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Originally published by TechCrunch.

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Everything was so much simpler before the Internet.

Back then, the VC world was neatly divided into IT and Health Care, and the whole rest of the U.S. economy could go about its merry business without worrying too much about Silicon Valley and the threat of “disruption.”

Then everything became connected to everything else, and then, with mobile, everyone became connected to everything, and voila … no industry is safe.

In the late 1990s, the media and retail industries drew the attention of entrepreneurs and VCs first, leading to Amazon, eBay, Google, Yahoo, AOL, etc.

After a sojourn in the trough of disillusionment, entrepreneurs have gone on to target the rest of the economy, including transportation, hospitality, food, education, agriculture, manufacturing, logistics, as well as the four horsemen of fintech (payments, lending, investing and insurance).

This phenomenon, may it live long and prosper, undergirds the current re-expansion of venture capital from its post-2000 hibernation.

The logic goes that while IT and healthcare are finite industries, which may in fact be maturing and slowing down, VCs can now fund entrepreneurs attacking multiple hundred-billion-dollar opportunities across the economy, thus uncapping the rewards available to our asset class.

I believe this development to be real and durable with a level of fervency only a deeply self-interested party can muster.

That said, it poses a new challenge for entrepreneurs, VCs and, ultimately, the acquirers and IPO buyers who provide us liquidity: How do we value these new types of companies that bring a new set of toys to an old set of sandboxes?

We are once again learning the old lesson that if it walks like a duck and quacks like a duck, it probably shouldn’t get a SaaS multiple.

Many of the current high-fliers have advanced the notion that while they participate in traditional industries, they should still be viewed and valued as technology companies.

This is a dangerous idea that is currently being dispelled one unicorn at a time, with painful and bloody results.

We are once again learning the old lesson that if it walks like a duck and quacks like a duck, it probably shouldn’t get a SaaS multiple.

In fintech, the newly popular neighborhood where I live, we have had at least two recent examples of companies being hoisted on this petard.

The first was Zenefits, a commercial insurance broker with a compelling and novel business model.

They figured out that, in light of the fact that a broker makes money from insurance carrier commissions, they could afford to build and give away high-quality HR software as a way to acquire clients. The software itself helped in the process of benefits administration, which knit the model together in an elegant way, i.e. it wasn’t simply a bribe or a spiff to induce clients to use the brokerage services.

I won’t go into the particulars of their comeuppance, which has been told in lurid detailelsewhere, but ultimately it turned out that the company took too many shortcuts in a highly regulated industry, displeasing regulators and disappointing customers.

More recently we’ve seen LendingClub lose most of its market cap due to sloppy compliance and governance procedures.

What these companies had in common was that they lived in a willful state of denial about who and what they were.

What these companies had in common was that they lived in a willful state of denial about who and what they were. From podiums at conferences and in investor materials, they proclaimed that they were “technology companies,” “Internet companies,” “marketplaces” and “platforms.”

They did this in the cynical hope of getting a higher valuation at every turn. What we’ve learned is that the consequences of this are far worse than the inevitable collapse of valuation metrics back to traditional frameworks. The downfall is compounded by two additional factors:

  • People lose trust in the company and its leadership. Regardless of the regulatory issues that have hobbled Zenefits and LendingClub, there was a growing resentment of the hype-driven categorization both companies made into a fetish. I would frequently hear people say that they liked LendingClub’s growth and financial profile, but wished they would admit that they were a specialty lender with a unique funding model versus a marketplace. After a while, it makes you question the CEO’s motivations, judgement or both.
  • The company itself fails to take on the necessary compliance culture. If you ignore or reject the fact that you are a broker/dealer/lender/merchant acquirer or whatever you actually are, you will inevitably slight the regulatory obligation that comes with that identity.You will also miss the opportunity to benefit from the lessons of the past; almost all of these hard lessons have been learned before, by other companies.

What exactly are these companies running from?

In general, the valuation frameworks that exist for a set of comparables are there for historical reasons, based on economic attractiveness. To the extent that your company defies those traditional norms based on its innovation, it will get a better valuation than its peer group. That’s how capitalism works. It may take some time and will certainly require some proof, but it is inevitable.

Financial Engines, a tech-enabled RIA, trades at a 51X PE ratio, over 2X that of Charles Schwab. PayPal, a mobile and Internet-focused payments company, trades at a 36X PE ratio, nearly 3X that of Amex. MarketAxess, a trading platform for fixed income securities, trades at a 49X PE ratio, 2.5X that of Nasdaq. I could go on.

It turns out that it’s not a terrible thing to have the best house in a stodgy neighborhood.

Entrepreneurs have to weave a story every day, often a story that differs slightly or meaningfully from reality at that moment. They have to convince employees, customers, partners and investors that the future will be different than the present in unlikely ways, and find methods to demonstrate that some of this promise has already come true. They need to do this in a manner that never calls their integrity into question, even as they create their own version of reality.

When you add to this challenge the burden of having to disclaim their true identity so as to don a more highly valued mantle, the strain is impossible. A former associate of mine named Polonius probably said it best:

This above all: to thine own self be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.

[I am indebted to Isaac Oates and Andy Stewart for their help with this essay, though of course any errors are my own.]

Originally published at Forbes.com

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Credit, private or public, is of greatest consequence to every country. Of this, it might be called the invigorating principle. -Alexander Hamilton

So which is it? Is lending a good business, where moats and profit pools are durable and one can build billions in equity value … or is it an inevitable cash bonfire when the cycle turns? Is credit a critical lubricant for the economy, the more the better, or a creeping contagion to be limited, particularly in the “shadow” banking system? As someone who co-led the seed round in one of the first alternative lending companies (OnDeck), and went on to serve as Chairman, but who has not invested in a single lender since, I stand somewhat astraddle this issue. After watching closely for ten years, I remain convinced that the leaders of Alt Lending 1.0 (specifically Lending Club, SoFi and OnDeck), if they can avoid getting acquired due to depressed stock prices, will build enduring platforms. I am most worried about the wave of “me, too” players that came next, Alt Lending 2.0. Most of them built their business plans on the now shifting sands of temporarily high valuations and cheap capital, and have insufficient differentiation to carve out a durable niche. I am most excited about the Alt Lending 3.0 players, who have had the ability to learn the appropriate lessons of the past decade and can both pick their spots and choose a more capital efficient path.

If you look at the question with an eye towards history, what is perhaps most surprising is that venture capitalists are thinking about lending at all. In the past, non-bank lending was either about disreputable segments or scale finance companies, and in either case raised equity with the promise of distributing yield based on high ROE, not primarily creating high multiples through exits. What changed? In a phrase, “marketplace lending”.

To explain what that is, I’ll quote myself … I was asked by a banker in 2014, before any of the lending IPOs, to explain Lending Club. Here’s what I wrote back to him (edited for brevity and clarity):

I’m quite familiar with them.  They are the pioneer in an innovative new funding model for specialty finance companies, whereby they originate loans and then sell them off entirely, without keeping any of the risk or needing to tie up any equity capital in their assets.  They receive a ~4% origination fee and an ongoing 1% annual servicing fee on the assets.  They benefit from a number of unsustainable trends, including:

  • historically low yield environment
  • a massive amount of high interest rate credit card debt burdening consumers, as a result of the credit crisis
  • a robust credit environment, with defaults at historical lows
  • banks and credit unions still “in their bunkers” relative to making new unsecured personal loans to consumers

I believe many or all of these trends will reverse in the next 2-3 years, but Lending Club has built a substantial business and diversified away from their historical base of unsecured consumer loans, so I believe they will end up being a survivor.  To the extent to which their innovation (marketplace funding of loans) is durable, it will have created a new species of competitor for banks, pure play loan originators who can compete based on marketing prowess, underwriting skill, proprietary product creation and other areas where FIs have historically been weak.

