What comes after MarketPlace Lending?

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Now that Lending Club is past its crisis mode and is just another mature company that has to impress investors with predictable growth in financials on a quarterly basis, we look at where the puck is headed in Lending.

What innovation will change the Lending game and create companies as big as Lending Club ten years from now?

Disclosure: I sold shares in Lending Club just before their recent quarterly earnings (Q4), having been fortunate enough to buy in at 3.51 after writing this post. Although I expect Lending Club to do well, the shares no longer have the great margin of safety that they did right after the crisis in May.

This post looks at four innovations that focus on two big imperatives facing any Lending entrepreneur – reducing Customer Acquisition Cost (where Customer = Borrower) and reducing Cost Of Capital (reducing the intermediary cost):

  • The next generation Deposit Account
  • Just in time Borrowing by consumers
  • Big Data for the lending to Micro Entrepreneurs
  • Automated working capital financing for SME

The next generation Deposit Account.

One big reason Banks have a low cost of capital is that consumers are willing to put up with lousy interest rates in order to get safety i.e. to know that their money is not at risk. The next generation Deposit Account could change that and our thesis is that the next generation Deposit Account will be based on the Lending Account.

Market Place Lending has created the first real banking innovation in hundreds of years which is the Lending Account. Until the likes of Prosper, Lending Club, Funding Circle and Lufax came along, consumers could have a Deposit Account (lend money to a bank) and a Loan Account (borrow money from a Bank) but could not directly lend in any simple scalable way.

This post shows how one Consumer has used Lending Accounts to make good money, much better than Lending to a Bank via a Deposit Account.

Most people don’t want to a) work that hard b) take that much risk. This is where the next generation Deposit Account is awaiting a great entrepreneur. The next generation Deposit Account will be a Lending Account that is ultra low risk and short tenor. Let’s start with tenor. If you are willing to lock up your capital for a few years, you can use existing Market Place Lending accounts. Compare the risk-adjusted return over 3 years compared to locking up your money in a 3 year Deposit account or a AAA Sovereign Bond and the Market Place Lending account looks pretty good.

However, most people want to have cash available at short notice for emergencies. They might want the notice/tenor to be weeks or at most months. That is hard to do using Market Place Lending accounts because the Borrower needs longer to repay. Unless you work hard to resell on a Secondary Market such as Foliofn, this is not an option.

This requires some financial engineering – the sort of thing that Wall Street has always done well. Through a mix of securitization, secondary markets and a cap & floor based guaranty, this is feasible. The arbitrage between lending to bank (Deposit account) and lending directly is big enough to give any entrepreneur enough to play with.

A note on securitization. Although securitization is seen as the villain of the Great Financial Crisis of 2008, there is nothing wrong with securitization per se. The issue is transparency. If you can hide a bunch of dodgy BBB loans in a shiny AAA package that is bad. If BBB loans are sold to those who know how to manage the risk/reward trade off, then markets are working as they should.

In addition to financial engineering, some UX magic is needed to make this as  simple for consumers as opening a Deposit Account.

If anybody is working on this, please let us know in comments.

Just in time Borrowing by consumers

The way a Market Place Lender like Lending Club or Prosper finds borrowers is remarkably old-fashioned. There is a lot of direct mail and search engine marketing to find consumers who want to refinance expensive credit card debt.

What if you eliminated the credit card phase and the Market Place Lender could acquire customers at the point of sale? That is what Klarna is doing for example; the proposition is bill me and I promise to pay. That can work in small, homogenous and relatively wealthy countries (eg Nordics, Switzerland) where the default rates will be relatively low.

This can also work at the opposite end of the spectrum in huge and relatively poor countries (such as China, India, Africa) where Credit Card penetration is low ie new models can appear at the point of sale to deliver lower cost borrowing to consumers at the point of purchase.

What is unclear is whether these new borrower acquisition models at the point of purchase will be part of a Lending Marketplace or part of an ecosystem that delivers customers to the Lending Marketplaces.

Big Data for the lending to Micro Entrepreneurs

You can lend to business or consumer or to the grey area in between of the self-employed “micro entrepreneur” where companies like Iwoca operate. The key here is that the revenue sources for these self-employed micro entrepreneurs are data rich services such as Uber, AirBnB, Amazon, Alibaba, eBay etc and data is the key to assessing lending risk.

