Venture Capital Funds Remain Hungry for Fintechs

Fintech investment isn’t drying up, so much as resetting from rabid to rational. That’s the assessment of several bank-backed fintech investment funds, where interest in striking deals remains high.

“Given the reset in valuations, more disciplined cash burn in the companies we are looking at and record deal flow, it’s a great environment for us and I expect us to step up our pace of investments in 2023,” says Adam Aspes, general partner at JAM Special Opportunity Ventures.

Over the past two years, its JAM FINTOP joint venture has raised about $312 million from a network of more than 90 bank investors to put into promising fintech and blockchain technology. It has two funds with a five-year investment period, “so we are still in the very early days of deploying capital,” Aspes says.

Regulators have signaled that they’ll be scrutinizing bank-fintech partnerships more closely and reviewing how well compliance issues are addressed. That might have unsettled some venture capitalists, especially those from outside the industry who are sometimes referred to as fintech “tourists.” But Aspes is unphased.

“We have always had a thesis [that] there would be greater emphasis on fintechs being compliant with a bank’s regulated rails,” he says. “So, I don’t think our investment thesis has changed, but I think the market is definitely moving in our direction,” especially in the areas of blockchain technology and banking as a service, or BaaS.

Activity at the venture capital divisions of the largest U.S. banks has not cooled off significantly either, says Grant Easterbrook, a fintech consultant.

“While the total dollars involved may be down relative to 2021 — as firms retrench in a down market and valuations fall — I am not seeing any signs of a major pullback from fintech,” Easterbook says. “Banks know that technology continues to be both a weakness and an opportunity, and they are looking for deals.”

Carey Ransom, managing director of the BankTech Ventures fund, is on the hunt for “real solutions to real problems,” and thinks the fintech shakeout will benefit investors like him. His goal is to find fintechs that can be of value to the more than 100 community banks in his fund by advancing their digital transformation efforts in some way. So the fund isn’t just injecting capital, but helping the fintechs grow.

“We have increasing relevance in a market shift like this,” Ransom says. “We have a very clear value proposition.”

In his view, the market had gotten out of whack with all the free-flowing money over the last year. Now the focus is on more sensible valuation metrics. “Some of it is just returning back to the right valuations and fundamentals,” he says.

David Francione, managing director and head of fintech at Capstone Partners in Boston, has a similar take, pointing out that 2021 skewed perceptions in more ways than one. With the pent-up demand following the Covid-19 pandemic, “2021 was a record year by anybody’s imagination for any metric.”

He notes that investment in fintechs for this year is up compared to the years prior to 2021, so he thinks the dramatic drop-off needs to be put into perspective. “If you strip out 2021, and you look at the prior three or so years before that, this year is still a record year, relatively speaking,” Francione says.

Still, he would not be surprised if there is a lull in activity, given factors like the geopolitical environment and the threat of a recession.

“I think this year is sort of a transition year. Things are probably taking a little bit longer to finance. At least that’s what we’re seeing in some of the transactions that we’re in,” says Francione, whose firm was recently acquired by the $179 billion Huntington Bancshares in Columbus, Ohio. “I would call it more of a pause than anything.”

Like Ransom, Francione thinks the pause could benefit banks that want to partner with fintechs. Francione’s advice to fintechs is to reflect on what they can do to solve a problem that banks — or more importantly, the bank’s customers — have.

“A lot of these fintechs that we’re talking to, they think, ‘Oh, this bank could be interesting.’ But sometimes they don’t really understand why and what they can really do for them. So they really have to peel back the onion and figure out: Who are their customers? Is it a similar target market? What are some of their needs? Does our technology solution address those needs? Can they integrate easily? What is the real value that they’re going to bring to this potential bank partnership, whether the partnership is in the form of an investment or is strictly a partnership to resell some of its products?”

Ransom says he has been in meetings where fintech executives come in saying they are out to disrupt banks. Then they find out that Ransom works with banks and because they need to raise money, “mid-conversation they shift their tone to, ‘Maybe I can help banks,’” he says.

His top recommendation to fintech executives that want to work with BankTech Ventures is to understand the value their technology can provide to community banks. “If we have to explain it, they’ll lack credibility,” Ransom says.