Marketplace lending is the “technology” that creates the biggest risk for FIs on the asset side, in the same way that prepaid is the “technology” that creates the biggest risk on the liability side (per this essay):

One of the good things about being an obstinate cuss with no capacity for new ideas is that it creates efficiencies like this one … I don’t have to change a word of this, even two years later.

Marketplace Lending

It is still possible, though I believe increasingly unlikely, that marketplace lending will be a durable innovation. As a society, we decided that mortgage originators should hold some risk in the product they create after they nearly destroyed the world in 2007; should other types of credit be treated differently? The specific mechanism used, whereby a bank technically originates the asset on behalf of the marketplace lender for compliance reasons, has been challenged by the courts. A more straight-forward risk to the model is demand for these assets through cycles. In normal yield and risk environments, asset owners have required that originators be aligned with them regarding asset quality. If rates rise and credit quality deteriorates, this demand will likely re-emerge.

That said, I don’t think it matters whether marketplace lending ends up being a viable long-term funding strategy or not. What Lending Club, OnDeck and others proved was that they could effectively compete with banks and build share in their respective categories. The unique way that Lending Club funded its assets was a feature, not the entire product. As an example, when I backed OnDeck originally, it was before marketplace lending (or “peer to peer” lending, as it was originally called) was in vogue, and the assumption was that we would have to follow the traditional asset funding path. That path involves funding initial loans using 100% equity, until the assets are proven out, then layering in leverage over time. This generally starts with a 50% loan-to-value advance rate, eventually climbing to 80-90% over time as/if the assets perform. Ultimately, you can build a highly redundant funding machine, as OnDeck has done, with essentially equal parts balance sheet funding (using high advance rate leverage and an SPV), rated securitizations and whole loan sales (the prosaic, old school term for what now goes by the dazzling nom de guerre marketplace lending).

As an amusing aside, I’ve now been involved in two public panel discussions and multiple private conversations with Lending Club investors around funding models. It always goes the same way … they say that there is no more resilient model in capitalism than a marketplace model, hence the ineffable beauty of Lending Club. I then ask how a marketplace could be more resilient than a marketplace PLUS a securitization conduit PLUS committed multi-year balance sheet funding (the SoFi, Avant and OnDeck model, among others). Following that I am branded an apostate and asked to relinquish my Fintech Fan Club ™ membership card. In point of fact, I consider no fewer than 6 current or past Lending Club board participants close personal friends, and the visionary investments they made in that company cemented their reputation as great investors. I just think the reason they chose well is the classic venture capital formulation of “great founder, big market”, rather than any notion that Lending Club discovered the credit equivalent of cold fusion. The fact that Lending Club was able to scale without using equity in its loans because of the marketplace model was a brilliant strategy, but far from the most important aspect of the success of the company.

The things that matters about how you fund your assets are a)cost, b)liquidity and c)risk … as an originator, you need to manage all three. The marketplace-only model focuses exclusively on risk, and emphasizes to the point of fetish the idea that the originator bears no ongoing exposure to the assets once sold. Of course that’s not true: If all of your assets go pear-shaped, you’re almost as screwed as if you owned them. Risk is not the only thing to focus on.

Venture Capital in Alternative Lending

The debate around marketplace lending is a bit of a sideshow. The fundamental questions are:

  • Can non-bank lenders take share from banks?
  • If so, in what categories?
  • Can it be done in such a way that equity investors can earn venture-type returns?

I do believe that non-bank lenders will take share from banks, though I think they have to pick their spots carefully. I think an economic model can be built that works through cycles, though there will be some white knuckle moments along the way. Marketplace lending, or whole loan sales, can be a useful part of a diversified funding scheme, but is not mission-critical to creating venture returns.

To understand why and where banks are vulnerable, we need to decompose lending into its critical parts: Customer Acquisition, Credit, Funding, Servicing/Customer Relationship Management.

Lenders have to attract customers, figure out if they want to lend to them, fund the assets that they create and then service and collect from the borrowers over time. Despite much rhetoric to the contrary, banks are not particularly terrible at any of these skills, and they benefit from enormous economies of scale across the entire value chain. In order to compete, non-bank lenders need to pick one or multiples of those aspects of the chain, and differentiate in a way that is hard for banks to follow.

Funding Advantage

The hardest way to compete with banks is relative to funding, which makes it all the more peculiar that the alternative lending sector has come to be branded by its asset funding methodology, marketplace lending. The average cost of funds for a bank, according to the FDIC, is 0.06%, assuming they fund their loans using deposits. OnDeck’s funding costs for its assets averages 5.3%. Lending Club has paid a median return to its asset purchasers of 7.4%. Any start-up lender, particularly in unsecured or novel credit categories, will start out with rates in the mid-teens, if they can get leverage at all. No one can fund cheaper than a bank.

While we’re on costs for a moment, another common anti-bank argument is around inefficiency in terms of marketing and servicing. Lending Club estimates that the big banks suffer from operating expenses as a percent of loan balances on the order of 5-7%, while it has marketing and servicing costs of around half that amount. While true, I’ll point out that most of the bank expenses they highlight are fixed expenses like branches and compliance, which makes that expense burden irrelevant to the profitability of the marginal loan. In addition, what banks overspend in these areas they make up for in IT and G&A … for example, banks on average spend 7% of revenue on tech, compared to 12% at Lending Club and a whopping 24% at OnDeck. When combined with the enormous and irreducible funding cost disadvantage, we can safely say that neither funding nor cost structure represent areas of long term competitive advantage for the insurgents. That leaves us with Customer Acquisition, Credit and Servicing/CRM, plus combinations of the above. The good news here is that there is opportunity in each.

Credit Advantage

Most start-up originators focus on the opportunity to innovate in credit decisioning. The headline appeal of new data sources and new data science seem too good to be true as a way to compete with stodgy old banks. And, in fact, they are indeed too good to be true. Building new credit models is hard, inherently time-consuming and expensive. Fundamentally, you can’t figure out how to distinguish between the “goods” and the “bads” without sufficient “bads”, and “bads” cost you money. Credit losses can also take some time to develop, depending on the category, and assets can behave quite differently in different economic cycles. Until you have a model that is proven in a highly durable way, your cost of capital will be very high.

But wait, it gets harder. Sexy new data sources can be tricky, particularly in consumer lending. Not only can you not intentionally use criteria that the regulators view as prejudicial, you also can’t leverage variables that seem innocuous but end up being correlated with things like race and marital status. Further, the new data itself isn’t interesting; what’s interesting is how it affects credit quality. You can have all of the hypotheses you want about how data should rank risk, but no one cares until you demonstrate it.

The recipe for success here starts with picking a truly underserved segment. Then figure out some new methods for sifting the gold from what everyone else sees as sand; this will end up being a combination of data sources, data science and hard won credit observations. At least some of your credit observations have to be non-obvious. One good test is to see if FICO scores help to sort risk; if they do, pick another category … banks understand FICO scores. It is important to choose a segment with relatively small dollar amounts and relatively short duration. Credit models are judged on unit performance more than dollar performance, and small dollar/short duration lending allows for many more “bads” on far fewer dollars. It is also a bulwark against bank competition. With larger loans, banks can and will invest human resources to underwrite loans; with smaller loans, they don’t have that option. Finally, while starting in an out of favor category is probably essential, it can’t remain true forever. You have to have a game plan for moving mainstream once you’ve built your competitive advantage in underwriting.