Automated working capital financing for SME

Approved Payables Finance when the SME sells to Global 2000 type Corporates is working well. The APR is far lower than the SME would get from traditional finance or AltFi and Lenders get short tenor, self-liquidating high grade debt at far better interest rates than Sovereign Bond lending.

To date this has remained a niche play, despite working so well. This will scale when two things happen:

– An open standard drives e-invoicing to 90% plus adoption (the remaining 10% can be forced, enabing huge cuts in AR and AP processes). Once AR and AP is entirely digital, inserting just in time working capital financing options is easy.

– A credit rating for SME; today this only works when buyer is “investment grade”i.e. a corporate with a credit rating from an agency such as Moody’s, S&P or Fitch . If a butcher selling to a baker or candlestick maker could evaluate the credit rating of the  baker or candlestick maker, pricing credit would be simple and thus the APR would come down a lot. This is not rocket science and as always it is a data problem. All you need to know is does the baker or candlestick maker pay their bills on time.

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If anybody is working on solutions for the kind of innovation profiled here that we have not already mentioned, please tell us in comments.

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This week in InsurTech shows how fast the market is globalizing

global-insurance

It is hard to sip from a firehose and the InsurTech innovation pipeline in 2017 is a major gusher. As we parse this week’s news stories, one theme jumps out and this theme goes a long way to explain why the InsurTech innovation pipeline is such a gusher.

The theme is globalization.

5 InsurTech stories this week illustrate the globalization theme:  

  • Digital Fine Print goes from Seed to Asia via America and London
  • Australian insurer IAG establishes an Insurtech hub in Singapore
  • Youse is the very first Brazilian InsurTech brand
  • The first InsurTech conference in Quebec City
  • The first InsurTech VC fund in flyover country

Digital Fine Print goes from Seed to Asia via America and London

The news: the story broke on CrowdFund Insider. This one is as global as it gets. An American Insurance Company (MetLife) partners with an early stage London based InsurTech startup (Digital Fine Print) to move into Asia.

This story also shows the capital efficiency value of Incumbent partnerships and social media. Digital Fine Print is going into Asia having raised only $400k. Conventional wisdom was that you should wait until your $400m round before going global. However if you can use the back end platform of an incumbent and use social media at the front end, it is time to challenge that conventional wisdom. (Daily Fintech is totally global, with subscribers in 130 countries and we have not yet raised any outside capital).

Australian insurer IAG establishes an Insurtech incubator in Singapore

The news: It will be called Firemark Labs and was reported in multiple venues, here is one. IAG = Insurance Australia Group. It underwrites over $11.4 billion of premium per annum and is active in many Asian countries. The incubator (do we call them “hubs” or accelerators today?) has the usual job of scouting for innovation.

Score another one for Singapore – see here for our story about CXA. This story also illustrates the value brought by the very proactive Monetary Authority of Singapore (MAS) and its Chief FinTech Officer, Sopnendu Mohanty.

This is an inter Asia story – no American or European ventures. The Australia Singapore nexus makes sense as the Australian economy is tied to Asia.

The Incubator has access to cash through IAG’s $ 75 million venture fund.

The trend looks clear. MetLife already has an active Singapore-based innovation center called LumenLab. One can envisage each global insurance company having an InsurTech incubator in the 20 or more global cities with an active Fintech scene.

Youse is the first Brazilian InsurTech brand

The news: It is really only a “we are here” announcement with a lot of big picture data about how big InsurTech is.

Youse was created by Grupo Caixa Seguradora as a digital venture within a big company. We have seen some of these become successful in banking (see our Pirates With Ties interview series for some good success stories), even though cultural mismatch kills most intrapreneurial ventures.

Nubank in banking is a Brazilian specific example of a digital Neobank (but VC funded unlike Youse).

The first InsurTech conference in Quebec City

The news: InsurtechQC is the first conference dedicated to Insurtech in Quebec City. It takes place on April 3rd and has both local and international speakers.

The first InsurTech VC fund in flyover country

I know, I know, I should not refer to flyover country. It’s an old habit from living in New York and flying a lot to California. It sounds elitist and I apologize for that. The significant trend is that the Silicon Valley model of innovation has gone global and global does not just mean places like London, Zurich and Singapore. It also means places like Des Moines, Iowa.

The news: A Des Moines, Iowa-based VC fund called ManchesterStory Group backed by a consortium of insurance companies is looking for Insurtech deals.

“The new firm said it cannot disclose the insurance carriers behind it until the fund closes.”

