Archives For FinTech

Race to the Bottom

Matt Harris —  May 5, 2014 — 4 Comments
I don't always invest in commodity products, but when I do, I prefer not to lose all my money.

I’d like to think that the vast majority of the investments we make are in companies whose products and services are not commodities, and not subject to the brutal forces of commoditization.

In those cases, we are looking at markets where companies can win based on product differentiation, or where what they are doing is very hard and/or protected by intellectual property.  That said, the broadest definition of what we as venture capital investors do is invest in disruption, and certainly one of the vectors of disruption is through commoditization.  So while backing a company about to be commoditized is, well, stupid … backing a company that is doing the disruptive commoditizing can be exciting (despite some recent commentary to the contrary.)

Exciting, and terrifying.

Particularly terrifying if you don’t have a gameplan; without one, you may succeed at chowdering an industry’s margin structure without creating any value.  Through trial and error in this field of endeavor, I have found four general models that can work.

1. Be the lowest cost provider

One of the sneaky elements of our investment in Simple (fka BankSimple) was that, while the common perception was of a company leveraging awesome mobile-first design and zero fees to acquire and delight customers, the actual key was the ability to serve customers far more cheaply and hence more profitably than banks.  The customer acquisition stuff worked also, which was nice, but in fact the way to make money in the DDA segment (a commodity) is through disruptively low costs.

Another segment purportedly running this playbook is the “peer to peer” lending community (Merely writing that phrase makes me want to tear my hair out.  While it’s kind of delightful to imagine a multi-billion dollar hedge fund and a near-prime borrower as “peers”, it’s not exactly accurate.) I’ve seen a ton of charts detailing the “cost to serve” advantages of these companies.  My issue with this analysis is that, of the meaningful elements of the cost bar of a lending  business, at least three (cost to acquire, cost of credit losses and cost of capital) far outweigh cost to serve.

The one thing we know conclusively is that these lenders have a stratospherically higher cost of capital than their bank competitors, who leverage their nearly free deposits for liquidity.  Alternative lenders who can create durable advantages in customer acquisition and/or underwriting will create value; merely being low cost in terms of operations will not be sufficient.

2. Lock up differentiated distribution

In the relatively near future, most retail investors will have their money managed using algorithms that solve for market returns, properly allocated across asset classes, rebalanced tax efficiently and optimized for minimal fees.  This will be hideously disruptive for stockbrokers and other corrupt money managers, but will it create value for the disrupters?

There are a whole crop of new companies who are steadily building Assets Under Management using this new model.  The challenge is that the classic “cost to acquire vs. lifetime value” math is almost always upside down when you are providing a service that is, by definition, undifferentiated and focused on lower costs.  The winner(s) here will be those companies who get introduced to their customers for free, either through harnessing viral growth (has not yet happened in this category, though Robin Hood is showing signs) or figuring out a high volume channel.

3. Serve the previously unserved (and ideally previously unserveable)

Square has had a tough time in the press recently.  They have gone from a $10B IPO candidate to a lost cause/acqui-hire in a 3-4 months, on no news.  This says more about the state of financial punditry than it does about Square.

PayPal figured out something fundamental 15 years ago, which is that while most underwriting models start by saying “no”, it’s smarter to say “yes” to nearly everyone and then throttle usage on the backend.  In this way, you enable faster growth and accumulate the necessary “bads” to train your models, all the while managing losses through tightly gated credit limits.  High delinquencies, but low severity.  Square adapted this methodology to merchant underwriting, and in doing so enabled millions of merchants previously shut out of electronic payments to get in the game.  At various times in their lifecycle, they have been over-valued, but those who now dismiss them do so at their own peril.  Their recent moves, to tack back from their experiments with Starbucks and p2p remittance towards a more robust value proposition for small merchants, represent a doubling down on what made them special to begin with.

Merchant payments has never been a particularly interesting business.  Retailers fundamentally don’t care who provides their payments, and will ultimately largely view it as an embedded feature of a commerce system.  But Square’s landgrab in a previously unserved segment may provide them with sufficient escape velocity to make their optimistic investors look smart, particularly when combined with a legendary founder and a world class team.  And I’m enough of a contrarian to have their back now that the world has turned against them.

4. Change the game

This is the one in a million shot, and ultimately why most of us do what we do. Once in a career, maybe, you get a chance to back a team that is turning a commodity business into one that creates huge value for customers and for the company.

Merchant payments is a commodity?

 Well, what if you also have the cardholder information, and can disintermediate the visa/mastercard model by creating an “on us” transaction.

Remittances are a commodity?

How about turning cross-border cash transfers into cross-border commerce, and enabling immigrants to pay bills, top up mobile phones and create gift cards for free, instead of getting gouged on fees.

Factoring is a commodity that can’t scale?

What if you had comprehensive information on when the buyers would pay their bills, and could turn a risky transaction into a riskless transaction.

All of these are big bets, and none of them may pay off.  But the juice is surely worth the squeeze.

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.