There are relatively few examples of companies that have gotten all of these elements right, but there are some. Oportun provides credit to otherwise highly disadvantaged Hispanic borrowers. What a bank sees as a 620 FICO, Oportun sees as an employed but challenged immigrant with a spotless record of sending remittances home. Sub-prime and near-prime lenders like Avant and LendUp have proven out extremely advanced consumer credit models in unattractive segments, and are working quickly to leverage those models into more mainstream businesses. In small business, OnDeck chose a large segment that had historically been attractive but hard to serve. Where a bank sees a generic SMB with a business owner FICO score of 650, OnDeck sees a plumber with far higher efficiency than comparable businesses in its zip code, and a glowing set of reviews on Angie’s List. This hard work comes at a cost; OnDeck’s R&D expenditures, noted above, are characteristic of the successful companies in this category. You have to have real IP to win here.

These companies are building defensible moats against bank competitors for a variety of fundamental reasons. The one area where the funding cost advantage that banks have doesn’t work for them is in areas where new credit models are required. Regulators insist that banks keep disproportionate amounts of equity capital in reserve when they try new things, and while their debt capital (ie, deposits) is cheap, bank equity capital is quite dear. In addition, these segments generally start out with high APR models. They can support high interest rates, as by definition these customers don’t have good alternatives, and as discussed, they require high interest rates to compensate for the risk and elevated cost of capital. Over time, APRs can come down dramatically, but these segments are generally dismissed in the early days as predatory or niche.

Customer Acquisition Advantage

Developing an advantage in Customer Acquisition is harder than it might appear. At first blush, it might seem that all it takes is to pick an unloved segment and get to know its idiosyncrasies and tendencies well enough to create a focused channel and tailored dialogue. In practice, progressive and thoughtful traditional lenders like Capital One have mined most of the segments large enough to build a business around. The only way to build a durable competitive moat based on Customer Acquisition is to become integrated into a channel that is proprietary, contextual anddata-rich.

Integration is an old lending concept that has been reinvented in the modern age of networked computing and hosted software. Decades-old companies like Synchrony and Alliance Data were “integrated” at the point of sale in the form of paper applications for store-branded credit cards; now we have modern versions like Greensky, Bread and Affirm. These companies don’t leverage their channel to find a new or underserved segment; instead, they gain access to well understood, prime consumer credit via partnerships with companies hoping to sell things more efficiently.

It has historically been critical that these integrations be proprietary. Most, or all, of these companies insist that they be the only credit option in that channel (or at least have exclusivity by credit tier), and in fact, in most categories the credit providers get paid by the channel to lend, as well as by the borrower. It continues to surprise me that merchants have allowed this to continue in the age of marketplace lending. If I ran a retailer, I would not only refuse to subsidize point of sale lending with a merchant discount, I would run a real-time auction between lenders for each consumer seeking credit to make a purchase. This is likely not feasible today, but certainly technically possible over time.

On the B2B side, good examples of this are starting to emerge in the reinvention of commercial sales finance. Companies like Noesis and Wunder are providing tools to vendors of HVAC, solar and other high ROI systems to both prove the value of this equipment to business customers and finance the sale at the same time. For years, Bluetarp has been replacing the historical role of vendors in providing trade finance to the buyers of construction materials; now they as well as new entrants like Behalf are pushing this methodology into other verticals.

The home run is when the credit offer is not only presented in context, but also can be structured with the benefit of relevant data. Fundbox lends to small businesses by advancing them payment on receivables, in what is akin to a traditional factoring transaction (though without claim to the asset). They integrate with online accounting systems like Quickbooks, which not only provide them access to customers, but do so in a way that allows them to learn a great deal about the creditworthiness and demand for capital of their prospective customers. Bluestem Brands has a business called Paycheck Direct, in which they integrate with payroll systems to provide access to an e-commerce catalog on credit to low FICO employees; by having access to the payroll system for both underwriting and collections, they have a massive advantage over payday lenders.

One company that is synthesizing all of these elements is AvidXchange. Avid’s core business is Accounts Payable automation and commercial payments; they integrate and control the payment process of B2B customers. Based on that data, they know when and if suppliers are going to get paid, and in fact are responsible for making those payments. As such, they are in a unique position to make highly attractive credit offers to otherwise cash-starved vendors, leveraging their native integrations, proprietary access, ability to make contextual offers and data-rich software footprint. They can provide capital to the least creditworthy vendors simply based on the strength of the buyer and Avid’s insight into the likelihood of payment. This kind of position allows more than just sifting for gold (differentiating the creditworthy from the non-creditworthy), it actually creates the opportunity for the more alchemical process of turning fundamentally credit-challenged customers into good risk.

Servicing/CRM Advantage

A promising but infrequently used vector in the lending space is to capitalize on a servicing, or more accurately, customer relationship-oriented strategy. The hero company here is SoFi, who focuses on the HENRY segment (High Earning, Not Rich Yet). They started with student loans, as a low risk asset class that had historically been underwritten in an unsophisticated fashion. With its narrow spreads and government subsidies, student lending in and of itself was unlikely to be a sustainable niche, particularly in a rising rate environment. To the credit of the SoFi team, they knew this from the outset, and treated student lending as their gateway product; they have now launched a nearly full suite of consumer financial products into their loyal base of student lending customers. The company generated that loyalty through laser focus, and by going above and beyond for their customers. It is hard to imagine a traditional bank lender providing job placement services for their borrowers, much less networking dinners and dating services.

Where Do We Go From Here?

While I’ve come to be known as a skeptic on marketplace lending per se, I see a great deal of opportunity in alternative lending more broadly. That said, things are going to get harder before they get easier. Valuations are down significantly, and the market volatility combined with a slowing economy will produce challenges with both default rates and access to liquidity. Of the alternative lending 1.0 players, Lending Club will be a survivor, and a long term leader. While it doesn’t have many of the distinctions I note above as important, it has scale, a brand in the capital markets for producing high quality assets, and an unbelievable management team. In fact, Lending Club may be the best example of managerial execution in a commodity market since Amazon, and like Amazon, if they continue on their current path they will figure out a way to create enormous value. OnDeck, in a sense, has an easier road ahead. They are very far along an experience curve with regard to the new world of small business lending, and it’s hard to imagine someone catching them. I worry about the 2.0 originators, which tend to be only slightly differentiated fast followers of either Lending Club or OnDeck; it will be very hard to be anything other than the leader in this shaky market environment.

I’m quite excited about Alt Lending 3.0, made up of earlier stage originators whose strategies line up with the precepts above, and who have gotten the memo about appropriate valuations and capital efficiency. For lending high flyers, as for the rest of the “unicorns”, the notion that high growth and “disruption” justify valuations detached from estimates of future cash production has gone away. Companies seeking funding in the lending space today generally have less of the Gold Rush mentality of the Alt Lending 2.0 players, who sought to take advantage of an enthusiastic investing community; instead, they are motivated by legitimately unmet needs and the prospect of meaningful moats. For the first time in a decade, I’m feeling like it’s a great time to be starting a lending company

Redefining FinTech

Matt Harris —  December 17, 2013 — 14 Comments

I’ve spent the better part of my career investing in technology companies involved in financial services.  Given that, it’s a bit surprising how much I hate the term FinTech.

