Corporate Finance in the FinTech era

Today we are witnessing banking activities being disrupted, vertical by vertical. Instead of banks sitting on technology and using it to their own benefit, FinTech is about giving the end-user the power of technology, via user-friendly products.

Is the corporate finance industry (incl. venture capital, private equity, investment banking advisory) ready for FinTech? And if so, what would that look like?

So far corporate finance has gone through two major phases and it is about to enter a third major phase:

– Until 1980s:

personal relationship based finance

– From 1980s until now:

balance sheet driven finance

– Next up:

technology driven finance (= FinTech)

Finance 1.0: relationship based finance

Until roughly the early 1980s, finance was dominated by Wall Street based and London based firms, and business revolved largely around personal relationships. These firms were mostly partnerships, led by a handful of power brokers who today still have famous banks named after them (although most names disappeared during the industry consolidation that came with Finance 2.0). Bankers of this era were seen as a major catalyst for industrial and technological progress. One of these power brokers was John Pierpont Morgan, founder of JP Morgan.

He was super connected in both the business and political world. He played a major role in the formation of US Steel and General Electric (he also invested in the Titanic). Governments had close relationships with him and other brokers as they were seen as crucial to finance deficits caused by  wars.

JP Morgan has some great quotes attributed to him. My favorite JP Morgan quote is: “A man generally has two reasons for doing a thing. One that sounds good, and a real one”. But a more relevant quote is:“A man I do not trust could not get money from me on all the bonds in Christendom”.

This type of “old-fashioned” relationship based finance lasted until about the 1980s.

Finance 2.0: balance sheet based finance

Then, in the early 1980s, a new type of finance emerged: balance sheet driven finance, or Finance 2.0. This change came because of a “perfect storm” ofde-regulationandfinancial innovation.

De-regulation enabled the formation of mega banks and also allowed banks to take more risks using their own balance sheet. Instead of competing for business based on personal relationships, banks used their balance sheet to “muscle” their way into profitable business opportunities. In this “pay to play” game, the bigger you were, the better for you. This of course incentivised industry people to chase mega deals (“elephant hunting”), thus paving the way for mega buyouts, such as the iconic $25 billion leveraged buyout of RJR Nabisco by KKR in 1989. Such mega-deals required large amounts of finance, involved high arrangement fees for participating banks. De-regulation almost immediately also led to the first bailouts, during the Savings & Loan crisis between 1989 and 1995.

A second big catalyst for Finance 2.0 was financial innovation: option pricing theory and computerised trading, which led to the growth of the hedge fund industry and “prop trading” activity inside banks. Banks created huge trading floors which often became their main profit centers. As with de-regulation, also financial innovation led to a large bail-out: in 1998 the hedge fund LTCM imploded and threatened to drag the whole stock market in the back hole it had created.

Markets supposedly had become hyper-efficient: electronic trading, seamless global markets, and financial innovation made markets less risky. Or so most of us thought, regulators included. In reality, financial institutions had merely found new ways to take margins through the back-door by underwriting risks others were unable to take, but -as we now all know- risks which eventually re-emerged elsewhere and ended up mostly borne by unsuspecting others (taxpayers, central banks, and less sophisticated market participants). In hindsight, financial markets were characterised by in-transparency, secrecy and complexity nobody fully understood, under the guise of hyper-efficiency and innovation.

Complexity also led to excesses and sometimes super high payouts which from hindsight were not all merit based. We tried so hard to incentivise the financial sector (including investment funds) to work hard in our interest and reward them well for it, but we turned out to have been paying for very mediocre or even bad performance. From hindsight, the financial industry had become imbalanced and rigged, mostly working for the benefit of itself.

Although finance 2.0 and banking 2.0 are today still very much alive, and in fact still a growing industry, we are on the verge of moving to a new era of fintech, or finance 3.0.

Finance 3.0

Today we are witnessing banking activities being disrupted, one by one.Instead of banks sitting on technology while servicing the end users, FinTech is about giving the end-user direct access to technology, via user-friendly products, and free flow of information

The potential benefits are multitude, but here are a few:

1) Simplification

Peer-to-peer loan businesses are stripping out unnecessary costs by using technology and eliminating branches et cetera thus creating a sustainable competitive advantage. This is very much analogous to the airline revolution where low cost operations have structurally reduced the cost and hurdles of flying.

2) Transparency

Transparency results in the removal of hidden fees, while providing users with real-time information about where their money is and what the service provider is doing for them.

3) Less friction and barriers

De-institutionalisation ultimately means a more open playing field, where historical pedigree is less important and real-time reputation more important. In venture capital we see fragmentation and emergence of smaller funds, micro funds, super angel investors, and entrepreneurs instead of institutional funds.

Seed Stage / Angel Investing

The cost of launching a startup been reduced dramatically. Creating a prototype can be done in a matter of weeks, tested in the market in months, and a company doesn’t need millions to get off the ground. So platforms are ideally suited to micro-fund a company and then invest more as there is proof of concept.

Simultaneously, crowdfunding is potentially making seed investing more viable by enabling small investors to spread risks more. Since seed investing in a startup is like investing in an out of the money option, with very low success changes, spreading bets is valuable. Still, the problems of adverse selection and asymmetric information still need to be solved by these platforms. Future returns achieved by the average crowdfunding investor will be the metric to judge this by: they need to be able to achieve a return at least close to that of the stock market (say 8%+ being realistically attainable for most investors).

How fits into all this: corporate finance

Dealroom’s mission is (1) to help professional investors make the better investment decision based on all the information available and (2) to simplify the process of capital raising for founders of rapidly growing companies.

Furthermore, our platform is built based on the expectation that venture capital and private equity in the future will involve less traditional closed-end GP funds and involve more direct investing by LPs, through syndicates that are lead by investors with good reputations. To enable this, we need platforms where market participants are closely connected, can easily exchange data, and can choose to share investment opportunities, while keeping track of everyone’s activity, reputation and investment performance.

This is what we are working on. John Pierpont Morgan himself said: “Go as far as you can see. When you get there, you’ll be able to see farther.” Exactly what we plan to to do.