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Cybersecurity: The next frontier for investors?

IHS Markit interviewed industry leaders and investors, including Akamai, Clango, Full Frame Technology and Ibex Investors who all agreed that the cybersecurity is an increasingly important, high growth industry. The free 20-page White Paper with charts, financial metrics and full interview transcripts is available at https://ihsmarkit.com/Info/0820/cybersecurity-next-frontier-investors.html )

Given the current set of business challenges presented by COVID-19, our speakers all pointed out that their clients’ main priority was to get as close as possible to the state of business as usual. With their services having to rapidly migrate to predominantly online delivery, this warranted access to their portals for end customers while ensuring their employees can work with all the internal resources they accessed when in the office. Once the available solutions were assured, safety was given paramount importance.

Our points were further validated by data from the IHS Markit Research Signals team, who in collaboration with cybersecurity ratings company BitSight, provide analysis on cyber readiness and rank companies accordingly. We looked at companies with various ranks, compared their financial performance and valuation metrics. The comparison revealed that companies with the highest possible rank offered greater returns to their investors year to date.

Key findings:

  • The recovery in global economic output to pre-pandemic levels is expected to take two to three years, although may take longer, subject to further restrictions
  • The IT spend could be reduced even as high as by a third, with many businesses struggling to survive past the pandemic
  • Progressive organisations keep migrating their technology to digital and understood the importance of advanced cybersecurity
  • Out of 25 traded cybersecurity specialists, 20 increased their share value between 31st December 2019 and 31st July 2020 - the average unweighted return was 41%
  • There is a causal relationship between the company’s cybersecurity readiness – manifested in a higher BitSight / IHS Markit rank – and their equity performance
  • The (innovative) cybersecurity start-ups are high on investors’ priority list
  • When valuing early stage companies in the midst of pandemic, it may not be enough to focus on their stage of development, recent round of financing and market conditions, but one should consider complex techniques such as Scenario-Based Model (or PWERM), Option Pricing Model, or Milestone-Based Model (or adjusted price or recent investment). The fair value does not equal a “fire sale” price.

Economy vs Infrastructure

According to the IHS Markit Economics & Country Risk team, the global economy is in the midst of the worst downturn since the 1930s. Although modest recoveries are expected in the second half of 2020, real global GDP is projected to fall 5.5%, more than three times the contraction in the 2009 aftermath of the global financial crisis. The recovery in global economic output to pre-pandemic levels is expected to take two to three years, although may take longer, subject to further restrictions.

IT spend typically exhibits a strong positive correlation to GDP growth and – like previous recessions – it is expected that the overall investment into new IT projects will be reduced. We believe that the IT spend could be reduced even as high as by a third, with many businesses struggling to survive past the pandemic. However, it is also a time where progressive organisations keep migrating their technology to digital. Some will realise their employees’ have not been affected while working remotely and the emergence of a hybrid workforce is an opportunity to reduce tangible assets and operational expenses with the extended IT infrastructure.

The continued successes of data-driven companies and innovative industries such as fintech, remote video production, AI automation and autonomous vehicles will support continued demand for cybersecurity. Further progress of these industries is partially dependent on a full-fledged cybersecurity solutions landscape. Cybersecurity is an indispensable component of that commercial success and must be considered as a priority.

Common types of cyber threats

There are several ways to group and describe various types of cyber threats. For instance, Cisco considers seven types;

- (Distributed) Denial-of-service (DDoS) attack – floods systems, servers, or networks with traffic to exhaust resources and bandwidth and as a result, the system is unable to fulfil legitimate requests

- DNS (Domain Name System) tunneling – utilizes the DNS protocol to communicate non-DNS traffic over port 53. DNS requests are manipulated to exfiltrate data from a compromised system to the attacker’s infrastructure

- Malware – malicious software, including spyware, ransomware, viruses, and worms

- Man-in-the-middle (MitM) (eavesdropping attacks) – attackers insert themselves into a two-party transaction, e.g. on unsecured public Wi-Fi, attackers can insert themselves between a visitor’s device and the network

- Phishing – sending fraudulent communications that appear to come from a reputable source in order to obtain personal information

- Structured Query Language (SQL) injection – attacker inserts malicious code into a server that uses SQL and forces the server to reveal information it normally would not

- Zero-day exploit – attack released after a network vulnerability is announced but before a patch or solution is implemented

