The financial services sector is the largest addressable market in every country we invest. At the same time, it is the most outdated industry with limited reach and little to no digitalisation. As a result, consumers must rely on usurious informal lending channels, and businesses are unable to grow without access to the working capital they need. The opportunity we see for FinTech startups is twofold: firstly, to build the financial infrastructure to facilitate the development and growth of digital financial services, and secondly to develop lending products to meet the needs of businesses and consumers. Sturgeon invests in both types of businesses within the framework we lay out below.
The Scale of the Problem
Sitting in Europe or the US, it is perhaps difficult to comprehend the state of financial services in many emerging markets. While most of us have complaints about the quality of service provided by incumbent financial institutions, we are accustomed to using our cards to make payments both offline and online, manage our finances through a mobile app or online banking, and access credit to buy a fridge, a car, or a house. The system is by no means perfect, and the last two decades have seen the emergence of FinTech’s such as PayPal, Stripe, and Revolut which have bridged the gaps in the system and built entirely new products and services along the way.
The contrast with emerging markets could not be starker. In Uzbekistan for example, less than 40% of individuals have a bank account, and less than 3% have borrowed from a formal financial institution. 55% of Nigerians do not hold a bank account; 45% of Pakistanis (or 100 million people) are unbanked; approximately 50% of the Indonesian population is either unbanked or financially underserved. This low level of financial penetration and inclusion is a result of perverse incentives for incumbent banks, weak payment infrastructure, and a lack of data on consumers and businesses to underwrite lending. The investment opportunity is therefore massive, to generate both significant social impact and financial returns for investors.
Consumer & SME Lending
Starting with the lending opportunity, the potential is matched by significant risks that both traditional financial institutions and FinTech’s face in building scalable products to meet the needs of businesses and consumers. Success is dependent on solving three key challenges: data, distribution, and balance sheet access. The historical under-penetration of formal financial services means that there are almost no credit data available, and centralised credit bureaus or scoring agencies are either nascent or non-existent. This lack of data is the primary reason traditional financial institutions with low-risk tolerance have been unwilling to lend to small businesses or consumers. It is compounded by the predominance of cash as a means of transaction in the economy, which makes both the distribution and collection of loans a challenge. The combination of these factors means the informal lending that does exist is characterised by usurious rates to compensate for high defaults amongst financially naïve users.
Some startups are attempting to tackle this opportunity through pure play lending models, an approach that we believe fails to address and solve the three key challenges and is therefore unsustainable in the long term. Firstly, they do not have any formal financial data on which to build their scoring models. While there are options to use alternative data points, actual financial transactions remain the strongest means of effective risk management. They are therefore obliged to lend “blind” to consumers and use investors’ capital to test and develop scoring models on small samples that struggle to scale. Secondly, distribution is a double-edged sword. Since they do not have existing channels, they must spend aggressively on marketing and customer acquisition leading to high CAC and low retention. However, on the other hand, it is easy to give financially unaware borrowers a loan when you need to do so in order to build both data and a user base. The combination of poor data and distribution gives rise to what is the most painful aspect for VC dollars that have funded the loan book – defaults. With no credit data and profligate lending policies, the most common result is NPL levels that make investors’ eyes water. Sometimes these bad loans are disguised in rapid portfolio growth, but our experience is that they quickly become apparent and force the startup to scale back its efforts and fail to live up to its own and VC expectations.
Sturgeon’s strategy is different. We look for businesses that can build significant user bases by providing valuable products or services that generate the data necessary to score borrowers, act as a distribution channel with minimal CAC, and lead to low default rates and long-term profitability. One such example is ZoodPay, a consumer super app that leveraged its B2C ecommerce marketplace to build first consumer and now SME lending products. ZoodPay’s scoring models were built and tested on the real transaction data from the 10m users on ZoodMall, its ecommerce marketplace. This platform also serves as distribution for lending with little or no customer acquisition cost, which in turn supports the growth of the marketplace with higher conversion rates and average order values. As a result, ZoodPay’s NPLs have remained sub-5% as it has scaled the portfolio to $120m in annualised GTV across 5 countries, and expanded distribution beyond its own marketplace to other online platforms and offline through retailers and partnerships with payment networks. The marketplace and consumer lending data and distribution have now been leveraged to create SME lending products that solve the working capital needs of its online and offline merchant partners.
