Should banks buy payments Fintechs?

Rarely. Bank culture stifles Fintech agility – and that’s a good thing!

Key insights in this post

• Historically, banks have outlasted payments startups with a few key exceptions like PayPal

• Acquiring is an exception where Fintechs have taken share from both banks and non-banks

• Banks and payments Fintechs are natural complements, with the Banks providing distribution and the Fintechs providing innovation

• In recent years, M&A activity has heated up in a few areas

  • In Health Care payments, JPM & BAC both bought Fintechs

  • In Small Business acquiring, both PNC & USB bought ISVs

  • In wholesale acquiring, JPM bought WePay to access their technology rather than their customer base

• Fintech acquisition has a poor track record. The reasons include:

  • Bank budgeting policies slow down Fintech investment

  • Bank ownership ups regulatory scrutiny, diverting investment to compliance

  • Banks have lower risk tolerance, limiting Fintech TAM

  • Bank compensation plans diminish employee retention

  • Regional bank ownership limits Fintech distribution footprint and growth

• Partnership is a better alternative than M&A as it still pairs bank distribution with Fintech innovation; however, there are pitfalls to avoid:

  • Ensure products are bank-branded to retain cross-sell flexibility

  • Don’t empower the Fintech to market leadership to avoid a power imbalance

  • Plan an exit strategy in case the Fintech ultimately fails or exits to a rival

Introduction

One of my favorite business quotations is::

“The battle between every startup and incumbent comes down to whether the startup gets distribution before the incumbent gets innovation.” — Alex Rampell, Andreesen Horowitz

Payments is no exception, in payments, incumbents usually win in the end. That may surprise some readers, but I think it’s true. Before my time at McKinsey, the firm analyzed the success rate of payments startups in the Dot.com era. Hundreds of startups entered payments, but, after the 2000 market crash, only about a dozen survived: One was PayPal and another was Checkfree – later acquired by First Data. The rest are long forgotten.

We again have hundreds of payments startups, of which a couple of dozen are material, and a dozen or so are now public. In most market niches, the incumbents are not losing much share while insurgents are gaining volume but not profits. That can’t go on forever.

Interestingly, PayPal, the rare winner in the last round is facing challengers now:

• Apple Pay is outgrowing PayPal as a digital wallet — in-person, in-app, and in eCommerce; Paze is entering the space with an unknown trajectory

• Stripe & Shopify have occupied PayPal’s core niche as a gateway for small business eCommerce and Shopify launched Shop Pay as a competing eWallet

• Adyen & Stripe have occupied the Enterprise eCommerce/Omnichannel space that Braintree/PayPal pioneered

• Square and other ISVs limited PayPal’s reach into Small Business in-person via iZettle and PayPal Here

• Zelle is far bigger than Venmo and growing faster

The biggest winner of all may be Apple, with Apple Pay & Apple Card. But, Apple are neither an incumbent nor a startup. Apple Pay leveraged the fact that IOS users account for ~75% of card spend. Apple got all the big card issuers to support Apple Pay – and pay for the privilege. Although the 6 biggest issuers had 75%+ market share, they could not resist Apple’s economic terms to access iPhone distribution.

The banks also have a notch on their belt. Zelle beat Venmo, Cash App & Apple Pay Cash. Facebook and Google had P2P services at one time but folded. In P2P, the banks were the insurgent that started with distribution. Zelle owner banks had ~50% share of Consumer DDA and other members brought that share up to 70%+. Those bank customers already had a mobile app into which Zelle simply appeared. Zelle also settled real-time into the bank account. Venmo & Cash App have to convince consumers to download their apps and move money to stored value.

As my readers know, incumbent banks held off Neobanks insurgents. Despite claims to the contrary, bank Digital assets are every bit as good as Neobanks’ except in the low-balance segment. Neobanks have that segment to themselves not because they are digitally better, but because the Durbin amendment gives them more revenue per debit transaction – so they can offer free accounts to the low-balance consumers. That advantage disappears for higher-balance customers where Neobanks have almost no share.

Merchant Acquiring is the exception, but it is also the least core to banking. Companies like Stripe, Square, Adyen & Toast strike me as here to stay – the insurgents did get distribution before most incumbents got innovation. However, few banks are material in Acquiring — instead the losers are incumbent nonbanks, with Fiserv/Clover as a key exception

The M&A temptation

A few major Banks acquired payments Fintechs in the last few years:

• In Health Care, JPM bought InstaMed and BAC bought AxiaMed. Both provide portals for consumers to pay their share of hospital bills. These acquisitions coupled huge commercial banking distribution to the Fintechs’ innovations

• In ISVs, USB bought Talech & PNC bought Linga. Both banks already had small business-centric merchant acquiring but had not built their own ISVs. These banks added ISV innovation to their small business banking distribution; however, neither has become among the market leaders among ISVs

• In online payments, JPM bought WePay. WePay was a platform that specialized in crowdfunding sites. It was similar to Stripe but much smaller. JPM re-purposed it as a gateway to provide wholesale processing for ISVs. WePay had the API infrastructure to do that. So JPM provided distribution for WePay innovation

I may have missed some, but these are among the biggest. Other banks bought startups, but not in payments per se.