The fintech founders who tend to be a fit for his fund — which is backed by banks ranging in size from $200 million to $20 billion in assets — are less flashy and more pragmatic. The ideal founders also have taken care to capitalize the fintech properly.

“Don’t raise $100 million for a business that’ll sell for $200 million,” Ransom says. “That’s a change we have seen — which I see as healthy.”

Those that take on too much money create a situation where the risk is no longer worth the potential return for investors. But the total amount raised is not the only concern; the types of investments can also be an issue.

He believes some fintechs take on too much “preference capital,” the outside money that gets priority for returns over common shares, which the founding executives tend to own. If the executives think they are unlikely to get paid, it misaligns incentives and creates a risk that they could decide to leave the fintech, Ransom says.

If some fintechs are in a sudden scramble to cut expenses, slow the cash burn and move from growth to profitability faster, fintech analyst Alex Johnson suggests that it is to be expected after the heady cash free-for-all that prevailed last year.

“Between 2019 and 2021, money was just too readily available. A lot of tourists — founders looking to get rich quickly and generalist VC firms sitting on massive piles of cash — wandered into fintech and screwed stuff up,” Johnson writes in a recent edition of his Fintech Takes newsletter.

A growth-over-everything mindset prevailed and a lot of bad behavior got overlooked. “One example: the alarming amount of first-party fraud that has been tolerated by neobanks in recent years,” he writes. “And now we are all suffering through the hangover.”

Should You Invest in a Venture Fund?

Community banks needing to innovate are hoping they can gain an edge — and valuable exposure — by investing in venture capital funds focused on early-stage financial technology companies.

Investing directly or indirectly in fintechs is a new undertaking for many community banks that may lack the expertise or bandwidth to take this next step toward innovation. VC funds give small banks a way to learn about emerging technologies, connect with new potential partners and even capture some of the financial upside of the investment. But is this opportunity right for all banks?

The investments can jump start “a virtuous circle” of improvements and returns, Anton Schutz, president at Mendon Capital Advisors Corp., argues in the second quarter issue of Bank Director magazine. Schutz is one of the partners behind Mendon Ventures’ BankTech Fund, which has about 40 banks invested as limited partners, according to S&P Global Market Intelligence.

If there is a return, it might not appear solely as a line item on the bank’s balance sheet, in other words. A bank that implements the technology from a fintech following a fund introduction might become more effective or productive or secure over time. The impact of these funds on bank innovation could be less of a transformation and more of an evolution — if the investments play out as predicted.

But these bets still carry drawbacks and risks. Venture capital dollars have flocked to the fintech space, pushing up valuations. In 2021, $1 out of every $5 in venture capital investments went to the fintech space, making up 21% of all investments, according to CB Insight’s Global State of Venture report for 2021. Participating in a VC fund might distract management teams from their existing digital transformation plan, and the investments could fail to produce attractive returns — or even record a loss.

Bank Director has created the following discussion guide for boards at institutions that are exploring whether to invest in venture capital funds. This list of questions is by no means exhaustive; directors and executives should engage with external resources for specific concerns and strategies that are appropriate for their bank.

1. How does venture capital investing fit into our innovation strategy?
How do we approach innovation and fintech partnerships in general? How would a fund help us innovate? Do we expect the fund to direct our innovation, or do we have a clear strategy and idea of what we need?

2. What are we trying to change?
What pain points does our institution need to solve through technology? What solutions or fintech partners have we explored on our own? Do we need help meeting potential partners from a VC fund, or can we do it through other avenues, such as partnering with an accelerator or attending conferences?

3. What fund or funds should we invest in?
What venture capital funds are raising capital from community bank investors? Who leads and advises those funds? What is their approach to due diligence? Do they have nonbank or big bank investors? What companies have they invested in, and are those companies aligned with our values? What is the capital commitment to join a fund? Should we join multiple funds?

4. What is our risk tolerance?
What other ways could we use this capital, and what would the return on investment be? How important are financial returns? What is our risk tolerance for financial losses? Is our due diligence approach sufficient, or do we need some assistance?

