Aggregate FinTech funding, M&A, and IPO count for 2020 mask the incredible stress and turbulence that FinTechs, investors, and market participants felt during the year. While there was a dip in funding and M&A activity in Q2 and Q3, the year was supported by massive funding rounds and astronomical valuations, especially for a few high-flying Unicorns, including Coinbase, RobinHood, Chime, and Stripe. The broader story of what happened this year was “a flight to quality” among investors towards companies that were scaling up well at the start of COVID. Simultaneously, business models dependent on spending large amounts of money to acquire customers and without concrete plans to monetize these customers struggled. This Viewpoint chronicles significant FinTech developments across six sectors and describes crucial drivers behind them.
Public FinTechs Acted Like a High Beta Stock
Following the March lockdown, public markets fell off a cliff, with the S&P 500 down 34% between February and March this year. The private FinTech market was bracing for a similar downturn. But just like the public markets (including FinTech stocks) recovered quickly, the private market also began recovering by early Summer and ended the year very well.
The chart above illustrates how the S&P, Nasdaq, and the Rosenblatt FinTech index performed over Dec 11th, 2019 – Dec 11th, 2020. (The Rosenblatt index is an equally weighted index of 26 public FinTech companies in the US, including firms like Paypal and Square). The major insight is that the FinTech index acted like a high beta stock with large convexity. It outperformed broader indices leading up to Feb 2020 and then again during the recovery from May-Oct. During February’s market high and the March low, when the S&P fell 34%, and Nasdaq was down 30%, the FinTech Index declined 46%! So, it severely underperformed the S&P and Nasdaq and acted like a high beta stock. As markets started improving over late Spring and into the Summer, the FinTech index outperformed the S&P500 and Nasdaq. Between the March lows and through Dec 11th, the S&P is up 63%, Nasdaq is up 81% but the FinTech index is up a whopping 112%!
Rosenblatt’s Framework to Study FinTech Sectors
Our Banking group created the framework illustrated in the chart below to analyze different FinTech sectors and advise clients during transactions. It focuses on each sector’s business model – how each makes money, its expense structure, and unique risks. There are a wide variety of business models, costs, and risks across different FinTech sectors, resulting in a wide disparity in how they perform. In a turbulent year like 2020, market conditions and the COVID lockdown exacerbated the disparity in how different sectors performed and how firms within the same sector fared, just like what we witnessed in the public market.
Let’s use this model to analyze what happened in each of the six major FinTech sectors in 2020.
Challenger Banks Gained Traction in 2020
2020 was a good year for some parts of this sector, which benefitted from COVID-19-driven acceleration to digital adoption and convenient remote access. It was a big advantage Challenger Banks enjoy over most incumbents who were burdened by weaker digital platforms. Chime, Revolut, NuBank, N26, and Starling were top performers and were rewarded by multi-fold increases in valuation following a total of $3.1Bill of new capital invested in these firms in 2020. Revolut and Starling Bank were the only two banks in this sector to reach profitability this year. Leading Challenger Banks in the US, UK, and continental Europe were big beneficiaries of government stimulus, distributing grants/loans to SMBs which had two benefits: 1) it became a powerful customer acquisition strategy, and 2) it gave them additional fees that made up for lost revenue due to lower economic activity. Cross River, which serves FinTechs like Stripe, Affirm, Bluevine, and Kabbage, was among the top 15 US banks that distributed PPP loans (it distributed $6 billion in loans averaging $38K).
However, it wasn’t a rosy picture for all Challenger Banks (CBs), and the disparity between the top and median players widened in 2020. Consumer-focused Challenger Banks were more exposed to the COVID slowdown than firms like Starling Bank, who have a diversified client base, which helped it weather the downturn better. Pure play CBs who depend mostly on Interchange fees and earn very little from higher-margin products like loans and mortgages were already facing headwinds in 2019, and COVID exacerbated the situation. E.g., Monzo’s financials reveal the tough economics of pureplay CBs. Its default rate rose into the 20% range in 2020, entirely unsustainable for most lenders.
