Venture capitalists reap the fintech whirlwind

The two years of ‘crazy time’ are at an end and fintechs will find less investment money floating around in the second half of 2022

Technology investing came back down to earth in the spring. A combination of a stock market rout – which has seen the tech-heavy Nasdaq Composite fall by 32% so far this year – Russia’s invasion of Ukraine, inflation that is touching 10% in some developed markets, interest-rate hikes and intimations of recession caused some venture capitalists to pause for thought and others to rediscover a sense of caution. 

Last year, venture-capital funding of fintech ballooned to $131.5 billion (£109 billion) worldwide, nearly three times the $49 billion that was invested in 2020, according to CB Insights. The consensus among investors is that this annual total is unlikely to be repeated any time soon. 

Better Tomorrow Ventures’ founding partner Sheel Mohnot said: “My gut feeling is that we’ll have less investment than in 2021.” At the recent Founders’ Forum event in Oxfordshire, he said it was clear that some investors, especially the “tourists” who had only discovered an appetite for fintech investing since 2020, have already “checked out of the market”. 

Silicon Valley-based investors Andreessen Horowitz (also known as a16z), say valuations of publicly listed fintech companies have collapsed from 25 times forward revenues in October 2021 to four times forward earnings in May, a bigger reduction than in any other tech sector. 

This has had knock-on effects for valuations in the unquoted space. Hoxton Ventures’ analyst Hussein Kanji said: “I don’t think anywhere near as much money is going to be flowing in this year as we saw last year. You have to be very vigilant about the macroeconomic picture, especially where the middle classes are getting hurt.”

He pointed out that Britain was behind the curve in recognising changed market realities. “In the US, fintech investors were getting panicky in February-March but the Europeans didn’t seem to get the memo until late May.” 

He said that as they seek alternatives to the so-called “cash burn” approach amid a tougher funding environment, some fintech companies will struggle to readjust their business models. There will be “some wreckage” in the fintech sector, said Kanji.

One consequence of the downturn is that investors are taking longer to make investment decisions. Due diligence and tyre-kicking, which until recently was only taking a couple of days, is taking several weeks, according to Mohnot. Another is that investors are shifting their focus away from customer-facing fintechs, such as neobanks – whose customer acquisition costs are often very high – and are more enthusiastic about infrastructure fintechs, which provide so-called “picks and shovels” for incumbents and other financial firms. 

Henry O’Brien, a British fintech investor and co-founder of Mural Capital said: “Venture capitalists are looking for infrastructure and capital/asset-light business models that can be scaled up fast.” 

However even infrastructure businesses will not be fully immune to the downdrafts. 

Kanji says: “Everyone’s looking at two variables: unit economics – whether the business is capable of making money – and speed of growth. If a company is growing at 400%, really lean and generating healthy margins, there will still be a queue of people wanting to invest.”

Share prices of listed fintech firms have generally fallen by 65% to 75% since their initial public offerings and, for some venture capitalists, this is a reliable proxy for the unquoted sector. 

My gut feeling is that we’ll have less investment than in 2021

O’Brien believes investors’ appetites for deals, and unlisted companies’ valuations are going to be collateral damage, though he also predicts falling valuations will precipitate a string of trade sales in the sector: “It will be worth watching for major acquisitions by global banks, insurance companies, payments companies.”

Mohnot predicts a slowdown in mergers and acquisitions activity during the second half of 2022. Regarding trade sales, he said: “The acquirers’ stock prices are depressed compared to what they were, so they don’t want to make stock-funded acquisitions and they don’t want to pay cash, since they don’t know how tough it’s going to be to raise the next incremental dollar.” 

He predicts that some overvalued companies should be able to use their overvalued stock to make acquisitions, though suspects this window is rapidly closing.

What we are seeing, says Mohnot, is a return to 2019 levels of market activity, after a 2020 to 2021 period which was, in effect, an aberration: “Due to Covid, near-zero interest rates and a bunch of other things, we had a two-year crazy time. Valuations were getting ahead of themselves and the second half of 2021 was just nuts.” 

Now he believes the market is becoming more disciplined and, indeed, normal again. “We’ve snapped back to an earlier time. Europe is a little bit behind the US in making the shift back.” 

While they are generally a negative for the sector, Mohnot also points out that higher interest rates will be beneficial for some fintech players: Mercury, a neobank in which many startups deposit the proceeds of their funding rounds, for example. 

“As a company that makes money from deposits, they’re suddenly making a lot more money than before.” 

Kanji says “the top 5% or 10% of fintech companies are still getting transactioned”, with proactive investors knocking on their doors trying to persuade them to embark in further funding rounds. 

“You would have thought that, in a recessionary market, people would be pulling back and everything would stall but, with really interesting companies, deals are still being done,” he adds.

In the long term, the customer-facing and infrastructure sectors of fintech will continue to offer attractive investment opportunities, says Mohnot. “If you step back for a moment, there’s a lot that is broken in finance. And if there’s a lot that is broken, there’s a lot of opportunity. From a macro perspective, massive changes that will be beneficial for consumers are going to come from fintech.” 

O’Brien says that, without question, fintech will remain an attractive sector. “Fintech and the need for financial services underpins so many business models,” he says, adding that 50% to 60% of investments made by Menlo Park California-based Sequoia Capital in emerging markets is being channelled into fintech. 

“When you tie in blockchain-related projects and also decentralised finance, I think fintech and all adjacencies will remain a core focus for most.”