Investing in Fintech: Venture Capital and Beyond

Investopedia describes Fintech below:

“Financial technology (Fintech) is used to describe new tech that seeks to improve and automate the delivery and use of financial services. At its core, Fintech is utilized to help companies, business owners and consumers better manage their financial operations, processes, and lives by utilizing specialized software and algorithms that are used on computers and, increasingly, smartphones.”

This is a broad definition that is fitting because Fintech is a broad product/investment category. However, there are some pretty basic reasons behind why it has been a lucrative category.

One of the biggest ways that Fintech companies make money is by intermediating transactions, aka “Middle Manning” transactions. This is especially effective when there are tons of transactions!

The second is by accumulating “float.” This is how Warren Buffett made much of his fortune. Here is how he describes the benefits of a float:

“Insurers receive premiums upfront and pay claims later. ... This collect-now, pay-later model leaves us holding large sums -- money we call ‘float’ -- that will eventually go to others. Meanwhile, we get to invest this float for Berkshire's benefit.”

In short, any gains made from investing the “float” remain with the company.

Fintech companies that have been able to capitalize on intermediating exchanges or accumulating “float” have done very well. Some have even done both.

Lastly, the hallmark of modern tech companies is the ability to scale software platforms. The benefit of a scaling software platform is that each new customer costs essentially zero to onboard to your company. You already hired and paid software engineers to build software. Now, you only need to add more servers as the number of customers you serve grows, which is a good problem to have.

So, the question becomes “Are VC’s pushing up the value of their Fintech portfolio companies the way that SoftBank propped up the value of WeWork before a spectacular collapse in value?”

A report from KPMG, entitled Pulse of Fintech, shows this is not the case as there has been robust M&A activity as well as Private Equity investment in the space. In fact, 2020 saw the third-highest total with $105 billion invested in the space. This is despite a lackadaisical first half of the year due to the pandemic. Second-half investment of $71.9 billion more than doubled the first half of the year’s total of $33.4 billion.

KPMG’s numbers cover the global opportunity set but show that only $42 billion of the $105 billion invested in the space came from VCs. This shows that there are a lot of exit opportunities for Venture Capitalists looking to cash in on earlier investments.

One interesting case study is the Fintech company, Plaid, which was set to be taken over by Visa for $5.3 billion. The Department of Justice filed an anti-trust lawsuit to prevent the deal from taking place. Visa eventually walked away from the deal.

After Visa walked away, Plaid raised more money at an even higher valuation of $13.4 billion. That shows that there was value remaining on the table for Visa even as they were paying up for this unicorn.

Public company and Fintech darling, Square, is now worth upwards of $100 billion.

This shows that some Fintech companies can continue to grow as public companies, and that even with valuations at upwards of $10 billion, there is still a lot of upside to be captured. Square achieved this by sitting in the middle of many transactions AND by maintaining a “float” as its customers hold money in their digital accounts.

So, it is not hard to understand why Private Equity and giant corporations collectively outweigh Venture Capital as larger pieces of the investment puzzle. In fact, in Plaid’s last round, the Private Equity firm, Silver Lake, participated alongside Ribbit Capital and the VC fund, Altimeter Capital, that led the round.

Another Fintech darling that validated all its earliest private investors this year was Coinbase.

The company did not even raise more money when it went public, opting for what is known as a Direct Listing. Coinbase is similar to Square in that they hold assets for their clients and get to charge them fees on transactions as well!

Another well-known Fintech start-up is Robinhood. The firm came under pressure during the GameStop saga, which we wrote about here, but raised $3.4 billion of funding at lightning speed. Some of the biggest names in Venture Capital smelled opportunity as venerable Wall Street firms were being margin called.

Across the pond, the UK-based company Revolut is lining up investors for what it hopes is a $10 billion+ round. The Fintech company is currently applying for a banking license in the UK where it hopes to be able to take customer deposits. Once again, we have an example of a company that is capturing transaction fees and accumulating “float.”

Dan Loeb of Third Point saw his portfolio company, Upstart, IPO within the last year and the company has posted fantastic returns since.

UPST Stock Chart

Additional sources of capital have arrived on the scene as well. SPACs, which are short for Special Purpose Acquisition Companies, have burst onto the scene as a “new” way to take companies public. This avenue for exits is being taken advantage of by Venture Capitalists as a way to stay or get invested in Fintech companies even as they go public.

For example, Chamath Palihapitiya, the founder of Social Capital, valued SoFi at $8.65 billion in a deal to take the company public.

SoFi, which started as a company focused on refinancing student loans, has expanded its reach and “…now offers stock and cryptocurrency trading, personal and mortgage loans, and wealth management services.”

Some lesser-known players are taking advantage of the SPAC boom as well. Fintech startup OppFi is going public and hoping to follow the SoFi playbook. The firm offers high interest rate loans to consumers who cannot get funded at your everyday bank branch. The firm hopes its consumers can graduate to products with better lending rates and eventually build towards a brighter future by investing in stocks or by getting a mortgage from the platform.

While those are nascent dreams for OppFi the Chairman of the SPAC it’s chosen to partner with knows something about Fintech. Joe Moglia was the former Chairman and CEO of TD Ameritrade.

As we discussed in our Active vs Passive piece, the cost of capital is low, and a lot of the fixed income opportunity set offers a negative return.

10-Year Yield (USGG10YR Index)

Barclays Global Aggregate Negative Yielding Debt Market Value USD (BNYDMVU Index)

This means that some investors are willing to take big swings with Fintech companies by trying to take market share. It can even be argued that some of these firms have added previously unbanked consumers to the market thanks to their strong branding.

Market change and disruptive technology such as Fintech will always lead to new risks. The recent novelty of Fintech may make it difficult to identify such emerging risks with the increased size and scale of these companies may face, as well as from other market participants, customers, and regulators. Moreover, some commentators have stated that a Fintech bubble is forming as money keeps pouring into these companies that are facing increased competition. Inevitably some Fintech companies will fail as they increasingly fight over the same market share. While this only details some of the Fintech risks, it is important for investors to understand that even with the opportunities available in Fintech, there is no guarantee that each Fintech investment will be successful.

Fintech is rife with opportunities. It is a broad category with many different types of products. But the two main ways of profiting are intermediating transactions and accumulating float. Fintech companies are able to beat existing market players by producing consumer-friendly software and are being aided by cheap capital.

So much value has been and will continue to be created in the space. Investors jump at the opportunity to get an allocation to companies even as their valuations continue to increase. Sometimes the investors that have traditionally trafficked in earlier stage companies just cannot let go of these investments at later stages as the economics are too enticing. Sometimes executives who have grown companies from their earliest stages into giant corporations are itching to be part of the process all over again.

Whatever the reason, contact Crystal to find out the exposure we offer to Fintech through our various Private Equity, Venture Capital, and Hedge Fund products.