Fintech: Is the Tide Turning?

There has been an explosion in the number of U.S. fintech companies in the last decade. While they vary widely, what they do have in common is that they have aimed at inefficiencies—either the tech, service or price—of existing providers. As a result, they’ve been valued highly—but the underlying assumptions driving those high valuations are starting to change, causing a shift in the overall market.

A fintech company is one that provides any new technology that seeks to improve and automate the delivery and use of financial services. These organizations proliferated due to the flexibility of developing new tech from scratch. Fintechs have the operational advantage that they don’t have to alter or replace legacy platforms. These startups also flourished as a group because they emerged at a time when capital was cheap and abundant due to low global interest rates.

Assessing the Value of Fintech Startups

These new fintechs gained attention quickly, due to their high user numbers, the way they disrupted the financial industry, and for their high valuations.

However, there has recently been a re-assessment of these valuation models. Previously, the focus was almost entirely on growth in users, while ignoring profitability—and often without a path to profitability in the medium term.

The Nasdaq IPO of Brazilian-based fintech XP Inc at the end of 2019 proved that investors are starting to re-focus on current profitability as well as future potential.

Without profits today, many investors now see an unbalanced business model: the risk being that as soon as the fintech begins to try to charge market rates, they become a target for another fintech to undercut them. This is exacerbated by the fact that customers are largely buying on price and don’t have loyalty to the specific fintechs.

XP became the world’s ninth-largest IPO of last year as investors flocked to buy nearly $2 billion of shares of a company that offers these blended attributes. XP generated $172 million in profit in the first nine months of 2019 on revenues of $910 million.

At the same time, SoftBank has been writing down the value of its technology fund, Vision, the world’s largest such venture capital fund, as its growth valuation model has stalled. In the three months prior to September 2019, the fund devalued its 80 company-strong portfolio by more than $5 billion, and further write-downs are expected.

Tech investors around the world are keenly observing these losses incurred by the world’s most famous tech investor. Vision is known for innovating the “spray and pray” approach to portfolio development: investing in multiple growth stories with the belief that you capture the leaders of tomorrow within that broad targeting strategy.

Expanding the Fintech Business Model

The success of the XP IPO is an example of another leading trend in the fintech world. A large part of the IPO funds are to be used to extend the company’s existing fintech platform (largely a digital investment and brokerage platform) into a full banking platform by offering credit to its customers.

This move to offer credit is part of a broader “re-bundling” strategy on the part of fintechs as they try to become full- (or at least fuller) service platforms. Most research by independent analysts forecasts that the key part of the financial relationship will be credit.

That’s because credit creates “stickiness” in relationships with clients. Offering credit has the potential to tie-in clients for a long time and create opportunities to develop a broad-ranging relationship that could include cross-selling other services.

While the re-emergence of credit as the primary relationship is not new in financial services, it will be unique to fintechs. Credit will also ultimately be profitable, though it will create operational challenges for smaller, niche companies.

And if fintechs begin to grow aggressively from their niches to compete with others, then that means no single niche player will be able to build margins over time to be a successful business model.

Risks to Offering Credit

The challenge for fintechs currently attempting to rebundle to offer a fuller range of financial products is that very few of them are in a position to offer credit. That's mainly due to capital constraints. Being revenue-based, they don’t have the balance sheet to offer loans to customers, because they don’t have deposits to use as funding.

Despite the rapid growth of digital banking, the vast majority of new fintech accounts are secondary accounts, with most customers opening digital accounts to be able to use free payments or access offers but still retain checking relationships with physical banks. These fintechs also can’t compete with incumbents for the cost of funds in the capital markets.

Even if fintechs can solve for the high cost of funds, other structural issues could frustrate the credit strategy. For example, offering credit would take the fintech into a new and more onerous regulatory world—and one that would add significant regulatory compliance costs.

Fintechs would also need to develop the internal processes and expertise to offer credit. That would be challenged by the fact that new digital banks face the "adverse selection" problem: much of the initial demand for credit would be from individuals and companies that aren’t serviced by the traditional banks and would therefore likely be a risky credit segment.

The Winners of Tomorrow?

Following the fragmentation of the financial services market by fintechs, a new category of “superapps” are starting to emerge—leading to rationalization of individual fintechs (as they merge, are bought, or disappear).

The role of credit will likely determine the success of those apps—and that gives banks, a natural provider of credit, the advantage in the next stage of market development. This could mean that banks how had a hard time in the past decade—as fintechs attacked banks’ niches and eroded banks profitability—could ultimately emerge as winners. The pendulum is now swinging back their way as fintechs struggle to add the breadth and scale that is needed to build profitable business models.

Banks that have invested in digitization are now seeing the market come back to them. The industry will likely look significantly different in five years, as fintechs grapple with the reversal of the trend to fragmentation and the focus of all players becomes breadth, depth and—yes—profitability.