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2017 VC FinTech Investment Landscape: An Investor View

By Sophie Winwood, Head of Partnerships, Innovate Finance

A report produced by Innovate Finance, in collaboration with PitchBook, found that the UK had its best year on record for VC investment into FinTech in 2017 and was a global leader in terms of capital invested and deal volume, second only to the US.

I spoke to leading FinTech VCs about their take on why we’ve had such a bumper year, the verticals they are interested in, which wider macro trends and external factors are most likely to affect the industry and exit environment, and how they see the future of FinTech shaping up over the next five years.

With special thanks for engaging with me:

  • Alex MacPherson, Partner – Octopus Ventures
  • Alston Zecha, Director – Eight Roads
  • Andrei Brasoveanu, Principal – Accel
  • Dan Bailey, Investment Manager – MMC Ventures
  • Gareth Jefferies, Investment Manager – Northzone
  • Mark Beeston, Partner – Illuminate Financial
  • Rob Moffat, Partner – Balderton Capital
  • Saalim Chowdhury, Partner – 500 Startups
  • Tara Reeves, Partner and Remus Brett, Venture Partner – Local Globe
  • Thomas Olszewski, Associate – Frontline Ventures
  • Tim Levene, Partner – Augmentum Capital
  • Yann Ranchere, Partner – Anthemis
  • DN Capital

2017 VC investment into UK FinTech saw its best year on record, with $1.8bn of capital invested over 224 deals, a 153% increase YoY. This news has been greeted with a sigh of relief (and a cheer of excitement), after the disappointment of 2016, when we saw investment drop to just over $700m, largely attributed to sentiment around Brexit. It looks like UK FinTech investment is back on track.

I, and many in the industry, see this as the inevitable result of the UK’s leading FinTech position and fundamental strength as a FinTech ecosystem. Octopus Ventures certainly agree: “The UK has world leading financial services businesses and we are now creating world leading FinTech companies”. Augmentum Capital thinks that the UK remains very much the epicentre of FinTech and as such it continues to attract new companies and fresh capital both from corporates and venture funds. Accel calls out London specifically as being the world’s main FinTech hub, with an ecosystem of incumbent institutions and startups of unparalleled depth.

Another major contributor to this successful result is the fact that the FinTech industry is maturing. Large FinTechs are now becoming household names, employing hundreds of people, and raising large rounds, which Balderton Capital notes is a great sign of UK FinTech businesses really breaking out and reaching global scale. We are also seeing an increased number of early stage startups entering the industry, across the whole value chain of financial services. MMC Ventures attributes this to London offering a great confluence of Technology and Finance hubs, which attracts global FinTech talent.

FinTech is also now benefitting from a stronger talent base. Experts from both banks and technology companies are now seeing FinTech as an attractive career choice, with notable big moves. 500 Startups is seeing more mature technologists stepping out and starting to build their own ventures while Local Globe notes that talent is also coming from a second generation of FinTech and other tech company success stories, with founders and/or early employees backing or starting new FinTech businesses.

When discussing UK FinTech, we have to of course mention the progressive regulatory environment, fostered by the FCA, the government and other organisations and industry bodies. Anthemis notes that the UK has always been forward-looking in its approach to regulatory sandboxes and other guide rails for the market. Indeed, in 2017 we saw the FCA reveal their third cohort, which for the first time included banks. We also saw the FinTech industry gear up for PDS2 and Open Banking in 2017, with DN Capital commenting that the opening up of previously proprietary data stores due to regulation is supporting growth and innovation of the sector.

More generally, the availability of capital in the UK and globally, is thought to have played an important part in fuelling investment figures. Eight Roads believes that there are currently high volumes of capital looking for yields from both international and UK sources and they are seeing existing funds being joined by a number of new, active VC firms, and others who have recently started London based funds.

FinTech Investment Trends

While Challenger Banks and Money Transfer & FX verticals came out on top in terms of 2017 VC investment, this is largely due to companies within these verticals being more mature and therefore attracting larger rounds. It was good to hear that for many VCs, business model remains important regardless of vertical. The key qualities many look for are businesses that drive demand for financial services and create real value for the end consumer. Local Globe see that there are still significant investment opportunities, as each FinTech vertical can support several large businesses that could turn into unicorns.

One trend we are seeing, as noted in a report Innovate Finance produced with Magister Advisors, is the rise of B2B FinTech solutions. This came across when speaking to VCs, with one area of interest being solutions for the SME space. Accel has backed several companies within SME finance and sees an ongoing opportunity in this area, especially as more and more SMEs are adopting cloud software for core operational tasks. DN Capital agrees: “We believe that SMEs are still constrained by slow and inefficient processes in the banks”. Looking forward, Northzone will be looking particularly closely at the B2B space, as it has the furthest to go.

