Fintech trends: M&A and strategic partnerships

16 min read

Key points

  • Fintech is poised for a surge in M&A deal activity
  • The fintech sectors likely to see most deal activity include: open banking, neobanks, regtech, greentech, paytechs (including embedded finance and buy now, pay later) and central bank digital currency and its digital infrastructure providers
  • In part, this activity will be characterized by the consolidation of fintech companies, in order to strengthen finances and speed up growth strategies and scale
  • Recent events in the global banking sector will make it harder for some fintech companies to raise finance and achieve significant growth organically. This will also drive M&A as a growth strategy
  • Fintech companies will also look to form strategic partnerships with larger corporations, in order to leverage their wider customer bases and brands and drive up scale and customer acquisition

Our M&A lawyers predict a new wave of technology sector M&A centered on the consolidation of existing market participants, together with investors taking advantage of lower valuations to acquire strategic stakes in scaleable technologies. The fintech sector is likely to see a large amount of this deal activity. In addition, many smaller fintechs are finding it challenging to rapidly build scale and achieve deep market penetration and will seek out strategic partnerships with larger corporations to do so. Those fintechs will hope to leverage the larger, more established financial institutions' wider customer bases and better-known brands and then use these elements to scale up and drive growth.

Markets are still sizing up the impact and potential fallout from the bailout of Silicon Valley Bank and the buyout of Credit Suisse by UBS. However, in the short term it has become harder to raise finance and this will also put further pressure on those smaller players in the sector experiencing funding pressures, to consolidate or market themselves for sale.

The following six fintech sectors will likely be in high demand from acquirers, investors and potential partners.

1. Open banking

Open banking in its broadest sense is the use of open application program interfaces (APIs) that enable secure and effective communication between payment service providers to access banking transactions and other customer data from banks and financial institutions. Open banking APIs can also facilitate the initiation of payments directly from one payment account to another, bypassing the current card payments infrastructure and scheme rules. For merchants, payment initiation services offer the prospect of lower overall transaction processing fees, as well as the potential to offer customers alternative payment methods to reduce friction at checkout.

In many developed jurisdictions only companies authorized by a financial regulator are allowed to access financial data or to initiate payments on a customer's behalf. This access to data allows those third parties to develop new products and services that customers can use to manage their finances in new and innovative ways. The objective is to simplify how financial information is retrieved, shared, processed and presented. A good example of this is the use of open banking data to deliver an efficient and streamlined credit application process, whereby lenders are able to analyze a potential borrower's financial standing based on multiple data points such as income and outgoing payments to run an affordability assessment on the proposed loan.

This sector has faced challenges related to public awareness and market perception and is likely to experience M&A consolidation. Customer uptake of payment initiation services in particular has been low, often due to a general lack of awareness and understanding of the products themselves. Since payment card fees are charged to the merchant and not to the customer, there is little direct incentive for customers to switch payment methods. Traditional credit cards are known for their customer incentive programs and protection against fraud. In the shorter term, we predict that payment initiation services will not displace traditional payment cards but will be increasingly used for larger items such as rent and bill payments, particularly as open banking is moving toward enabling variable recurring payments. However, there has been a general shift underway toward innovation among payment initiation service providers (PISP). The increasing prevalence of options to initiate payments using third-party providers at online checkout, and innovations such as the use of QR codes, could erode the status of card payments as the dominant payment method over time.

Data security has been a major concern generally in the technology industry and the nature of open banking, with multiple entry points where customer data could potentially be intercepted, might create a heightened risk level in the minds of some customers. Measures brought in to comply with the European regulatory requirements of Strong Customer Authentication (SCA), in order to reduce fraud and make online and contactless offline payments more secure, have addressed many concerns in practice. However, it may take some time for customers to recognize the security features in place to protect them from unauthorized use of their open banking applications, which include widespread use of multi-factor authentication that strengthens access security by requiring two authentication factors to verify a customer's identity. Authentication factors can include something you know (e.g. username and password), something you have (e.g. access to a smartphone app), or something you are (e.g. fingerprints or facial recognition technology) to approve open banking authentication requests.

The likelihood is that larger players in this sector, with deeper pockets, better profile and access to higher marketing spend, may look to seize the opportunity to hoover up smaller operators in the sector and consolidate the offering. Traditional banks have also invested in and acquired the technology to diversify their own product offerings. See, for example, the range of "pay-by-bank" solutions that are currently available from some of the largest financial institutions. In part, they will also be looking to hedge their bets on the possible future direction of this segment of the industry. Also, large banks and other financial services businesses forming strategic partnerships with smaller technology providers in this space will be able to leverage their size and brand recognition to drive scale, at a level that many smaller fintech operators cannot afford to do on their own.