Another critical insight is that most Challenger Banks until 2020 focused on acquiring new customers and got used to widely available VC money to fund their customer acquisition. Investors rewarded these efforts of CBs to acquire customers, and the number of new app downloads became a key barometer for funding rounds and valuations. But as market conditions got more challenging in 2020, and investors became more skittish, there was heightened scrutiny on a bank’s ability to monetize the customers it had acquired (i.e., increasing the LTV/CAC ratio), and that’s where the pure-play firms struggled. Hence the relative outperformance of diversified banks like Revolut who could better monetize customers already on its platform compared to pure-play CBs.
Going forward, pure-play CBs face tough competition from four areas: 1) other digital banks, 2) full-service incumbent financial institutions including new entrants like Goldman Sachs, 3) a flurry of FinTechs entering consumer banking from Payments and Wealth Management, and 4) merchants beginning to offer banking services in partnership with platform providers like Shopify, which runs on Stripe’s Treasury platform.
An interesting case study of a successful Challenger Bank is Starling. Despite having fewer customer accounts (around 1.7 million) than competitors like Revolut, which has 13.5 million, Starling has a high proportion of B2B wholesale clients, which helped it weather this year’s downturn better. It was less impacted by lower reliance on Interchange-fee-based transactional revenue and because it has less cross-border flow, which hurt competitors like Revolut and N26. Starling also benefited immensely from the UK government's "emergency coronavirus financing scheme," which became a significant growth catalyst and a source of new customers. Consumer accounts have risen 72% over 2019, while business accounts grew 245% from 74,000 in 2019 to 256,000 at the end of 2020. All this resulted in Starling’s revenue growth to 108Mill Pounds in 2020, a 55% increase over 2019, helping it become the first digital bank to achieve profitability. One of the lesser-known facts about Starling is that they also white-label their offering, which generates orthogonal BaaS revenues, just like Stripe and other FinTech players are beginning to do in the US.
Digital Lending: A Big Reversal of Fortunes in 2020
Before COVID struck, Alternative lenders were doing well, tweaking their marketplace models by becoming regulated entities, with firms like LendingClub ambitiously acquiring banks (Radius Bank in Feb 2020), the first time a FinTech acquired a traditional bank. But 2020 was a rude awakening for many Alt-Lenders who faced their first test of a downturn.
Lending Club’s stock declined 70% from Jan-Oct 2020 but has since recovered. Pressure on digital lenders was evident this year, with former high-flyers like Kabbage halting lending and selling out to Amex and OnDeck selling out to Enova for $90 million at $1.38 per share, a fraction of its all-time-high shortly after the IPO.
But as 2020 progressed, things began to look better for Alt Lenders. According to dv01’s data, delinquency rates at big platforms (Best Egg, Lending Club, Upstart, and SoFI) were better than the worst that was expected in the Spring: they were 6% before the crisis, peaked at 16% in April, but recovered to 9% by the Fall. The warning is that with COVID continuing and government stimulus expiring, default rates may rise again, severely hurting this segment. Going into 2021: the question is whether a 9% delinquency rate will become the new normal for the industry? If it does, that would crimp returns significantly and threaten a lot of the digital lenders.
One part of this sector that has been doing well is the "Buy Now Pay Later" segment (BNPL), whose prospects improved during COVID. According to McKinsey, POS lending is growing at 20%, much faster than other lending segments like cards or personal loans growing at 6-8%. While the concept of installment lending is not new, what’s new is that modern-day BNPL players have integrated installment plans seamlessly with the purchase decision, providing unparallel flexibility to consumers. During COVID, while the traditional marketplace models languished, Point-of-Sale lending has been one of the few bright posts in the Lending sector, especially for those firms that were aligned with retailers that benefited from the pandemic, growing at 10% YoY. This model has become a serious alternative to traditional cards and got a big shot in the arm during the COVID lockdown as physical credit card transactions plummeted. BNPL players did very well, including behemoths like Paypal, Affirm, and Klarna, and smaller guys like Afterpay, ChargeAfter, QuadPay, Sezzle, and Uplift.
