FinTech companies can be classified as- a) debt funding platforms, b) equity funding platforms, c) wealth management platforms, d) payment processing solutions and e) others. In this note we discuss only the Debt Funding FinTechs. Debt Funding FinTechs use technology and ‘big data’ to provide faster, cheaper and higher debt financing to those businesses that are either not covered, or partially covered, by traditional banks. They do this by a) automating credit evaluation data collection, and/or b) using new data streams to develop more sophisticated picture of business’ repayment capability. Based on risk ownership, they can be categorized as a) Balance sheet lenders, b) matchmaking marketplaces, c) hybrid models.
The three foundational pillars of success of a business lending venture are – a) cost of borrowing money for further lending, b) incremental cost of acquiring new customers and c) cost of loan processing. Established banks and NBFCs can borrow money cheaper than FinTech start-ups. This puts these FinTechs at a disadvantage. Established banks and large NBFCs also have on-ground footprint and relationships which can be leveraged to add new target segments at low incremental costs. Standalone FinTechs need to devise non-traditional customer acquisition approaches, like using digital marketing strategies and possibly using existing networks of loan syndicators as virtual franchisees. FinTech start-ups can also bypass many human and infrastructure costs of banks by using tech solutions that are cheaper, faster and more reliable for operational efficiency.
Key to sustainable growth for Debt Funding FinTech start-ups lies in obsessive customer orientation. This means – a) product structured to serve the client’s specific needs, targeting specific market verticals, b) providing an outstanding User Experience using best in class UI-UX resources, and c) ensuring a human touch by extending client engagement beyond the electronic screens.
Top four questions that the investors should ask while evaluating Debt Funding FinTechs are – a) Is the start-up just automating data collection or has it developed a proprietary non-conventional credit risk evaluation methodology? b) Does it fit seamlessly into the normal flow of client’s business transactions? c) How is the business model structured to minimize default / late-payment risk? (Virtual-factoring type of arrangements work best), d) Is it a one man / few men show or is there an org structure with institutionalized processes?
By using combination of competition and cooperation strategies, and promoting both intrapreneurial ventures and in-house product developments across functions, banks are fighting back the FinTech start-ups. They will provide tough competition to these start-ups very soon.
FinTech, FinTech everywhere… but what does it mean?
You know something is overhyped when your taxi driver and your barber start talking about it. FinTech is not there yet… but the number of times the phrase ‘we are a FinTech company’ is used these days, does give one a moment of pause.
FinTech is many things to many people. Broadly FinTech companies can be classified into the following Categories –
a. Debt Funding Platforms– online platforms for small businesses and entrepreneurs to access loans. E.g.- Lending Club, OnDeck, GroupLend, Kiva, closer to home – Capital Float, Neogrowth, Indifi, IndiaLends, Rangde
b. Equity Funding Platforms– online platforms for crowd-sourcing of equity investments in start-ups and early stage businesses. E.g. – Fundersclub, Globevestor
c. Wealth Management Platforms– technology driven solutions for automated wealth management recommendations. E.g. – Wealthfront, Betterment, Intelligent Portfolios
d. Payment Processing solutions– products for simplifying and/or automating various steps of the payment / cash flow value chains. E.g. – Currency Cloud, Square, Tipalti, Flint, Check, Zipmark, Stripe , Astropay, WePay
e. Others – BillGuard (personal finance tracking and fraud monitoring), BankingUp (virtual banking) etc
And then there is the whole ecosystem of virtual currencies and mobile wallets and the platforms built around them. Each one these categories has a world of depth in its own right. In this note we touch upon only the Debt Funding FinTechs.
Debt Funding FinTechs – Shylock, the moneylender, didn’t see this coming
Depending on how broadly you define this space, the estimates for unserved / underserved small business lending market opportunity in India vary from tens of billions to hundreds of billions of Dollars. We can leave the exact calculations to the academics and consultants; but irrespective of the exact numbers, anyone with some field experience will tell you that the opportunity is huge!
Debt Funding FinTechs use technology and ‘big data’ (another over-used term) to provide faster, cheaper and higher debt financing to those businesses that are either not covered, or partially covered, by traditional banking channels. So a business that had to resort to local money-lenders to get a loan, and who in return demanded their due pound of flesh in the form of 20% to 25% (or even higher) interest, can now reach out to these Debt Funding FinTechs and get a lower cost loan… that too with minimal paperwork, and in most cases without any collateral.