A second example is that of Abhi and NowPay, which provide earned wage access in Pakistan and salary advance in Egypt respectively. The beauty of this model is that it is embedded within the existing employer-employee relationship, solving all three challenges in one. Data is available in the form of historical salary payments, including both cash and digital, therefore providing a complete picture of a borrower’s financial position. Distribution through the B2B2C model unlocks an entire employee base with the onboarding of each employer, meaning CAC is minimal. And defaults are effectively zero because employees are only able to borrow within the limits of their salary and the counterparty risk is the employer. The model is also more sustainable than alternative payday lending, with lower rates and proportionate limits. From this basic product, both Abhi and NowPay have the data and distribution to increase the financial literacy of their users and offer them more complex financial products as well as complementary services like payments, cards, and insurance.
A third and final example is Trukkr, a startup that is banking the unbanked $35b logistics sector in Pakistan. Trukkr has built a powerful and sticky transport management system (TMS) along with hardware integrations with Shippers and Carriers to give unprecedented origination to finance the value chain at scale. The core TMS software solves a fundamental problem for Trukkr’s customers, giving them visibility and insight over their entire logistics movements. This B2B software is a profitable business in its own right with strong recurring revenues, and serves as the base for data and distribution of lending products for historically underserved stakeholders. Off the back of this they have quickly scaled the loan portfolio with low-to-no NPLs, acquired an NBFI license to grow further, and successfully raised and begun deploying a dollar-denominated credit line. Being so tightly embedded and integrated with every player in the value chain, Trukkr has the opportunity to launch new financial products and services as they grow.
There remains the third key challenge – balance sheet access. The first stage of building a FinTech lending business is the same across emerging and developed markets, which is to first use their own equity to test and refine the scoring models and build a sample size large enough to draw meaningful conclusions around user behaviour. The second stage in developed markets is to look for venture debt to scale the loan book to the point where a FinTech can access larger, lower cost credit facilities from banks or financial markets. This venture debt is not readily available for FinTech’s in emerging markets, and the cost of what is available from the likes of Lendable, post-hedging costs, can be prohibitive. It is not impossible, and it can be a useful if not hugely profitable tool to grow the loan book further, but it is difficult to succeed at scale. We believe there is an opportunity for more venture debt players in these markets, if the correct structures can be found.
The alternative is to partner with local banks who have large deposit bases (typically the licenses under which FinTech’s lend do not allow them to take deposits) and limited distribution. However, the mentality and technical sophistication of these institutions is slow, risk averse, and difficult to integrate with. In order to work with these institutions and access the local currency credit lines that can really unlock lending at scale, FinTech’s must demonstrate that they have effectively solved the first two challenges of data and distribution. We believe that models such as ZoodPay, Abhi, NowPay and Trukkr are inherently better positioned to do so than the pureplay neobanks. For the reasons outlined above, they have higher quality data and superior distribution, which combines to reduce NPLs significantly. When approaching local banks, who face internal and governmental pressure to increase consumer and SME lending, the incentives to work with them are more compelling and the chances of success higher. ZoodPay, for example, has already successfully accessed such credit lines in multiple markets based on the strength of its distribution and data.
These types of embedded finance are the opportunities that we like in our target markets, and we look for several features when reviewing an investment. Firstly, the core business model should be sustainable in its own right. In our opinion, companies that attempt to rapidly grow market share through aggressive marketing and discounting with the promise of monetisation in the future through lending are as risky as pure play lending products. The significant capital required to build and maintain a meaningful user base increases the risk of failure in emerging markets where the VC funding pool is shallow, and the necessity to scale financing increases the risk of overextending the loan book. Therefore, we prefer B2B SaaS solutions with strong recurring revenues or higher margin marketplaces as the means of distribution. Secondly, a team with deep experience in lending should be in place. Too often we see lending proposed by a business whose team’s core competencies lie elsewhere. Taking ZoodPay as an example, the co-founder has 10+ years’ experience lending in emerging markets, and from day 1 brought in a team of more than 20 on the credit and risk side to build the models. Thirdly, the lending model should be sustainable and proportionate to the financial literacy and capacity of the borrower. A core tenet of our investment approach is to support financial inclusion; this should be done sustainably and will take time to achieve. Startups looking to make a quick profit at the expense of their users should look elsewhere for funding.