There are two caveats to this brightening picture. 1) Massive government stimulus may have depressed default rates for BNPL players, and defaults could rise in Q1 2021, hurting the model. 2) Not everyone has done well in the BNPL sector. There is enormous variety in how firms have performed in 2020 depending on their target customer. If a firm’s customers were restaurants and hotels, it got hit badly. But if a BNPL’s customers enabled discretionary spending (e.g., Affirm with Peloton), it fared much better.
A good case study for a BNPL player is Affirm that did well during COVID with its top-line growing 93% $510Mill in the fiscal year 2020, ending June 30th. Based on this success, it raised a $500Mill round in Sep 2020, and was supposed to file in December to go public at a $8-10Bill valuation but has delayed its IPO to 2021. What’s interesting about Affirm and its POS model is that by attaching itself at the POS with a merchant, it enhances the merchant’s sales closing rate and earns a commission on the merchant’s sale. That can be a big boost to revenues. For firms like Affirm and Klarna, almost 50% of their revenue comes from such commissions, and only 35% from lending spreads, which is usually the biggest source of revenue for most lenders.
Payments: The Brightest Spot in FinTech in 2020
Payments was one of the standout performers in the FinTech sector in 2020. Though the shutdown paralyzed large parts of the US and the global economy, curtailing consumption and reducing payment transactions at Visa/MasterCard by 25%, the shift to digital payments significantly benefitted payment FinTechs like Stripe and Square, who did extremely well. Let’s analyze Square and Stripe’s success as case studies of the broader transformation taking place in the Payments space.
The most powerful aspect about Square is that it has built an end-to-end network extending from consumers on the one hand and merchants on the other, something no other company has been able to do in such a short time. It has evolved into a closed-loop system extending across its POS, its much popular Cash App, and Square Capital. It received a banking license in April 2020, allowing it to offer banking services.
Square’s involvement in the Payment Protection Plan helped earn transaction revenue and became a powerful customer acquisition tool.
Square’s Gross Payment Volume has grown at a CAGR of 15% for the last few years, rising from $85Bill in 2018 to $113 billion in 2020. Revenue has grown at a CAGR of 141% from $1.6Bill in 2018, $4.7Bill in 2019, and a consensus estimate of $9.3Bill in 2020. Investors have bid up its stock price 276% YTD (as of Dec 22nd), recognizing Square’s evolution beyond Payments into other high margin products, including merchant banking, cash management, and Bitcoin (which contributed 50% of its gross revenue in 2020).
Nothing makes the point about Square’s success, and more broadly the success of modern-day FinTechs, better than looking at the time that Square and Venmo took to acquire 60 million customers compared to JPMorganChase. It took JPM 60 years and five major acquisitions to amass 60 million customers. How long did it take Square’s Cash App and Paypal’s Venmo to do that? Ten years for Venmo and just seven years for Square’s Cash app. That’s the power of incredible technology, platforms, and the vision of FinTech pioneers like Jack Dorsey and Dan Schulman. Another subtle point worth noting is that firms like Square are creating a culture and a brand that is fresh, new, exciting and which appeals very strongly to millennials. That’s a significant departure from the way traditional incumbent institutions have branded themselves.
The next Payments FinTech redefining this space is Stripe: the highest valued FinTech Unicorn globally, valued at $35 billion at its last funding round. Stripe has strategically positioned itself at the intersection of Finance and eCommerce, something no incumbent financial institution and very few FinTechs have been able to do. That’s why investors are considering funding it for another $600Mill in the next few months at a reported $80-100Bill valuation.
The chart below illustrates the roll-out of Stripe Treasury, an API that embeds financial products (FDIC-insured savings accounts, debit cards) directly into Shopify’s platform, offering over a million merchants ‘out-of-the-box’ financial services. The smartest part of this arrangement is that Stripe doesn’t take balance sheet risk and doesn’t have to be regulated as a bank, as it has partnered with Barclays, Citi, Evolve, and Goldman Sachs at the back-end. We believe this a terrific window into the future of modern financial services when FinTechs like Stripe and Square will be able to extract value from both industries and achieve massive scale, by sitting at the intersection of Finance and eCommerce. There will also be significant implications for traditional financial institutions as they find themselves relegated to the sidelines and become less relevant to end customers.
