Number of the Week: $8.64 million (explanation below)
Does It Matter if Fintech Is Overvalued?
If you haven’t seen a news article or blog post lately wringing its hands over whether the fintech sector is overvalued or indeed in a bubble, just wait a few minutes: there is bound to be another one soon.
It’s conspicuous how often this charge comes around, and in different forms. Last summer, Barron’s raised the question of whether fintech stocks are overpriced. More recently, American Banker pondered whether the apparently shrinking share of global market capitalization of the banking and payment industries that traditional banks account for — 72% today, down from 96% a decade ago — should be a cause for worry. (This concern was itself prompted by a somewhat fuzzy statistic presented by The Economist.)
So let’s put the spoiler up high: Yes, fintech companies are overvalued. The more important question is: How much does that overvaluation actually matter?
The first bit of context to consider is the valuation of the market as a whole. We’re in the middle of the worst global pandemic in a century, and the reaction of the American stock market has been a slump that lasted maybe three months. If people need something to freak out about, it should be that. (And those who pay attention to such things do seem to be spooked; the Nobel Prize-winning economist Robert Shiller assembles a Crash Confidence Index, and recently pointed out that “an overwhelming majority of investors said there was a greater than 10 percent probability of an imminent crash — really, a remarkable indicator that people are quite worried.”)
In that overvalued market, are fintech companies really the most overvalued? It’s not an easy case to make. Nasdaq has a financial technology index, which as of the last October trading day is near, but not quite at, the level it hit on February 20th of this year. Contrast that with the Nasdaq composite index as a whole, which is 14% higher than it was when things started to tumble in February.
Presumably some of the concern about a “fintech bubble” represents a fear that the sector could crash as the dot-com companies did, starting in early 2000. There is a lot to say about that comparison (a future FIN installment!), but I will confine myself to two quick points. The first is that stock niches such as fintech can go down without crashing the broader market. While researching another topic this week, I came across this Wall Street Journal story from 2016. It noted: “Shares of U.S. firms including LendingClub Corp., OnDeck Capital Inc., and Square Inc. are down an average of 23% in 2016, while Elevate Credit Inc., an online subprime consumer lender in the U.S., delayed an IPO scheduled for the week of Jan. 22, citing difficult market conditions. Share prices for London-listed funds that buy marketplace loans have also declined.”
The second point is that I think the dot-com crash’s responsibility for the U.S. recession that lasted from March to November of 2001 is overplayed in the public imagination. This week I revisited The Roaring Nineties, an excellent history by Joseph Stiglitz, another Nobel Prize-winning economist. I was struck by how little weight Stiglitz gives to the boom and bust of dot-coms compared, say, to rampant deregulation and a corrupt Wall Street environment.
In search of informed and rational opinion about fintech valuations, I turned to Lonne Jaffe, a managing director at Insight Partners. In an e-mail, he said: “Valuations appear high and for some fintech businesses they definitely are; as investors have seen the significant number of billion-dollar outcomes in fintech there has been an influx of capital into the segment.” He argued nonetheless that “even though revenue multiples have gone up for fintech companies, once you adjust for revenue quality and growth rate (e.g. the ‘PEG ratio’) valuations have actually been fairly flat.”
How do investors like Jaffe evaluate what a private fintech firm (and remember that at this stage the majority of fintech companies are still private) is worth? He said: “There are a number of metrics that serve as signals of market pull: e.g. growth rate, scale, increasing gross margins, decreasing customer acquisition costs, high gross retention rates, and increasing spend from existing customers. There are also many important qualitative factors, such as having product differentiation, or having cultures that attract and retain high-quality and diverse talent.”
Now, you might say that a VC who intends to stay active in fintech investing is of course going to argue that the sector is not overheated—and you’d have a point. But remember, too, that VCs don’t want the sector’s valuations to get too out of control; if they do, then VCs will be impelled to put up more money for the same or lower stakes in the companies they invest in.
And that just leads to the bigger question, which is: Who needs to care if fintech companies are overvalued? If you’re invested in public fintech companies (again, there aren’t all that many of them) and you’re not enjoying the upward ride, you should consider selling. But if, like me, you aren’t, there are plenty of other things to worry about, like when we will know the outcome of the 2020 presidential election.
Who Are the Real Fintech Borrowers?
Fintech lenders commonly pitch to investors that their company has special-sauce methods to find credit-worthy customers that elude traditional lenders, and will make money through faithful paybacks at rates that are perfectly optimized. To consumers, the fintech pledge is that they will get a better rate than traditional lenders, and get the money super-fast.
A controversial but thorough research paper published this week suggests that, aside from the speedy delivery, none of these pledges may be true in the typical case. The paper is titled “Fintech Borrowers: Lax-Screening or Cream-Skimming?,” and is authored by Marco di Maggio of Harvard Business School and Vincent Yao of Georgia State’s College of Business. The pair studied years of personal loans and sifted through data from one of the three major credit rating agencies and concluded:
Fintech borrowers are more, not less, likely to default than their counterparts who borrow from traditional banks;
Given that higher risk, fintech borrowers often pay a higher interest rate than they would at a traditional bank;
Lending to these higher-risk borrowers allows fintech lenders to initially build market share, and from there they fan out to safer lenders;
Fintech lenders largely rely on the same credit-rating data that everybody else looks at, as opposed to special-sauce channels.
An earlier version of this paper had been presented (including to the New York Fed) in 2018, making some fintech players, di Maggio told me in an interview this week, “very, very upset.” It’s now been peer-reviewed and is officially published, and has a lot of analysis that wasn’t in the 2018 version, even if the gist is similar.
How to account for the gap between the fintech hype and the paper’s more pedestrian findings? Di Maggio explained that much has to do with who the fintech borrower is, and why she is borrowing (echoing some of the issues discussed in last week’s FIN). The typical fintech customer borrows more than the typical bank loan customer, and wants cash to consolidate credit-card debt. What happens after getting the loan, however, is that the fintech borrower uses it to pay off only some of the credit-card debt. Then over time (on average about eight months) the fintech borrower has simply taken on more debt, and ends up defaulting more often than the bank borrower; fifteen months after the loan, the fintech defaults are more than twice as common.
The fintechs know this going in, de Maggio and Yao argue, and accordingly charge a higher rate than banks do. Fintech customers may never even perceive the higher rate, because it’s at least lower than what they were paying on their credit card debt.
Di Maggio and Yao examined loans that were made between 2012 and 2017. Di Maggio acknowledged that since then, there may be newer fintech lenders — he mentioned Upstart — who have better and genuinely innovative models that don’t follow the study’s pattern. Nonetheless, the paper is an important corrective to the way that fintech companies portray themselves.
🦈Number of the Week: The average cost of a corporate data breach in the United States is $8.64 million, far greater than the global average of $3.86 million. The figure came up during the announcement this week that the Atlanta-based cybersecurity firm Bluefin has raised $25 million.
🦈If the Trump Administration’s crackdown on China trade was supposed to slow investment activity between the two countries, the folks at Lufax didn’t get the memo. The company, which is one of China’s largest online wealth management platforms, raised $2.36 billion on the New York Stock Exchange this week, the biggest China-to-U.S. listing in more than two years.
🦈The Detroit-based financial services firm Ally has sponsored an island on Animal Crossing. I am certain that in five years this will be looked at as the first great salvo in redefining how banks reach millennial customers, and in no way as a cheap gimmick that is months late in hopping on a pandemic-fueled bandwagon. 🙄