They have company in Des Moines.  The Global Insurance Accelerator was launched in 2013 with backing from seven insurance companies and has since added 3 more.

Closer to mainstream customers and lower cost base sound like good ingredients for venture success.

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Applying Loose Coupling software principles to enterprise digital transformation

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Loosely coupled vs tightly coupled is no longer much of a debate in software. There are debates about how to do it well, but it is generally recognized that loose coupling is more robust to failure (even anti-fragile) and more scalable. The best example is the Internet itself. Imagine a version of the Internet controlled by a single big company or government. You would get something like Prestel or Minitel. If you have not heard of either, I rest my case.

This debate becomes relevant to business strategy and digital transformation, as many of the most valuable companies are simply software systems with an economic model attached – think of Google, Facebook, Alibaba, Amazon etc. When we talk about digital transformation of incumbents, we are really talking about turning industrial era companies into software systems with an economic model attached.

The question then is how should the components in that software system interact with each other? Or to put it in more MBA terms, how do business units work together to create synergistic value (aka one plus one is more than two).

This is not an academic debate for bankers. The question today is less about “too big to fail”. Governments do not have the cash for a bailout (with the possible exception of China). The debate is now more about “too big to manage”, or to put it more accurately “too complex to manage” (because big is good as long as it is robust). Tightly coupled is complex and fragile.

To understand how bad tight coupling is, try fixing one line of code in a legacy system. For the non-technical subscribers let me walk you through that one.

Try fixing one line of code in a legacy system

Many enterprise systems have thousands of components. If you ever wondered why big banks with lots of legacy systems are not agile, try fixing one line of code in one of those legacy systems. You will see what it looks like when a butterfly flapping its wings in China creates a hurricane in Florida. Developers have a term for how to deal with this – dependency management. If you fix one component you must know how it will impact related components and any change needs lots and lots of testing (failure to do so is career threatening).

Stack, platform, ecosystem and other faulty analogies

This is from one of my favorite thinkers about the future of software called Jon Udell:

“Here are some analogies we use when talking about software:

Construction: Programs are houses built on foundations called platforms.

Ecology: Programs are organisms that depend on ecosystem services provided by platforms.

Community: Programs work together in accordance with rules defined by platforms.

Architecture: Programs are planned, designed, and built according to architectural plans.

Economics: Programs are producers and consumers of services.

Computer hardware: Programs are components that attach to a shared bus.”

Analogies are useful to introduce a subject to a lay audience, but they can get in the way when trying to get to the next level. I tend to prefer “Ecosystem” as the analogy because the APIs do not only work up or down the stack. For example, one consumer-facing application could interact with another consumer-facing application without necessarily going through a layer below them in the “Stack”. I also try to avoid the Architecture analogy because that implies a level of rigidity which is dangerous. In an ecosystem we have emergent behavior. When one releases an Open API to the outside world, a good result is the unexpected, serendipitous application that nobody had planned for but which totally changes the game.

Applied to digital transformation, all of these are a form of systemic innovation.

Systemic innovation

Back in the summer of 2015, we interviewed Haydn Shaughnessy, co-founder of the consultancy The Disruption House, whose book Shift, A User’s Guide to the New Economy is a look at systemic innovation.

He told us:

“The system threatening innovation is coming from outside the industry, from China tech companies, which have quite different balance sheet constraints, and as ever the open source community. Banks don’t understand system innovation. They think in terms of product. Compare this to what the Chinese technology platforms are doing.  I think western banks will be swamped by system level innovation soon and FinTech investments won’t provide an answer to that. The change is not just about digital and the start ups we see right now are just not scaling fast enough. The change is about new skills, new processes, new services and new business models. Digital is the wrong war cry and the start-up is not a big enough axe.”

The way Steve Jobs created a product like the iPod is by assembling it from lots of loosely coupled components. Of course they were tightly integrated within the product, but via well-defined interfaces so that one vendor can easily be replaced by another vendor. Apple is the opposite of open. They like secrecy and control. Today’s consumer electronics business in China works more like an open ecosystem. Branded, consumer facing companies such as Xiaomi emerge from this ecosystem, but it is the ecosystem that is more interesting than any single company. Like Silicon Valley, this is an ecosystem that rapidly creates big companies, but it is a fundamentally different ecosystem.

Chinese business ecosystems

John Hagel, one of the leading business strategists, is author of The Only Sustainable Edge where he describes how Chinese tech companies are partnering to build products way more efficiently than they could by creating everything in-house.

