A bull case for fintech venture capital

Tourist investors may well be leaving the fintech venture capital market, but many still expect to see long-term returns from startups innovating banking and finance.

Image source: Pexels/Michelangelo Buonarroti

The longest bull market in history began in March 2009 and ended about 13 years later at the start of 2022.

While this primarily refers to public stock markets which rose year after year after the financial crisis the fall of approx. 50 percent in 2008, followed an ever-increasing phenomenon of venture capital financing of private startups. No category benefited more from this explosion of cheap money than fintech.

With the world in the grip of rising interest rates, sky-high inflation and a series of geopolitical disputes, is the party over?

The latest data indicate a large decline. In the first six months of 2022, venture capital investment in UK fintech companies fell to $9.6 billion, a reduction of two-thirds compared to the same period in 2021, according to data from KPMG.

For fintech, however, a long-term secular growth story may still play out.

The argument is that fintech can become, as biotechnology 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 replace creaky and inefficient incumbents.

This will mean a dual role in providing mainstream M&A targets for banks and other financial institutions, as well as IPOs for prominent success stories.

The data point that should give investors real reason to get excited about this trend is looking at how much global financial players are spending on digital transformation, says Time Levene, CEO of Augmentum Fintech, a UK-listed venture capital firm.

More specifically, how much of the digital transformation cost is spent on existing legacy infrastructure versus banks building their own new infrastructure?

“They spend hundreds of billions of dollars a year globally, much of which is burned inefficiently,” Levene said at an AltFi webinar last week.

“There is a recognition … by the global financial institutions that they cannot solve all their problems from within. They are actively looking for external solutions,” he added.

Levene, which supports a number of fintech companies such as Zopa, Grover, Tide, iwoca, Seedrs and Habito, derives the simple narrative from what you might call Fintech 1.0, of purely ‘disrupting banks’ core business’, being replaced by a greater willingness to collaborate .

“We’re seeing a lot of b2b fintechs and infrastructure fintechs working and operating at real scale, which gives these global financial institutions a lot more comfort on their part to work together,” he said.

Boom time

It’s no secret that almost all successful fintech startups have taken on significant amounts of VC funding to get there.

The venture capital boom, unprecedented in financial history, had a strong peak in 2021. Fintech startups raised approx. $125 billion globally from venture capital investors in 2021, according to data from Dealroom.

This represents a nearly three-fold (2.8x) increase over 2020 numbers, as the pandemic led to a surge of interest in fintech startups taking advantage of what many believed to be a rapid acceleration of digitization.

Patrick Kavanagh, a prolific fintech angel investor who was an early backer of Robinhood as well as the current founder of Atlantic Money, says that in recent years venture capital investors have become increasingly exuberant when it comes to pricing returns.

“VCs started to get extremely competitive about rounds. They were dragging expectations of growth forward,” he said.

This was particularly exemplified by two firms Coatue and Tiger that followed in a type of mental model originally led by Softbank to offer an almost index-like investment philosophy based on the market constantly growing.

“I think that approach works when you like very low interest rates and there are very few barriers to growth. But I think it also only includes really top-line numbers like revenue growth. It doesn’t really take into account any costs of the business or unit economics,” Kavanagh said.

“That’s where the story really is. The thing where people have opened their eyes in the last six months when some kind of interest rate started to go up, he added.

While the 2021 numbers were largely inflated by funding “mega-rounds,” which make up roughly two-thirds of the total, early-stage funding also increased.

2021 was an “outlier,” says Levene, who says we cannot deny that we have a very difficult macroeconomic backdrop that is likely to worsen further into 2023.

Calm down

Venture Capital investments globally fell from $66.5 billion in the first half of 2021 to $52.6 billion in the first half of 2022. While this represents a drop, the figure remains robust.

“You have to separate the macroeconomic background from the venture background. 2021 was a year like no other in European venture, so we had more funding in fintech than at any time in the previous history, and in any way, Levene added.

“I think you have to look at 2018 19 as more realistic benchmarks, and I think 2022 started well, but there was a real lag from 21, where deals that were done and closed in Q4 were announced,” Levene said.

Henrik Grim, GM Europe of Capchase, which provides venture debt financing to startups, agrees, saying that unlike the tech crashes of 2000 and 2008, the current dynamic is a return to the more cautious valuations and risk appetite of years past.

“Over the past 18 months, we’ve seen some crazy public and private valuations. Since the summer, valuations have returned to very close to what we saw during most of 2013-2018,” he said.

“My sense is that this technology downturn is going to be very uneven. Pure technology companies like SaaS, cybersecurity and many fintech startups are going to be much less exposed than technology-enabled companies. The latter, with their lower margins and capital efficiency, are going to experience it as a very tough time Immediate delivery, proptech and brick-and-mortar retailers are going to find the next year very tough, he said.

Downturn

Most VCs seem to agree that the funding levels seen in 2020 and 2021 were unsustainable and unlikely to be repeated for some time.

However, Grim says that while it is likely, we will see a further decline across all tech funding stages in three to nine month time frames, and valuations will likely return to 2017-2019 levels.

“Looking back to when I started venture capital in 2015, the fundamentals of investing were very much in vogue. We talked 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 is difficult to isolate the depth and length of the current decline in deal funding, we are definitely seeing a significant negative shift in risk appetite and funding availability in fintech and the broader technology ecosystem.

“Many of the recent failed fintech investments are low-margin businesses with poor capital efficiency. They simply wouldn’t have started as quickly as five years ago, because they wouldn’t have had as much funding. Since then, investors have become increasingly competitive in looking for the next big opportunity, becoming more aggressive and less diligent, Grim added.

A moderate funding environment seems likely, investors seem to agree on “outlier” years like those since the pandemic, and fall away to a bullish but more linear trend line when it comes to funding volumes.

However, this “normalization” of the market will also be reinforced by more “dry powder” from investors in the venture market than at any time in previous history, says Levene, who also expects valuations to move in a manner more similar to growth rates. in 2019.

“I think the opportunity for fintech is still huge. I think the amount of capital that’s available is still significant. You see a lot of those investors who came to the market for the first time, and some people call them unfriendly tourist investors who start to walk out of the money, Levene said.

There has also been a huge re-focusing for many fintech companies. Growth at any cost has given way to greater emphasis on unit economics and sustainable monetization, as well as high-value products and customers.

In the short to medium term, it is hard not to see how fintech venture capital funding will be driven by interest rate movements which will almost certainly continue their upward movement. In the longer term, a sustained focus prompted by this setback will help fintech strengthen its long-term story.