#29 Are Neobanks Overvalued

Looking at the Neobank space and contextualising their valuations

Hi all - This is the 29th edition of Frontier Fintech. A big thanks to my regular readers and subscribers. To those who are yet to subscribe, hit the subscribe button below and share with your colleagues and friends. 🚀

With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves. - Warren Buffett

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.” - Warren Buffett

Globally, Neobanks have been on the up and up when it comes to valuations. Revolut recently confirmed an US$ 800 million fundraise at a valuation of US$ 33 billion. Nubank earlier in the year raised US$ 400 million and then six months later raised US$ 750 million at a US$ 45 billion valuation. The interesting thing here is that Berkshire Hathaway participated in the round. Recently, Chime raised US$ 750 million at a US$ 25 billion valuation. In Africa, Kuda Bank broke records when it announced a US$ 55 million series B valuing the company at US$ 500 million. The neobank bug has caught Africa particularly with Kuda Bank’s raise. India has not been far behind with Neobanks such as Jupiter and Novo both raising big rounds.

Initially, my article was meant to cover the African neobank space, but the more I researched this phenomenon the more I realised that some of the concepts applied at a global rather than local level. I wanted to understand whether the neobank fund raises are sustainable and whether real value is being created. In the course of my research, I figured out that there are both positive and negative arguments. Therefore, I will just lay them out.

For the sake of the article, Neobanks are defined as firms that offer financial services traditionally offered by banks exclusively through online or digital channels exclusively. Additionally, it may be useful for the sake of this article to define them as banks that are digitally native with technology defining their approaches to core banking tasks such as compliance, customer onboarding, KYC, credit scoring and most other tasks in the banking value chain.

The recent fundraise by Kuda Bank brought about angst and excitement in equal measure. A collective gasp could be heard throughout the continent as it was announced. On one hand, excitement that African Fintechs are getting global attention and that local founders can raise such rounds. On the other hand, there was concern that the space is overheating and if indeed a bubble bursts, the African fintech scene will take a long time to recover. This article by Maya Horgan Famodu best captures the concerns.

Comparisons to local banks such as GT Bank which has a valuation of US$ 2 billion were given as signs of exuberance. How can a bank that is barely 2 years old with significantly less revenue be valued at a quarter of the valuation of one of Nigeria’s most profitable banks? Across the continent, bank executives are scratching their heads at these valuations given that most banks are trading at less than 1.0x book value. Investors across Africa and globally are discounting any future earnings growth whilst stating that they don’t believe that bank books accurately reflect their stated value. 

I am not an Oracle and I won’t predict whether Neobanks are overvalued or undervalued, but I will state a few frameworks that I use to understand the value added brought about by Neobanks and their full economic promise. As stated at the beginning of this newsletter, in the long-term, the value of any company is defined solely by the cash flows it can bring to its investors over the long-term. Anything else is purely speculation or unique market factors that are difficult to replicate.

Manufacturing vs Distribution

This is one of the least covered elements when discussing Fintechs both in Africa and globally. There is a taxonomy when it comes to banking and financial services. On one hand there is the manufacturing of financial services which includes elements such as fractional reserve banking, maturity transformation, liquidity transformation and credit transformation. These are the core activities of a bank and are the heavily regulated elements that have societal implications. When a bank collapses, it is mostly because it has failed in its capacity to manufacture financial services. Additionally, manufacturing is capital intensive and benefits from scale economies. In the absence of scale economies, banks can execute their manufacturing services by focusing on serving specific niches very well. This can include banking a niche group such as military officers, large corporations or farmers.

Distribution on the other hand is concerned about how banks grow and serve their customers. This has been done traditionally through branches and ATMs. Recently, this has expanded into mobile apps and web browsers. The recent trend towards open banking is a regulator driven approach to disentangle manufacturing from distribution with the idea that improved distribution can lead to better client outcomes. Of course, banks that build powerful distribution mechanisms can use this to power their manufacturing business. The diagram below from GT Bank best captures this, the bank uses its retail distribution capabilities to grow liabilities which are then lent onwards to corporate customers.