This is an example of necessity being the mother of invention. Chinese companies have grown despite lacking two critical things that we take totally for granted in the West:

  • Intellectual Property (IP) protection
  • Well-developed capital markets.

The Chinese firms turned these weaknesses into advantages through their approach to partnering – classic Jiu Jitsu.

Enterprise vs Silicon Valley vs Shanzhai

Traditional 20th century enterprises are tightly coupled. That is the essence of vertical integration and it worked well when the challenge was the manufacturing and distribution of physical products. This changes in the digital era, when the winners are companies that create digital ecosystems such as Google, Amazon, Alibaba and AirBnB.

Digital transformation does not just mean adding a digital front end – however mobile savvy it is. It means re-engineering the company from the ground up to create a digital ecosystem. That re-engineering has to be based on loose-coupling.

The Silicon Valley ecosystem has been much studied. The Chinese electronics ecosystem dubbed Shanzhai is less well known. For a good description of Shanzhai, go to this article in The Atlantic.

Both Silicon Valley and Shanzhai ecosystems work on loosely coupled principles and that means that the companies that emerge from those ecosystems are loosely coupled in their DNA. Partnering is not an add-on, it is a core competency.

A bank is a tightly coupled enterprise ecosystem

A traditional Bank is a tightly coupled enterprise ecosystem comprising these 4 different accounts each serving a different need:

  • Current/Checking account (payments in and out).
  • Deposit/Savings account (having some spare cash for emergencies without any risk to capital).
  • Wealth Management Account (earning money on longer term savings using fixed income, equities and other assets, earning more return by taking some risk).
  • Loan account (borrowing money).

The only new account innovation in hundreds years is the Lending Account from Marketplace Lending. This the Loan account in reverse.

Startups are unbundling this tightly coupled enterprise ecosystem of accounts. They do one thing and one thing only. Regulatory innovation is keeping up, so that you can now for example just get a Payment License to use as Current/Checking account and a different license for a Deposit Account.

This is great for innovation. It does however leave the consumer to become their own systems integrator, using a lot of sneaker net and spreadsheets. As most consumers don’t want to do this, traditional banks are OK for now with their tightly integrated offerings.

The next wave of innovation is about “rebundling” and this is done using loose coupling.  The Fintech Rebundling can be done by startups or by Banks. It is a genuinely level playing field enabled by Open APIs. It is perfectly suited to Red Ocean markets. In Blue Ocean markets, the “do one thing and one thing only” startup mantra is more appropriate.  Startups tend to go for Blue Ocean markets and banks tend to fail at Blue Ocean markets due to organizational forces that attack such a radical idea. So Banks tend to operate in Red Ocean markets where they need to innovate in order to counter moves by traditional competitors and Fintech ventures to capture Millenials and other parts of the market that are up for grabs.  Rebundling is a strategic response by Banks in these Red Ocean markets and a way to create new competitive moat.

The Unbundled Bank looks like this (replace those HiFi components with standalone accounts):

hifi-separates

Digital transformation is about building something more like this:

ipod

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SoFi buying Zenbanx either signals the first Mega NeoBank or a unicorn losing the plot

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SoFi became famous for raising $1 billion in Q3 of 2015. Unicorn valuation is big club (with more hype than reality as we said during the mega hype phase at the end of 2014), but a unicorn round (raising $1 billion in a single round)  is a very elite club. We normally only see unicorn rounds in China, where the investors are big companies rather than funds. This story also has a China twist, read on for that.

SoFi timed their $1 billion raise perfectly in late 2015 when Fintech was still in Wave 1 (the “this is revolutionary” wave as defined in this post). Since then Market Place Lending (MPL) hit some problems that dragged down the whole Fintech market and we went through Wave 2, when the conventional wisdom was that entrepreneurs should knock politely on the doors of the incumbent banks because they control the pace of change.

The news that SoFi was buying Zenbanx signals that SoFi has no plans to knock politely on the doors of the incumbents – they want to compete head on with the banks.

This could mean we are witnessing the birth of a Mega NeoBank. Or it could mean we are witnessing a company that raised too much during the hype cycle and is now losing the plot. This is post shines a light on that question. The answer will reveal a lot about the state of the Fintech market as well as the specific fate of SoFi.

