Swallowing the Financial Value-chain from the Point-of-Sale
Apologies to those of you who reached out regarding last week’s article. I got a little bogged down with work & decided to enjoy the long-weekend :)
This week, back to the exciting world of fintech:
Why, paradoxically, alternative lenders may struggle more in Emerging Markets
The lending value chain and the “3Ds” of comparative advantage
A payments bubble or have investors found a trojan horse for lending?
The Developing Divide: Will “Every Company be a Fintech Company?” or will it be “One Fintech Company for Everyone”?
While starting any business is tough, the VC-backed world of winner-take-all economics can be particularly cutthroat. A standard playbook has emerged: sell a massive vision, raise a large round, and burn like crazy to suck the oxygen out of the room from your competition. The goal is to reach escape velocity at your given level of aggregation - either locally, regionally, or globally.
Blitzscale. And then milk the resulting network.
This applies to many digital businesses. Investors will stomach years of losses because of the global reach and quasi-monopolist profits offered at the other end. However, lending has always had a different tune. After all, anyone can give someone else money. The trick is getting it back. Threading this needle - between growth and sound underwriting - is difficult.
The credit gap - for both consumers and SMEs in China, India, and Southeast Asia is massive. Banks do not have the bandwidth or the processes in place to effectively service lower-tier customers. Tech-enabled solutions can play a meaningful role. Through phone scraping, teleco data, social media, marketplace orders, payments data, payroll info - you name it - alternative lenders cobble together data points to more accurately assess a borrower’s risk of default - at a lower cost - allowing them to service customers left outside of the banking system.
It’s a bit of a tight-rope walk. In the good times, investors hope to consolidate around a “market leader” - generally assessed by the size of the loan book. Competitors also raise VC-money and start going after the same customers. While there is a large pool of eligible “unbanked / underbanked” individuals in Emerging Asia, there is a reason many of them are underbanked. While the first rung or two outside of the banking system tend to provide sound risk-reward, the race heats up as more competitors enter the ring. The slippery slope begins. More and more lenders raise funding, each chasing less and less viable borrowers in an effort to expand their loan-book - the vanity metric to show investors they are the “market leader”.
Then, predictably, the music stops.
The “100+ different risk-variables assessed”, the “37 machine learning PHDs”, and the “propriety-ML-based models” are great - as long as the expansion keeps rolling. But then you hit 2008 or 2020, and the percentage of non-performing loans can jump from something resembling Harvard’s acceptance rate to a respectable Sequoia China return. You start seeing headlines like: “Akulaku in limbo, Indonesian consumer loan players need a system reboot.” The tide comes in, and it turns out many alternative lenders have no swim trunks.
The thing is, pure lending businesses just don’t have real network effects or barriers to entry. There is always someone out there during the good times who will give more money away, at better rates than you. It’s human nature and it’s put on steroids during an upcycle in the world of turbo-charged VC-backed startups.
Building a sustainable lending business takes discipline. But building a massive lending business takes something else entirely.
Why Lenders Won’t Win in Lending
I view alternative lenders kind of like the small hyena who stumbles upon a carcass before the pride of lions approach. Sure, they noticed the opportunity first and had a few tasty bites of high ADR, but are unlikely to capture most of the prize long-term.
To be candid, I’m not a fintech specialist, so I welcome feedback on the below. However, in breaking down the lending value chain, I think we start to see why. To be successful in capturing the opportunity, you need three things:
Distribution - do you own the customer relationship? Is it sticky & high frequency?
Data - do you have differentiated data sets and strong underwriting capabilities to better price risks?
Deposits - do you have access to a sustainable, low-cost source of funds? (i.e. are you a bank?)
Few have all three. Consumer tech platforms have #1, generally struggle on #2 and do not have #3. Alternative Lenders do not have #1, claim to have #2, and don’t have #3. Most traditional banks only have #3 and often struggle with #1 and #2 in the digital world. That’s a simplification which varies by geography, but in general, a good heuristic.
Each player starts from its core and then pushes into the other legs of the triangle to enhance its position - through building, buying, or partnering. The level of success will vary by geography - depending on digitization of the banks and existing customer relationships and regulatory barriers.
The dirty secret is while “data is the new oil” yadada, in the emerging geographies #1 or #3 are often better starting points. Data is important. However, platforms are protected by a sticky customer relationship and banks have regulatory monopolies on cheap capital. #2 is the easiest to squeeze.
To be fair: Are consumers & SMEs in emerging markets massively underserved? Is this a massive market opportunity? Are their platforms with large customer bases and limited underwriting capabilities which will look for partners? Are there banks looking to expand their distribution footprint through alt lenders?
However, without a sticky, high frequency relationship with the customer, you tend to get commoditized over time. And without a sustained, lower cost of capital, your spreads are gradually chipped away.
Lending club is one of many cautionary tales.
Payments - Bringing Moats to Lending
The previous investor shine which faded from alternative lending has moved onto payments. Looking at valuations of Stripe, Square, Ant, Adyen, Paypal, PayTM, GoPay, Visa, MercadoLibre(Pago)… you name it… the expectations for future growth and cashflows are tremendous.
Interestingly, the core revenue streams for many of these companies will likely prove unsustainable in the long-run. Merchant discount rates (“MDRs” i.e. payment fees) are likely to decline over time as competition in digital payments increase. Globally, I would expect the 2 - 3% fees in the US & other parts of the world to saunter down to the 0.5 - 0.6% MDRs charged by AliPay and WeChat Pay. So… why do these businesses often trade at 10x+ forward revenues?
