Attracting private equity investment in a changing market

Fintech has had several boom years, raising unprecedented amounts of capital and producing a large number of successful scale-ups. But with the economic winds seemingly turning, what will become of fintech and its ability to attract funds? We take a look at private equity (PE), ask what the current market outlook is and reveal what fintechs should know to attract the right investor.

What is the difference between venture capital and private equity?

Many fintech entrepreneurs will be familiar with venture capital. It is one of the most popular ways for up-and-coming fintechs to secure finance, and due to the fintech sector’s relative youth until now, it has received more attention than private equity. As the name suggests, venture capital is oriented towards smaller, younger startups. Venture capitalists invest in promising companies in return for a small stake in the business, hoping that it will grow rapidly in a short period of time and deliver high returns.

In contrast, private equity is focused on more mature businesses that have already had some success and growth. They can be businesses that have some kind of financial difficulty that requires an activist investor or potential restructuring. PE firms tend to take a larger stake, and may take over a public company with the aim of delisting it.

“The private equity stage is similar to going from grammar school to college,” says John Clark, managing director of Royal Park Partners. “At this point, the company has demonstrated product-market fit – congratulations! The investors in the next stage of a company’s development are likely to come out of Harvard Business School or McKinsey, so expect laser focus on the nuts and bolts of the business, such as customer acquisition cost (CAC) metrics, lifetime value (LTV), total addressable market (TAM), cash flow, profitability at unit economic level and competitive landscape.

“This group of investors is not looking for 10 times cash return, but a more modest three-to-five times. They are therefore keen to convince you that the valuation today is too high and cannot make money unless they add structure to a deal (downside protection). The rationale is that they make fewer but more concentrated investments and appear to have a board seat and/or an observer seat as well.

“At this stage, the thinking is ‘how do we get you from $10 million in revenue to $40 million or $50 million in three to five years?’ It becomes a tactical and strategy-driven process, focused on professionalizing the organization. This tends to be the biggest shock for entrepreneurs when they transition from VC to growth/PE investors.”

What is the state of the current PE market?

Much has been made of the current economic conditions and whether they are favorable for investment. It’s possible that recent economic developments – high inflation and the specter of a global recession – could eventually put a dent in PE interest in fintech, but the latest figures we have underline how quickly PE investment has grown in recent years.

“Private equity investors have become increasingly attracted to fintech over the past five years,” said Sam Lawson, VP of Capital Markets for Crowdcube. “US$12bn was invested in fintech by PE across 144 deals in 2021 – a new record significantly above the previous record of US$5bn in 2018. Fintech’s relatively higher gross margin and cash flow profile makes it attractive to PE. It is also an extremely scalable sector – financial services touch everyone, everywhere.”

However, private equity is still dwarfed by venture capital funding. VC investments in fintech amounted to $115 billion in 2021, according to KPMG’s Pulse of Fintech report, almost triple the $46 billion investment that VCs made in fintech the previous year. This increased level of investment may reflect an industry coming of age, or it may indicate that new sub-sectors are coming to the fore.

Anton Ruddenklau, Global Fintech Leader for KPMG, says: “We are seeing an incredible amount of interest in all kinds of fintech companies, with record funding in areas such as blockchain and crypto, cyber security and wealth technology. While payments remain a significant driver of fintech activity, the sector is expanding every day.”

Crowdcube’s Sam Lawson adds: “Especially now, private equity will look to invest in maturing sub-sectors of fintech that address long-term market trends, such as the increased threat of cybercrime, the demand for embedded financial services and the inefficiencies of today’s core banking infrastructure”.

What do private equity firms look for in an investment?

“H1 2022 has seen a somewhat inevitable decline in private equity deal rates across the board, although Europe has been more resilient,” Lawson continues. “Over the coming quarters, we may see a further reduction in new deals as rising prices, falling GDP, declining consumer confidence and the ongoing war in Ukraine affect businesses.

“But PE is currently sitting on historic amounts of unallocated capital. Due to its breadth and relatively attractive financial profile, we expect fintech to continue to be one of the key areas for investment.

“In the short term, private equity activity can concentrate on ‘take-privates’, investing in listed fintechs that may have suffered from sharp falls in the public markets. In the private markets, in the medium term, a deteriorating venture capital market may provide an opportunity for PE to step in to partner with unloved but otherwise healthy VC portfolio companies.”

So what should fintechs know if they want to attract PE investment? “Revenue growth and profitability are central to attracting inward investment,” explains Lawson. “Especially now, it is important to prove the ability to generate cash flow to garner investor interest.

“In the short term, VCs will focus resources on their existing portfolio companies, which means that the pace of new investment may slow down. Fintechs should look to their existing investors to provide additional funding, but may also find solutions in alternative funding. Equity crowdfunding, for example, may be a source of additional capital from existing VC investors who may be stepping up again.”