Cybersecurity vendors

Cybersecurity is a vast topic and many businesses play significant roles in protecting the safety of organisations and individuals online, providing services that span across cloud, network, IoT, consumer, threat detection, consulting, advisory or awareness. Amongst the most prominent solution providers are large corporations for whom cybersecurity is just one pillar in their rich technology product portfolio. These can be grouped as:

• Traded: e.g.: Accenture, Akamai, AT&T, AWS, BAE Systems, BT, Cisco, IBM, Intel, Lockheed Martin, Northrop Grumman, Microsoft or Verizon;

• Private diversified businesses such as KPMG, and EY;

But many leading cybersecurity specialists remain private. For example:

• Checkmarx, Clango, Cynet, Gigamon, Herjavec Group, Imperva, Optiv, Palantir, SonicWall, SparkCognition, Tanium and Thycotic, TrapX Security

Publicly traded cybersecurity specialists – where all or most of their operational revenues are associated with online security – act as a good proxy for industry performance

  • Out of 25 traded cybersecurity companies, 20 increased their share value between 31st December 2019 and 31st July 2020
  • The average unweighted return was 41%
  • The share price of Zscaler and CrowdStrike increased by 179% and 127% respectively.
  • The cumulative market cap for all 25 companies amplified by over US$53bn to reach US$226bn.

Companies with the best cybersecurity have had better share price performance (YTD) and have higher valuation multiples

There is a causal relationship between the company’s cybersecurity readiness – manifested in a higher BitSight / IHS Markit rank – and their equity performance. The 37 highest performers with a top rank of 1 offered more attractive valuation multiplies than the 35 businesses that were ranked at the bottom. It is worth noting that the top performers also benchmarked very highly against the S&P 500 averages.

Amongst the companies with highest readiness score:

  • The unweighted average share price declined by 2% during the period between 31st December 2019 and 31st July 2020
  • The cumulative Enterprise Value increased by 13%
  • 22 experienced negative NTM Revenue Adjustment with an average unweighted increase of 2.6%
  • Amongst the companies with lowest readiness score:
  • The unweighted average share price declined by 17%, with five recording a decline at or below 40%
  • The cumulative Enterprise Value increased by 6.5%
  • 21 experienced negative NTM Revenue Adjustment with an average unweighted increase of -6.1%

Industry and Investor voice

Despite financial uncertainty attributed to the outbreak of COVID-19 pandemic and associated lockdown measures, the majority of developed businesses increased their spending on security solutions to enable their employees to work remotely and their customers to access uninterrupted services. We believe that many leading cyber services have never been busier in building safe networks and ensuring their clients’ protection.

The following experts were invited to share their views on cybersecurity priorities and opinions on the matter:

- Martin Turner – Founder, Full Frame Technology, a boutique cybersecurity training provider

- Gerhard Giese – Cybersecurity Specialist at Akamai, the largest content delivery network (CDN) and a leading enterprise security provider

- Arun Kothanath – Chief Security Strategist at Clango, a leading system integrator specialising in Identity and Asset Management

- Brian Abrams, President of Ibex Investors about their cybersecurity investments and how to increase the chance of selecting most promising companies. In his response, Brian shares Ibex processes and encourages other investors to work together.

(Full interviews available with the free to download paper at: https://ihsmarkit.com/Info/0820/cybersecurity-next-frontier-investors.html )

Giese: “The week of June 21, Akamai mitigated the largest packet per second (PPS) distributed denial-of-service (DDoS) attack ever recorded on its platform. The attack generated 809 million packets per second (Mpps), targeting a large European bank”.

Turner: “Awareness of cybersecurity is mixed. (It) tends to be at the bottom of the to-do list until something happens to make it a priority”

Giese: “A lot of companies were unprepared for a situation where almost 100% of their employees had to suddenly start working from home”

Kothanath: “With the new situation companies had to increase their VPN capacity by many folds and thousands more devices needed the end point protection. (…) you have, instead of your company network, 500 different providers you must deal with and make sure that they all have the same level of security.”

Giese: “There are at least two trade-offs with cybersecurity: measuring your ROI before you are attacked and user experience that could be lowered.”

Turner: “embed cybersecurity in the fabric of the organisation, so that it becomes an integral part of everyday life”

Kothanath: “We have been advising customers to think about what is going to happen in six months and what potential scenarios may emerge, including what will happen when thousands of employees get back to their offices after months of working from home.”

Abrams: “(Investing in Israel) comes down to an incredible pool of skilled entrepreneurs with a tremendous background in terms of what they do in the army, the ability to transfer that know-how from the army into the private sector and then the culture of innovating very quickly as there is no fear of failure.”