This post will cover

  • What do Zenbanx do?
  • Who funded Zenbanx?
  • What comparable events help with analysis?
  • The TenCent China part of the story
  • Our take

What do Zenbanx do?

In the words of Mike Cagney, CEO of SoFi, when announcing the deal, Zenbax offers a “mobile banking account that lets people save, send and spend in multiple currencies.”

Save, send and spend has a nice ring to it. It describes quite simply why we use a bank. Oh and borrow and that is what SoFi already enables.

Two key things about this:

  • This is not just a Current/Checking account, covered by some payment license and using a pre-paid mobile wallet. It is also a Deposit account which as per the Zenbanx FAQ is FDIC insured. That is a big deal for a Market Place Lender like SoFi. It means they can get a low cost of capital. This looks like a head to head competitor for the Goldman Sachs Marcus service.
  • It is a multi-currency account. It will be interesting to see what SoFi does with this. It may simply remain a cross border money transfer service to American customers; SoFi is totally focused on the American today. Or they may use it at some stage to go global.

Who Funded Zenbanx

Crunchbase does not show the Zenbanx investor. Possibly it was changed post acquisition. So we went to CB Insights and found three Seed Investors:

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  • DCM is a classic Silicon Valley VC.
  • TenCent is the T in BAT (more on them later).
  • Recruit Strategic Partners is less well known. They come from Japan but invest globally. They are a 100% subsidiary of Recruit Holdings, a diversified company that began in the 1960s as an advertising agency that specialized in university newspapers.

What comparable events help with analysis?

  • BBVA acquisition of Simple in 2014. BBVA paid $117mn in 2014 and has since taken impairment charges but claims to be happy with the deal and to continue investing. The great results of a digital bank incubated by an incumbent such as ING (see interview here) indicates that they could be successful.

The TenCent China part of the story

TenCent was a Seed Investor in Zenbanx. In December, Zenbanx announced how they are using WeChat to offer what they call “conversational banking”.  Expect Facebook to be paying close attention as they figure how to monetize that $19bn WhatsApp deal. Alibaba is already the dragon in the room with their acquisition of MoneyGram.

The long-awaited move of GAFA and BAT into payments is happening now.

Our take

Banking is a service business not a winner takes all network effects business (see this post for more on that theme).

So we expect a number of full stack global Neobanks to be successful. So both N26 and SoFi can be success stories, albeit with different strategies. As can Neobanks incubated within an incumbent such as BBVA and ING. Whether the starting point is a VC backed startup or a legacy bank, the end game is the same. This is the convergence thesis we first outlined here.

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CXA Group $25 million Series B shows the maturing of InsurTech and future of Innovation Capital

 

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Closing a Series A round is tough (the “Series A Crunch”), but closing a Series B is even tougher. You have to show great metrics at all levels. Series B is the “show me round”.

So when we see a big Series B round in the white hot InsurTech sector we pay attention.

In this post we look at the trends and insights behind the news that a Singapore-based health InsurTech venture called CXA Group has closed a $25 million Series B round from Facebook’s co-founder Eduardo Saverin’s B Capital Group and Singapore’s EDBI.

This news illustrates 6 major themes:

– Innovation Capital goes where it feels welcome

– Innovation capital goes where there is opportunity and that is shifting to Asia

– Singapore just scored a goal in the Fintech Hubs Global Tournament.

– The UHNWI Super Angels will shake up the “permanent aristocracy” of top tier VC Funds.

– The role of Government in building Fintech hubs

– This could be Zenefits done right

Note on terminology: we refer to Innovation Capital as the combination of cash + connections + know how that has historically been called Venture Capital. For reasons explained later, the historical term – Venture Capital – has outlived its Sell By Date.

Innovation capital goes where it feels welcome

This is not complex. Countries with zero capital gains tax on long term investments will attract a lot of Ultra High Net Worth Individuals (UHNWI aka Family Offices). Eduardo Saverin is an example – a Brazilian who famously renounced his US Citizenship in 2011 to take up residence in Singapore.

What is new is the blurring of lines between these UHNWI Super Angels and traditional Institutional Venture Capital. More on that later.

Innovation capital goes where there is opportunity and that is shifting to Asia

Asia is the 21st century growth story.

This statement wins the “Captain Obvious Award”. What is interesting is the time lag between when the growth shifts and when the innovation capital shifts. For a while, Innovation Capital in the middle aged world (America) and the old world (Europe) knew how to invest and saw the growth shifting to Asia. It was American VC money flowing into Asia. The next iteration, happening now, is when Asian VC money flows into Asia. This deal illustrates that shift.

