The death of fintech is greatly exaggerated (and why we’re entering a golden age for fintech scaleups)
Fintech summer of 2021 has given way to the winter of 2022–23, bypassing autumn almost entirely. But in years to come, we’ll look back to today and realize how early in the fintech revolution we still are.
Following a number of recent fintech IPOs, we have a quarterly window into how quality fintech scaleups are maturing, alongside those we’ve backed via LocalGlobe/Latitude.
We believe that, for the best, future state profitability is underestimated, unique data and distribution advantages underplayed and high product velocity undervalued.
There’s no doubt that fintechs face an uncertain macro landscape today. Many will struggle. But the strongest will emerge more robust for having lived a full economic cycle, with the opportunity to capture a disproportionate, profitable share of global economic activity.
There are multiple, compounding reasons we’re entering a golden era for scale up fintechs.
A profitable mash up
The strongest fintechs will look like a profitable mash up of software and financial services. Like great software companies, high-growth fintechs can benefit from significant gross margin and operating cost leverage as key cost lines grow modestly in $ terms, while shrinking as a percentage of revenue.
For instance, Nubank’s efficiency ratio (opex / net revenue) has fallen from 92 percent to 47 percent in just 2 years.
This won’t be the case for all fintechs; PayPal’s efficiency ratio has remained stubbornly in the high 70s, percentage-wise, for nearly a decade. To glimpse which fintechs stand to benefit most, look out for location of employees (salary inflation) as well as long term investment in technical infrastructure and automation — more on both below.
Some fintechs further benefit from data-led virtuous loops, which are a potential multiplier on future profitability; data-led customer insights can drive superior underwriting and personalisation, which in turn will support quality growth driving down cost of capital, thereby supporting further investment in growth… and so on.
Profitability will not be evenly distributed across fintechs. But some are already showing their potential. Wise* is so structurally profitable that it virtually constrains EBITDA margins at c.20% by continuing to double down on growth and R&D spend, while net revenues grow at over 50% YoY. By contrast, Wise’s 100-year-old competitor, Western Union, is maximizing profitability to a similar level but with declining top line revenue.
The inevitability of AI in fintech
All fintech scaleups we work with are highly attuned to how AI could transform key elements of their businesses. This is a big topic, so for now a few summary thoughts.
Practical applications of AI will include:
- enhancing underwriting and product personalization
- controlling fraud detection and prevention
- offering superior portfolio and risk management (this is not new with the likes of Bridgewater Associates having led the way)
- enhancing internal treasury and capital management (Wise has long been training models to predict currency demand), and
- reducing customer service costs (one of the toughest cost lines to scale efficiently)
But this impact will not be evenly distributed, and growth stage fintechs stand to benefit disproportionately.
With significant volumes of proprietary data needed to meaningfully train models, plus high compute costs, scaled fintechs can access the vital raw materials to drive impactful AI. They are also likely to have the engineering and product resources to work AI into their businesses.
Conversely, growth stage businesses are young and nimble enough still to be able to meaningfully build AI into their products and processes — they have not yet become proverbial oil tankers finding it hard to reset course.
Not too young, not too old — the current crop of growth stage fintechs has timed it just right.
Financial services is not a ‘move fast and break things’ industry and regulatory regimes will act as guardrails around how AI is applied in certain areas. Again, this benefits emerging leaders with the resources and relationships to engage with regulators.
In short, AI will create new revenue generation opportunities, help reduce losses, drive down costs and enhance how fintechs manage their cash flows and balance sheets. And incumbent fintechs with scale, strong balance sheets plus large customer bases and data sets can benefit disproportionately.
A call option on future generations
Fintechs command a disproportionate pull over younger generations, effectively making them a geared call option on the future economic activity of these generations as they grow their influence on the economy.
The installed base of quality fintechs is impressive. For instance, less than 3 years after launching in Mexico and Colombia, Nubank now accounts for a third of newly issued cards; staggeringly fast growth in market share versus incumbents. While fintechs are for many in Africa their first interaction with the non-cash based economy, representing a huge multi-decade wave for fintechs to surf.
This is similar picture for new generations of business customers; in the UK, Tide* accounts for just under 10% of SMB accounts today, more than double the number of the nearest high street competitor.
The recent mini-banking crisis we’ve been through since SVB’s demise will only have accelerated this generational shift to fintechs, as it is more widely understood that digital first offerings can be structurally more flexible and resilient in guarding depositors’ funds.
Product velocity as an asset
Fintechs have achieved rapid scale and generational resonance in part by embedding viral features, such as peer-to-peer payments and bill splitting — a product-led muscle which is not intuitive to most financial institutions. Monzo’s* coral card demonstrated an empathy with younger customers and became synonymous with a brand which still today has a uniquely high share of organic sign ups (again, supporting high long term profitability potential).
This points towards a differentiated product DNA. Indeed it’s a daunting task to launch a new fintech today; startups need to pick their areas carefully as emerging incumbents relentlessly extend their offerings and reach.
Mark Goldberg highlights the financial hydra that CashApp has become, and this pace of product execution can be an enduring competitive advantage — think Apple vs. Nokia or Google vs. Yahoo!. As more fintechs transition to public markets in coming years, maintaining product velocity and DNA will be as much a cultural challenge, as a strategic one.
