The UK fintech market has been on a roll. In 2021, investment hit £27.59bn, a sevenfold increase on the £3.85bn achieved a year earlier, according to KPMG’s Pulse of Fintech report. That was driven by record deal-making activity as fintechs bounced back from the pandemic. The total number of M&A, private equity and venture capital transactions reached 601 last year, up from 470 in 2020, according to the report.
“We’ve been through a period of very strong growth, particularly coming out of Covid,” says John Hallsworth, partner and fintech co-lead at KPMG UK. “There’s been a lot of investment activity as a vast amount of private capital has been looking to invest in emerging tech, and the move to digital has really helped accelerate that even more.”
That period of expansion, however, has started to stall. The economic outlook is less buoyant, with the UK economy poised for slower growth in the months ahead. Interest rates are also on the rise, which may create challenges for some fintechs, says Hallsworth.
“First of all, the cost of funding has gone up,” he says. “And secondly, the economic conditions mean that investors are more nervous about what they invest in and so it’s harder to attract investment.”
Added to that, the regulatory backdrop continues to intensify. Areas such as cryptocurrency and buy now pay later are likely to face increased scrutiny, which will potentially temper growth in those markets. Yet those headwinds are not going to have a uniformly negative impact, with some fintech sub-sectors expected to fare better as market conditions become more challenging to navigate.
In the more mature fintech sectors, there’s going to be a flight to quality and established businesses, which could trigger consolidation
“The economic backdrop is going to significantly influence which fintech use cases are going to be supported,” says Joe Cassidy, partner and head of FS strategy at KPMG UK. “Fintech businesses that are non-discretionary are the ones that have the most chance of doing well in this environment, while those which are discretionary and are focused on B2C (business-to-consumer) activities may lag slightly behind.”
Sectors set for success
Those sub-sectors that are likely to thrive in the current environment are regtech businesses, cyber-related services, wealthtech firms and alternative financing providers that are helping funnel money towards small and medium-sized enterprises (SMEs).
Regtech businesses are likely to benefit given the broader regulatory backdrop and the hefty compliance burden financial institutions continue to face. Given the tighter labour market and rising compliance costs, financial institutions are increasingly looking to technology to manage regulatory change more efficiently.
“KYC (know your customer) and AML (anti-money laundering) responsibilities are increasing, not diminishing, so this is an area where we are seeing a lot of interest and a lot of competing companies, some of which are extremely viable and investable as we go forward,” says Cassidy.
Cybersecurity businesses are also going to be in demand, as many financial institutions have expanded the perimeter of their organisations by enabling widespread remote working. In addition, increased cyber threats and fraud means digital surveillance needs to step up accordingly.
The UK’s Data Reform Bill and the emergence of an open finance framework are likely to favour wealthtech firms who will be able to access shared data on a customer’s entire financial situation. Meanwhile, fintechs focused on providing working capital, trade finance and supply chain finance are also likely to benefit given the growing financial pressures on SMEs as economic conditions deteriorate.
“There still remains a lot of capital to invest,” says Jeremy Welch, head of KPMG UK’s financial services deal advisory. “To start with, we’re still transitioning to a digital future and therefore the sector remains attractive to investors investing for the long term. There’s also been an amelioration in valuations–a lot of people felt the market was getting frothy last year, so that may make investment slightly more attractive even if that capital may be redirected to different sub-sectors.”
A tighter grip on finances
While some sectors have the potential to thrive in the current climate, fintechs with strong attributes – those that have untapped growth potential in new markets, or businesses that are already profitable – will continue to command premium valuations regardless of sector, says Welch. “In the more mature fintech sectors, there’s going to be a flight to quality and established businesses, which could trigger consolidation.”
Investors are also going to be more focused on cash burn rates than absolute growth. For those businesses that might be more vulnerable to any economic downturn and that have been operating in an environment where previously there was a lot of cheap capital available, they are going to have to tighten their belts, says Welch.
“They need to focus on what they’re spending money on, assess the effectiveness and cost of customer acquisition channels, and maybe cut back on some of the geographies that they’re trying to target or the sheer number of products they’re trying to launch,” he says. “Discretionary spend will be controlled and we have already seen a few contemplated layoffs and hiring freezes. So cash will become more important.”
There is one positive. Many fintechs have already raised ample capital and are coming into this period of uncertainty with relatively robust balance sheets. “Companies may have a high cash-burn rate, but it’s not like they have no cash available,” says Welch.
Those fintechs that have yet to reach profitability and whose business models will potentially be more challenged by less bullish market conditions may be forced to reset their expectations.
“It’s inevitable during this stage of the cycle that there’s a lot of early-stage disruptors who don’t have the cash flow coming in but have got interesting intellectual property that they could try to commercialise in other ways,” says Cassidy.
Potential deal activity
To start with, fintechs could seek a broad range of M&A opportunities. One potential route is for large fintechs or those with the cash available for acquisitions to bring in technology that is complementary to their existing business. A second route is for venture capital or private equity firms to look at combining some of their portfolio companies to create a more rounded fintech proposition. Or another route is via traditional financial institutions or advisory firms that could be interested in acquiring businesses that enhance their existing service offerings.
Other options are also on the table, says Cassidy. “They could refinance, they could give up some equity or they could partner,” he says. “It’s all about how they feel in those circumstances.”
Some fintechs may also pivot from offering B2C services to selling directly to other businesses, with business model pivots a feature of previous periods of economic turbulence. “We often see fintechs white labelling their technology and being used by big financial institutions that don’t have the ability to build their own,” says Hannah Dobson, fintech co-lead and indirect tax partner at KPMG UK.