Source:

GT Bank Annual Presentation - (Check retail deposits viz corporate loans)

A number of Fintech apps seem to be focusing on the less profitable distribution elements as opposed to manufacturing which traditionally are cost centres. The idea has been to offer customers products or services that are traditionally offered at the distribution phase such as low cost funds transfers, cheaper FX and account orchestration. Of course credit-led Neobanks such as Dave, Chime, Nubank and Tinkoff have built significant manufacturing businesses and that’s why they’re potentially further ahead on the path to profitability than their distribution heavy peers such as Revolut, Monzo and others. OakNorth and WeBank are other examples of Neobanks that have successfully mixed manufacturing and distribution. 

Of course, there is a potential business model where a Fintech or Neobank that has significant distribution capabilities helps a bank in the manufacturing element through origination. We have seen this happen successfully with M-Pesa and NCBA Bank with M-Shwari as well as Ant Financial with their partner regional banks. Jumo is another example of an African Fintech partnering with banks for credit origination.

It can be argued that some of the distribution heavy Neobanks such as Revolut are investing heavily in global distribution with a view of converting this into global manufacturing once scale has been achieved. If this is the case, then growth at all costs may be a useful though extremely risky strategy.

Market Failure vs Market Inefficiency

Market failure occurs when supply and demand don’t clear. This usually happens with public goods such as roads and security where the government has to step in to cater for this failure of the market. It can also exist in the market due to the inability of incumbents to offer a service to segments of the population. On the other hand, markets can be served but inefficiently. Neobanks are thus approaching markets based on the above dichotomy.

Nubank and Tinkoff have responded to market failure and offered a credit card to customers who were underserved by the traditional banking sector. Revolut, Monzo and Starling in my view are responding to market inefficiency where such services already exist but are distributed or packaged inefficiently. Stripe and Square responded to market failure by enabling merchant acquisition for groups (the long-tail) that were previously excluded.

Of course, with a great product, your initial customer base will grow from the previously excluded to the previously included who now want a better product. This has been the case with both Stripe and Nubank. 

Analogue examples can be given. Equity Bank in Kenya and GT Bank of Nigeria grew on the back of enabling people who were previously ignored by the banking system due to onerous KYC or minimum balance requirements. Nonetheless, as they grew, previously included became part of their clientele. These include large corporate customers who can now benefit from lower cost loans and cheaper FX generated from the retail base. 

I would venture to say market making Neobanks such as Dave, Nubank and Tinkoff have a brighter future than Neobanks that are responding to market inefficiency. In finance in particular, it’s more profitable to grow based on a new market as opposed to entering an existing market largely due to the inertia of account switching. Everyone complains about their existing bank but then does nothing about it.

Incumbents and the Innovation Stack

“We shape our homes and then our homes shape us” - Winston Churchill

The global banking revenue pools are predicted by McKinsey to reach between US$ 5.5 and 7 trillion based on a number of scenarios in a post-covid world. These are the revenue pools being targeted by Neobanks and in some cases, additional markets are being created that could drive these revenue pools higher. Arguably, as Neobanks achieve scale, there is a likelihood that the empire will strike back. This is a theme that is well articulated on this podcast of Invest Like the Best by Carl Kawaja. The idea is that as digital disruptors grow, traditional companies facing extinction will react and fight back for market share. Examples given are Walmart and Target building powerful e-commerce propositions in their quest to win back market share from Amazon.

It’s only a matter of time before banks respond with their own digital propositions and win back market share from neobanks, goes the thinking. There are many ways of dealing with this idea and in my view, I’m guided by the concept of “the innovation stack”. This idea has been brilliantly articulated by Jim McKelvey, a co-founder of Square. Square has grown to be a US$ 123 billion market cap powerhouse with revenues of US$ 9.5 billion. The idea is that as a start-up grows, it solves numerous problems and thus develops specific capabilities that are invisible to the outside. Countless optimisations lead to invisible innovations such as organisational structure, reporting lines, recruitment principles, workflows and mindsets that are impossible to copy. The example given in the innovation stack is that Amazon wanted to get into the acquiring business with a product similar to Square’s and eventually failed.

