Attracting private equity investment in a changing market

Fintech has enjoyed several boom years, raking in unprecedented amounts of capital and producing a high number of successful scale-ups. But with the economic winds seemingly turning, what will become of fintech and its ability to attract funds? We take a look at private equity (PE), asking what the current market prospects are and revealing what fintechs should know in order to attract the right investor.

What’s the difference between venture capital and private equity?

Many fintech founders will be familiar with venture capital. It’s one of the most popular ways for up-and-coming fintechs to secure finance, and because of the relative nascency of the fintech sector until now, it has garnered more attention than private equity. As the name suggests, venture capital is oriented towards smaller, younger startups. Venture capitalists invest in promising companies in return for a smaller stake in the business, in the hope that it will grow rapidly in a short time and deliver a high return.

By contrast, private equity is focused towards more mature businesses that have already enjoyed some success and growth. They may be businesses that are enduring some sort of financial difficulty that requires an activist investor or potential restructuring. PE firms tend to take a larger stake, and may take over a public company with a view to delisting it.

“The private equity stage is akin to moving from grammar school to college,” says John Clark, Managing Director at Royal Park Partners. “At this point, the company has demonstrated product market fit – congratulations! The investors at the next stage of a company’s evolution are likely coming out of Harvard Business School or McKinsey, so expect laser focus on the nuts and bolts of the business, such as metrics on customer acquisition cost (CAC), lifetime value (LTV), total addressable market (TAM), cash flow, profitability at a unit economic level and competitive landscape.

“This group of investors isn’t looking for 10-times cash returns, but a more modest three-to-five times. They are therefore keen to convince you the valuation today is too high and cannot make any money unless they add structure to a deal (downside protection). The rationale is they make fewer but more concentrated investments and look to have a board seat and/or an observer seat as well.

“At this stage, the thinking is ‘how do we get you from US$10mn of revenues to US$40mn or US$50mn in three-to-five years?’ It becomes a tactical and strategy-driven process, focused on professionalising the organisation. This tends to be the biggest shock to founders as they transition from VC to growth/PE investors.”

What is the state of the current PE market?

A lot has been made of the current economic conditions, and whether they’re conducive to investment. It’s possible that the latest economic developments – high inflation and the spectre of a global recession – may eventually put a dent in PE’s interest in fintech, but the latest figures we have underline just how rapidly PE investment has grown over the last few years.

“Private equity investors have become increasingly attracted to fintech over the last five years,” says Sam Lawson, VP of Capital Markets for Crowdcube. “US$12bn was invested in fintech by PE across 144 deals in 2021 – a new record that’s substantially above the prior record of US$5bn in 2018. Fintech’s relatively higher gross margin and cash flow profile make it attractive to PE. It’s also an extremely scalable sector – financial services touch everyone, everywhere.”

Private equity is still dwarfed by venture capital funding, though. VC investment in fintech amounted to US$115bn in 2021, according to KPMG’s Pulse of Fintech report, almost triple the US$46bn investment that VCs made into fintech the year before. This heightened level of investment may reflect an industry coming of age, or it might indicate that new sub-sectors are coming to the fore.

Anton Ruddenklau, Global Fintech Leader for KPMG, says: “We’re seeing an incredible amount of interest in all manner of fintech companies, with record funding in areas like blockchain and crypto, cybersecurity, and wealthtech. While payments remain a significant driver of fintech activity, the sector is broadening every day.”

Crowdcube’s Sam Lawson adds: “Especially now, private equity will be looking to invest in maturing sub-sectors of fintech that are addressing long-term market trends, such as the increased threat of cybercrime, demand for embedded financial services and the inefficiency of current core banking infrastructure”.

What do private equity firms look for in an investment?

“H1 2022 has seen a somewhat inevitable deceleration in the rate of private equity dealmaking across the board, though Europe has been more resilient,” Lawson continues. “Over the coming quarters, we may see a further reduction in new deals as rising rates, declining GDP, falling consumer confidence and the ongoing war in Ukraine impacts businesses.

“However, PE currently sits on historic amounts of unallocated capital. Due to its breadth and relatively attractive financial profile, we expect fintech to continue to be one of the key areas of investment.

“In the short term, private equity activity may concentrate on ‘take-privates’, investing in publicly traded fintechs that may have suffered from steep declines in the public markets. In the private markets, over the medium term, a souring venture capital market may present an opportunity for PE to step in to partner with unloved but otherwise healthy VC portfolio companies.”

So what should fintechs know if they want to attract PE investment? “Revenue growth and profitability are central to attracting inward investment,” Lawson explains. “Now in particular, proving the ability to generate cash flow is vital to gathering investor interest.

“In the short-term, VCs will focus resources on their existing portfolio companies, meaning the rate of new investment may slow. Fintechs should look to their existing investors to provide additional funding, but may also find solutions in alternative finance. Equity crowdfunding, for example, can be a source of additional capital following on from existing VC investors who may be re-upping.”