Another B2B area we are seeing an increase in activity is in Capital Markets: solutions to complex front-, middle- and backoffice problems are emerging in the form of FinTech solutions, as explore in a report from EY and Innovate Finance, Capital Markets: innovation and the FinTech landscape. Illuminate Financial, a VC fund purely focussed on Capital Markets FinTech, thinks we are in the early stages of a total market structure refresh driven by the multiple challenges of industry deleveraging, multijurisdictional regulation and a tight compliance environment. The industry needs to improve its efficiency in all areas both to maintain compliance but also to retool its inherent scalability and cost base.

Underlying banking infrastructure is another area of interest, especially as incumbents are increasingly having to compete with challenger banks with no legacy infrastructure. Accel sees an ongoing opportunity in banking, both in the infrastructure layer as well as in new consumer applications leveraging open banking, while MMC Ventures think legacy financial institutions are starting to look at their own banking stacks in a more fundamental way: “While innovation teams in banks have been active for a while, little has been done to touch the mainframe systems on which they operate; we believe that is beginning to change.”

Crypto-currencies and ICOs providing an alternative source of capital was a trend that made an impact in 2017. ICOs reportedly raised over $3BN, will bitcoin hit a price just short of $20,000 (although this has subsequently fallen quite dramatically). Anthemis think it’s still a nascent space: “There’s a lot of hype and speculation around crypto specifically, but the core ideas that are driving it have an incredible amount of potential.” Eight Roads thinks we are in a bubble and “Despite the countless headlines and column inches they have captured, ICOs and crypto so far haven’t really changed other business models in the wider FinTech space.”

Despite the hype, the technology underlying cryptocurrencies – distributed ledger and blockchain – has not seen as much traction in Financial Services as we would have expected. However, many investors (and institutions) still believe the technology has the potential to truly transform financial services as we know it today. Octopus Ventures expect to see the first true application of distributed ledger and smart contracts start to be applied and adopted in 2018 while Accel have seen some interesting solutions emerge, in particular for the capital markets and infrastructure side.

External factors and Macro trends affecting the UK FinTech industry

The Brexit vote is a macro trend that everyone is certainly paying attention to, however many VCs think it didn’t have as significant an effect in 2017 and it certainly didn’t have an impact on investment. Anthemis think entrepreneurs are looking at how it could affect access to the regulated European market as well as availability of talent. Northzone agree that Brexit didn’t really have a strong impact by virtue of the uncertainty around timing.

However, looking forward, the political uncertainty around the Brexit negotiations has the potential to have a big impact on the FinTech industry. Balderton Capital think, “It will really hit home in 2018 that UK financial services are going to take a big blow here.” The freezing of access for UK domiciled funds to the European Investment Fund (EIF) in response to Brexit is also a worry, with Augmentum Capital placing importance on the ability of British Business Bank to effectively replace EIF as a funder of UK venture to drive tech investing.

Several major regulations are either coming into force or have come into force in 2018, (PSD2 / Open Banking, GDRP and MIFID2) which are likely to have a large impact. Augmentum Capital see these new regulations as opportunities, in particular, where incumbents realise they need digital solutions in the changing environment. Anthemis see this mainly benefitting the startups, believing: “Larger institutions have capital and expertise, but may not have a clear understanding of where customer data resides within a complex legacy system and find themselves scrambling to meet requirement deadlines.” When looking specifically at PSD2 / Open Banking, MMC Ventures expect implementation will enable startups to build FinTech applications that directly pull data from banks, catalysing innovation in the space, as they are able to access significantly more and cleaner consumer data than was previously possible. However, 500 Startups think it is inevitable that there will be minor security breaches in relation to Open Banking which may set back its progress.

The opening up of data in this way ushers in the threat that large technology companies (Google, Amazon, Apple) will become more involved in offering financial products and services. Octopus Ventures comments: “This started in payments (think Apple and Amazon), but we are beginning to see additional services being offered such as insurance.” Local Globe agree that, in the future, platforms like Apple, Amazon, Facebook, Ebay/Paypal, will have a broader personalised financial services offering. When considering large tech companies, we also cannot ignore Asia. Ant Financial (formely AliPay), established by Alibaba, raised an eye watering $4.5BN in 2016, while Tencent’s WeChat hit 980 million active users in Q3 2017.

FinTechs and banks are also having to react to the changing demographic of the consumer. Local Globe comments: The millennial segment is coming into financial services. They are facing stagnant wage growth, higher housing costs and higher student loans while, at the same time, they are much more open to non-traditional financial services providers.” Augmentum Capital agrees, stating: “Consumer adoption of new technologies is continuing to move forward, changing consumer behaviour.”

