With tighter lending standards and increased regulations in the wake of the financial crisis, traditional banks are often unwilling or unable to lend to their riskier individual or small business customers. Alternative financing solutions from fintech companies have stepped in to fill the void. Two of the main fintech categories are peer-to-peer lending and crowdfunding. The Financial Times reports that peer-to-peer and crowdfunding sites grew an astounding 84% year over year.1 And there’s no sign of slowing. Warren Mead of KPMG posits that 2016 is the year “alternative financial options finally join the ranks of the mainstream”.2 Further, Morgan Stanley estimates the alternative finance industry could grow to $490 billion by 2020.3
Many ‘peer-to-peer lending’ companies serve individuals that might not normally qualify for a loan through traditional channels. With traditional banks seemingly doing everything possible to deter depositors, there is substantial pent-up demand by investors to earn decent returns on their capital. Popular Peer-to-Peer lending sites have sprung up including Funding Circle and Prosper Marketplace.
In startup or peer-to-peer lending, rates of return can be substantially higher.
Since 2009, average net returns have ranged between 5% and 9%, considerably higher than comparable US Treasuries or AAA investment grade bonds.4 As it turns out, banks now account for one quarter of lending on peer-to-peer sites.5
Crowdfunding has gained traction by taking out the middleman so investors can directly fund companies or projects they choose without having to pay investment fees to a fund. Conversely, startups needing capital don’t have to explore the costly venture capital or investment banking routes if they can cheaply find investors through crowdfunding sites like Kickstarter and Indiegogo.
But sometimes startups are very resistant to giving up equity stakes. After all, the founders have put their blood sweat and tears into these projects and are resistant to part with too much personal ownership. This battle is waged frequently on the popular television show ‘Shark Tank’. Startups can also choose to access crowdfunded debt (similar to peer-to-peer lending but for businesses-often in the real estate area). Sometimes, private equity funds come in and can split the difference by providing an investment in exchange for debt that is later convertible into equity.
If You Can’t Beat Them, Join Them
As Fintechs continue to chip away at bank’s core businesses such as lending and capital raising, banks are forced to deal with the threat. Bank-tech partnerships are increasing as banks adapt and pursue more symbiotic relationship with Fintech challengers. Deutsche Bank’s Chief Data Officer echoed this sentiment, “It’s not the institution verses the startup anymore; it’s how to partner”.6 Bankers have the knowledge and resources, but not always the technological savvy for the next generation of services.
For example, big banks often find it inefficient to initiate smaller sized loans to individuals and small businesses. But Fintech startups can automate and streamline this process, helping big banks address an underserved area. Banks can even earn referral fees on smaller loans they have no interest in holding on their books. We’ve seen several big banks already move into partnerships, notably Royal Bank of Scotland partnering with Funding Circle and JP Morgan with OnDeck Capital.7
If You Still Can’t Beat Them, Buy Them
For large, less nimble financial institutions, it may make more sense to deter the threat by simply acquiring the disruptor. It may also be more profitable. While most financial M&A acquisitions target a similar financial competitor, banks might consider acquiring technology companies that can complement their businesses. According to A.T. Kearney, a technology company that automates back-office functions for financial institutions share price outperformance was enhanced 10-15% following a financial services firm’s acquisition of a tech company.8
Compare this to just a 4%-6% average when acquiring another financial services company. This demonstrates that technology is driving profitability for banks and their shareholders.
Examples of big banks that decided it was simpler to purchase a Fintech challenger was Citibank, who acquired money transfer service company PayQuik.com, US Bank buying prepaid card processor FSV Payments and Barclay’s purchase of software services and marketer Analog Analytics.9
Other banks just buying stakes in these Fintech startups, such as ING, Scotiabank and Grupo Santander who participated in an early financing round for small business online lender Kabbage.10
If You Still Can’t Beat Them, Become Them
Forget the image of the teenage tech geek in their garage, the next generation of Fintech startups are being created from banking alum. Some crowdfunding sites, such as OpenEnergy, offer financing that is “backed by Wall Street expertise.”11
Open Energy is a fintech startup founded and run by Wall Street or High Street finance professionals, that focuses on alternative energy solutions including solar. It is financed by GLI Finance Limited, which provides alternative financing solutions to small and medium enterprises (SMEs). Open Energy’s senior management team is comprised of alum from Chase Bank and Dresdner Bank.12
But it’s not just management that is providing the bridge, the Board of Directors for Fintech companies are increasingly represented by professionals with impressive traditional financing careers. GLI Finance’s board has alum from Australia’s Macquarie Bank, KMPG and Morgan Grenfell.13
Equity Research Crowdfunding
Lastly, an interesting new Fintech trend is crowdfunded equity research. Sites such as SumZero and Stockviews have sprung up to challenge the notion that high-quality research needs to be done by analysts from deep-pocketed, sell-side banks. SumZero helps smaller, aspiring hedge funds raise money by facilitating capital introductions.
Managers create a profile and can display their firm’s research on SumZero’s website where institutional investors can conduct due diligence and look for the next great, unknown manager. Even for hedge funds, it’s not always easy to raise money.
Smaller funds find it difficult to raise capital without a long track record of performance, a brand name or the right manager pedigree. This isn’t because the managers aren’t capable, it’s more because the institutional investor, whether an endowment, family office or insurance company wants to be able to invest where some street cred has already been established.
If a no-name fund blows up and the investment goes sour, that person that committed the capital may be looking for another job. Institutional investors often find it simply too risky to invest in smaller, unknown funds.
Despite their risky reputations, investing in smaller hedge funds can be a positive. They can be more nimble and often generate more alpha (risk-adjusted returns). Large fund managers often miss out on opportunities in the small or micro-cap sector. Buying a stake in a small company becomes difficult without moving the stock before a sizeable position can be completed.
Institutions can also negotiate better terms on their investments with smaller funds, often widdling down the traditional ‘2&20’ fee structure (2% of assets under management and 20% of profits). When a fund becomes so big, it can become a victim of its own successes. Hedge funds with $100 million or more must register with the SEC. In the future, they could be designated as too big to fail institutions, which could curtail their risk-taking.
An obscure Houston-based hedge fund named Bison Interests was able to land a $20 million investment from an endowment off SumZero’s platform.14 The fund’s manager, a relatively unknown 32-year old named Joshua Young, would have normally had to go through the traditional channels of capital introduction, a slow and tightly controlled process that normally takes months or even years.
The takeaway is that finance professionals shouldn’t be overly concerned with Fintech startups taking down big banks. Banks may actually increase hiring for professionals that can help bridge the gap between the traditional banking and technology sides of the business.