In other cases, fintechs may apply their technology to another consumer market that is more in demand. Partnerships and joint ventures (JVs) between fintechs and traditional financial institutions are also an effective way of commercialising valuable intellectual property developed by fintechs.
“Fintechs who have already taken steps to identify, protect and optimise their intellectual property assets will fare better in partnerships and JV arrangements,” says Usman Wahid, a technology law partner at KPMG UK. “Optimisation of intellectual property, in particular, should enable fintechs to effectively segment their IP for use in partnerships and JVs without weakening their standalone core business.”
Solving for bigger problems
Government efforts to supercharge the fintech industry may also create new opportunities for existing businesses to pivot or enter new markets. For example, the Kalifa Review of the UK fintech industry – which KPMG made significant contributions towards, with KPMG UK’s vice chair of financial services Kay Swinburne co-chairing the policy and regulation chapter – is designed to encourage more innovation and make the industry more investable.
In this more testing environment, there is also an opportunity for firms to think more ambitiously about how they can develop as the market matures. “A lot of the fintech world today is focused on niches rather than necessarily solving end-to-end problems,” says Hallsworth. “There’s an opportunity in this environment for fintechs to think bigger and try to solve some of the big problems on an end-to-end basis and by doing it in a collaborative way.”
Ultimately, the key to remaining successful in the period ahead will not only hinge on the value and utility of a firm’s technology, it will also rely on the quality of the people running the business.
“The fintechs that will stand out from the crowd if we enter into difficult times will be the ones that have a unique product that’s solving a problem,” says Dobson. “But it’s also important to have a really good management team who can anticipate problems and then prepare for these accordingly. Invest in really good people to run your business and your business will survive.”
For more information, visit home.kpmg/uk/en/Fintech
Q&A: Navigating tougher times
Fintechs are facing increased challenges as economic growth slows. Co-leads of KPMG UK’s fintech team Hannah Dobson and John Hallsworth discuss the steps fintech leaders should take to emerge from this period stronger
Q: What should fintechs be doing now to future-proof themselves?
HD: Have the right structure in place from the outset. That means keeping it simple, don’t over-complicate what your business is doing. Protect your core business – which for most fintechs is their technology. Put yourself in the best position for fundraising by getting the basics right so investors focus on investing in your business rather than being concerned about the contents of diligence reports. Investors want to invest in the people (the founders), and they want to invest in a brilliant idea that solves a problem. So, make it obvious what that is. And have an eye looking to the future. Do you want an exit? Do you want to make acquisitions? What is it you want to do?
Fintechs often don’t properly consider their VAT position. They cannot generally reclaim VAT on all their costs and this may either not be realised, or those costs are 20% more expensive than predicted by the business
Q: How can fintechs be smarter about their finances?
HD: Fintech businesses at their very core are entrepreneurial, and development of the idea and technology is the primary focus in the early years of the business. Often what is left behind, from lack of time or experience, is the day-to-day finances and tax position of the business. But not paying attention to those finances will take you under if you’re not careful. If you run out of money, or if you end up with a significant unexpected VAT bill, it will be more challenging to attract investment.
There are many government schemes that can support technology businesses. You can claim R&D tax relief, and there are things like Patent Box, which can reduce your corporate tax rate down to 10%. Fintechs often don’t properly consider their VAT position. They cannot generally reclaim VAT on all their costs and this may either not be realised, or those costs are 20% more expensive than predicted by the business. This is significant when cash is so important in the early years of a fintech.
Q: What upcoming regulations should fintechs be looking to get on top of?
JH: The regulatory environment can be stimulative for fintechs. There are some specific areas in the market which will be brought into the regulatory envelope such as crypto and buy now pay later. If you’re a credible, regulated business, then you’re going to watch both of those markets shake out quickly, and so the more credible businesses can capitalise on that position. Another enabling regulation is the data reform bill, which will effectively expand open banking to become open finance. Open banking has been a real benefit for fintechs because you can leverage the data in banks and create new propositions. Now as it grows to become open finance, the ability for fintechs to add value to the end consumer becomes much greater.
Q: What should fintechs be doing to retain and attract the best talent?
HD: People want to go and work with the larger well-known fintechs because of the name and because of who they are. But sometimes they get through the door, and they find that fintechs have a lot of growing up to do in terms of retention and HR skills. If they’re going to keep the really talented people that are attracted to go and work there, they have to do things slightly differently.
Fintechs may also need to rethink other incentives. For example, the assumption that equity prices will increase stands to be challenged in light of recent economic headwinds. Therefore, fintech companies need to assess how effective their incentives are against a potential new reality, in particular where companies have offered share options or growth shares which may now not appear as attractive. Reassessing this is a sensible step for all fintechs, alongside a review of their tax effectiveness on the basis that capital gains tax rates continue to be significantly lower than tax on employment income.
Q: How should fintechs be approaching fundraising in the current environment?
HD: If you turn the clock back probably three or four years, fundraising for fintechs was very similar to the dot-com boom. Investors have been very enthusiastic about backing anything fintech-related. But then the world paused and said what are we actually investing in? Above all, they are investing in the people. Then they look at how the business is going to turn a profit. So at what point is it going to stop burning through cash? And then, finally, where’s the business going to end up? Is it easy to copy?
JH: There’s also a maturing in the way that big financial institutions are looking at fintechs. A few of the major banks are putting in what we would call demand equity – investing in a fintech and then routing business through it, increasing its value. That model is becoming more prevalent and we can expect more of that, especially in these times where valuations have come down.
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