Debt Funding FinTechs solve the problem of providing faster, cheaper and higher credit to businesses by –
a. Automating credit evaluation data collection by accessing it directly from the backend systems – e.g. bank account statements, credit ratings, sales / order flow data, sales / income tax returns; and / or
b. Using new data streams to develop more sophisticated picture of business’ repayment capability – e.g. data from PoS swipe machines, ERP data of anchor client linked vendors / distributors, e-commerce sales data, credit card receivables data, social profiling etc.
Within the larger domain of Debt Funding / Business Lending platforms, the platforms that match individual people having some extra cash to invest in an alternate asset class with small entrepreneurs who need cash to grow their businesses are called P2P lending platforms. However today >80% of funds on P2P lending platforms also originate from institutional sources. So for all practical purposes, institutional money dominates the sourcing side of the equation on all Debt Funding platforms. The exception to this general rule being some social lending platforms (e.g. kiva, rangde), but they cater to a narrowly defined segment of micro-entrepreneurs with very small ticket sizes and serve a specific social impact purpose. These FinTechs don’t fall in the category of massively scalable, potential unicorn opportunity. So we don’t discuss them here.
From the perspective of risk ownership, Debt Funding FinTechs can be categorized as –
a. Balance Sheet Lending – the FinTech borrows at X% from other sources (institutional money) and then lends at (X + Y)% to businesses. The risk of default is owned by the FinTech.
b. Matchmaking Marketplaces – The FinTech creates the credit risk dashboards of potential borrowers and makes them visible to potential lenders (usually banks / NBFCs), who can chose to lend the money. The default risk is owned by the lenders.
c. Hybrid models – There are many formats of hybrid platforms that lay somewhere in between the above two models. There are some risk sharing models in which the platform assumes a part of the default risk and puts its own skin in the game to demonstrate its confidence in its own risk modelling methodology, thus projecting confidence to other participating lenders as well. Then there are preferred partnership models in which the ‘premium partners’ get first choice of potential borrowers before the same are made visible to wider set of participating lenders.
A smart algorithm does not a FinTech maketh….
Let’s keep the hype around the term ‘FinTech’ aside for a moment. The 3 foundational pillars of a Business Lending venture are –
a. Cost of borrowing money for further lending
b. Cost of acquiring new customers (more specifically – incremental cost of acquiring new customers)
c. Cost of loan processing
Let’s pick these up one by one-
a. Cost of borrowing money –
Just as a large established business with past track record finds it cheaper to borrow money, so do established banks and large NBFCs find is cheaper to borrow money than new stand-alone FinTech start-ups. Large incumbent NBFCs have a 2% to 4% advantage in cost of accessing funds over new stand-alone FinTechs in this space. This gap increases further when comparing stand alone FinTechs with established banks, who have access to low cost deposits by individuals and businesses in the current / savings accounts. That puts standalone FinTech companies at a significant cost disadvantage when it comes to long term sustainability. There isn’t much that a start-up FinTech can do about it in the early critical years of its lifecycle, so we can park this point on the side for the time being.
b. Incremental cost of acquiring new customers –
Established banks and large NBFCs have a large on-ground footprint and relationships across industries which, if used smartly, can be leveraged to add new target segments at low incremental costs. E.g. a technology savvy bank having an ongoing relationship with a large auto-parts OEM manufacturer can leverage that relationship to extend anchor-client linked working capital facilities to the OEM’s small sub-vendors. Similarly a bank providing current / saving account facilities to small business owners can start cross-selling business working capital loans to these existing customers. This captive user base is easy to tap into and comparatively easy to convert.
Stand alone FinTechs that do not have existing relationships in the market and that do not provide a large array of financial services for cross-selling opportunities, need to devise low cost non-traditional customer acquisition approaches. E.g. a digital marketing strategy by using a combination of a small in-house team complemented by a good outsourced digital marketing agency can be used to reach out to the target segment. Once the customer is acquired, on-boarding has to be as smooth and paperless as possible to minimize the on-ground coordination and logistics costs that traditional banks have to bear.
