Long Take: Acquisition arbitrage between public and private fintech revenues, highlighted by Figure and Starling

Hi Fintech futurists --

This week, we cover the following:

  • Thesis: In this analysis, we explore an overarching framework for the M&A activity in the fintech, big tech, and crypto ecosystems. We discuss acquihiring, horizontal and vertical consolidation, as well as the differences between growth and value oriented acquisition rationales. The core insight, however, is about the arbitrage between the fintech and financial services capital markets, as evidenced by the recent transactions for Starling and Figure.

  • Topics: mergers and acquisitions, private equity, venture capital, mortgages, crypto, acquihires, big tech

  • Tags: Starling, Fleet, Figure, Homebridge, Citizens, HSBC, Amazon, Square, Afterpay, Coinbase, Binance, FTX

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Long Take

We noticed an interesting but strange coincidence last week in the Short Takes.

Two fintech companies that we track fairly closely — Starling and Figure — both acquired mortgage businesses. This kicked off consideration for what motivates Fintech acquisitions, and in particular what motivates Fintech acquisitions in the current state of the market cycle. After some noodling, we have an explanatory logic, and are going to use the following framework to look at a number of transactions and motivations.

Traditional M&A frameworks would have us categorize acquisitions by size, strategic intent, and economic impact. A small purchase would be an “acqui-hire”, a transaction to add hard-to-find talent to the product or engineering team. Amazon, Google, and Facebook were minting acquihire millionaires in the mid 2010s, with a target $1-2 million per person vesting over 4 years.

For example below, you can see a lot of purchasing activity in developer tooling and artificial intelligence, two areas that are quite niche and hard to build organically, but without meaningful economics. Better to pay to bring people in to accelerate functionality, even if the acquisitions take a while to pay off. And you are probably not price sensitive at this size.

In crypto, where talent is still painfully scarce, it is not unusual to see young teams joining larger houses as well (see Token Data chart below). In the bear markets of 2018 and 2019, there are numerous transactions taking place that are not driven by industrial logic (i.e., revenue or scale), but by building a team and finding a soft landing.

Something changes in 2020 and 2021, which is that the bull market has allowed crypto projects to build up a balance sheet that can be used more productively for consolidation and commercial expansion. Further, some economic models — like DeFi and NFTs — start to work, while others end up acquired.

Mid-Size Acquisitions for Growth

Next, there are mid-size acquisitions that can meaningfully build a commercial footprint. That can extend to simply buying revenue in a business that is adjacent to yours, thereby extending your own revenue or client footprint. If we look back to the spider chart of tech acquisitions by industry above, we would expect the physical goods and services to scale up Amazon in its core eCommerce capability. Consider Whole Foods, a category extension for the retailer. Similarly the communication apps and tools, like WhatsApp, scale up Facebook and its social graph.

We can rhetorically describe this activity as a monopolist buying up its competition leveraging its strong cashflow generation capability. That may or may not be true, but that is what consolidation signals to the market. See this compelling Washington Post study, and in particular the distinction between original and new sectors for the tech companies below. The number of “original sector” acquisitions has been 40 for Amazon, 28 for Facebook, and 81 for Google.

It is also deeply interesting that the tech firms do 2x more acquisitions in new sectors that are non-core to the main business. Without falling into a rabbit hole, we would just categorize this behavior by the industry’s internalization of “novelty search” as a way to grow the overall pie, rather than by trying to move in a linear fashion towards quarterly earnings. This leads to platform shifts and new blue ocean markets.

For comparison, Finance is investing in Finance, with potentially blockchain and artificial intelligence being the deep tech outliers. Everything is done with an eye towards next quarter performance. You don’t see Wells Fargo trying to buy a music business, like Square did.

When switching the lens to crypto, there is a much broader plan for the revenue generating incumbents. Coinbase, Binance, and Kraken led the way in 2020 according to data from The Block. If we were to consider 2021, the story would also include FTX — the $18 billion crypto derivatives exchange which bought portfolio app BlockFolio and has a tight connection to specialist blockchain Solana.

Crypto exchanges have spectacular revenue generation capacity, and — unlike miners for whatever reason — are much more likely to expand into new industries, as well as acquire down the value chain. Adjacent opportunities abound given the industry’s long term Metaverse thesis, as well as the need to catalyze institutional financial adoption, thus leading to acquisitions across the banking, data, gaming, and media sectors.

Over time, we think the value chain will be controlled by fewer players and end up more coherent and standardized. Vertical integration examples include institutional investment shop Galaxy buying crypto custodian BitGo (to be able to have more control over assets under management), Coinbase acquiring Xapo (same reason), PayPal acquiring Curv (to get closer to onchain assets), or Binance buying CoinMarketCap (to acquire customers into the exchange). As a company, you want to be fast and take out manufacturing costs.

Acquisitions for Transformation and Value

The last type of consolidation we want to touch in is the “transformative” kind, where there is a merger of equals, meaning the value that each company brings to the table is largely equivalent. This doesn’t happen unless there is severe industry pressure from either fixed costs, such as regulation, or competitive pressures, such as disruption. In this case, both the target and acquirer recognize that they are not going to be the one gobbling up the world, and that a combination that grows the top-line while taking out redundant cost is valuable.

Is Square’s acquisition of Afterpay an example of this? While the sizes of the companies point to *No* — Square at $120B, Afterpay at $30B — industry pressures reflecting merchant, consumer, and payment rail platform synergy would suggest otherwise. Competition for Square’s position in the industry is increasing.