Historically, FinTech has defined the technology vendor community selling into banks and broker/dealers.  Until 2008, this was a reasonably good business.  Since then, there has been increasing consolidation, both on the financial institution side and on the vendor side.  As a result, while ostensibly there are still thousands of banks in the US, the vast majority of the budget is tied up by 20 FIs, and the vast majority of the revenue goes to the large, incumbent vendors.  It is a classic logjam, and woe betide any small firm looking to selling into that mess.

The much more interesting opportunity in financial services isn’t selling to financial institutions, it is competing with them.  As I have written elsewhere, banks in general are retreating from customer-facing activities, not vigorously defending their turf.  This happened in merchant payments, for example, even in advance of the financial crisis.  In 1988, banks had 62% market share in the acquiring industry; now they have 38% and shrinking.  Currently, banks are losing share in the DDA market, the lending market and the personal finance market, among others.  I anticipate that the corporate treasury services market will be next, hence my current obsession with b2b payments.

As you might expect, entrepreneurs figured out this new reality far more rapidly than venture capitalists.  One example from my experience is OnDeck, a small business lending company, and a ridiculously fun and exciting company to be involved with.  I invested in their first round of capital and have been on the board since 2006.  From the time of that initial investment until I finally came to my senses, I was one of several investor directors urging the company to offer their underwriting and processing platform to banks as a vendor, in addition to (or instead of) being a direct lender to small businesses.  Thankfully, the entrepreneur (Mitch Jacobs) and the CEO (Noah Breslow) kept their eyes on the prize, and while the company has several very productive referral relationships with financial institutions, OnDeck has continued to originate loans directly.  As a result, it has grown like topsy and will soon pass the $1B mark in terms of capital lent to small businesses.

To paraphrase the pushback of the management team, their basic argument went like this, “Do we really want to put our destiny in the hands of bankers?”  That argument, in brief, explains why every time someone asks me if I invest in “FinTech companies”, I respond that actually I invest in financial services companies.  Given that this distinction, while meaningful to me, is always met with blank stares, I’ve now tried to put some analysis around it, which you can see here:

Market Cap - Bank vs non bank analysis vjb5(2)

My colleagues and I (thanks to Jordan Bettman and Matt Brennan for their help with this) defined three universes of companies:  Banks, Bank Vendors and (for lack of a better term) Finsurgents, ie, companies providing functionality that had historically been the province of banks.  The results are clear.  The bank vendors’ market capitalization relative to banks’ market cap remains relative constant, with a slight premium reflecting the fact that technology spending at banks is growing faster than bank revenue.  But the Finsurgents’ market cap relative to banks grows at twice the rate, which is quite logical in that these players are taking an increasing share of profit pools that would otherwise belong to banks, not depending on banks for their revenue.

In defining these groups, we had the requirement that the companies be public for the whole period 2003-2013.  As such, while the bank and bank vendor universes contain all the logical players (vendors include Fiserv, Deluxe, D+H, TSYS, Diebold, ACI, etc), the Finsurgent group misses key players who have either gone public post 2003 (Visa, Mastercard, Fleetcor, Wright Express, Cardtronics, Vantiv, Higher One, Greendot, Netspend), plus companies who are still private or are subsidiaries (Square, Paypal/Braintree, Stripe, Lending Club, OnDeck), not to mention the entire Bitcoin universe, etc.  In 10 years, I suspect that these lines will have entirely diverged, as the banks become relatively stable financial utilities, their vendors settle into a symbiotic but unexciting and slow upgrade and refresh cycle and the Finsurgents complete their takeover of customer facing applications and innovation in the sector.

 

Submerging Payments

Matt Harris —  December 5, 2013 — Leave a comment

The mimagesost important development in merchant payments right now isn’t happening in Silicon Valley (though I do think PayPal is only a few chess moves away from becoming the fifth network.)  It isn’t happening in New York City (though I’m increasingly convinced that NYC can be the center of the alternative lending universe.)  It isn’t happening in Atlanta (though I do like the mojo Frank Bisignano has brought back to First Data.)  And it isn’t in cyberspace (though surely math-based currencies will have their day.)

It’s in Durango, Colorado.  And it will likely destroy much more value than it creates.

The trend I’m referring to is commonly referred to as integrated payments, or embedded payments, but I think of it as submerged payments.  The leading (and, indeed, defining) company in the space is Mercury Payments, in remote Durango.  Before Mercury, the traditional retail payments industry practice was for merchants to make two decisions regarding their point of sale (POS); first, they pick a software provider, and then separately, a payments provider.  Sometimes these two were loosely coupled through various integrations, but rarely were they tightly linked (basically never for small and medium sized merchants) and almost never sold together.  In the world of on premise software, it was difficult to merge a necessarily dynamic platform like a payment processing system, which changes frequently due to association rules, with a static POS system that could only be upgraded through CDs sent in the mail.

What Mercury realized was that the increasing adoption of SaaS-based solutions at retail meant that payments could be far more easily (and far more tightly) integrated into POS software.  They began a landgrab in the retail software developer community, offering payments wholesale to these developers, who could then offer attractive rates to their customers on an embedded basis.  Better yet, they could use the payment card data (with sensitive details tokenized) as the basis for a CRM system, so that in essence the payments platform became the identity utility for the software system.  Good luck to the ISO salesperson who walks into a salon looking to sell payments at a 5 basis point discount, when for the merchant a decision to change payment processing providers means switching software vendors, or at least losing access to your customers’ tokenized card numbers.

Merchant acquirers currently differentiate primarily on distribution (generally feet on the street), and only at the margin on technology, approval rates, customer service and uptime.  In a submerged payments world, that is entirely flipped around.  Distribution changes from sales to business development, and payment companies will be pitching POS developers on their technological sophistication, advanced features and nimbleness.  Those are not adjectives commonly thrown around about the incumbent merchant acquirers today.

This trend is not entirely lost on the industry.  Both Vantiv and Global Payments have made acquisitions in the space (see here and here), and everyone else has at least added the word “integrated” somewhere on their website.  But they are also doing some of the wrong things, in particular acquiring or investing in POS software companies themselves.  If I’m a developer, am I going to choose an embedded payments partner who has a software package in the market competing with me?

Ultimately, regardless of what they do, this is a bad trend for the sector.  Payments are becoming dial tone … expected to be there, always on but never acknowledged, and certainly not worthy of a premium price.  At its IPO, Mercury will likely be worth $2-3B, representing approximately 5% of the enterprise value of the merchant acquiring segment, by my estimates.  In five years, they will likely be worth $5B, given the likely share gains they will see as SaaS POS systems crowd out on premise software.  Sadly, by that point, I expect they will be fully 20% of the segment’s market value, as price erosion and market share losses degrade the margin structures of their over-levered, largely fixed cost competitors.

It turns out that no one wants to buy payments, they just want commerce.

What’s The Big Idea?

Matt Harris —  October 4, 2013 — 4 Comments

Perhaps I’m just simpleminded, but one of the most important things I look for in a company is the ability to summarize the problem they are solving in one sentence.  Often, at the outset, I’m less interested in solutions than problems; I want to be asked a question that stops me in my tracks.  At the heart of most transformative companies is a simple question, and once you’ve heard that question you are instantly convinced that there has to be a better way.