Financial Infrastructure
Our second focus is on companies that are building the financial infrastructure to enable access to data and distribution for financial service providers. Unlike in developed markets where the digital payment rails are well established and supportive of both offline and online business, in emerging markets, the majority of transactions are still cash-based. Concurrently, data collection and default management are ad hoc, and relationship-based, rather than systematic and digital. Startups building this infrastructure are attractive investment opportunities because they represent an opportunity to invest in digitalisation and growth in financial inclusion across the whole economy, not just through one vertical or business model.
In this vein, we invested in Payze, a Georgian start-up building the “Stripe for the CIS region”. Much like when Stripe launched in the US, businesses in the region today struggle to accept and process online payments, meaning they continue to rely on cash on delivery and are unable to scale internationally. Payze offers the infrastructure that allows businesses to accept digital payments from local and international cards in local and foreign currency, and to quickly enter new markets and start transacting – a process that previously took months. The CIS region has a population of 240m and a GDP of $1.9tn, and current e-commerce penetration ranges from 8% in Ukraine down to <1% in Uzbekistan. Assuming the region follows the global trend of increased e-commerce penetration, then the total e-commerce market could be +$200bn in the next 5 years, and Payze is an opportunity to invest in this secular trend.
Another portfolio investment, Datacultr, is solving the problem of debt collections across emerging markets. Datacultr is a data-driven debt collection and risk mitigation platform which collateralises borrowers’ smartphones to drive loan repayment through behavioural engagement and build a credit history for “new to credit” customers. Rather than the simplistic model of locking the phone when a borrower is late with their payment, Datacultr educates them from the start of the loan period, reminds them of due dates, and nudges them based on behavioural templates including blocking most used apps, with locking the last resort. Their model improves debt collections by 4x vs industry norms and reduces first-month defaults by 25%, non-performing loans by up to 67%, and the cost of collections by 45%. As more startups and traditional financial institutions enter the consumer lending market, Datacultr can be a key component in managing the default challenge that they will certainly face.
The opportunity to ride the wave of increasing financial inclusion and FinTech lending investments is one that we at Sturgeon are always interested in, however, they do come with their own challenges. The primary one is the regulatory requirements for any startup that is building the financial plumbing of an economy’s future. Although generally supportive, Central Banks in our markets tend to be cautious by default and building their trust is an iterative and time-consuming process. Tied to this is the technical challenge of both building the product and integrating it with the country's existing and new financial service providers. There can also be the challenge of the government or Central Bank launching their own alternative infrastructure, such as the RAAST payments system in Pakistan. In order to manage these risks, we look for founding teams with extensive experience in both working with regulators and financial institutions as well as deep product expertise. The founders of Payze, for example, have more than 10 years of experience working in the Georgian financial sector, while the founders of Datacultr previously worked with some of the largest telco’s and device manufacturers. This domain expertise is vital to navigating the labyrinth of bureaucracy that characterises the regulators and financial institutions in these markets, and the rewards for doing so successfully are commensurately large.
FinTech for Financial Inclusion
Embedded within our FinTech investments is our impact target to support employment and financial inclusion in the markets we invest. Without solving the challenges of data, distribution, and defaults, individuals will not be able to access the financial services they need to improve their quality of life. Businesses will not be able to grow and create employment opportunities. It is easy to give people money, but it is difficult to do so in a sustainable way for both the borrower and the lender. Our focus on positive impact leads us toward sustainable business models that avoid usurious practices and can contribute to their countries' long-term economic and social development.
For more information please reach out to the team or visit STURGEONCAPITAL.COM.