Another possible approach of customer acquisition can be co-opting networks of loan syndicators (usually run by local CAs and ex-bankers) by addressing their pain areas – high rate of client attrition and manpower intensive non-scalable business models. By incorporating modules addressing their pain areas into the Debt Funding Platform product, these loan syndicators can be used as the Platform’s franchisees / brand ambassadors for customer acquisition.
c. Cost of loan processing –
Banks employ costly human resources for document processing, risk evaluation and loan disbursal processes. On top of that, there is the heavy fixed infrastructure cost of impressive looking bank branches spread across the country to maintain physical contact with clients. FinTech start-ups bypass most of these costs by using smart technology solutions. Loan applications can be made online wherein only a few basic details are asked. Rest of the requisite data is pulled directly from the backend through system level integrations, or atleast through ‘pseudo – automation’ in which some low cost employee in the backend office manually copies some of the relevant data from one system onto FinTech’s database. Accessing relevant data directly from systems has three advantages –
i. It’s faster – no need for physical documents to be prepared, attested and sent to bank branch / backend processing centres.
ii. It’s dependable – tougher to fudge system data then to fudge physical documents, especially if it resides on third party systems.
iii. It’s cost effective – system based data integration saves on a lot of manual processing time and cost.
This data is then processed by smart algorithms that create easy-to-read dashboards along with approval recommendations. Human intervention is minimized, and even eliminated, in this process.
Rome wasn’t built in a day, but it was built to last for centuries
Well, no one really thinks in terms of centuries, or even decades anymore, but you have got to grow and prosper at least till a proper high value exit.
The key to sustainable growth for Debt Funding FinTech start-ups is obsessive customer orientation (here comes another over-used and abused phrase). Small businesses have always got the ‘step-child’ treatment from banks. So if you meet someone who’s never been treated too well and shower them with some TLC (Tender Loving Care), then they are going to remember you for a long time, even when new suitors come along. In times to come not just incumbent banks and large NBFCs will start using FinTech to increase their reach to these unserved/ underserved business, the newly licensed Small Finance Banks (10 entities recently licensed by RBI) will aggressively reach out to these segments using technology solutions. So if you want to grow and sustain in this business then you got to be obsessed with customer experience.
Some elements of customer orientation for these start-ups while dealing with their clients are –
a. Product designed to serve the client’s specific needs –
Successful Debt Funding FinTechs will need to take vertical approach to market segmentation. The balance sheet and monthly cash flow of an e-commerce apparel seller, an auto-parts manufacturer, a travel agent, an Ola affiliate driver, a Mother Diary vendor, a petrol pump franchisee and a grocery shop owner are very different from each other. The go-to-market, client on-boarding, loan processing, repayment cycle and client servicing approaches need to be tailored to the needs of each of these separately. Even the risk evaluation algorithms for each of these have to be altered to incorporate the nuances of the respective market segments.
That involves taking some tough trade-off decisions – prioritizing some segments over the others and proactively investing resources into those whole-heartedly. As someone once said – ‘Strategy is not about deciding what to do but deciding what not to do’.
b. An outstanding User Experience –
Tech related start-ups are often led by engineers who put a more weightage on ‘hard aspects’ (solving the engineering problem) and less weightage on the soft aspects of UI – UX design. However we live in a human world where the clients are humans, not machines. A Product Manager working in conjunction with a good UI-UX design agency should put a lot of thought and scientific principles into the flow of action events on the product, the number of clicks for task completion, type and placement of content, the colours and fonts, the type of actions (click /swipe/rotate/tilt) etc. The investment in best in class UI-UX design agencies pays back many times. In a chaotic world where we are surrounded by randomness all around, a well thought-out and beautifully designed product with intuitive design can seduce people into spending more time with it. And as we all know, more time often translates into more trust and more trust often translates into more business.
An example of impact of UI-UX design is the match-making app Tinder. Tinder did not have the largest database of potential matches to start with, but it did give you the smoothest match search experience. You swipe left or your swipe right, and if you are interested then you can see only the details that are most relevant for your decision making, and nothing else. There is zero clutter. The product is also designed to minimise the data entry effort from the user… relevant data is picked up from your Facebook profile. As a result Tinder is what it is today… no other competitor comes even close to its market dominance.
c. Bringing in the human touch – Debt Funding start-ups need to remember one principle above all else – they are playing in the finance business, not technology business. To survive in this business you can use technology as an enabler but you have to treat human relationships as the paramount basic hygiene factor. The FinTech – Client relationship must exist beyond the screen of a laptop or the mobile phone. This doesn’t necessarily mean deploying large numbers of expensive Relationship Managers across all geographies and client segments. But this does mean investing in CRM tools and other technology resources (e.g. live chat) backing up the suitably hired sales people. Do not make the mistake of saving costs by trying to fully automate the entire business lending life-cycle and removing all human touch.