Starting with a question, rather than with a solution, gives you a telling diagnostic for the magnitude of the problem.  Way too many companies start with a solution and go looking for a problem, and as a result end up without anyone who really needs what they are selling.  Perhaps the most acute example of this in financial services is the current obsession with mobile wallets at point of sale.  “Why can’t I pay for something with my cell phone?” is about as much of a burning question as “Why can’t my dog speak French?”; both things would be cool but aren’t exactly mission critical.

Here are some examples from the industries I follow:

  • Square/Braintree/Stripe:  Why can’t most merchants take credit and debit cards?
  • Xoom/iSend:  Why are international remittance fees 10% of the value being transferred?
  • Taulia/Tradeshift/Billtrust:  Why are most business to business payments made by paper check?
  • Wealthfront/SigFig:  How can the asset management industry extract so much value while significantly underperforming index funds?
  • CAN/Kabbage/OnDeck:  Why do banks underwrite small business loans using the business owner’s credit score?
  • The Climate Corporation:  Why can’t we predict the weather?
  • Bluebird/Moven/Simple:  Is it necessary for banks to charge fees?
  • Paypal/Dwolla:  Why is it so hard to move money around?
  • SoFi/Common Bond:  Why do all student loans have the same interest rate?
  • ZipCar/RentTheRunway:  Why do we have to own expensive goods that we use infrequently?
  • Yapstone/Plastiq/Zipmark:  Why do I still pay my rent with a paper check?
  • DriveFactor/CellControl:  Why do good drivers subsidize bad drivers?

Once you have your question, then you can do the required research to find out the answer.  Sometimes the answer is a brick wall, but other times the answer points towards a solution.  Frequently, as you can see from my answers below, there have been legitimate blockers to a solution historically, but advances in technology newly allow hard problems to be solved.  When you find a circumstance like this, a painfully acute problem that was historically intractable, but due to new innovations is now solvable, please email me.

My Answers:

  • Payments acceptance:  Primitive and stodgy underwriting needlessly excludes many low risk merchants; legacy hardware creates a prohibitive fixed cost for low volume merchants.
  • Remittance expense:  Cash handling, both on the send and receive side, is wildly expensive.
  • Paper in B2B payments:  There is tremendous inertia, driven by workflow on both the AP and AR side.  [This will not be solved quickly]
  • Value destruction in asset management:  In the absence of clear data, investing choices have been driven by brand preference vs. rational analysis.
  • FICO scores in small business lending:  Historically it has been the only scalable and low cost way to underwrite a sub-$100,000 loan.
  • Weather prediction:  The data capture and analysis problem has been too large and expensive to solve.
  • Banking fees:  Banks have to support a very expensive branch infrastructure, as branch location has historically been the primary decision factor for consumers in selecting a bank.
  • Money movement:  The four party payment model and the resulting interchange economics were built to compensate issuers for credit transactions and have been inappropriately applied to other types of money movement.
  • Student lending:  Government driven programs are slow to change, and as a society we have issues with financial discrimination relative to education (and health care.)  [This may still end up being a problem]
  • Sharing economy:  The transaction costs in rental models have outweighed the benefits in the absence of inexpensive real time communication networks and scale infrastructure investments.
  • Checks in rent payment:  Landlords have mini-monopolies once renters move in, and therefore lack motivation to sacrifice any economics to make payments easier.
  • Auto insurance:  Collecting information on safe vs. risky driving has historically been impossible.
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[This post originally appeared on forbes.com here:  http://www.forbes.com/sites/bruceupbin/2013/02/15/tokenization-and-the-collapse-of-the-credit-card-payment-model/]

It’s been a fascinating couple of weeks in the token world.  We have Monopoly’s decision to replace the iron with a cat, based on a poll launched on their Facebook page.  Feels like selection bias to me; is anyone surprised that the population of people who are fans of board games on Facebook also like cats?

More germane to my obsession with payments was the announcement that Braintree re-launched Venmo as a cardholder side multi-merchant tokenization system.  I realize that’s a mouthful, but here’s what it means:

  • Braintree provides payment acceptance to many (most?) of the most popular online and mobile merchants, like Uber, Fab, HotelTonight, LevelUp, etc.
  • Because all of these merchants have huge mobile traffic, they encourage users to “vault” (ie, store) their credit card information with them, so when they return they can check out with one click (or in the case of Uber, no clicks.)  In actuality, all of these payment card details are vaulted at Braintree.
  • Braintree has convinced at least some of these merchants to contribute their users, on an opt-in basis, to a consortium, such that if I am an Uber customer, and I show up to HotelTonight for the first time, Braintree recognizes me and asks me if I want to use the credentials I’ve already stored with Uber to check out with HotelTonight.
  • Braintree has 35MM credit cards vaulted … maybe 20% of the adult US population, and probably 100% of the early and mid adopters in this country.
  • The reason this works, from a security perspective, is the data on the device you are using.  Because they fingerprint your phone (or PC), and require a password, they have the classic “something you have” and “something you know” security formulation nailed.  In the mobile use case, they also have fraud sensitive data like location; if anything I think this will be a more secure transaction than a typical e-commerce situation (more on that later.)

In the real world, the concept of a token generally refers to the act of substituting something simple and convenient for something more cumbersome or complicated.  Think of the utility of a subway token in preference to cash, or (as in Monopoly), how much easier it is to move a game piece around a board than your physical self.  In the payments world, tokens have traditionally been used to enhance information security.  Tokenization* is a system where you substitute a proxy set of identifying information for the real payment card data, so that merchants don’t have to handle this sensitive and regulated data and it isn’t exposed more than necessary.  This original logic for tokenization (keeping merchants free from hosting payments data) has been taken to the next level by Braintree … the same idea is now being used to make the payment experience quicker and easier, through their consortium model (“if you’ve paid anywhere else, you can pay here, too.)

The important irony here, which is also true of Square’s tokenization strategy (Square Wallet, where you the Wallet serves as a “token” to mask the underlying payment card credentials), is that the tokens being used are actually more authentic than the underlying “real” identity.  Historically and generally, tokens are nonsense strings of characters, designed to abstract away from and hide the true goodies, your credit card number.  But consider the token that Braintree is using:  the fingerprint of your device plus your location plus a password.  And Square?  They use a picture of your face.  What’s more real, a 16 digit number or a picture of your face?  Remember, the purpose of the payments query that a merchant initiates when you try to pay for something, whether on-line or in-store, is authentication, ie, are you actually you?  This gets done through the inherently flawed mechanism of merely checking that the card that has been presented (or typed in) is actually valid.  What Braintree and Square have done is create self-authenticating tokens in a natively multi-merchant construct, and that is a frigging big deal.

The current retail payments industry rests on what is called the four party payment model.  The four parties in question are:  1)cardholder, 2)cardholder’s bank, 3)merchant and 4)merchant’s processor/bank (known as the merchant acquirer).  When the cardholder swipes their card at a merchant, the card and transaction data flow through the merchant acquirer to the cardholder’s bank, which confirms that the cardholder is authorized to make the transaction.  This structure was invented and is perpetuated by Visa and Mastercard, who serve as the information switches between the four parties.

They’ve never been linked, that I’ve read, but I think it’s more than a coincidence that Visa was founded shortly after the interstate highway system.  Before Visa, non-cash transactions were done using store credit … because most merchants knew most of their customers before the 1950s, you didn’t need elaborate authentication schemes.  After the 1950s, Americans grew far more mobile, and store credit became less practical; hence Visa and Mastercard emerged, to enable transactions between strangers.  If you’ve ever used Square Wallet, you’ll know what I’m talking about here:  it feels like the 1940s.  When your face pops up on the retailer’s point of sales system, and the clerk calls you by name, you are no longer a stranger.  I’ve yet to have the pleasure, but I’m certain that when I show up on OpenTable and am greeted by name and asked if I want to check out with my Uber credentials, I will also feel warmly recognized.