2. Neobanks

Neobanks have seen a rapid expansion in recent years and offer huge appeal to tech-saavy customers seeking easy, hassle-free banking options. Sometimes referred to as "challenger banks," they have been compared to digital disruptors in other industries. Neobanks are a type of digital financial institution that operate exclusively online, without traditional physical branch networks. They often start life as non-bank financial institutions (engaged in payment services and/or electronic money), before evolving over time to secure a full banking license. The customer appeal is usually in the modern marketing messaging and social media interactions, user-friendly apps and a seamless digital experience. Usually there are no account fees, no monthly balance requirements and account opening is a quick and easy process. Some of those neobanks that go on to obtain banking licenses are able to offer higher interest rates on savings due to their lower operating costs compared to High Street lenders.

However many neobanks, some of which have yet to turn a profit, are facing economic headwinds. Neobanks usually have limited sources of income. Many are highly reliant on interchange transactional fees and concentrate on a particular market segment or core product, typically a form of payment account or digital wallet. The neobanks that are not actual banks do not typically offer loans, credit cards or other financial services products, due to funding constraints and other regulatory considerations. It has also been difficult for many neobanks to scale, given the cost of customer acquisition and considerable marketing costs involved in growing awareness of their nascent brands. Instead, they often partner with established banks and financial institutions (for example, institutions that offer "banking-as-a-service" solutions) in order to be able to offer a wider range of financial services as an intermediary or on a "white-label" basis, while taking a share of the fees.

There are also significant barriers to market entry to overcome. Neobanks which start life as non-bank financial institutions may not be subject to such onerous levels of regulation as traditional banks, but this means they are limited in what they can do. For example, while non-bank financial institutions may not be subject to the same capital requirements as banks, they are unable to use the money they hold on behalf of customers to lend or invest.

Customer perception and trust is also an issue and has been further damaged by recent events in the global banking sector. While deposits held by licensed banks are protected by government-backed deposit guarantee schemes, customer money held by certain non-bank financial institutions must be held separately from a payment institution or electronic money institution's own funds, in segregated safeguarding accounts at traditional banking institutions. While a customer's money may be protected in the event of insolvency of a non-bank financial institution under applicable regulations, the lack of explicit government-backed protection may be off-putting for some potential customers. Regulators are also looking with increased scrutiny at non-bank neobanks to ensure customers are not misled into thinking they are licensed banks and afforded the same protections granted to bank depositors.

Given the challenges, logic suggests that the next period of development will see consolidation activity in this sector. Many neobanks already work closely with traditional banks and so we are also likely to see more strategic partnerships, as those traditional banks offer their scale and brand strength in return for access to the technology solutions offered by their newer and more agile rivals. For smaller neobanks, raising capital in the current environment will be more challenging, more expensive and likely to be on more investor-friendly terms. These factors are also likely to drive a push toward consolidation or acquisition, over organic growth. Neobanks that are cash-constrained and running out of capital will find it increasingly difficult to maintain ownership independence and will be prime acquisition targets.

3. Regtech

Companies are subject to ever-increasing levels of new laws and regulations and the demand for regulatory technology solutions shows no signs of abating. This is particularly true of the financial services industry itself, where financial institutions receive constant waves of new data to process and deal with, usually at huge cost to themselves. The penalties for breach of laws and regulations can be severe, in addition to any reputational damage or potential personal liability for directors and those performing controlled functions.

Regtech companies use cloud technology, machine learning and data analytics to provide process mapping and cost-effective solutions for matters such as customer identity verification, KYC (know-your-customer), sanctions and AML (anti-money laundering) procedures, fraud checks and prevention and general risk management. Robotic process automation (RPA) software robotics are used for automating repetitive, rule-based, time-consuming tasks where human input is not required. In the case of the financial services industry, this and more general application AI is used not just for regulatory compliance, but also for matters such as automating underwriting and consumer lending, analyzing customer behavior, directing customer service operations and handling complaints. While regtech does not provide a means for senior management to absolve themselves of personal accountability, the scope of support afforded by regtech will continue to be a highly-valued means of driving efficiency and elevating the capabilities of in-house compliance functions. Despite an overall slowdown in the technology industry, regtech remains in high demand, including as an attractive target for M&A activity generally.

4. Greentech

Environmentally friendly "green fintech" is still in its relative infancy compared to other fintech, but the drive by industries and governments to advance ESG initiatives and sustainable practices means that greentech will remain high on the agenda for many potential acquirers and investors.

Examples of greentech include the development of algorithms that use personal purchasing data to automatically estimate a consumer's personal carbon footprint, or to encourage consumers to avoid investing in or buying from companies with poor environmental track records. Companies can also use greentech to direct a portion of their profits to green initiatives such as carbon-removal or renewal energy and give customers the opportunity to participate in this by apportioning a small percentage of the amount the customer spends into such initiatives. More complex business models include pooling investment for sustainable projects in renewable energy sources and/or sourcing clean energy from emerging market countries.