So why is bank M&A in payments so rare? I believe Fintech models are incompatible with regulated entities like banks:

1. Growth driven rather than earnings driven. Bank budget cycles and investment constraints slow that growth down; and most Fintechs lose money today

2. Lightly supervised. Fintechs are subject to CFPB and FinCen rules but aren’t big enough for constant scrutiny. When a bank buys a Fintech, investment and resources get diverted to compliance because scrutiny goes up

3. More risk tolerant. Banks are uncomfortable with headline risk. They may need to “exit” a material share of the customer base, undermining valuation

4. Offset low compensation with an exit premium. It is hard to earn a windfall working for a bank. The most talented Fintech staff often leave after getting their earnout. Fintech dynamism walks out the door with them.

5. Serve a national market. Only the biggest banks are national. Limiting Fintech distribution to bank channels shrinks Fintech TAM

Let’s review each point in detail:

1. Growth versus earnings

Payments Fintechs usually aren’t earning material profit. Their reporting focuses on metrics like Gross Payments Volume (GPV) or Gross Profit rather than Net Income. For some of them it may even be hard to find Net Income in their reporting.

The GPV gambit is not just played by Fintechs. JPM only publishes GPV as a measure of its merchant acquiring performance, but Acquiring is just a fraction of what JPM does. If all a Fintech does is merchant acquiring, you want to see more than just GPV.

The Gross Profit metric is a common Fintech tactic. They are trying to show what banks call “contribution” – the incremental net revenue from new TPV after subtracting direct, variable costs (“costs of revenue”). This shows investors if revenue growth is on track to eventually cover fixed costs. In contrast, banks do not report the contribution concept. They report business unit profits in a more conventional manner, i.e., total revenue less total cost.

Further, once a Fintech is part of a bank it gets allocated bank overheads. Those overheads are typically more costly than what the Fintech supported. So, even after shutting down all the Fintech’s own functional units, total costs go up, not down.

Note that bank overheads are not higher due to inefficiency, but because banks internalize more risks. The Fintech might keep overheads down by living with exposures that a bank would find intolerable. So, the bank spends money to mitigate risk, while the Fintech just lives with the risk. When Fintechs mature or go public, they too spend more money on risk mitigation, so overhead spending converges.

The key point is that Fintech financials and bank financials are not directly comparable and need to be normalized to understand acquisition impact.

2. Regulation

Payments Fintechs are regulated, despite rumors to the contrary. They have to comply with FinCen and CFPB rules among others; however, Fintechs are not as closely supervised as banks. Fintechs often operate under State-level money transmitter licenses rather than a bank charter. Most state regulators have neither the resources nor the expertise to closely supervise their payments activities.

One example is from my time at JPM. We never deployed digital functionality until it was ADA-compliant and had a Spanish language version. The bank genuinely wanted to do the right thing, but we also knew we were in everyone’s crosshairs if we screwed up including regulators, legislators, activist groups, class action lawyers and the like. So, we tried to be buttoned up from a compliance perspective.

In contrast, Fintechs may launch general UIs first, and only later add accessibility and Spanish capabilities. That is economically rational, but not something JPM could risk. Once a Fintech joins a big bank, they need to be more sensitive to the broader compliance & control agenda. That will slow things down.

Where speed is in tension with compliance, Fintechs will choose speed while banks will choose compliance. That is the way our government wants banks to operate, so this is a feature, not a bug. But it means a Fintech will lose dynamism under bank ownership.

3. Risk

Banks have very formal frameworks for managing and mitigating risk. The regulators require this, but most large banks would likely do it anyway. After living through at least a half dozen banking crises, I sure want them to! Banks still have crises (remember SVB & First Republic just a year ago), but the crises are generally for a risk that was not foreseeable except in hindsight.

My experience with Fintechs is different. They run lean and can’t afford to measure and manage every risk. They are chasing growth so they can’t afford to hedge too much. As one example, payment startups innovate around some KYC rules. They onboard a client quickly, but don’t settle with the client until KYC is complete. In contrast, a bank wouldn’t process at all for that client until KYC is tied up in a bow.

Another example is headline risk. One of my favorite stories involved due diligence on a modest-sized payments company. I was asked to analyze a small Acquiring unit. The unit made nice margins despite being sub-scale which was odd. I went through the client list and found a few “Adult” merchants. The management team assured me that these accounted for only 5% of volume. That turned out to be true. But that 5% accounted for 95% of profit.

The networks had rules limiting chargeback rates to under 1% and chargebacks produced a lot of the Adult revenue. The processor needed enough low risk clients to keep the portfolio-level chargeback rate under 1%. Effectively the non-Adult clients were whitewash so that the overall portfolio performed under the threshold. Needless to say, the PE firm would have “exited” all the Adult clients, making the overall business unattractive, so the purchase didn’t go through.

