to the new economy. It's pretty transversal. It can be found in technologies around SaaS (Software as a Service), cloud and big data, but you also find it in media in the form of advertising tech, telecoms (Internet of Things), industrials (smart manufacturing), utilities (smart cities and smart grid), banking (FinTech) and insurance (InsurTech). It's particularly related to the digital revolution, the move to online, off-premises, mobile, everything related to innovation in the past 10 years. It crosses every single sector.

Most digital companies are funded by VC firms, and very few are profitable. They are funded on a 12-24 month cycle and grow very fast, so they go through the cash and then need to raise new capital. This means that financing is the primary driver of activity. Last year was an historic high in the history of digital for capital financing and deal activity. Financing for VC-backed companies was $130bn worldwide, after $90bn in 2014 and $50bn in 2013, which underlines the kind of explosive growth in digital financing for recent years. Deal sizes have also increased because valuations increased in that period.

In the fourth quarter of 2015 in the US there was some excess in valuations of digital companies, and that led to a slowdown that was confirmed in the first half of this year. So we have seen a roll-back in activity this year but it is still at a high level, similar to 2014 and well above the levels of 2012-2013. We're still probably going to top 2014 this year, but it will be some way off 2015 because of a realisation that valuations have reached unsustainable levels, especially in the US.
Where is most activity taking place?
The US has seen the most deal activity and the highest valuations, but Europe is still seeing pretty healthy activity because VC funds are still growing in size in Europe, despite a less buoyant environment compared to last year.

The one element that has dampened the atmosphere in Europe is Brexit. FinTech was a big focus in the UK, because of the passporting of financial activities that was possible through Europe and the fact that London was the financial hub for Europe. In the second quarter there was a slowdown in deal activity in the UK, specifically in FinTech, and capital raising was down 40% in the UK in the quarter.

In contrast, Germany did very well in the first half. Germany is known for e-commerce because of Rocket Internet, one of the leading financing houses for e-commerce. France has also been very robust.
What are the biggest deals over the past year?
The largest deal we have seen, at the frontier of tech and digital, is the acquisition of ARM in the UK by Softbank for €28bn, which Softbank presented as a play on the Internet of Things. There was also Microsoft's acquisition of LinkedIn for €25bn, which is a big symbol of traditional tech buying into digital. The other very large deal was Unilever buying Dollar Shave Club, a new on-line subscription-based service, for more than $1bn. There was also talk of Lyft, an Uber lookalike, being in discussions with General Motors at about $6bn, so these are big numbers.

In Europe one of the most talked-about acquisitions was Nokia buying Withings, a French business that manufactures wearables for health, for close to €200m. There has also been some capital raising in Europe at fairly high valuations. Online fashion and e-commerce firm FarFetch raised $110m; Cabify, another Uber-type business, raised $120m; Number26, a digital-only bank in Germany, $40m; and Letgo, a consumer-to-consumer goods market place, $100m.
How easy is it to put a valuation on digital companies?
It is an area of discomfort for traditional bricks-and-mortar firms, which are used to looking at discounted cashflow analyses and using profitability multiples for valuation purposes, because none of these businesses are profitable or cashflow-generating. So it requires an effort to project forward and look at a few key things: What is the addressable market of the business over time? And what is the likely success and market share? Once you have done that, then you can define some level of potential future profitability. But the risk attached to those ventures is significantly higher than in a traditional business. That is something that traditional corporates struggle with, whereas the VC community is completely used to it.
Which segments of digital are most active
Today the two biggest sectors for activity, especially M&A, are Internet of Things and big data analytics. The other hot spot remains Cloud and SaaS. Healthcare and payments are also growing.
To what extent are traditional businesses investing in digital?
There is clearly a large focus by corporates on digital. Most groups now have chief digital officers or chief innovation officers. We are seeing a more aggressive approach from some groups, as shown by the Unilever/Dollar Shave Club deal and Nokia/Withings. And companies as mainstream as SNCF and Peugeot have also done deals in the digital segment. It is definitely picking up and it is a trend that will accelerate.
How do these corporates invest in digital?
Some of them start by investing in venture funds to test the water. Others set up their own venture arms - corporate venture capital now accounts for 25% of all VC financing, and the largest VC funds in the world are corporates, such as Google Ventures, Intel Capital, Cisco Ventures. And the final step is direct investment, including a majority or 100% stake, through M&A. So there are three planks and some do all three.

Digital's potential has not gone unnoticed in Asia. With softening domestic returns in China, the continent's powerhouse, a new surge of outbound M&A is shaking up the market. 
For more details, read:
The Great Chinese Takeaway


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