Impact of COVID-19 on M&A activity in the fintech space
When COVID-19 forced us into lockdown I was asked for a comment on the outlook for funding for fintech and I could be forgiven for claiming my view at the time has been proven – that fintech funding or acquisition interest would all but stop for all but the highest quality opportunities.
I feel somewhat differently now and having lived through the COVID crisis for over five months, it is a good opportunity to reassess.
At the time I contended for any professional investor or those with a mandate to execute an inorganic growth strategy, writing an investment cheque or agreeing to a sales and purchase agreement (SPA) represents a good day in the office. So, it would not be for the want of trying that investment activity could slow down.
However, the practical realities of getting deals done is very different. At the highest level, getting to the point at which cash (or other securities) changes hands requires a four step process: i) engage with a company and build a relationship with the management team, ii) agree a three-to-five year business plan, iii) ascribe a value to said business plan, and iv) conduct a due diligence exercise and complete customary closing mechanics.
I had argued that as great as Zoom is, building the basis for a long-term relationship via video was challenging (call me old fashioned). Furthermore, while there are certainly some snazzy slides decks and whizzy financial models going around most executive teams right now, getting clarity and alignment on a medium-term business plan from both the demand and resource perspective was near on impossible. Then, gaining sufficient conviction to ascribe an appropriate value to that business plan which both buyer and seller are happy with – well good luck with that. As a result, the investment landscape would grind to a halt. And, if you evaluated the investment activity so far in 2020 this is the picture that has emerged.
Figures published in August 2020 by Innovate Finance, for the UK market, suggest fintech funding by value dropped by around 40% in H1 2020 vs. H1 2019. And the majority of that funding went to just five companies: Revolut, Checkout, Starling, Onfido, and Thought Machine – a flight to perceived quality.
FT Partners reported, on a global basis, that mergers and acquisitions (M&A) volume in Q2 2020 was the lowest quarterly volume since Q2 2013. However, extrapolating from these few early data points would, in my now revised view, be overly conservative and does not reflect the opportunities emerging across a number of fintech categories.
Reassessing why we are where we are, I now feel the aforementioned dynamic represents a momentary pause while the wider community took a very deep breath and watched if we would enter a downward spiral of doom toward a full-blown financial crisis.
To begin to think through the implications on the investment and M&A activity in the fintech space I have found it helpful to think about what the COVID crisis is and is not, and what fintech is and is not.
This provides insight into the temporal effects of the crisis overlaid on the underlying drivers of fintech. Not to trivialise the intricacies of the COVID crisis or the different speeds at which individual countries are responding but I have viewed the COVID crisis on a spectrum from health crisis on the far left, to economic crisis in the middle, and financial crisis on the far right. To add to that I see fintech as a spectrum from “traditional” financial services with a smattering of technology on one end, to enterprise technology selling to financial institutions on the other.
The further we progress from left to right on the COVID spectrum and the closer you sit on the “traditional end” of fintech the more challenging an environment one could face. On all dimensions: commercial, operational, and financial, challenges lie ahead. Strategic acquirers will likely have balance sheet issues of their own so cash funded acquisitions are out, the capital markets will de facto be shut, so debt funding acquisitions is highly unlikely which incidentally also takes out your private equity (PE) buyers (although historically PE buyers of fintech have been only around 10% by volume, according to FT Partners).
We could see stock transactions trying to square that circle, but this is unlikely to be viable in many cases. Similarly, the valuation correction is unlikely to attract anyone other than the most value orientated investor which will not do much to boost volumes. In the not so severe version of this scenario but when prevailing rates remain low, the continued compression of core banking profitability could lead to the search for alternative revenue lines (e.g. subscription or premium services). Acquiring to speed up the time it takes to “go-to-market” could be on the table.
If we arrive wholesale at the other end of the spectrum and escape relatively unscathed economically and you sell enterprise technology to financial services, you will likely be in for a near term bumper period. The very seductive narrative of “digital acceleration” is actually playing out, we have seen sales cycles shorten and there is much less browsing in the aisles – buyers mean business.
This type of growth agenda is likely to attract investment interest as funds look to deploy the oodles of dry powder on the books. Also, from an M&A perspective the “capability” add-on strategy will see renewed focus as incumbents and roll-ups look for upsell and cross sell opportunities to their existing customer bases.
In the middle, the grey area, is where many question marks remain. Businesses that have raised money at the top end of valuations, or those that favoured a “build it now and monetise it later” approach, or those business models directly exposed to consumer or small and medium-sized (SME) credit (as just one example) may very well find the investment and buyout audiences less receptive.
This last category in particular is a nice articulation of how legacy technology just can’t handle a societal or economic shock – in this context lenders which rely of static data packets or thin credit files to assess credit worthiness just can’t evaluate the impact of furlough or mortgage holidays – it simply doesn’t work at scale. Many insurance verticals suffer a similar shortcoming. The contingent in contingent liability just became a guess! One way or another, investors have repriced their capital in this middle ground
Overall though, the mood is lightening. The market is pricing a more positive outlook for banks globally, with most banks’ price-to-book now trading above even pre-COVID levels (December 2019). Some North American banks have enjoyed 50% growth in this multiple while more than 20% growth over the same period for European banks has not been uncommon.
If market volatility is an indicator of M&A appetite (which it is) the indicators also suggest a more positive landscape. The VIX (the ticker symbol and the popular name for the Chicago Board Options Exchange’s CBOE Volatility Index) has settled down to a 25-35 range, which while elevated from a historic range around the mid-teens, is a welcome retreat from the 50-70 range during “peak” COVID. Reflecting this, investors are back out there reviewing business plans and evaluating assets again willing to do the work to deploy capital. Deals are moving through the funnel again, and transactions are being concluded.
In summary, relative to five months ago when the investment activity trajectory was very much down, it does now feel that directionally we are pointing up. As to the gradient of that trajectory or the pace with which we move in that direction, we will have to see.