What’s next for investment in tech?
By Daniel Domberger, partner, Livingstone
Circumstances conspired to make 2019 a challenging year for private equity. But it could prove a pivotal one for the industry and the fintech start-ups relying on its investment.
While overall private equity (PE) investment levels remained high, and in some sectors made up for a reduction in international buyers acquiring UK businesses, activity slowed in two distinct periods during the year.
The first was early in the year in the run up to the original March 29 Brexit deadline, the first date on which the UK was due to leave the EU. Investment in UK firms in the first quarter slowed in comparison to the end of 2018, to the previous year and in comparison, to other regions, such as the US (not altogether free of political upheaval), which saw less of a decline.
With uncertainty over the length of the extension continuing into April, activity in the second quarter was also subdued. Furthermore, no sooner had it begun to recover than the UK was faced with the election. Again, many investors and funds are left sitting on their hands.
Given the significant implications of the UK departing from the EU without a deal or a change of government, this is perhaps not surprising. But it is worth noting two points.
The first is that domestic political risk is back in a big way as far as investors are concerned. After more than a decade in which the political climate has been broadly favourable for private equity, political uncertainty is having a marked effect on activity, and investors are increasingly open about saying so.
Secondly, for fintech in particular, uncertainty over future regulations – and even which regulatory regime might be expected to apply – makes it harder for PE investors to back earlier-stage disruptive businesses. This means investors in 2020 are likely to focus on businesses with more established platforms and less grandiose ambitions. For example, established fintech businesses (not necessarily profitable) will be more attractive than disruptive startups. Those seeking capital for international expansion are more likely to find it if they are seeking a complementary pillar for an established domestic platform (perhaps as a Brexit hedge), rather than rushing to conquer all the white space at once.
Political uncertainty, therefore, looks likely to be, if not a continuing, then at least a recurring issue for PE investors in future and is likely to favour more developed fintech players. For the UK and London fintech sector overall, meanwhile, its status as the hottest European fintech start-up scene may be under threat from the likes of Paris if the uncertainty persists.
Growth v. profit – the pendulum
Together with political uncertainty, there is one other big trend we saw in 2019 that will have consequences for the future for fintech, too: the shift away from revenue growth at any cost, towards a greater focus on underlying profitability and the path to an ultimate exit.
A number of big financial investors and particularly venture capital (VC) funds have invested massive amounts of money to grow firms that carry big overheads, on the basis that they will be extremely profitable at scale. The model has now proved extremely successful for a generation of companies initially highly-valued on a revenue multiple basis, and which have now ‘grown into’ those valuations which can be supported on the basis of their profitability too.
Nevertheless, lessons learned along the way are encouraging investors to refine the concept. The model works well for software, for example, with extremely high margins and low costs of delivery. For a number of other businesses, however, which leverage technology but are, in reality, more traditional in terms of their cost profiles and margins, the model has faltered: Overheads grow along with the business or the margins mean a profitable scale may be out of reach.
In the past, many of these “technology-enabled” businesses have been able to style themselves as tech companies and achieve much higher valuations than traditional businesses that, in truth, they closely resemble. That’s as true in fintech as elsewhere. PE investors, however, are keener now to avoid these category errors.
In practice, the strength of the London fintech market, the continuing innovation and the appetite of many financial investors for the sector, and entrepreneurs’ search for growth funding means we will continue to see deals done and significant successes. But we are likely to see two things as well.
First, greater discernment from financial investors when it comes to evaluating businesses and greater scrutiny of whether they really are technology platforms, are genuinely “tech-enabled,” or are just deploying commodity tech to run traditional businesses.
Second, an increased skepticism that headline growth is enough, and greater focus on underlying unit economics and the path to profitability and exit. This means we’re likely to see some fintech firms re-evaluating the costs and benefits of public and private ownership.