5. Paytechs, embedded finance and BNPL

Paytechs cover a wide range of services in the payments value chain, including payment service providers and payments facilitators (PayFacs), networks creating new payment solutions and payment technology suppliers. Embedded payments and embedded finance form an important feature of the evolving payments industry. The concept of embedded finance has been around for a while in different shapes and forms, but continues to be one of the fastest growing sectors in fintech.

The key driver behind this growth has been the rise of e-commerce platforms and marketplaces and the concept covers essentially anything involving the integration of financial services into non-financial websites and apps to create an "invisible" payment solution which is instant, hassle-free and embedded into the customer experience. The most popular example is payments via a digital wallet, but examples also include embedded payments via social media platforms, within games and virtual reality, via wearable devices, facial recognition, car license plate recognition for parking, or an app connected to a device such as a refrigerator or cupboard.

An important part of this growth story has been buy now, pay later (BNPL) offered on e-commerce sites. The advantage of BNPL is that users can access credit without leaving the platform, usually with payments then staggered over a period and no fees or interest, provided you pay off the balance within the agreed period. The BNPL model can offer access via apps, browser extensions or just physical payment or store cards. From the customer's perspective this offers an improved and seamless shopping experience and easy-to-obtain credit at point-of-sale, together with the cash flow advantages of spreading the payments over time.

However, BNPL is under a lot of regulatory pressure in different jurisdictions. There are concerns that many customers do not fully understand the implications of what they are signing up for, or will take on more debt than they can afford and without a proper credit and affordability assessment. While BNPL payment terms tend to be fee and interest free within the agreed payment period, late payments do typically incur fees, interest and other charges and the concern is that this will push more consumers into debt. Inevitably the regulations will continue to tighten and BNPL models will be subject to more and more robust consumer protections and tougher credit checks. Rising interest rates have also pushed up the cost of capital for providers and makes it more expensive for them to offer interest-free terms to customers. BNPL providers typically bear the cost of the interest-free period themselves, charging the merchants a transaction fee and usually working on a model which assumes that approximately 20 percent of customers will end up incurring fees and interest for late-payment.

These increased regulatory compliance and borrowing costs will squeeze margins and in turn create pressure on providers to scale up their models and, in the case of the smaller players in the market, to consolidate.

6. Digital currencies and CBDC

Central bank digital currency (CBDC) is the next stage in the evolution of digital currencies. CBDC is digital or electronic money issued by a country's central bank. As with regular digital currency, it isn't represented by physical notes or coins but instead is in the form of an amount represented on a digital ledger. Like cryptocurrency and cryptoassets, CBDC offers the potential to incorporate security features such as traceability to prevent counterfeiting and illicit activity. However, unlike cryptocurrencies or cryptoassets, which are issued privately, CBDCs are typically denominated in the currency of the issuing country, backed by government or central bank guarantees and have an exchangeable value into the currency and at the amount in which they are denominated. CBDCs can be used in-store or online to make payments and are aimed at increasing transparency and efficiency of (and, some would say, governmental oversight over) digital payment services. International payments across borders in particular should see efficiencies in terms of time and costs.

Some countries like China and India have already started to introduce CBDCs, while others including Japan, Sweden and the UK have announced an intention to do so. Traditional banks will want to embed CBDCs into their existing products and services, while neobanks and other new providers will look for ways to develop their business model to incorporate them.

From an M&A perspective, the fintech companies in high demand in this space will include those able to develop new payment infrastructure solutions for CBDCs. This principally will be around matters such as smart contracts, new lines of payment settlement and payment automation, together with tokenization and settlement via shared or distributed ledger technology (DLT), being the technological infrastructure and protocols that allow simultaneous access, validation and record updating across a networked database. Central banks are likely to favor DLT implemented via a private network over fully decentralized blockchain technology because the fully open and transparent nature of the blockchain may not be fully compatible with the laws and regulations set by the relevant jurisdiction. Private network DLT will also give central banks and governments the ability to set permissions and thus maintain more elements of control and the ability to apply and monitor taxation.

The technology around digital wallets will be in high demand as it develops to accommodate CBDCs. Digital wallets in their current form are online payment tools, usually in the form of an app. They are protected by encryption and store traditional payment card information together with things like digital tickets and e-vouchers. Some of the best known digital wallets are Apple Pay, Google Pay, Samsung Pay and PayPal. Crypto wallets also exist as a type of wallet which stores cryptocurrency passwords in one place. These don't hold the cryptocurrencies themselves, but instead facilitate access to them. They come in both digital form and also as physical hardware (similar to a USB stick). In practical terms they enable customers to manage their currencies in one place, to send and receive money and to pay in crypto where it is accepted. The technology infrastructure for digital wallets will need to keep up with developments in CBDCs and to deal with practical challenges like identity privacy and transaction confidentiality, as well as conforming to the legal and regulatory frameworks established by the relevant countries' governments and central banks. Those fintechs that are able to meet these challenges will be in high demand from acquirers and investors alike.

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