1) Digital payment penetration remains quite low with plenty of share to take globally from cash
2) Payments are sticky, high frequency, provide meaningful data and are an overall great place to start a more expansive relationship with the customer or SME
Unlike alternative lenders, payments have aggregation qualities - merchants want to be where the consumers are and vice versa. Payments are also a good starting point to expand the financial offering with additional layers of software / financial services. Digital payments therefore have high growth potential, moats (at scale), sticky customers (or SMEs), and valuable data to leverage into more profitable products.
Investors may have found network effects for the massive lending opportunity after-all. Just not where they originally expected.
The “Developing” Divide - All for One or One for All?
While America led the global payments revolution a half century ago with magnetic striped cards, the financial value chain of the “developing” world is divorcing from this bank / card centric model. Without the benefit of modern tech and large platforms, developed-world payment ecosystems evolved slowly with banks at their center leading to a more fragmented value chain. Banks, payment gateways, processors, cards, issuers, acquirers, more banks, more cards all evolved around banks at the core - the most powerful players at the time.
Today is different. And the relative power between banks and internet companies in the emerging world is shifting. In a world where cash is concentrated in a few internet champions with large, smartphone equipped user bases and limited digital payment penetration - concentration and vertical integration of the fintech value-chain seems more likely. There becomes a real possibility to wrestle power from the banks, build an alternative network, and swallow the financial supply chain from the top.
“The China Playbook”.
Instead of payment processors / gateways (Paypal, Stripe, Adyen), mobile payment solutions (Venmo, Square Cash), consumer lending (Affirm, Lending Club), SME lending (Kabbage, Funding Circle), crowd funding (Kickstarter), credit scoring (Credit Karma), savings account (Chase, Max) , asset management (Wealthfront, Robinhood) all hosted by different parties, in China… it’s Ant. This is the new playbook in India, Southeast Asia, and LATAM which every large tech company hopes to replicate.
But it all starts with owning the customer and being present at the point of sale.
Payments are the network, the moat & the data all rolled into one. Without payments, the other prizes dry up. Unlike lending, eWallets follow a power-law distribution - with 1 or 2 capturing the majority of the market - which is why tech titans are prepared to spend dearly to get their flywheel going. The war in Indonesia showcased below is evidence enough.
In a digital world, successfully blitzscaling payments becomes the key to sustainably profitable lending...and then insurance…. and then asset management. And as we witnessed in China, payments tend to follow winner-take-most economics.
However, it won’t happen overnight.
The most effective wallets tend to have a compelling use case to limit the cost of acquisition and lock out competitors. Looking at eBay -> PayPal, Alibaba -> AliPay, MercadoLibre -> MercadoPago, SE -> SEAmoney, eCommerce has clearly been effective, though not exclusive (WeChat, PayTM, GoPay etc). The war is fierce and will often split market share by use case (i.e. in Indonesia a customer may use GoPay for ride-hailing, Traveloka PayLater for Travel, or OVO / ShopeePay for eCommerce etc.) If this holds, the payments and therefore the financial services opportunity would evolve in a more fragmented manner.
This initial phase of fragmentation presents the best odds for “neutral enablers” to insert themselves into the equation. Platform-agnostic paylater products, cash loans, and insurance products will attempt to scale horizontally across platforms not siloed to a specific use case. This is the how financial services is evolving in the developed world. In the west, perhaps “everyone will be fintech company” as the fragmented customer touchpoints are “enabled” by “embedded” solutions any company can leverage to offer financial services.
More of a platform play vs the dominant eWallet as an aggregator.
To be fair, there is still a chance this is how the world evolves in Emerging Asia. A series of digital enablers which sit between consumer platforms and pools of capital providing an API tech-stack of ID verification, KYC and Credit Scoring which scale across platforms and capture substantial value. National payment schemes and standardized QRs could push the outcome in this direction. There are also questions of ultimate eWallet adoption in many geographies (high growth but still <10% penetration in many areas) which would open the door for the evolution of “embedded” finance to service a more distributed ecosystem.
However, in the internet age, power-laws tend to be quite powerful and emerging market banks are not moving quickly. If an eWallet is able to reach escape velocity, every merchant and consumer will basically need to “embed” / integrate with one company - the eWallet champion. Considering how concentrated internet usage tends to be in the early stages of economic development, it becomes a lot easier for one company to capture the opportunity.
And that is where the fun begins.
At that point, the juggernaut will be hard to stop. Leveraging the tip of the spear in distribution and access to all consumers and merchants on the network, data becomes abundant. Abundant data tends to produce the best underwriting algorithms with alternative lenders and banks Gini Scores (accuracy) left in the dust. Possessing hard-won, sticky distribution relationships and now superior data sets, the champion is like Thanos - turning his efforts to the final infinity stone: Deposits.
Deposits require a banking license which is often out of reach depending on the regulatory environment. However, the champion has a few tricks. Keeping cash in the ecosystem through charge-out fees and other incentives becomes the norm - incentivizing spend in the ecosystem and away from the banking system. The platform can also partner with brokers to offer investment products - cutting out the banks.
Having consolidated both distribution and the data, the eWallet provider will also have substantial leverage in negotiating with fragmented, old-school banks. Banks will have little choice but to partner on less favorable terms - providing the platform with access to low-cost capital.
Looking at value-capture, either #1 swallows the whole chain or splits it with a fragmented group of #3s.
In a world of concentrated internet champions and consolidating payments, #2 is fighting an uphill battle.
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