Over the last decade, $5 trillion of market value has been created in financial services.¹ The sector’s gross profit pool has swelled to an amount larger than any other major group – larger than software, e-commerce, semis, and even healthcare. Since financial services are ingrained into nearly every aspect of our life and work, it is a natural target for disruption and innovation. Fintech has just experienced its very first venture-fueled innovation cycle with the percent of venture dollars rising from <5% of dollars deployed in 2011 to ~22% in 2021.² Hundreds of billions of dollars invested in the space has fueled a new wave of technology evolution around the world from omni-channel payment providers to B2B payments and fully re-bundled digital banks.
Despite this momentum, fintech is relatively nascent and today represents just 2% of public financial services market cap.³ Consider the fact that the average public fintech company is only 12 years old, while the average legacy financial services company is 96 years old.⁴ The recent downturn has also illuminated the fact that there are many unsustainable business models within fintech. While bull markets and exuberant optimism over innovation go hand-in-hand, the sector is idiosyncratic in the sense that many of the business models that have received venture capital funding will not survive long enough to reach the next cycle. There are valuable lessons learned for everyone involved, but with trillions of dollars of unpenetrated market value and a substantial IPO backlog, there is a lot to be excited about over the next decade in fintech.
We believe the next cycle of fintech innovation will dramatically alter the financial services landscape as we know it today. Our learnings have shown us there are certain business models that stand to win. We believe the next generation of enduring fintech requires a focus on owning the balance sheet, maniacal re-bundling, a B2B lean, an openness to the future of crypto, and building in high margin sub-verticals across emerging markets.
1. Tale of Two Business Models and Introducing the “Rule of 200”
Fintech has received special attention during this downturn as a category hit harder than most. While this is true, context is important. Prior to the correction this year, the sector was trading at 40x – 60x forward gross profit multiples, a massive increase from even a few years ago.⁵ Fintech also differs from other sectors because it spans many different business models across and within B2B to B2C. In enterprise software, for comparison, companies are primarily concerned with building conviction in the end market as the business model itself has very little variation across applications.
In analyzing which business models have weathered the storm over the last decade, we developed the “Rule of 200” for mature, generally public businesses within fintech. Similar to the “Rule of 40” for software companies, which captures the health of the business in all market conditions, the “Rule of 200” posits that fintechs should be targeting net retention rate, revenue growth, gross margin, and operating margin above 200%. There are admittedly a lot of variables in this calculation, and that is a direct function of the business model variance in the sector. We are all aware of the low gross margin business that is highly retentive and growing rapidly (payment service providers!), or the high gross margin business with poor retention and high OpEx (pure lending). As with any analysis, it is dangerous to put too much weight on one or two variables, and we believe the “Rule of 200” helps to resolve this.
As you will see in our supporting deck, this rule highlights payments infrastructure, banking software, B2B payments, and fully bundled consumer-facing business models as the current premium assets. Our hope is that this framework helps solidify the types of businesses that will endure through the current downturn and attract the most capital and operator talent over the next ten years.
2. Balance Sheets Are Necessary Evils
Balance sheet businesses in fintech have traditionally been viewed in a negative light. The market had valued fintechs at 40x - 60x forward gross profit, and that made sense at the time.⁶ However, in a rising interest rate environment, legacy banks, insurance providers, and asset managers have the potential to weather down cycles better than capital light business models, e.g., insurtech and consumer-facing fintech. The increase in the federal funds rate to above 2% has forced the current cohort of fintech operators and investors to grasp new business model concepts and metrics such as Net Interest Margin.
Throughout this cycle, we have witnessed a variety of deals with partner banks that have led to compressed gross margins due to high funding costs and/or acquisitions. While we do not believe this will disappear at the very earliest stages of company building in fintech, we do believe businesses can and should embrace a balance sheet sooner than later.
While balance sheet businesses will trade at lower multiples in many macro conditions, we posit that the superior unit economics and lower beta on valuations will be a key learning and substantial change for operators over the next decade.