This is horribly threatening for all of the incumbent players in the four party model:  traditional acquirers, issuer and the networks.  Plain vanilla merchant acquirers will struggle to compete with Braintree online and Square offline as their tokenized user bases grow (NB:  Square is actually well behind Braintree on this front and we’ll see how they do; IRL is harder than online.)  The issuers lose their ability to differentiate.  Once tokenized and hidden, any given card product is far more vulnerable to being displaced, as the issuers have already learned from PayPal.  How do you stay “top of wallet” when there is no real wallet?  As for the networks, their demise is harder to articulate.  Visa and Mastercard are fortresses, growing 20% per year like clockwork, despite the law of large numbers.  I will leave it at this:  in a world where everyone is known, there is no need for an omniscient middleman.  That feels like a scary fact for the networks.

*Per usual in these blog posts, I’m sure there is a specific definition of tokenization that I’m getting wrong.

Salesmanship of Fools

Matt Harris —  December 26, 2012 — 7 Comments

I was talking to a fellow VC the other day, who I know but not well, and he was clearly searching for something to compliment me on, and what he come up with was “hey, I really appreciate how you’re not always nice on Twitter.” As I replied “thank you… I think?”, I was actually thinking that my portfolio companies sure I wish I were nicer, and followed the standard tradition of hyping them at every turn. Hopefully most of them went in knowing that salesmanship, in the traditional sense at least, is not my forte.

They should also know that it used to be worse. When we were starting Village Ventures 12 years ago, and particularly in the aftermath of the bubble, I used to have a downright dystopian sales strategy. I would go in to see potential investors and spend the first 20 minutes talking about how horrible the environment was: “You know, I agree, that’s bad news, but what’s worse is this…”. After setting the appropriate nuclear winter tone, I would go into my spiel: “As we’ve discussed, it’s not obvious that anyone will ever make money again, but if anyone were to, it’s not impossible it would be us…”. Then I would get to my big finish: “I’m sure this isn’t a fit for you now, but if we’re both still in business in a year or two, we should circle up and chat again…”.

After months of this, my then partner Bo took me aside and explained how things worked. To paraphrase, he made it clear that while I wasn’t ever going to star in Glengarry Glen Ross, I could get better. First, I needed to understand that being negative is a crutch. It’s easier to look smart when you’re being critical and dour, and so it can be a refuge for the insecure. Second, people not only expect salesmanship, but they actually want to be sold. Investors know that salesmanship is important to success, for VCs and particularly for entrepreneurs, so in a sense investor meetings are not only a test of your strategy, but also a test of how well you can persuade. This coaching was at least incrementally effective and I’m proud to say I’ve gone from horrible to bad over the last decade or so.
This all got me thinking about the different levels of salesmanship, which I think could stand to be better understood. The top rung is probably pretty obvious: to paraphrase Lewis Gersh, the prototypical salesman is one who could not only sell ice to Eskimos, but could sell them Sarah Palin for Governor as well. There is something deeply cynical, though obviously effective and maybe necessary, about this type of sales … it requires no link between reality and what is being claimed.

The other end of the spectrum is where I think I’ve ended up, which is that I can be persuasive if and only if I believe in what I’m selling, and my belief system is pretty well defined and constrained by a normal probability distribution. In other words, I can definitely be wrong, but not on purpose. The middle ground is the area I find most interesting, which are those people who technically only sell things they believe in, but are capable of such wild optimism (when it’s in their self-interest) that they can believe a whole hell of a lot. As such, the distinction between them and the unethical (my view) salesperson is a pretty fine line, when it comes down to it.

I’d like to think that at the core of entrepreneurship lies innovation, but you could make a good case that the actual core is salesmanship and persuasion. As such, I think it’s important for all of us in the field to remember that it’s a multi-round (and increasingly public) game that we play, which has enormous implications for sales philosophy and strategy.  One of my general gripes about entrepreneurs and VCs is the hype machine aspects of it, and i think too many people take comfort that they aren’t actually “lying”, they’re just being optimistic.  Ultimately the choice comes down to either a)sell stuff you don’t truly believe in; b)be ineffective because you don’t feel comfortable selling what you’re working on; or c)only work on projects you truly believe in, so as to be in a position to sell like crazy. I think the answer is obvious.

Square Puck

Matt Harris —  November 24, 2012 — 21 Comments

Replica of first hockey puck ever used (it actually was square-ish)

Square Puck:  sounds dangerous, right?  I think it is.

There’s a famous/trite expression, commonly cited in the venture business, about how you want to skate to where the puck is going, not to where it is right now.  As I watch the payments industry grapple to deal with the phenomenon of Square’s micro-merchant processing business, I’m reminded of this truism, and increasingly convinced that all the incumbents are skating in the wrong direction.  This doesn’t mean that Square will achieve the kind of world domination that their valuation implies, but it does mean that lots of other folks are wasting vast resources and time pursuing the wrong goals.

In just the last week, Bank of America announced a micro-merchant offering, and TSYS bought ProPay, a vertically focused Square clone.  In the past year, we’ve seen a steady drumbeat of product announcements from Verifone, Intuit, PayPal, NCR, WorldPay* and PayAnywhere*, all directly focused on competing with Square’s dongle-based merchant payments service.  Meanwhile, in the investment community, there is a lot of self-satisfied sniggering about Square’s business model, in which it is assumed that given pricing and risk, Square loses money on every swipe.  Their recent move to undercut Starbuck’s already razor thin processing costs, even though they aren’t the low cost provider, reinforces this view … there’s no way that is profitable business for Square.  If Square is entirely dependent on merchant processing revenues, they are not only overvalued, they are in fact worthless … that business will never produce meaningful cash or be strategic to anyone.

But that’s irrelevant, as it is increasingly obvious that the merchant side of Square’s business is somewhere they had to start, but nowhere near where they plan to land.  At the end of the day, Square is a consumer-facing company; that is their DNA, their culture and their IP.  The entire merchant processing effort is a loss leader, a necessary evil on the way to building up sufficient retail coverage to make their mobile app useful to consumers.  It’s not too different from what LevelUp is doing, but Square’s approach, both in terms of pricing and design, is far more elegant and nuanced, probably because they control their own payments infrastructure and LevelUp outsources to Braintree.   All of the incumbent merchant processing and terminal infrastructure players who are freaking out about this and building direct rivals are totally missing the point, and are lunging to compete in a segment that will ultimately have a negative profit pool.

Typically in this blog, and more generally in life, I avoid making explicit recommendations and predictions.  I’ve just been humbled too many times by the world’s unpredictability.  But I’m going to make an exception in this case.

The recommendation is that Verifone should swallow their pride and do a comprehensive business development deal with Square, where they enable their entire existing merchant base to accept Pay With Square in exchange for essentially taking over Square’s merchant processing hardware business.  Given Verifone’s bluster and defensiveness regarding Square, I think this is unlikely, but it would be a master stroke.  Square doesn’t think hardware is strategic and is increasingly just trying to build their merchant base (see:  Starbucks deal) and they are only messing with Verifone as an accidental byproduct of their initial go to market strategy.  Square would do this deal if Verifone could convince them that they would take good care of their customers.