See the Rubinstein take here. We like this part in particular:

Whatever the reason, Buy Now Pay Later is a useful way for merchants to convert debit-sized baskets into credit-sized baskets with no incremental risk and only slightly higher cost. Its popularity has bred a lot of competition. As well as Affirm and Klarna, Apple is launching a Buy Now Pay Later product in partnership with Goldman Sachs, and PayPal is investing heavily. The deal between Afterpay and Square recognises the changing competitive landscape, but it does something more.

As we discussed in our Square write-up, Square has built two independent ecosystems that are approaching critical mass – an ecosystem of merchants (Seller) and an ecosystem of consumers (Cash App). The holy grail is to connect them (the “third horizon” as management puts it) to capture all the value available when the two sides transact.

As a different data point, Citizens acquiring the US footprint of HSBC and Investors Bancorp is an example of industry consolidation pressure. When traditional banking services are seen as a commodity, the choices for players in the middle market are either to (1) claw their way up to bigger scale, or (2) get swept up in consolidation. Take a look at the language the acquirer uses: “immediately accretive”, “cost savings opportunities”, “fills branch gap”.

That doesn’t sounds like selling the science fiction future of 90% annual growth as articulated by Square. It’s also perhaps not particularly transformative for Citizens, but rather supports horisontal consolidation in value-driven market. Still, we think it makes a good example of the type of thinking that goes into an FIS/Worldpay or Fiserv/First Data type deal.

In fact, such deals are sufficiently repeatable that they can form the backbone of a financial services private equity industry. A good number of financial transactions are being done by KKR, BlackStone, Apollo and a variety of other cashflow focused investment houses, with the goal of consolidating industry players. As a reference, check out the Financial Technology Partners quarterly report’s M&A section, and the names of the acquirers.

SPAC vehicles accelerate that financialization of M&A in finance as well, trying to bring the valuations of the private markets to the public markets. That can often be a tough sell, though on occasion well performing companies do make it through.

Key Takeaways

We’ve gone on a journey to highlight transactions of different sizes and rationales across tech, finance, and the things in between. Let’s land where we started, which is with Figure and Starling.

Starling is paying £50 million for the “buy-to-let lending operation” of Fleet Mortgages. This will lock in Starling as the underwriter of choice for about £800 million originations per year, priced per below.

Origination fees appear to be in the 150-200 bps range, so that would yield maybe £15 million per year in revenue. Starling today has a lending balance sheet of £2.3B, on which it earns an annualized £100 million; so let’s assume that the £1.75B of Fleet’s existing balance sheet will print half that amount. Using these very rough numbers, we would guesstimate Starling is buying this traditional financial business for 1-3x revenues, while trading at 10x revenue ($1.5B for $150MM ARR).

This is what we would call market valuation arbitrage. Starling’s revenues are shiny and growing. Not so for a legacy underwriter.

If we look at Figure, a comparable story emerges.

Figure is merging with lender Homebridge, which originates $25 billion per year and has 1,500 customers and 2,500 employees. For comparison, Figure has originated $5 billion in total tokenized securities on its proprietary blockchain Provenance, but is valued at approximately $3.2 billion after raising a cumulative $1.6 billion. Let’s triangulate Figure’s revenue number — (1) suppose $2.5 billion was originated last year and yielded a 2% fee, inclusive of any non-origination stuff, for $50 million, and (2) suppose a 32x revenue private multiple, suggesting a $100 million ARR. We’re gonna go with $75 million ARR.

As for Homebridge, we are just going to ignore the complexity of trying to understand whether it has a balance sheet and how it charges for its services. Instead, let’s just say that $25 billion per year is 10x larger that $2.5 billion, and assume the commercialization on that lending is about the same. If this transaction was a merger of equals, then it would imply that Figure’s revenues are 10x more valuable than that of Homebridge — same as the numbers for Starling/Fleet.

This is literally what Mike Cagney says about the deal in his commentary here:

Earlier this year, [the CEO of Homebridge] and I spoke about the growing spread between mortgage and fintech valuation.  Our mutual consensus was that mortgage is perceived as transactional and rate driven, while fintech is perceived as comprehensive, tech-forward and relationship driven.  Investors are willing to give fintechs time to prove out their thesis of low-cost cross sell and high contribution and profit margins.  VCs have taken the “Let’s get 15 million customers, and then we’ll figure out how to monetize them” approach to markets like challenger banking.  But mortgage has some significant advantages in the battle for the customer, including better data and, interestingly, human loan officers.

He plots the combined revenue of the business to be $1B in 2022 on $30B in loans, implying a 3% take rate, therefore yielding a 2021 revenue of about $750 million, most of which is Homebridge.

Here’s the punchline. If Figure retains a 30x valuation multiple and hits $1B of total mortgage related revenues next year, it will likely get SPACed into the public markets by Apollo for $30 billion. Not bad for 4 years of work.

In revisiting our M&A framework, this valuation gap highlight a structural incentive for acquisitions — arbitraging the public and private multiples on financial revenues. Is it SaaS? Is it Fintech? Is it Crypto? Is it transactional? Is it recurring?

In a hot market like right now, anything goes. In a bear market however, these cashflows will provide a much needed buffer for operating a grounded business. There are other mega-trends driving M&A activity, like the unbundling and rebundling of different product lines, and the hollowing out of the commoditized middle market. But the arbitrage one is certainly one of the most interesting, and runs counter to the concept of incumbents buying Fintechs to accelerate digital transformation. Rather, Fintechs are buying incumbents to accelerate digital disruption.

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