3. B2B Fundamentally “Easier” Than B2C Today
The “Rule of 200” emphasizes net revenue retention, and B2B outpaces B2C 125% vs 94% on average.⁷ In addition to simply being conditioned to pay for more services, businesses naturally grow profits over time at a rate more than double that of consumers. From 1997 to 2021, U.S. per capita outlays grew only 29% while per capita business profits rose 70%, or in line with GDP growth.⁸ In a fiercely competitive digital advertising environment, the ability to cross-sell to expand ARPU is critical.
The switching costs for businesses relative to consumers are much higher with financial products. B2B integrations are cumbersome and require buy-in from multiple parties. Consumers find themselves chasing yield and simply shopping for new experiences. While there are some B2C fintech winners in the market today, we see higher potential upside in the near-term for the B2B business model. Though taking on incumbents is never “easy,” fintechs have a better opportunity to succeed by serving the enterprise.
4. Emerging Markets Present Unprecedented Greenfield
As technology becomes ubiquitous even in the farthest-reaching corners of the globe, we are seeing internet and smartphone penetration grow rapidly in certain regions like Latin America. Complementing a population that is rapidly coming online is the fact that competition in financial services internationally is half that (at best) of the U.S. and Europe. In Brazil, for example, there are half as many bank branches for every 100,000 residents.⁹ We also tend to see credit-to-GDP ratios that significantly trail more established geographies.
For incumbents who often struggle with customer service and innovation, doing business in emerging markets is practically impossible due to the increasing rate at which locals are coming online. This is evidenced in the unprecedented growth rates (and profitability!) we are seeing with many fintechs pursuing these profit pools. We believe there are hundreds of billions of dollars in market cap set to be created in geographies where banks are underserving their customers.
5. Crypto Will Augment the Current Payments Landscape
Despite media attention on the recent downturn across the digital asset class, cryptocurrency’s market value is still almost one trillion dollars. While fair weather investors will flee the market in downturns, we cannot ignore the serious attention and investment by key players across global business such as Visa, Google, Square and Stripe. We believe the first true successful use case for crypto will be in payments, which was the original promise of the blockchain.
Cash App has had over 10 million users purchase BTC on the platform.¹⁰ Nubank reached 1 million crypto users after just one month of selling the product.¹¹ In the middle of the payments chain and ecosystem sit Visa and MasterCard, who have hundreds of product and engineering operators working on future crypto initiatives. On the acceptance side, major merchant acquirers like Square and Cloudwalk have fully enabled crypto acceptance, and the response has been incredible, e.g., Cloudwalk’s Brazilian Real digital stablecoin gained almost two million transactors in only a matter of months.¹²
Cryptocurrency offers the promise of making transactions cheaper, faster, and more compliant for all parties involved. While we’ll refrain from making any predictions as to the timing of its uptake, we remain optimistic that crypto will ultimately complement fiat in the global payments ecosystem.
The Path Forward
As you will see in the corresponding deck, the fintech revolution is still in its earliest innings. The public landscape remains quite small with only $250 billion of market cap spread out across 44 companies.¹³ We expect this universe to grow by 50% over the next three years alone.
We believe this most recent downturn will separate the winners from the losers, and that balance sheet-focused business models, B2B solutions, emerging market winners, and crypto payments hybrids will have the highest likelihood of success. At Coatue, we have been fortunate to back dozens of innovative fintech companies over the last ten years and we look forward to doing much more in this space over the next ten. We have no doubt that the future of financial services rests on the biggest ideas from fintech founders.
¹CapitalIQ and Coatue analysis as of Oct-22. ²CB Insights as of Oct-22. ³CapitalIQ and Coatue analysis as of Oct-22. ⁴CapitalIQ and Coatue analysis as of Oct-22. ⁵CapitalIQ analysis as of Oct-22. Comparison made between NASDAQ peak in Nov-21 and Oct-22. ⁶Market data from CapitalIQ as of Nov-21. ⁷Company disclosures and Coatue analysis as of Oct-22. ⁸U.S. Bureau of Economic Analysis, Federal of Reserve Economic Data, IBIS, and US Census Bureau ⁹World Bank data. ¹⁰Company disclosures. ¹¹Company disclosures. ¹²Coatue analysis as of Oct-22. ¹³CapitalIQ and Coatue analysis as of Oct-22.
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