The prediction is that in six to twelve months, the conventional wisdom on Square will have changed to reflect the growing reality that Square isn’t primarily a merchant acquirer, but instead a mobile wallet provider.  Pay With Square, just like Google Wallet, PayPal and the other wallet providers, creates a unified merchant-facing cardholder application, which aggregates the user’s existing payment accounts behind the scenes, and layers on offers and enhanced information.

At that point, someone (probably not Verifone, unfortunately for them; my bet is Heartland or Global Payments, with Chase Paymentech as a long shot) will do the business development deal I describe above and PayPal, Verifone, BAMS,TSYS et al will be left holding their dongles.  The whole merchant processing community will then lurch toward some kind of cardholder side functionality, directly or through partnerships, and an unbelievable amount of time will be wasted essentially recreating the current Visa/MC merchant-issuer network in a Balkanized and therefore useless way.  Discover will get bought by Google for $35B and Amex stock will go up 30%.

Unfortunately, by that point, the puck will have moved again, and Square will have abandoned the mobile wallet play in favor of their actual ultimate goal, which is to become a new tender type, disintermediating payment cards altogether.  He shoots…he scores!

*For the record, I think WorldPay and PayAnywhere, with their focus on the SMB segment vs. the true micro-merchant segment, have it right.  NB:  my firm is an investor in WorldPay.

Jamie Dimon

JP Morgan

 

 

 

 

 

 

 

It’s a hard time to be a banker.

I’ve had this post in my draft folder for a long time, held back from finishing and posting it by the concern that, at least until now, it didn’t seem all that hard to be Jamie Dimon (America’s Banker ™), and he certainly didn’t seem to need a defense.  Alas, no longer.  The final bastion of respectability and prescience in the banking industry has been resoundingly toppled, and we can now look upon the rout in retrospect and try to glean some lessons.

My conclusion is that the dystopian epic that is the story of late 20th century/early 21st century banking is, at heart, about a group of people asked to do the impossible.  For reasons I will articulate below, a catalog of constraints and ill winds conspired to create an unbridgeable gulf between what was asked of them and what they could conceivably achieve with the resources available.  Of course, the story is also filled with knaves and opportunists, and probably everyone involved made more money than was reasonable, but in my experience most of the actors were principled, working hard and trying to do the right thing.  Jamie Dimon serves us well as an example here.  His cardinal sin was not about risk-taking, greed or arrogance, it was his (basically virtuous) ambition to make JP Morgan an important, innovative and growthful company.  I believe strongly that those adjectives are not what should be sought by the CEO of a modern bank, and men like Dimon should find other lines of work.  All of the industry analysts exhorting our current banking leaders to “Do Better” should be change their tune to simply “Do Less.”

About 10 years ago, I decided to focus my investing career on financial services companies.  At the time, this was a bizarre choice for an early stage venture capitalist; I don’t think anyone else in the industry was similarly exclusively focused, and only around 2% of the VC dollars went into the sector.  I had a number of reasons for the choice, which I won’t go into in detail, but one of the most significant was my view that the increasingly radical levels of bank consolidation left the industry vulnerable to entrepreneurial competition.  As I thought about the industry, there were three key segments:  payments, lending and capital markets.  In each, the banks had one or several exposed flanks.  I wasn’t smart enough to predict the financial crisis, but frankly should have been.  It was evident from what I was seeing that the cracks in the dam would turn into deep fissures, in each one of those segments.

It may seem comical to those outside financial services, but there is in fact a robust industry that has grown up around the idea of banking innovation.  You could attend a conference every week of the year on the topic, and fill your non-conference hours reading newsletters and blog posts about it.  Most of what the pundits think the banks should be innovating around is payments, which is basically the act of moving money from point A to point B.  The problem with this idea is that a payment mechanism consists of two things:  a technology architecture and a set of rules.  The technology part is probably obvious, but the rules part is important and distinctive.  Payments is an eco-system business, and the rules define the roles played by all the coordinated but independent parties.  By definition, an innovative payment mechanism, one which represents an advance from what exists, involves an exotic and novel technology or a new set of rules — or both.  For a variety of reasons, most notably the fact that their systems are a patchwork quilt of archaic, mainframe based architectures cobbled together from the dozens of acquisitions behind each of our large banks, banks are not good at technology innovation [one caveat here:  some banks are very good at trading technology, more on that later.]  They have to spend nearly all of their time, energy and resources on vital functions like uptime and security, and that leaves very little for the kind of playful tinkering that underlies most breakthroughs.

Banks are even worse at evolving new rules.  There are three ways to make new rules, two of which don’t work.  The first is to get all parties to agree:  FAIL.  The second is for a small but powerful cohort to band together and try to exert their will on the others:  also FAIL, at least in banking, where despite the consolidation there are still over 8,000 banks in the country, and as many credit unions.  The third way is for a renegade establishment to break the existing rules and keep moving fast enough that they get to critical mass before the rule enforcers notice and can do anything about it.  Banks are not good at breaking rules, and are really not good at moving fast and avoiding regulators.  This is why payment innovation happens by companies like PayPal, Venmo, Dwolla, Zipmark, Simple and Stripe.  Is everything they are doing strictly by the book?  Not even close.  Will some of them achieve escape velocity before they get shut down?  Yes.  [Am I engaging in the pernicious blogger habit of asking and answering questions?  Yes I am.  Will I do it again later in this piece?  Yes, indeed, I will.]

So in the payments world, banks face critical shortcomings as it relates to innovating.  You would think that would be less true when it comes to lending.  After all, that is what banks were set up to do in the first place:  take in deposits from savers, and turn them into loans for borrowers, making money on the spread in between.  To a certain extent, this is still their core mission and they do it well.  There are four key dimensions of competition in lending:  cost of capital, credit losses, cost of customer acquisition and operating expenses.  For a plain vanilla consumer loan, say a mortgage, it’s very hard to beat banks.  They pay depositors roughly nothing (very low cost of capital); in ordinary course the FICO or consumer credit score is highly predictive (controlled credit losses); they benefit from large branch networks and high brand recognition (lowering customer acquisition, though online lead gen models have reduced their advantage here); and they run large, systematized factories for processing these loans (low operating costs).  But the dirty secret is that there isn’t a lot of money to be made in these commoditized categories, and every once in a while there is a crisis and you lose your shirt.  Banks need higher yielding assets, which come in the form of higher interest consumer loans, or business loans of all types.

Not coincidentally, if you canvas the fast growing world of alternative credit now, you will find largely two types of new entrants:  high rate consumer lenders (Wonga, Zestcash, Think Finance, Global Analytics, etc) and business lenders (Kabbage, The Receivables Exchange, Capital Access Network, On Deck Capital, etc.)  The entrepreneurs are, logically, going where the yield is, and where the banks aren’t (there’s a Jesse James joke to be made there somewhere, but I can’t quite sort it out.)  Banks are structurally disadvantaged from entering new areas of lending because the regulators force them to take capital charges against loan types that aren’t tried and true.  This negates their cost of capital advantage.  By definition, these loan types have short histories in terms of credit performance, and are only vaguely related to existing underwriting strategies, which takes away their credit loss advantage.  They probably still have a customer acquisition advantage, but their brands work against them in the consumer categories as they are incredibly skittish about being involved with anything high rate.  Finally, while they can be low cost where they have massive scale, at low levels of scale they are horrifically high cost, given average wages and the tendency of highly regulated entities to constantly invent new “i”s to dot and “t”s to cross.