I have seen this in action where as a bank competing in the local market, we launched specific digital propositions in the market. At every EXCO, my colleagues would always warn of this specific bank coming up with a new challenger proposition. Surely, their bigger budgets would wipe us out. However, an innovation stack is real. Elements such as support from the top, organisational structure, incentives and reporting lines as well as partnerships, vendors, proprietary tech etc all form the innovation stack and make it difficult to compete with a smaller company.

This works well in Neobank’s advantage. As they continue to evolve, they are creating specific skills and workflows that are digitally native and thus with scale, incumbent banks will not be able to catch up. The first 20 minutes of this talk by Stripe Co-Founder reflect the realities of a start-up and how if you’re thoughtful and solve enough problems for your customer, then you build a company that’s difficult to outcompete.

An additional point around the innovation stack particularly for Neobanks is the accelerating improvements within their tech stack. Given that these companies are digitally native with modern tech stacks, then with time as the underlying technologies improve, they will be able to benefit from technological improvements organically. This case has been made by Jeff Bezos in his annual letters. Amazon benefited from improved internet speeds, more powerful processors and chips and better smartphones. This point is important, a cement company for instance will not benefit from trucks improving their speed and efficiency at a rate of 100% per annum over a 10 year period. Analogue banks will not be able to process physical loan application forms 100x faster over a 5 year period.

If Neobanks manage to build powerful innovation stacks, then over the long run improvements in AI capabilities, GPU’s, smartphone capabilities and broadband speeds will supercharge their businesses.

Source: Softbank Investor Presentation

Venture Capital and the Inherent Incentives

Behind the growing Neobank valuations are Venture Capital firms. The nature of VC’s is that they raise funds from outside investors and then proceed to invest in start-ups with a view of benefitting from significant valuation gains in the long-run particularly through exits such as IPOs and trade sales. Unlike Private Equity, the VC model is based on power laws where the bulk of VC gains will be made on a few bets. Those few bets need to return 10x or 100x to cover other failed investments. 

The business model is as old as the ventures that funded firms such as the Dutch East Indian company or the South Sea explorations of the 18th century. Nonetheless, the business model as it is currently practiced was perfected in Sand Hill Road in Silicon Valley which is to VC what Wall Street is to traditional finance. 

Venture Capital, unlike Private Equity, is best suited to start-ups given that the risk tolerance is much higher and it often doesn’t load investee companies with debt. It’s thus best suited to the kind of investments that need to be done for market making companies such as start-ups. 

Over the last 10 years, the VC industry has grown significantly across all metrics.

Source:

Pitchbook and NVCA

The diagram above shows that total VC activity is already on track to surpass total 2020 levels as of mid 2021. At the current rate, total activity could be double 2020 levels. Packly M does a good job in explaining how this is possible and how we’re in the exponential age. It can be argued that we’re just at the beginning and total VC deals are expected to grow significantly larger. Exits such as Roblox, Coinbase and the recent Robinhood IPO have shown just how much value can be made in VC investments.

This dynamic has led to bigger deals and an expansion of the geographic coverage of VC investments. Additionally Fintech has benefited greatly with over US$ 760 billion being invested in HY 2021. 

On the supply side, larger pension assets, successful exits from founders, growing stock market values are all driving a wealth effect that is driving more capital into VCs. All this is driving demand for deals. The question then becomes whether we’re in a VC bubble or not. Of course, with a VC bubble, there will definitely be a start-up bubble. Zach Coelius of Coelius Capital had the following to say “Capital is flooding into the VC market because of high returns in VC...That leads to more investors splashing money around and driving up prices and investing in companies that shouldn't be invested in." On the other hand, Chirag Chotalia had the following to say; “The biggest revelation for me is the size of the outcomes really supports the quote-unquote frothiness in the cycle. In many ways, what was irrational a couple years ago is now much more rational today because of what we're seeing on the exit side."

