How UK fintech can survive a major funding freeze

The UK fintech sector has been a roaring success in recent years, as London’s status as a global financial hub made the country a magnet for dynamic startups. Digital challenger banks such as Starling, money transfer services such as Wise and investment apps such as Nutmeg have attracted billions of pounds in investment.

But as the economic outlook worsens both at home and abroad, the market’s luster has faded rapidly this year. The prospect of stagflation in the coming months hits investor confidence in high-tech industries particularly hard.

The combined equity investment raised by UK fintech firms plunged from £2.13bn during the second quarter of 2022 to £491m in the third quarter, according to research published by Beauhurst and Deloitte.

The number of fintech investment deals during that period also fell off a cliff, notes Beauhurst’s head of research and consultancy, Henry Whorwood,

“Investors have dramatically changed their behavior in the face of the deteriorating economic outlook,” he says. “Many newcomers to this asset class have cut activity as quickly as they started it.”

A cooling effect

Could the decline in sentiment accelerate and throw fintech activity into a deep freeze this winter? Company valuations have been cut as start-ups struggle to attract investment, while there have already been reports of firms in financial difficulty. Even Klarna, the phenomenally successful Swedish buy-now-pay-later (BNPL) finance provider, tried to raise new capital in June at less than half its peak value.

Praetura Ventures is a Manchester-based venture capital provider that invests in early-stage, high-growth companies across the country. It has supported around 30 companies since 2019.

“Attracting investment means demonstrating capital efficiency and a clear path to profitability, but this is difficult for fast-growing fintech startups,” says Praetura’s co-founder and MD, David Foreman. “That’s because their cost of entry into these markets is high and their business models tend to start making sense only when a critical mass of customers has been acquired. This critical mass turns out to be harder and more expensive to reach than it was in 2021.”

While fintech faces headwinds globally, the sector’s UK players have had some additional problems to contend with. Brexit has hampered their efforts to attract the best talent from abroad, while the recent economic instability caused by the ill-fated Truss government has shaken the confidence of foreign investors.

Still, most insiders see the funding drought as a natural adjustment after the unprecedented boom that tech companies enjoyed in the first months of the pandemic.

Steve Round is the co-founder of SaaScada, a UK startup that has developed a cloud-based platform for digital banking services. He believes that “the severity of the downturn is undoubtedly linked to international events. We need to assess fintech investments against the background of the global economic downturn and other external factors, such as the war in Ukraine, which make investors more cautious.”

A bumpy road ahead

It is inevitable that the road will get rockier for UK fintech as GDP growth falters and the rapid rise in interest rates to fight inflation ends a 13-year era of ultra-cheap money.

Some in the sector believe that young UK firms, many of which are still loss-making concerns, will need to adopt a more traditional model to be what venture capitalists call default alive – that is, on track to achieve profitability without needing further investment.

“The advice they’ll undoubtedly get from their existing investors is pretty straightforward,” says Sabrina Del Prete, founder and CEO of Kore Labs, a digital product management specialist. “It will be: reduce the cost base to only the essentials; narrow the focus to reduce the time it will take to achieve run-rate break-even; stay close to your investors and use their goodwill to access equity investments to protect the near term; do not take on debt; and finally, remain resilient in your business plan and have informed confidence in what you intend to do.”

Underlying strengths

It is inevitable that some firms will fail or be bought out in the next couple of years. But fintech fundamentals remain strong, so investment in the sector is unlikely to dry up permanently. That’s according to Rich Bayer, executive vice president and head of UK and EU sales at Clearpay, a BNPL platform that has raised almost £85m since it was founded in 2017.

He points out that BNPL is the UK’s fastest growing online payment method, and has proved particularly popular with Generation Y and Z consumers. By 2021, the segment accounted for almost £13bn of e-commerce spend. This sum is expected to double by 2025.

“The dip in investment the fintech sector is seeing this year compared to 2021’s exorbitant success should not distract us from this big picture,” Bayer asserts.

Other insiders note that the traditional high-street banks, faced with stiff competition from online challengers, will look to fintech for help in meeting changing consumer expectations. Large established players are therefore likely to continue to support or acquire innovative digital solutions.

The downturn may even encourage innovation, pushing certain sub-sectors of fintech to the fore, according to Round. For example, products designed to help banks manage consumer and commercial credit risk should flourish.

“Those who use data effectively are the ones to watch,” he says. “The future is all about data – the ability it gives you to track and predict changing customer needs and identify areas of trapped value. Such factors will enable users to get a larger share of wallet, even as the recession approaches.”

Nobody knows what the future holds, but it seems unlikely that UK fintech will become a story of boom and bust. If anything, the downturn will force weaker players out and force those with real potential to step up and demonstrate their worth. As the economy enters a potentially dangerous new phase, that’s no bad thing.