Investor’s dilemma – separating the wheat from the chaff
With the number of start-ups popping up in this space, consolidation is bound to happen sooner rather than later. But those who get it right in this first phase are going to reap rich rewards… Some through sell offs to strategic buyers and others through massive scale ups on their own. The stakes are high indeed.
Top four questions that the investors should ask while evaluating Debt Funding FinTechs are –
a. IP for Credit Risk Evaluation Methodology – Is the start-up just automating the collection of data used in traditional credit risk approaches or has it developed proprietary credit risk evaluating approaches using non-conventional data streams? If the start-up is just automating the conventional data collection then that is very easy to replicate by anyone else, including large banks and established NBFCs.
b. User Experience – Is it a technically brilliant product designed ‘by the engineers for the engineers’ or does it fit seamlessly into client’s normal flow of human business interactions? E.g. does the product demand potential loan applicant to change his regular business practice so that you get additional required data in the system? Does it provide for user friendly modes of engagement beyond the electronic screen? Is the business oriented towards just customer acquisition or does it provide in-built lifecycle relationship management support?
c. Business model Risk – How is the business model structured to minimize default / late-payment risk? Micro-finance experience from a few years back should serve as a good reminder of how borrowers can start gaming the system. The best platforms are those which are directly hooked into the cash flow channels as well. These structures work somewhat like virtual factoring mechanisms, wherein the borrower authorizes the lender to take future receivables directly from a third party, thus avoiding the need for the lender to follow-up with the borrower for repayments. In absence of these direct repayment structures, incidences of delays in payments by borrowers can provide a fatal blow to start-up FinTech ventures with limited cash kitty.
d. Team and org structure – Is it a one man / few men show or is there an org structure with institutionalized processes? When you are dealing with money as your prime commodity of business then you must have strong inbuilt checks and balances in the system. Sooner or later we can expect more regulatory oversight to come onto this sector. So it’s best to back those start-ups that understand this element to start with.
Considering that the large banks (and established NBFCs) have an advantage w.r.t. cost of funds and incremental cost of acquiring new customers, without a strong IP protected technology and other non–easily replicable USPs, it is going to be difficult for stand-alone start-ups in this space to survive.
The Empire strikes back
In theory, established banks and large NBFCs could replicate all that the FinTech start-ups do. But banks, like all large corporations, have legacy systems and processes. Any change in the same requires overcoming huge amount of internal friction and top-down commitment from some bold risk taking leaders. As management theory tells us, for a decision making manager in a large organization the cost of doing nothing is often lower than the cost of failing in a risky initiative… so more often than not managers resist change. That explains why so many FinTech start-ups have jumped into this space while banks have been slow to respond. This does not mean that established banks will not adapt to this new world of FinTech reality. In one of the FinTech events in San Francisco, Xignite Inc. CEO, Stephane Dubois mentioned in passing, “All banks have started considering themselves as tech companies.” By using smart combination of competition and cooperation strategies, and promoting both in-house intrapreneurial ventures and closely integrated product developments across respective functions, banks are beginning to ride the FinTech wave. As an indicator of that just think about all those ‘pre-approved loan’, ‘five minute loan approval’ calls, SMSes and emails that all of us get these days. But that’s a topic to be discussed at another time.
Rantej Singh has 14 years of experience in strategy, innovation and product management in large financial institutions and startups. He has founded/co-founded two high-impact businesses and angel-invested in a few more. Prior to his role as vice president of strategy and innovation at RML ISPL, a Thomson Reuters-incubated venture that was spun off using VC funding in 2013, he has worked with organizations like Bank of America Merrill Lynch, ICICI and GMG S.A. He is an MBA from IMD – Switzerland and is a co-author of ‘Practitioners Book on Trade Finance’, the recommended course book at Indian Institute of Banking and Finance for training both public and private sector bankers.