In 1975, Warren Buffett wrote a letter to Katherine Graham, the then custodian of the Washington Post company about the pension industry and how WaPo should manage their pension strategy. (the letter can be found here and is highly recommended) After stating how company pension assets were starting to outstrip the net assets of industrial companies, and how this was having an impact on managerial talent, he proceeded to say the following;

“And so the hunt was on. Wall Street abhors a commercial vacuum. If the will to believe stirs within the customer, the merchandise will be supplied - without warranty. When franchise companies are wanted by investors, franchise companies will be found - and recommended by the underwriters. If there are more to be found, they will be created. Similarly, if above average investment performance is sought, it will be promised in abundance - and at least the illusion will be produced.

Initially those who know better will resist promising the impossible. As the clientele first begins to drain away, advisors will argue the unsoundness of the new trend and the strengths of the old methods. But when the trickle gives signs to turning into a flood, business Darwinism will prevail and most organisations will adapt. This is what happened in the money management field.

… The (banks) felt obliged to seek improvement, or at least the appearance of improvement, as corporate managers searched for yardsticks by which to make their decisions as to whom care of this newly discovered giant “division” should be granted. The corporate managers naturally looked for groups with impressive organisational charts, lots of young talent, hungry but appropriately conscious of responsibility (heavy on MBAs from good schools), a capacity for speed in decision making and action - in short organisations that looked something like they perceived themselves.”

I’m not saying that this is exactly what is happening in the VC industry, but the parallels are eerily similar. Growing pension assets, a flood of money supply and dwindling returns from traditional assets such as bonds, real estate and traditional companies are all driving demand for VC returns.

In the start-up world, this has created a number of issues that don’t seem commercially sound.

1. Path dependence where more money is being thrown to solve a problem that’s not that important to solve because of significant prior commitments;

2. Start-up founders emerging as superstars and untouchable by VCs despite no signs of profitability or in some cases positive unit economics;

3. In Africa particularly, an insistence on “Scaling Across Africa” despite there not being any evidence of a single company in history that has achieved this feat. SAB Miller didn’t succeed in Kenya and Uganda, Diageo hasn’t cracked Southern Africa, Vodacom is not that big in Western Africa or North Africa, West African banks fare poorly in East Africa and no East African bank has crossed into Western Africa;

Other Considerations;

The following considerations also feature into whether Neobanks are overvalued;

1. SaaS mentality from VCs. Bessemer Ventures who have done greatly from investing in SaaS companies list 10 laws of the cloud with one of them being that scale wins in the cloud. Examples such as Slack, Zoom and Linkedin are given and indeed it’s true. The idea is that as you scale and achieve a dominant position in the market then above economic returns follow. Nonetheless, financial services don’t fit well into this mould given their regulated nature and their interoperability. Payments are interoperable unlike most cloud companies which aggregate users into a closed loop network of sorts. Blitzscaling in Fintech from the start may thus not be a useful strategy. Stripe for instance took two years to build their MVP and once they did, they served 50 or so clients with a very non-scalable attention to detail approach. Using this same logic, probably fintech infrastructure providers such as Flutterwave and Paystack may be able to justify their valuations;

2. Niche vs Wholesale - Most Neobanks that have raised huge valuations are mass market offerings. In Africa, Kuda Bank wants to be the bank for all Africans. Well, not all Africans are the same and thus how do you build a product that fits into everyone’s lifestyle. We have seen this in traditional banking. In Kenya for instance, it’s normal to open a bank account at Equity, KCB or Cooperative Bank when you’re a student or just starting off due to their low cost model. Nonetheless, as you go up the ladder, it’s natural to move towards NCBA, Standard Chartered or Stanbic due to their “better” high end services. I doubt you can successfully bank everyone;

3. Of course embedded finance and the fact that the likes of Square and Shopify are redefining the banking sector. It could be that non-banks could be the biggest threat to both Neobanks and traditional banks. As Bill Gates said “Banking is necessary, banks are not”.

The natural conclusion is that some neobanks will achieve their potential but quite a number will fail to do so. If ever the bubble if it exists, pops, then a shakeout of the sector will occur where real value adding companies will survive and hyperscale. This was the case with Amazon and PayPal after the dot-com crash.

As always thanks for reading and drop the comments below and let’s drive this conversation.

If you want a more detailed conversation on the above, kindly get in touch on samora.kariuki@frontierfintech.io