Given the structural disadvantages that face banks when they attempt to innovate in payments and lending, two areas that should be their bread and butter, is it so surprising that they pushed hard to end Glass Steagall and double down on their capital markets businesses?  I have this image of a bunch of men in grey (possibly brown) suits, sitting around a board meeting in the mid 1990s, post that credit crisis.  One of them stands up in the front of the room and says, “Right, then.  We’re facing stiff competition in all of our high margin payments business and we don’t know how to compete.  We just got our hats handed to us in mortgage, and all we can do on the lending side is pile the consumer card debt higher and deeper; we’ll do that, but it’ll only go so far.  We pushed hard into international, but lost our shirts in Latin America.  The way I see it, we can either admit defeat and become the financial equivalents of public utilities, or we can try to be like Goldman Sachs.  What’s it going to be boys?  ConEd, or the Concorde?”  In my mind, the motion to hire the lobbyists was passed unanimously and drinks were served before 5pm.

But there I go, demonizing bankers, which I promised not to do.  In fact, my image is flawed.  The meetings that caused the problems weren’t backroom meetings like that, they were shareholder meetings, way out in the open.  Bank CEOs were being pressured to grow earnings at 10%+/year, when in fact they should be expected to grow as a function of inflation and population.  Under that pressure, they behaved like human beings, which is to say they looked for ways to do the impossible.  The impossible, as it relates to the third core business of banks, is to prudently grow earnings quickly in a capital markets business.

Let’s look at this most recent JPM debacle as an example of the vise these guys are in.  First, you have to realize that these losses ($2-6B, depending on who you ask [my bet would be on or under the low end]) aren’t from one of their trading desks, which are either oriented towards taking positions to make money on them, or taking positions to facilitate a trade for a client.  The losses took place in a hedging operation, set up to manage and mitigate risk originating from other parts of the business.  There are those who claim that through mission creep, this group ended up making speculative bets way beyond their original brief.  I would submit it’s hard to know that one way or another, and that’s just the beginning of the list of things we don’t know.  We don’t know what the 1, 3 and 5 year P&L of this group looks like.  We don’t know how much profit was generated from the activities that these trades were meant to hedge against.  We still don’t know the ultimate disposition of these trades, much less what that would have looked like if JPM hadn’t been forced by the regulators to go public with their positions and forcibly unwind them.

The answers to all of these could be such that reasonable people would look upon these positions, in the context of the track record of the group and the broader business objectives, and say this was bad execution at worst, and a missed putt at the end of a great round at best.  What we do know is that even at the high end of the contemplated range, it represents less than a 5% hit to equity, and less than 30% of JPM’s annual profits in any of the last 3 years.  Bad news?  Surely.  Punishable by firing squad?  Not in my book.  But here’s the best part:  Predictable?  100%.  What is clear, beyond a shadow of a doubt, is that in capital markets (eerily like in payments or lending), the party that is less regulated is the party who will win.  The story of this bad JPM trade is one of the unregulated hedge fund wolves stalking and slaughtering a sheep wearing an electric fence shock collar.  Not a fair fight, and expecting that JPM will be a winner in similar fights in the future is laughable.

The good news, for bankers, is that there is a way forward.  There is a role, or a set of roles, for banks in all of these business that may not be exciting, high growth or particularly sexy, but can be high margin and massively defensible.  Banks should a)manage regulation and compliance; b)manage security/fraud/identity and c)steward depositor capital into risk managed pools.  Each of these roles demands a separate blog post, but suffice it to say that each is a critical infrastructure layer across the core segments of banking, and banks are uniquely situated, in terms of current regulation, technology assets, brand identity and culture, to own each layer.  By focusing on these roles and not trying to compete with nimbler foes, banks could massively reduce overhead, value at risk and operational complexity.  The banks themselves, and the bankers who work there, would go back to being perceived as pillars of the community, literally supporting the entire ecosystem of commerce.  Not entirely incidentally (at least not for me), a thousand or more entrepreneurial flowers would bloom, as businesses sprung up around the banks, fulfilling the customer facing and innovation functions that so desperately need to be filled.  I predict that companies like American Express (great at payments & brand), Capital One (great at marketing & credit risk) and Goldman Sachs (great at trading technology) would “de-bank”, and choose to partner with Citi, BofA, JPM and others, who would shed many non-core businesses.  This restructuring of the financial sector would put the US back on the path to being the global leader in this area, as well as de-risking the global economy.

And as for Jamie Dimon?  He should call me.  We can do something exciting together.  Definitely not a bank.

Job Creationism

Matt Harris —  December 15, 2011 — 5 Comments

I started my investing career doing leveraged buy-out deals at Bain Capital, working directly for Mitt Romney and his then small group of partners.  I left in 1997 to start my own venture capital firm, and part of my rationale was that I wanted to spend time creating jobs.

In the 14 years since then, I have learned many things.  Perhaps the first thing I learned is that 24 year old people shouldn’t start their own venture firms, but that’s another story.  One of the most important things I learned is that “creating jobs” is an extremely fraught concept.  As the scrutiny of Mitt’s career at Bain Capital begins to intensify, I’m reminded of my initial, naive take on this issue, and how far my thinking has come since then.  It seemed like the kind of unpopular topic that I should write a blog post about.

For the first 3 years of my venture career, until the spring of 2000, I did indeed “create jobs” right, left and center.  All of my companies were hiring anyone who had a pulse.  Fortunately, I was lucky enough to exit many of those investments before the music stopped, but by the summer of 2000, it was clear that all of us in the venture industry had created a few too many jobs, frankly.  I then spent much of the next 18 months uncreating jobs.  One of my CEOs at that time took to keeping a bottle of Jack Daniels in his desk, and at the end of each day of downsizing, we would grimly commiserate.  Bad times.

It’s actually a little strange that I was so intimately involved in all of those terminations.  Today, I probably wouldn’t be involved in firing anyone other than a CEO (god forbid) or a member of her senior staff, and then only if she wanted me there for support.  10 years ago I did more seed stage investing, and as such was more involved in the day to day details of my companies.  Even having said that, however, it still feels pretty self-aggrandizing to claim credit for “creating” any jobs.  I played a role in the maintenance of a healthy (or, a rational observer might claim, pathologically over-funded) early stage equity ecosystem, and I did my best to lend a helping hand as well.  But creating jobs?  I’m pretty sure the entrepreneurs did that, not the funders.

On a slightly more meta level, I have serious concerns about even the most rock star entrepreneur’s claim to job creation, on a net basis.  Let’s look at the newspaper industry (just in case I haven’t depressed you enough already.)  In 1990, the industry employed 460,000 people.  Today it employs 250,000, and is projected to shrink to 180,000.  The two companies who sucked all of the profits out of that business, Google and Craigslist, collectively employ about 25,000 people (Craigslist makes up 30 of that number.  Not a typo.)  So, did the heroes who founded and funded Google and Craigslist create 25,000 jobs, or did they destroy a quarter million jobs?

My point is this:  it’s all capitalism.  Bain Capital is a powerful motor in the capitalist machine, Village Ventures is a much smaller motor, but it’s the same machine.  It’s a big system that produces wealth for society in highly differential doses, and you either believe in it or you don’t.  Companies are naturally selected, if you will, through a process of vigorous competition, and there are definitely winners and losers.  You might even say that it comes down to the survival of the fittest.

I don’t side with the job creationists; I’m with Darwin on this one.