A bull case for fintech venture capital
'Tourist investors' may well be exiting the fintech venture capital market but many still expect to see long-term returns from startups innovating banking and finance.
The longest bull market in history began in March 2009 and, roughly, ended 13 years later at the start of 2022.
While this primarily refers to public equity markets which soared year after year following the financial crisis’ c.50 per cent plunge in 2008, a tandem ever-surging phenomenon of venture capital financing of private startups accompanied it. No category benefited from this explosion of cheap money more than fintech.
With the world in the grip of rising interest rates, soaring inflation and an array of geopolitical strife, is the party over?
The latest data suggest a big slow down. In the first six months of 2022 venture capital investment in UK fintech companies fell to $9.6bn, a reduction of two-thirds compared with the same period in 2021, according to data from KPMG.
For fintech, a long-term secular growth story, however, may well still play out.
The argument is fintech could become, as biotech did for pharmaceutical and healthcare companies in the 1980s and 1990s, and still is today, an outsourced innovation market as well as a platform for new businesses to grow very quickly and supersede creaking and inefficient incumbents.
This would mean a dual role in providing regular M&A targets for banks and other financial institutions, as well as stock market listings for stand out success stories.
The data point that should give investors real cause for excitement about this trend is looking at how much global financial incumbents spend on digital transformation, says Time Levene, the CEO of Augmentum Fintech, a listed venture capital vehicle in the UK.
More specifically, how much of that digital transformation spend is being used on existing legacy infrastructure versus banks building their own new infrastructure?
“They're spending hundreds of billions of dollars a year globally, MUCH of which much is being burnt ineffectively, Levene said on an AltFi webinar last week.
“There is a recognition…from the global financial institutions that they can't solve all their problems from within. They're actively looking for external solutions,” he added.
Levene, who backs a number of fintech companies such as Zopa, Grover, Tide,iwoca,Seedrs and Habito, infers the simple narrative from what you might call Fintech 1.0, of purely ‘disrupting banks core business’, is being replaced by a greater willingness for collaboration.
“We are seeing a lot of b2b fintechs and infrastructure fintechs working and operating at real scale which is giving those global financial institutions cause for much more comfort from their side to work collaboratively,” he said.
It is no secret that nearly all successful fintech startups have taken on substantial quantities of VC funding to get there.
The venture capital boom, unprecedented in financial history, saw a stark peak in 2021. Fintech startups, raised c.$125bn globally from venture capital investors in 2021, according to data from Dealroom.
This represents a nearly three times (2.8x) increase than the 2020 figures, as the pandemic prompted a wave of interest in fintech startups benefiting from what many believed was a rapid acceleration of digitalisation.
Patrick Kavanagh, a prolific fintech angel investor who was one of the first backers of Robinhood as well as the current founder of Atlantic Money, says in recent years venture capital investors became increasingly more exuberant when it comes to pricing in returns.
“VCs started becoming extremely competitive about rounds. They were pulling expectations of growth forward,” he said.
This was exemplified in particular by two firms Coatue and Tiger who followed in a type of mental model originally spearheaded by Softbank of providing an almost index-like investment philosophy predicated on the market continually growing.
“I think that approach works when you have like very low-interest rates and there are very few barriers to growth. But I think it also only incorporates really top-line numbers like revenue growth. It doesn't really take into consideration any costs of the business or unit economics,” Kavanagh said.
“That's where the story really is. That where people have opened their eyes in the last six months when sort of interest rates started going up,” he added.
While 2021’s numbers were inflated largely by funding ‘mega rounds’, which account for about two-thirds of the total, early-stage also boomed.
2021 was an “outlier” says Levene, who says we cannot deny we have a very difficult macroeconomic backdrop that will likely deteriorate further into 2023.
Venture Capital investment globally declined from $66.5bn in the first half of 2021 to $52.6bn in the first hald of this 2022. While this represents a fall, the number is still robust.
“You've got to separate the macroeconomic backdrop with venture backdrop. 2021 was a year like no other in European venture, so we had more funding in fintech than at any point in the previous history, and by quite some way,” Levene added.
“I think you've got to look at 2018 19 as more realistic benchmarks, and I think 2022 started off well, but there was a real lag from 21, where deals that were done and inked in Q4 were announced,” Levene said.
Henrik Grim, GM Europe of Capchase which provides venture debt funding to startups, agrees, saying unlike the 2000 and 2008 tech crashes, the current dynamic is a return to the more cautious valuations and risk appetite of former years.
“Over the past 18 months, we have seen some crazy public and private valuation metrics. Since the summer valuations have returned to very close to what we saw during most of 2013-2018,” he said.
“My feeling is that this tech downturn is going to be very uneven. Pure tech businesses like SaaS, cybersecurity and many fintech startups are going to be much less exposed than tech-enabled businesses. The latter, with their lower margins and capital efficiency, are going to find it a very tough time. Instant delivery, proptech and physical goods retailers are going to find the next year very tough,” he said.
Most VCs seem to agree that the levels of funding seen in 2020 and 2021 were unsustainable and unlikely to be repeated for some time.
Grim says, however, that while it is likely we will see a further drop across all tech funding stages in three to nine months' time volumes and valuations will likely bounce back to 2017-2019 levels.
“Looking back to when I started in venture capital in 2015, the fundamentals of investing were very much in vogue. We spoke about gross margins, capital efficiency and burn rates, and because of that, loved software businesses. We are now seeing a return to this thinking,” he said,
While it's hard to isolate the depth and length of the current slowdown in funding an deal-making, we're definitely seeing a significant negative shift in risk appetite and funding availability in fintech and the wider technology ecosystem.
“Many of the recently failed fintech investments are low-margin businesses with poor capital efficiency. They simply would not have gotten off the ground as quickly five years ago, because they would not have had the same amounts of funding. Since then, investors became increasingly competitive in looking for the next big opportunity, and got more aggressive and less diligent,” Grim added.
A moderate funding environment seems likely, investors seem to agree with ‘outlier’ years such as those since the pandemic, falling away to a bullish but more linear trend line when it comes to funding volumes.
This market ‘normalisation’ though will also be boosted by more ‘dry powder’ from investors in the venture market than at any point in previous history, says Levene, who also expects valuations to move in a fashion more similar to the rates of growth seen in 2019.
“ I think the opportunity for fintech is still enormous. I think the amount of capital available is still significant. You are seeing a lot of those investors that came in the market for the first time and some people unkindly call them tourist investors starting to exit the money,” Levene said.
There has also been a huge re-focusing for many fintech businesses. Growth at any cost has given way to the placing of greater importance on unit economics and sustainable revenue generation as well as product and the most high value customers.
In the short to medium term, it is hard to not see how venture capital financing of fintech will be driven by interest rate movement which will almost certainly continue its move upwards. In the longer term, a sustained focus prompted by this setback will help fintech solidify its long term story.