Singapore just scored a goal in the Fintech Hubs Tournament.

This deal demonstrates that Singapore is becoming a major Fintech Hub, leveraging smart regulation and its position at the heart of the Asia growth story.

The UHNWI Super Angels will shake up the permanent aristocracy of top tier VC Funds.

The lead investor is credited as “Eduardo Saverin’s B Capital Group”. If the PR said “Eduardo Saverin” then this would be classed as an Angel round. Whether B Capital Group has other investors is not that important because a single UHNWI individual or family has plenty of capital to deploy.

For a long time, we had Angels who led the way by investing early and then politely inviting the big funds to invest. This led to what the Ivey Business Journal describes as a permanent aristocracy of top tier funds.  The Super Angels with an institutional fund, such as Eduardo Saverin’s B Capital Group can give that permanent aristocracy a run for their money. Some of the partners of those top tier funds are now also setting up as Super Angels and just investing their own money. Like Hedge Funds that become Family Offices, they no longer manage other people’s money, they just invest their own money. This is partly driven by tax, as people see the political writing on the wall that signals the end of carried interest fees being taxed as capital gains.

This is why we see the term Venture Capital as past its sell by date and prefer the term Innovation Capital. What we normally think of us VC – funding early stage innovation – is being done by Angels and too many VC Funds have become part of the asset management industry  focussed on AUM fees and short term exits.

The role of Government in building Fintech hubs

Co-Lead on the deal was the corporate investment arm of the Singapore Economic Development Board call EDBI. This post looks at the increased role of governments in Fintech regulatory competition as governments calculate the economic return on innovation. Whether direct investment (“picking winners”) is the right way is debatable, but expect to see more government activity in Fintech.

This could be Zenefits done right

CXA is going after the employee benefits industry (pegged at $100 billion in Asia) with a free SaaS platform monetized via lead generation. If that sounds familiar, think Zenefits, the hyper-growth success that hit the speed buffer (for reasons described here).

CXA goes to the next level by helping employers unlock wellness through prevention and disease management.

The health InsurTech opportunity is no longer only about America.

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Announcing our Chief Commercial Officer

I am delighted to announce that we have appointed a Chief Commercial Officer to grow our business.

Julia Spiegel brings lots of entrepreneurial experience in both the commercial and non-profit worlds, with a strong focus in brand development, marketing, sales management, and event planning. Julia is global in her experience and outlook, which is critical as Daily Fintech subscribers (over 16,500 as I write) come from 130 countries. Julia is an American, currently residing in Switzerland, having lived and done business in Singapore, India and the United States.

Julia is fascinated by how history and geography play a role in the development of different cultures. She brings an openness, respect, and curiosity to working across regional and business cultures, looking for common interests to unify groups towards shared goals. Julia is keen to help grow the Daily Fintech brand and business with a clear understanding of the value that our content brings to our readers.

Contact information:

julia at DailyFintech dot com

Calpers and the quiet data driven disruption of Private Equity

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Private Equity is a classic clubby insider high margin business. If open data and networks always disrupt these types of business, then Private Equity is overdue for disruption. 

This post offers:

  • A brief history of Private Equity.
  • Private Equity in context to other asset classes.
  • Two big problems facing Private Equity.
  • The disruptive power of open performance data and what Calpers is already doing to bring about this change
  • One disruption scenario.
  • One venture going after this space.

This post is specifically about investing in mature, profitable private businesses. This is in contrast to early stage investing which is already being disrupted by crowdfunding networks for both accredited and non-accredited investors. Private Equity deals are usually control deals (vs early stage that are normally minority equity), so we usually refer to this as Private Equity Buyout. 