 

Exit environment

With FinTech maturing, one effect the industry is hoping to see is an increase level of exits. Anthemis says: “A lot of companies have grown up and the industry has found its footing, so we’ll see large incumbents buying startups, as well as complementary startups merging.” Octopus Ventures thinks that the FinTech exit environment presents a huge opportunity: “Traditional businesses are transforming themselves into tech businesses. The opportunity for high growth small business to therefore be acquired is exciting.” Augmentum Capital, however, thinks that we are still not there: “Although incumbents are increasingly watching Fintech startups as potential acquisition opportunities, the maturity of the sector is such that we would expect to see more material exits in 2-3 years’ time.”

It is likely that the increase in exits will be largely driven by large financial institutions. In 2017, we saw the rise of Corporate Venture Capital (“CVC”) participation in funding rounds, with 44% of the $20 million+ rounds involving at least one corporate or CVC. Local Globe thinks that corporates “will move beyond partnerships and CVCs, frustrated by the lack of impact and pace that some of these investments are having on their core businesses.” However, Balderton Capital notes: “[It is] hard to see the banks being very acquisitive in 2018.  While some banks might try to acquire one of the break out neobanks this year, we don’t think they will be willing to pay enough.”

There is an expectation that 2018 could be the year we finally see more FinTech IPOs. Eight Roads state that: “The rumoured Adyen IPO is one that everyone is closely watching, and there are a few other mooted IPOs which might also come to market e.g. IntegraFin or iZettle.” Anthemis also expects several IPOs to mark the coming of age of FinTech in 2018. Frontline Ventures thinks that although right now we have very few publicly traded VC backed FinTech companies, in five years’ time, we will have ten times as many. However, there are other ways for investors to get exposure to fintech companies for example through listed investment vehicles. Augmentum Capital has recently announced plans to raise up to £125m via an IPO on the London Stock exchange for a new fintech fund. “There are very few places you can go to right now to invest in fintech at the moment on the public markets,” said George O’Connor, analyst at Stifel. “So [this] taps into the zeitgeist.” according to The Financial Times.

However there is the argument that the exit environment will remain limited. DN Capital thinks that we will only see exits from the best companies who will look at public market exits; and the close followers who will be pursued by large traditional players to have a tech team/footprint/story.  Anything in the middle will struggle to find an exit. Illuminate Financial thinks that even if there are more exits, they may not be a positive thing: “Many deals will be announced where you have to read between the lines to work out if it was a successful exit or a limp across the line.”

Markets and the overall macro-economic conditions also remain a concern. Eight Roads thinks that if there’s negative economic data (e.g. adverse reaction to interest rate rises, excessive inflation) the exit window for FinTechs could tighten quite quickly.

 

What will FinTech industry look like five years from now?

PayPal CEO Dan Schulman said FinTech will change more in the next five years than the last 30, but how so?

We note a comment from Eight Road who said that, in five years’ time, we won’t call it FinTech but simply “Finance”. There is the hope that in the future, there will be no differentiation between Financial Services and FinTech, with technology and the digital experience deeply ingrained in all products and services. DN Capital thinks it will go beyond this, and that “FinTech will expand into areas that today do not feel like FinTech at all, like real time financial payments for priority lane access for semi-autonomous vehicles.”

There is a hope that blockchain and cryptocurrencies will be implemented to deliver real impact in the coming years. Anthemis predicts that this technology will have big implications for industries ranging from insurance to media to government, where consumers are clamouring for more transparency. Local Globe thinks that regulation around crytpocurrencies will bring challenges and opportunities in the capital markets space.

With regulation coming into play to encourage innovation and competition, we are likely to see a shift in the role and position of the traditional incumbents. Accel believe that the top ten consumer finance brands will be different in five years’ time and that it will likely include a mix of incumbents and newcomers, while Eight Roads still believe many of the big financial services players will still be around, but that there could be some household names that are much diminished.

Specifically looking at Capital Markets, Illuminate Financial Perhaps predict a very different vendor landscape, where the monolithic enterprise platforms have been replaced by a fully scalable cloud infrastructure: machine learning and RPA ensuring higher levels of automation and accuracy than ever before. Legacy vendors will perhaps be just that, resellers of a new flexible infrastructure where the value they deliver is in the scale of their organisations for marketing and product support.

There is also the hope that, as FinTech evolves, it will continue to focus on and benefit the  end consumer. Octopus Ventures thinks the customer will be at the heart of the proposition with platforms providing personalised services and products in a frictionless manner. Northzone agrees that the industry should be pushing to serve its customers better, be it businesses or consumers. 500 Startups believes FinTechs can only take advantage of this if they become more and more human and start being good at the social and emotional components of customer adoption.