Personal Investing and Wealth Management
A steep decline in public markets has historically scared away retail investors. But despite the decline in public markets and record volatility, retail investors aggressively entered the market this year, with record levels of retail trading fueled by people staying at home and the proliferation of free trading platforms like Robinhood. Rosenblatt’s Market Structure group estimates that almost 25% of equity trading volume this year was contributed by retail investors, compared to an average of 10% over the last ten years.
Growth in retail activity greatly benefitted traditional online brokers (Charles Schwab, E*Trade, TDAmeritrade) whose Daily Average Retail Trades (DARTS) rose over 150% YoY. But perhaps the biggest beneficiary of record trading volume were platforms like Robinhood and eToro that offer social-investing and gaming-like features that helped them acquire new customers. Robinhood, which is single-handedly responsible for pushing the industry towards Zero commissions over the last few years, combined free trading with a powerful UI/UX that helped it surf the COVID storm perfectly. Its Payment for Order Flow (PFOF) revenue model became a powerful driver as it became the biggest aggregator of retail flow, generating $90-140 million each quarter during Q1-Q3, 2020. PFOF, combined with revenues from other “back-office” services like margining and sec-lending, gave investors the confidence to plow $600 Million in new funds and drive Robinhood’s valuation to $13.5 Billion.
Now let’s consider what happened to robo advisors, a significant player in this market during the last few previous years. The most active category of investors in 2020 – millennials – were less interested in the asset allocation strategies of robo advisers and gravitated towards single stock trading offered by firms like Robinhood or the traditional online brokers. That resulted in Robinhood doubling its customer base between 2019-2020 compared to a combined 15% growth in the number of accounts across Betterment and Wealthfront. Meanwhile, former high flying FinTechs like Motif and Quantopian shut down this year.
Finally, just like “Banking-as-a-Service” is driving long-term growth in banking and payments, “Brokerage-as-a-Service” was a popular concept in 2020, with leading FinTechs like DriveWealth extending their platform to even more customers keen to roll-out trading services.
Capital Markets: Enjoying the Fruits of High Volatility
Capital Markets has always been a feast or famine business, and this year provided massive tailwinds for the institutional business. Higher volatility drove up transaction volumes, while market disruption caused wider spreads that boosted revenue. Traditional capital markets firms (institutional brokers, exchanges, clearing firms) benefitted greatly, increasing grew demand for other services that FinTechs offer. Shares for market makers like Virtu hit all-time highs, with 2020 revenue expected to be up 150% YoY. Meanwhile, deal activity was brisk in the capital markets/institutional investment data space: S&P acquired IHS Markit for $44 billion, ICE picked up Ellie Mae for $11 billion, LSE bought Refinitiv for $27 billion, and Bloomberg was rumored to be considering going public with a $60+ billion in valuation.
An important observation is that while the public markets are buoyant, an enormous amount of alpha is being harvested by investors in the private market. The breadth and variety of institutional investors making more significant allocations to private securities are growing rapidly, including pension funds, endowments, mutual funds, sovereign wealth funds, hedge funds, and family offices. But the private market lacks the infrastructure to support such investor interest and ambition fully. Fortunately, many smart FinTechs are building out infrastructure for the private market (exchanges, brokers, transfer agents), bringing greater transparency, liquidity, and trust to this space. One big area that saw substantial activity in 2020 was platforms that facilitate secondary trading of private securities. It’s a crowded market, including behemoths (Nasdaq Private Markets, Morgan Stanley Shareworks) and VC-funded players (Zanbato, Addeppar, EquityZen, Clearlist, and Carta).