Kothanath: “There are fascinating cybersecurity companies out there and they share a very innovative way of thinking: increasing the security while increasing the usability and reducing the cost”

Abrams: “When investing we look for five Ts: Team, Technology, Traction, Terms / Valuations and Total Opportunity”

Abrams: “We try to make successful companies a self-fulfilling process. We go in usually relatively early in their lifecycle and then aim to help them accomplish that big scale up for their crossing over from being Israeli technology-oriented business to an international sales-focused company.”

Valuation Considerations for Early-Stage and Innovative Companies

Ibex Investors and hundreds of other equity and debt investors trust IHS Markit’s independent valuations. IHS Markit’s valuation approach is based on generally accepted industry best practice – the International Private Equity and Venture Capital Valuation Guidelines issues by the IPEV Board, US GAAP and IFRS – incorporating the most widely used methodologies to establish a baseline valuation. The Private Equity & Debt Services practice – via a broad IHS Markit pool of talent and resources, including Technology, Energy & Chemicals, Healthcare, Economy & Country Risk, Automotive, Agriculture and their subsidiaries – supports pre-deal analysis, growth and buyout stages and provide subject matter expertise to fund managers and start-ups. At IHS Markit, we have developed scenarios for a number of business planning purposes ranging from operational decision making to regulatory strategy and its potential implications to inputs into due diligence valuations. The approach relies on the market-level insights from our economists who provide baseline estimates and assessments of direct economic risks and magnitudes.

Given the underlying portfolio companies’ stage of development, what should firms consider when preparing performing valuation?

- The change in market and sector pricing conditions;

- The complexity of the capital structure of the company;

- The recent developments in the underlying technology and innovation of the business and the industry; and

- The timeline and exit plan for the investor.

Due to the difficulty of gauging the probability and financial impact of the success or failure of development activities of early stage companies, one should be mindful that traditional valuation techniques may not be appropriate in all cases. It is also worth noting that, given the rate of change for certain early-stage companies, the price paid in a recent transaction may not be reflective of the fair value quicker than is typically the case.

In their latest valuation guidelines, the IPEV and the AICPA recommend the use of more complex valuation methodologies, when necessary. These complex valuation techniques may include:

- Scenario-Based Model (or PWERM);

- Option Pricing Model; or

- Milestone-Based Model (or adjusted price or recent investment).

As the impact of COVID-19 continues to ripple across the globe and affect the fundamental outlook of a wide array of sectors, the need to apply additional valuation techniques to estimate the fair value of investments is becoming increasingly necessary. This point was recognised by the International Private Equity and Venture Capital Valuation Guidelines Board (IPEV) who recently issued a Special Valuation Guidance note to assist with 31 March valuations.

Key aspects of the Special Guidance:

- Fair value must capture current market conditions. Fair value does not equal a “fire sale” price.

- Valuation inputs such as performance metrics and/or future cash flows need to be adjusted for the impact of the crisis.

- Greater uncertainty may translate into greater risk, which may translate into greater required returns, which may translate into lower asset values.

- It may no longer be appropriate for recent transaction prices, especially those from before the expansion of the pandemic to receive significant, if any, weight in determining fair value. This will increase the need for mark-to-model valuation techniques.

The board further highlights the following key aspects with respect to valuing certain types of equity and debt investments which should be considered on an investment by investment basis:

- The impact of the crisis on the portfolio company’s revenue/customers, supply chain, and operations must be rigorously considered.

- Adjustments to performance projections and/or metrics are likely to be necessary to reflect current conditions and uncertainty in projections.

- Scenario analysis is likely to be necessary to assess and incorporate the probability of the crisis extending for 3-, 6-, 12-, 18-months or longer.

- Liquidity needs must be evaluated more than ever. What is the likelihood of a loan covenant breach? What is the impact of customers delaying payments or nonpayment and the impact on reduced cash flow? What is the source of working capital required to “restart” the business if impacted by the crisis? A scenario analysis that weighs various potential outcomes (including the risk of default or potential government support) may be appropriate to assist in estimating fair value.

- Par value or face value or cost value is not automatically fair value. Credit spreads have widened for various industries, credit ratings, and terms, which will put downward pressure on fair valuation of debt instruments.

A webinar focusing on cybersecurity and investment opportunities is planned for October. To attend, please download the White Paper.

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Przemek Bozek

Przemek Bozek

Technology Specialist - Private Equity

IHS Markit

Member since

10 Mar 2020

Location

New York

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