Block’s rapidly growing product ecosystem (Source: FT Partners):
So how will this play out?
Quality fintechs will be more highly prized coming out of a downturn
Most quality fintechs are weathering their first economic downturn — and the market has voted with a significant compression in valuations:
In private markets, even Stripe — the mother of all private fintechs — raised at a down round, albeit a $50bn valuation downround.
Should we be entering a deep or sustained downturn, deft management will be required. Managing underwriting exposures and maintaining healthy balance sheets will be top priorities.
This is especially complex as we emerge from covid and lockdowns. It is becoming clear that this period led to contortions in consumer behaviour, amplified by direct government interventions into the economy. Fintechs, like all financial institutions, will need to be deft in understanding consumers’ and businesses’ true economic health when underwriting risk.
Cross-cycle experience will be an asset in management teams. Look to boards to understand which are best placed to offer a robust governance environment; grey hair, diverse perspectives and strong NEDs are assets now more than ever.
The fintechs that navigate this period successfully will emerge as not just turbo-charged fairweather profit-centers, but nimble, resilient cross-cycle businesses ready to compound at scale.
Reframing financial services
As more fintechs go public, analysts will continue to develop a nuanced framework for how they think about long term potential value creation. Traditional financial institutions often will be poor comps — the clues are there today.
Nubank’s core Brazil business delivered a 40% RoE in Q4 2022, up from an already very generous 20% just one quarter earlier. While an imperfect reference point, it’s interesting to note that this is 3x JPMorgan’s RoE.
Meanwhile, Adyen has grown net revenues 6x since listing in 2018, and today operates with over 50% EBITDA margins. This is >20% more profit generation than incumbent payments processor FIS, while delivering 400% greater top line growth over the same period.
Revenue stream-level sum of parts valuations (and/or potentially by market) will become the norm as fintechs extend how they serve their customers. For instance, how should one think about Shopify if not a software business, ecommerce business and payments business, plus emerging fintech (Shopify Capital) all in one?
The incumbents will fight back, through R&D and M&A
Scale matters in financial services, and the weighty balance sheets of incumbents will be brought to bear, with these balance sheets now groaning under cash generated in this new higher interest rate era.
Incumbents will acquire fintechs for their audiences (case studies include Intuit + Credit Karma, and even the ill-fated JPMorgan + Frank) their technology (Visa + Plaid, until not) and their highly skilled technical teams.
As Visa + Plaid underlines, we’ll hear a lot about antitrust over the coming years in fintech. Would any incumbent payments business be allowed to buy Stripe — or would Stripe be allowed to buy a major incumbent payments business? This is a question facing not just fintech, but tech more broadly.
And don’t dismiss financial services incumbents as tech-illiterate; did you know JPMorgan has published 580 research papers on AI? Meanwhile, Visa and Mastercard both have hundreds working in their blockchain divisions.
Either way, expect to see more fintech execs wearing blue blazers and more banking execs wearing jeans.
Where does opportunity lie today?
We believe that tomorrow belongs to fintechs building ‘efficiently scalable infrastructure’, founders who from the outset decided the fintech revolution should be more than a thin layer of digital distribution and UI. Rather they chose to build ground up, creating technical moats around customer delight, product opportunities and long term profitability pools.
Wise is a canonical example. Wise bypasses legacy correspondence banking infrastructure by owning its own FX liquidity matching and reconciliation system, slashing time and cost in the high profit/low customer satisfaction area of FX. It has remained disciplined in its focus, choosing for many years to shun upselling new products in favour of heavy reinvestment into infrastructure and deep local integrations, lowering marginal costs and speed of reconciliation.
This has created a powerful ‘Costco model’ whereby Wise can relentlessly lower prices for customers, attract more customers in doing so, generate more gross margin from higher volumes and then reinvest this to drive prices down further. If great companies compound at scale, Wise has earned the right to do so.
Rapyd’s* founders came from a cloud background and, when looking to build an ewallet business, experienced first-hand the lack of AWS-style infrastructure in payments to support innovators. So they built their own and Rapyd was born.
By focusing on the infrastructure layer, Rapyd has built an API much loved by developers which is as much as an ‘innovation layer’ as a network of payment networks; we are often surprised by the creative ways in which we see customers using Rapyd to solve complex global payment flow challenges.
Similarly, Melio’s* observation that 50% B2B payments in the US were carried out by cheque led to the creation of its own payments and reconciliation stack for B2B commerce. Furthermore, building this around nimble, modular architecture sets it apart from incumbents providers like Bill.com.
Such is the depth and complexity of the cross-border banking and regulatory framework that Raisin* has built to power its core cross border deposits business, it’s now able to serve this infrastructure to other fintech as a Banking-as-a-Service provider. The infrastructural and regulatory work to support this started many years ago while few were watching, and remains embedded in Raisin’s DNA today.
Efficiently scalable infrastructure can express itself in different forms, and this is a topic we’ll dig into deeper in future. But as a company DNA, we believe it is foundational to the most exciting opportunities we see in fintech today, including at growth stage.
The products and profit pools built as a result will demand reassessment as we leave fintech winter behind us.
*LocalGlobe/Latitude portfolio company