Carta is a perfect case study of a firm building out infrastructure for the private market. It has systematically evolved from managing cap tables to becoming the private market’s #1 fund admin, to rolling out CartaX, its trading platform for private securities. By 2024, Carta’s registry will cover $2Trillion of private assets. It is very well positioned to take advantage of the private market’s long-term growth and could be on the path to an IPO in 2021/2022.
With the growth in the Private Market expected to continue for many years to come, we believe there will be a tremendous investment opportunity for financing FinTechs like Carta, which are building the infrastructure for the private market.
Finally, this year saw an explosion in SPACs, with 225 getting created and raising $72 Billion, more than the $65 billion raised through regular IPOs this year. Significant institutional investor demand and private investors seeking quick exits fueled this growth in SPACs. There were 13 FinTech SPACs announced in 2020, of which four have listed: Farpoint, Metromile, OpenLending, and UWM. This compares to only two FinTech SPACs closed in 2019 and one in 2018. The momentum for SPACs looks like it will continue as we head into 2021.
InsurTech: Spared from the Worst of COVID, With a Surge in Demand for New Coverage
Insurance was spared the worst of the COVID crisis and performed significantly better than other FinTech sectors. Life and Health carriers had COVID claims, which were softened by government grants. In contrast, P&C carriers had pandemic exclusions and significantly lower claims due to the lockdown that halted travel and other activities. Meanwhile, COVID has boosted demand for covering emerging risks like climate change, pandemics, and pollution. This is a shot in the arm for InsurTechs with unique solutions that address such risks. We held a panel at our FinTech Summit in May 2020 on this topic with the CEOs of five leading InsurTechs who described how they address emerging risks: Arceo, Deep Labs, Risk Genius, Bold Penguin, and Thimble. A notable growth area has been cybersecurity and identity-related coverage that has seen an explosion in demand due to higher instances of fraud, identity theft, and hacking amidst a massive growth in online traffic.
A broad trend we see across the FinTech landscape, including Challenger Banks and in Payments, is for software-driven FinTechs to apply for banking licenses and become regulated entities. Similarly, in Insurance, InsurTechs are applying for licenses to become carriers and becoming regulated entities. They are shifting from pure software-driven business models like online marketplaces to risk-bearing activities traditionally provided by full-service carriers. Examples are Hippo, Bestow, Pie Insurance, and Root. InsurTechs are doing this for three reasons: 1) they have greater control over the insurance value chain with a full-stack model, 2) they can tap into a larger addressable market, and 3) they benefit from the perception of greater stability as a regulated entity. Investors are rewarding such moves with high valuations being accorded to InsurTechs, both in the public and private markets. Consider Lemonade, which has been trading at a 28-35x forward P/E multiple compared to other InsurTechs and carriers that trade at lower multiples.
Lastly, a wild card in this sector is the entry of Tesla, offering insurance in California with plans to extend across the US. We believe Tesla can change the rules of the game in Insurance, just like it is doing in almost every sector that it operates within. With advancements like autonomous driving, risk will shift from drivers to the manufacturer, with important implications for insurance coverage. Tesla recognizes this change and is positioning itself to best address this massive shift in auto insurance. Secondly, traditional insurers have relied on historical data to price and underwrite policies, which is inexact and can be inefficient, preventing them from providing tailored risk-based pricing. By using real-time information about drivers and environmental conditions, Tesla can more effectively underwrite risk and price policies competitively, passing on savings to customers. This is hugely beneficial to Tesla for two reasons: 1) Customers get an integrated service from one provider who sells them a car, services it, and also offers Insurance for it. 2) Tesla gains an orthogonal revenue stream boosting its long-term value.
That is a recap of the tremendous changes that happened in the FinTech sector in 2020. It was a year of several longer-term trends that preceded COVID, like the shift to digital payments, getting accelerated. But it was also a year of new-found realities like the ability for a large part of our economy to function, and a large proportion of our workforce, to be able to work remotely. Many of these changes will become permanent with crucial implications for who wins and who loses in the financial industry. But one thing is for sure. The long-term value proposition for digital finance and the FinTechs that deliver it remains very strong and the best days for our industry are ahead of us.