A brief history of Private Equity Buyout

Private Equity Buyouts has gone through three iterations:

  • Version 1: Lean Conglomerate. This was pioneered by Hanson Trust in the 1970s. They bought underperforming old companies and put in financial discipline and a new CEO who got a piece of the action after the business was sold. Hanson Trust was an operating company with diverse businesses, so the right name is conglomerate, but they kept Head Office very small and they were always willing to sell a business if the price was right. Their mental set was closer to a Fund than an operating company, so the appropriate tag is Lean Conglomerate. Many other firms did well applying the Hanson Trust model in different markets (often learned while working at Hanson Trust). For example, Misys took the Hanson Trust model and applied it to software and now there are many such software conglomerates.
  • Version 2: Leveraged Buyout Funds. This cut the HO function down even further so that Conglomerate morphs into Fund, but the practices and techniques were similar. KKR was the pioneer in the 1980s. These Funds use leverage to juice returns and force cost cuts. Using strong cash flows to pay down debt, a Fund could sell after 5 years without even changing the business and still get a good return.
  • Version 3. Take Private. This requires more work than the Leveraged Buyout model. It is about fixing what is dysfunctional in public markets – an obsession with quarterly earnings. Transformational change requires more than one or two quarters. One example is the $11.3 billion 2005 Sungard deal. Sungard, like Misys, had grown through acquisitions and at a certain point the result was too messy and the business needed to be revamped out of the eye of public investors.

Private Equity in context to other asset classes.

Private Equity is small in total assets compared to asset classes such as Public Equities and Fixed Income. Private Equity is one part of Alternatives which was $7.2 trillion in 2013 vs $56.7 for Traditional Investments. But note the growth rates.

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However, Private Equity is big in one area which is Fees. In this FT article it is revealed that one pension fund alone (Calpers, more on them later) paid $2.4 billion in fees to PE Funds.

High growth and high margins means that any entrepreneur listening to Jeff Bezos (“your fat margin is my opportunity”) should be paying attention.

Problem 1: Software is eating the world.

Private Equity Funds pitch themselves to Investors as being more conservative/less risky than their wild cousins doing early stage equity. They will do rigorous analysis of the past 10 years or longer to see how predictable the cash flows are. No dangerous projections based on new products for them, their models are rooted in real world actual results of proven products.

That sounds good, but is based on a fundamental error which is the assumption that the future will be like the past. The Digital Era overturns that assumption.

Consider the printed telephone books aka “Yellow Pages”. They were a license to print money for a long time and many Private Equity Funds bought into them for that reason. Now it is hard to find people who use printed telephone books for anything other than doorstops.

Or consider hotel chains after AirBnB or Private Banks after Robo Advisers. How do you model future cash flows in those scenarios?

Problem 2: capital oversupply

When everything else changes, you can count on the law of supply and demand as a constant. Private Equity has been such a good business for so long that investors have been pouring money into the best funds (who then get high fees on AUM and the ability to do the mega deals). The problem is that this results in a lot of capital chasing the best deals (what Private Equity guys call “dry powder”) which raises prices on entry and that depresses returns on exit.

Calpers – its the data stupid

Into this closed, clubby world (”if you have to ask the price you cannot afford it”) comes Calpers (California Public Employees Retirement System) with their Private Equity Program Fund Performance Review. This is data transparency in action. It is only one investor but that investor is so big that it is a significant data point. You can sort all the PE funds online by all these different criteria.

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Our thesis is that this data will drive a lot of innovation. Entrepreneurs will be able to show what they offer vs the competiton by referring to this data. It is like an Index for the Private Equity business.

Disruption scenario

Our thesis is that disruption will come from Family Offices, managing money for the Ultra High Net Worth Individuals (UHNWI) and their families. In the US alone there are 3,000 single-family offices with assets under management between $1 trillion and $1.2 trillion.

Four key points about Family Offices:

  • They like the high returns of Private Equity and don’t worry about the lack of liquidity with money “locked up” for years (because they are managing money for multiple generations).
  • They are agile because they don’t have any “explanation risk” (if something goes wrong they can learn from it and move on, they don’t have to explain their actions to investors).
  • They don’t compete with each other.
  • Many are still run by entrepreneurial families (who are used to taking measured risks to get better returns).

This makes the Angel List model of following a proven investor applicable to Private Equity. This is already happening in a small way with small networks of like-minded Family Offices working together on deals (referred to as “club deals”). This is where the entrepreneurial genes of the Family Office counts. Let’s say Family Office A made their money in Pharma and Family Office B made their money in Software. Family Office A follows Family Office B’s lead in Software and vice versa.

Angel List obviously works at the early stage end, but the brilliance of their innovation is that they take of all the “boring plumbing admin” stuff like reporting. That can apply to any form of asset management, including Private Equity.

Axial

One company going after the Private Equity space is Axial. They recently raised a $14m Series C and are led by a proven entrepreneur called Peter Lehrman who was part of the founding team at Gerson Lehrman Group (technology platform for on-demand business expertise).

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