FinTech debt as an asset class

Sep 11, 2021

crossboundary logoIn recent years, fintech lenders have become instrumental in increasing the adoption and usage of financial products and services for unbanked consumers and MSMEs across the world. Fintechs have proven to accelerate financial inclusion at a greater rate than traditional banks and microfinance services could alone. They do so by providing faster, cheaper, and more reliable financial products for the younger and more tech-savvy population. Point-of-sale financing, buy-now-pay-later (or BNPL) options, and other embedded finance options have lowered costs and expanded access to consumer credit options for broad new customer segments. Meanwhile, business-to-business digital solutions such as enterprise resource planners (ERPs), inventory management platforms, and digital marketplaces are allowing micro, small, and medium-sized enterprises (MSMEs) to create a data footprint that opens the door to formal credit access. Nimble fintech businesses are seizing the opportunity to use new data, digital channels, and ecosystems to deliver credit options to customers that, until recently, were invisible to traditional credit providers.

fintech debt graph - frontier markets blogThe global market for fintech lending has seen a rapid growth trajectory, particularly in emerging markets (EM). EM saw fintech lending volumes grow by an annualized rate of 83% over 2015-2018, reaching $8.9bn in 2018. While in 2015 EM contributed only to 3.4% of global lending volumes (excluding China), in 2018 the contribution amounted to 10%.

Furthermore, the COVID-19 pandemic spurred an unprecedented step-up in the adoption of digital payments and financial products, as the need to transact digitally became an imperative rather than simply an option. With these digital channels and patterns of engagement now familiar to and firmly entrenched amongst customers, the journey to the digital future of financial services has sped up immensely.

Yet, fintech entrepreneurs across emerging markets face significant challenges in sourcing debt capital to grow their businesses and scale their loan books. Fintech lenders in these markets generally struggle to attract loans from traditional banks, which tend to turn them down for lack of collateral or track record, or offer them extremely high interest rates. While established fintech lenders with extensive track records and large loan portfolios have some ability to tap into institutional investors, such as DFIs and impact funds, the options for earlier stage start-ups that provide innovative new types of credit to under-banked borrowers are few and far between. Consequently, founders often rely on internal funds and/or expensive equity funding to build their credit books, resulting in slower growth, increased dilution of founders’ stakes, and reduced impact and credit access for the underbanked.

In response to these challenges, several models have evolved to increase the access fintech lenders have to debt funding, such as peer-to-peer platforms (P2P), partnerships, and structured credit. P2P platforms allow fintech lenders to attract investment capital directly from private individuals to fund their loan growth. In return, they offer private investors superior returns compared to options such as bank deposits. However, given the concerns regulators have regarding consumer protection, P2P models tend to face complex regulations, and therefore the long-term sustainability and scalability of the model remains unproven. Next, some fintechs have developed successful bank partnerships which combine the digital origination, analytics, and user interface of the fintech with the capital capacity of bank balance sheets. While this can be a powerful combination, the devil is truly in the details – structure, risk-sharing, incentives, and value split must all be carefully calibrated to ensure a successful partnership. Finally, fintechs across many emerging markets are increasingly turning to structured credit to provide fuel for credit growth, using off-balance structures (e.g., trusts, SPVs) to allow investors to participate directly in the ownership of the credit assets originated and managed by the fintech lender. “While this approach requires sophisticated legal structuring, the scalability of this model and its ability to channel international investor capital directly to fintech loan portfolios is increasingly attracting the attention of the investment community” says Arjun Batra, Co-founder of Canary Capital, a fintech-focused credit provider.

What advantages do investors see in the structured credit approach to investing in fintech loan portfolios? Investors in the space highlight four key differentiators from traditional unsecured direct loans: yield, monitoring, security, and impact. The off-balance sheet structures significantly reduce the amount of equity capital fintechs must commit to driving loan portfolio growth, thereby allowing a more generous yield split, with investors willing to participate in the early-stage growth of their loan books. Next, leading investors in the fintech space are increasingly connecting with their fintech partners digitally to allow real-time monitoring of loan performance and asset quality metrics, offering increased capability to respond to changing portfolio dynamics. Third, the investor security position is typically bolstered by mechanisms for risk-sharing, such as over-collateralization, and the SPV or trust generally owns the loans or the future receivables, providing downside risk mitigation. Finally, investors may outline selection criteria loans must meet in order to qualify for inclusion in the credit structure, thereby targeting their investment capital towards particular types of borrowers or products that meet their impact criteria.

While global venture capital activity continues to dominate headlines in the fintech space, fintech debt is quietly attracting both attention and capital from yield-focused investors seeking exposure to the sector. Several well-established investors, such as Goldman Sachs and Victory Park, have been actively deploying capital in big-ticket blockbuster deals in the emerging market fintech space. At the same time, a growing number of sophisticated and tech-enabled investment managers are rapidly evolving into global leaders in the market for early-stage fintech debt capital, including Arc Labs, Lendable, Accial Capital, Helicap, and Goldfinch. With differentiated models and geographical focuses, these investment managers are swiftly illustrating that the combination of digital connectivity and effective structuring can connect fintech lenders across the global emerging markets space to the investment capital they need to grow and scale, while offering a distinct and attractive risk/return profile to investors seeking a fixed-income exposure to the emerging fintech debt asset class.

The global opportunity for fintech lenders has several strong tailwinds: secular growth in e-commerce, increased use of digital payments, government policies to increase economic formalization, and the continued expansion of the global middle class, particularly the young, digital natives that will drive future consumption and business formation. Fintech lenders are well positioned to grow in this environment by both expanding access to credit and gaining market share at the expense of traditional credit providers less capable of delivering digital credit solutions, but these players will need access to debt funding themselves to capitalize on the opportunity. Simply put, the demand for debt capital in the fintech space far exceeds the supply, and, given the growth runway for the fintech lending sector, these conditions will likely prevail for some time. The result is a uniquely attractive opportunity to respond for the limited number of investors with the technical and legal savvy, allowing these investors to both enable access to critical financial services in the most underserved markets and generate outsized financial returns.