5. What is our bandwidth and level of commitment?
What do we want to get out of our participation in a fund? Who from our bank will participate in fund calls, meetings or conferences? Would the bank use a product from an invested fintech, and if so, who would oversee that implantation or collaboration with the fintech? Do bank employees have the bandwidth and skills to take advantage of projects or collaborations that come from the fund?

A Path to Transparency for Alternative Investments


investments-3-7-18.pngCapital has been flowing into the alternative investment industry over the past few years, with some experts predicting that money invested in private funds will reach as much as $20 trillion by 2020. Preqin, which collects data on the alternative investment industry, recently published a study stating that there are as many as 17,000 private funds open for investment.

Strong returns and opportunities for diversification have attracted high net worth and institutional investors, who can invest in exponentially larger quantities than the average investor. Though these investors come with a greater ability to deploy capital, their size and influence translate into greater expectations and hurdles to meet in order to invest.

The word that best sums-up these growing expectations and hurdles is “transparency,” and this word has become a lightning rod when it comes to alternative investments like hedge, private equity and venture funds, along with special purpose vehicles and real estate.

As alternative assets have become a more common avenue for investment, transparency has grown in importance for investors. A 2017 study titled “Alts Transparency: Finding the Right Balance” by the Economist Intelligence Unit highlights this growth. Sixty-three percent of respondents listed “degree of transparency” as “very important” for alternative investments, which was ahead of all other considerations. Another statistic showed that the importance of transparency as a key issue for private fund managers has increased almost six-fold since the 2008 financial crisis.

Breaking this down further, the issue of transparency can be separated into two different types: (1) information about the fund, and (2) information about investors’ holdings within that fund. The first type deals with greater transparency of the overall performance of the fund, which includes the underlying assets in which that fund is invested and how risk is assessed and managed. The second type deals with greater transparency relating to investor-level performance. This includes metrics like investors’ allocation and return, and how fees are calculated.

There are a few reasons why the industry has struggled to deliver this type of information:

Complexity of Private Funds
There are key differences in reporting metrics between the various types of private funds. Performance metrics shown to an investor in a more liquid fund, such as a hedge fund, should be different than those reported for less liquid vehicles, such as private equity funds. Adding to the complexity, investments in alternatives can come in the form of limited partnerships, co-investments and direct holdings.

Outdated Technologies That Trap Data
Many of the widely used technologies for portfolio and investor-level accounting were created several years ago and because they lack Application Programming Interfaces, or APIs, they cannot integrate with each other or with other systems. This effectively traps the data contained within these systems, thereby restricting its usefulness and portability. This in turn has curtailed the ability to provide transparency to investors, as it restricts or prevents the necessary type of analysis, aggregation and modern presentation of data.

Lack of Leadership and Reporting Standardization
There is a lack of uniform reporting standards within the alternative investment industry. Although an increase in regulation along with the presence of organizations like the Institutional Limited Partners Assn. have helped advance standards in private equity, there is no current reporting standard across all types of private funds. Additionally, the party that should be responsible for delivering on transparency is unclear.

Despite these hurdles, the alternative investment industry must evolve and adapt. I would argue there are two key steps the industry must take to be able to deliver on investor demands for transparency and keep new capital flowing into private funds:

Move Towards True Digital Reporting
As it stands today, much of the industry reports performance information via static documents like PDFs, but this method traps data and inhibits interaction. By embracing new technology, the industry can move toward the type of dynamic, digital presentation of data that is experienced in brokerage and personal banking accounts. For example, cloud-based technology offerings can be integrated with accounting systems to liberate the data contained within for purposes of data mining, analysis and presentation.

Fund Administrators Must Take a Stronger Leadership Role
Fund administrators are best positioned to deliver on transparency needs given their role as independent third parties. They typically subscribe to the accounting systems that house this data and therefore have access to or create much of the analysis and reporting that is needed to deliver on transparency demands.

Helping their fund manager clients with transparency is good business for fund administrators, as it improves their overall quality of service to clients. All indications point to another banner year for alternative investments in 2018. However, investor demand for transparency will only continue to grow as alternative assets become more commonplace. The industry must modernize and adapt in order to stay ahead of the curve in the race for assets.