Venture Capital and the FinTech Boom
In recent years, the Financial Technology (FinTech) sector has witnessed a massive investment boom. A key contributor to this is the inflow of Venture Capital (VC) into the industry. The application of technological innovations to FinTech has been attracting tens of billions of dollars in venture capital in recent years. Examples of FinTech innovations include digital cash transfer services in Kenya and India and peer-to-peer lending platforms in China. These services, when developed in tandem with complementary government policies and regulatory frameworks, have the potential to expand financial services to hundreds of millions of people currently lacking access and to break new ground on the way finance is conducted. This article aims to shed light on the role of VC firms in the FinTech boom, and its implications for the world of finance.
What is Venture Capital?
Over the last few years, the VC industry has grown tremendously. Today, it is one of the most popular forms of raising capital for new companies (companies with an operating history of under 2 years). Venture Capital is a type of financing and a form of private equity that investors provide to startups. Investors tend to prefer companies that are believed to have long-term growth prospects and will provide Venture Capitalists (VCs) a good return on investment. It is important to note that these startups tend to be small and in the very early stages of business. This results in increased risks for investors. Hence, investors prefer companies that stand out with extremely high growth potential. Investors are almost always rewarded for their risk with a stake in the company through independent limited partnerships. The top quartile of VC funds has reportedly averaged annual returns of 15% to 27% over the last 10 years. On the other hand, the S&P 500 Index averaged an annual return of approximately 10% over the same period. These statistics may help one understand why working at a VC tends to be a lucrative option for many finance and investment professionals.
Why is Venture Capital Important?
VC money tends to play an essential role in the second part of the innovation life cycle- when a company aims to commercialize and market its innovation. It is estimated that over 80% of the money invested through VCs goes into building the infrastructure required to grow the business.
The popularity of VC firms can be attributed primarily to the very structure and mechanisms of capital markets-startups that have been in business for a relatively short time rarely have any institution to bank on for funding. As mentioned earlier, investments in these startups tend to be risky, and hence, banks charge higher interest rates for loans. Further, banks require firms to put up collateral in case they are unable to repay these loans. However, in an increasingly digital world, very few startups possess hard assets. Investment banks and public equity also tend to work in favor of the public investor and not a startup. In general, options for financing companies with less than $10 million in revenue are scarce. The primary aim of Venture Capital is to bridge this very gap for startups, while simultaneously earning high returns on risky investments for its own participants, and to attract Private Equity (PE) funds.
Typically, investors tend to be large financial firms or wealthy private individuals. These investments make up a relatively small percentage of their portfolio, and hence, investors tend to “have a lot of latitude” with the given investment. According to a Harvard Business Review article on Venture Capital, investors almost always make investment decisions based on which industry is growing and developing at a quick pace. In other words, regardless of the talent or charisma of individual entrepreneurs, they rarely receive backing from a VC if their businesses are in low-growth market segments. What these investment flows reflect, then, is a consistent pattern of capital allocation into industries where most companies are likely to look good in the near term.
This makes it clear why Venture Capital investments are flooding the FinTech industry, which has grown at 8% from 2015 until 2019 and is expected to rapidly grow at a CAGR of up to 11% until 2030. It is important to note that VCs in these high growth markets will also always be on the lookout for exit opportunities (in order to exit and invest in a new high growth market).
By strategically exiting a now well-established company, VCs can reap extraordinary returns at relatively low risk.
Venture Capital in FinTech
Research indicates that an increase in the availability of financial support fosters entrepreneurship, thereby increasing both, the “quantity and quality of entrepreneurship”. Thus, it is no surprise that an increase in the number of startups and improvements in the larger entrepreneurship ecosystem in an economy correlates to an increase in Venture Capital firms.
Further, an increase in the availability of VC money is believed to be directly correlated with an increase in the level of FinTech related entrepreneurial activities in a country. This is due to two reasons. The first reason is due to the financing role of VC investors. They provide “smart” money that is often crucial to form and grow innovative ventures. Second, entrepreneurial expectations are reinforced by perceived VC ability. In other words, when entrepreneurs assess their chances of success in establishing new ventures before founding ventures, VC availability is expected to positively affect the decision to enter into entrepreneurship by capital-constrained, would-be entrepreneurs. However, it is important to note that VCs do employ certain criteria while choosing which countries to invest in. These criteria include, but are not limited to human capital, market demand, and regulatory practices. This may explain why VC investors are likely to avoid investing in FinTech in countries with limited FinTech entrepreneurship. With respect to human capital factors, for example, VC investors typically focus on issues such as prior entrepreneurial experience. However, most new FinTech entrepreneurs lack prior entrepreneurial experience. Therefore, a time lag will exist before entrepreneurs with industry-specific experience emerge. Countries, where FinTech entrepreneurship is already established, will most definitely see a strengthening of the relationship between the available VC in a country and FinTech entrepreneurship.
Research also shows that the relatively new FinTech wave, (where investments amounted to 12 Billion USD in 2015) is attributed to the Great Financial Crisis (GFC) of 2008. Several skilled employees at major banks left during the recession and instead began their own entrepreneurial ventures. This in turn has led to more investment opportunities for VC funds, and more demand for VC investments in the FinTech sector. Additionally, once several banks stopped lending money in 2008, firms had no option but to turn to VCs.
A recent study by the IMF shows that the market valuations of public FinTech firms have quadrupled since the global financial crisis, outperforming many other sectors. This is attributed primarily due to a lack of trust in large financial institutions. Hence, scholars are of the opinion that the upsurge in FinTech startups certainly has the ability to “break the vicious circle of distrust and reduced financial soundness”. The extent of venture capital deals in the FinTech sector can be seen as a function of the differential enforcement level of financial rules among startups and large financial institutions. Further, post the GFC, several incumbent firms came under intense scrutiny by financial regulators in various countries globally. Hence, FinTech firms that focused on alternative investments (that are outside the scope of financial regulators), have greatly benefited and become attractive investment options. Another trend that has emerged in VCs funding FinTech startups post the GFC is that of a higher number of rounds in the funding process. Among small funds, FinTech was more than twice as important relative to non-FinTech, as compared to large funds, over the 2007 to 2015 period for the number of round investments.
Today, the US leads in VC FinTech funding, followed by the UK, and Germany.
An essential contributor to the success of VCs is experience. Hence, inexperienced VCs that start during a boom period tend to over-invest in fads and subsequently face more challenges in the bust phase of the business cycle. Hence, research suggests that the FinTech investment boom is partly driven by inexperienced VCs who are merely jumping onto the bandwagon. This is also predicted to result in less successful outcomes for VCs. It is important to note that VCs focused on FinTech investments will only succeed provided that there is a sufficiently well-developed FinTech ecosystem that already exists within a country. Without a FinTech industry of sufficient scale, it is unlikely that FinTech investments will be a major component in those predetermined investment policies or that dedicated FinTech VC funds will be established. For VC investors and their fund providers, it is only economically feasible to set up dedicated FinTech VC funds when the FinTech industry is of sufficient scale in a country, which in turn, guarantees high-quality deals. To conclude, VC funding has played a key role in establishing the global FinTech ecosystem, and its importance is only expected to rise.
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