A similar problem occurred more recently in ACH. Small originators were processing for Payday lenders who would re-present Returns over and over again; this could trigger many NSF fees for clients. Those small originators never breached the NACHA NSF threshold because they mixed the Payday stuff with normal volumes. Eventually, NACHA changed its rules to apply the NSF threshold at the individual client level rather than the bank level. That forced the PayDay clients to reform.

The biggest originating banks never engaged with Payday because they had brands to protect. The premium revenue didn’t offset the risk. Smaller originators could fly under the radar screen. What they were doing was legal and compliant, but incurred headline risk.

These kinds of calculations happen all the time where big banks avoid lucrative, but risky niches while smaller Fintechs or banks take those risks. I have seen circumstances where a big bank couldn’t buy a Fintech because its clients didn’t meet headline risk standards. The bank would have to exit too many clients representing too much revenue to justify the purchase price.

The lesson is that a bank acquiring a Fintech often lowers Fintech TAM to avoid risk.

4. Staff

This may be the biggest challenge of all. Startup staff are often taking below market compensation in return for a big payout on exit. If the bank buys the startup, they get their payout but lose motivation:

• The staff now have lower future upside. They will be tempted to leave for the next big opportunity when it arises

• The staff should see an upwards reset of their compensation to bank standards. That raises the cost structure and lowers the earnings potential of the acquisition

• The staff becomes compliance-oriented which slows down development. Even if they stay, their productivity declines

• The staff will not be content with annual increases a hair over inflation. Bank raises rarely keep pace with market comparables, so the best staff will leave for greener pastures

As a result, the agile staff the bank was counting on either leaves or becomes less agile. Often, competitiveness fades as an acquisition matures.

5. Geographic reach

While JPM, BAC, and WFC are effectively national, most other banks aren’t. Capital One and Citi have national Card brands, but their branch footprint is limited. And it is hard to cross-sell other banking products to Card-only customers – just ask American Express and Discover.

In contrast, most Fintechs sell on a national basis. If the synergy is from pushing Fintech products through Bank channels, that actually limits the Fintech’s TAM outside the Big 3. Developing a national sales force just to push the Fintech’s products is not something most regional banks can afford.

Regional banks buying Fintechs are paying for a national TAM but targeting only a regional TAM. The synergy doesn’t monetize for out-of-footprint opportunities.

What are the alternatives to M&A?

Banks are an efficient distribution channel to consumers and small businesses; but, they can’t build everything in-house. If M&A is not an option to meet customer needs, what should banks do instead?

Some gaps can be closed by licensing software or SaaS models, if competitive software is available. That is only economic if the use case is big enough. Bank utilities work when there are network effects to leverage, as in Zelle, Paze, and Akoya. But network effects are rare.

That leaves partnering with Fintechs as the most viable option. This still combines the Fintech’s innovation with the bank’s distribution, but by contract rather than by ownership. The Fintech can partner with several banks to get national coverage and the bank can partner with different Fintechs for distinct use cases. BILL & Melio are prominent examples of such partnering strategies.

It can be a win-win situation, but there are known pitfalls to plan for:

1. Don’t empower a Fintech to leading share

Banks tend to move in herds. If a big bank chooses a technology partner, smaller banks usually follow the leader. Scale economies then empower the biggest provider. That is why we have two main Card Processors (Fiserv, TSYS), a handful of core processors, etc. But sometimes these dynamics lead to a single dominant provider.

CheckFree demonstrates this point. CheckFree has ~80% share of bank Bill Pay. It is hard for competitors to break in because they need to build a directory of thousands of billers to do so. A few other directories are around, but none compares to CheckFree’s.

CheckFree owes that share to a long-forgotten bank utility called Integrion. I know, because I was involved. Integrion solved a pre-internet challenge with PC banking – dial up capacity. Consumers had to dial in to their bank for PC banking, so every bank was building capacity. Integrion would pool all that capacity at scale. IBM would build and manage the infrastructure.

Integrion also thought Bill Pay would be the killer app for PC banking. Several large banks built their own bill pay engines and several Fintechs built third-party services, including Inuit and CheckFree. The utility partnered with CheckFree rather than build its own service. In return, each bank got warrants in CheckFree provided they met enrollment goals. In theory, that aligned interests.

Integrion empowered CheckFree as the leading bill pay provider with the biggest banks providing the distribution channel. Many of those banks dropped their proprietary services as a result. Of course, none of them met their sign-up targets to earn their warrants, which meant CheckFree got all that volume without giving up any equity. Further, the internet emerged shortly thereafter to power online banking – which didn’t require dial-up infrastructure.

The banks gave CheckFree market leadership, which CheckFree added to by buying competitors, like Intuit’s service. Banks thought the warrants would align interests, but, those warrants never vested. To this day banks complain about CheckFree’s costs. They may finally have a way out with the Request for Payments model in RTP/FedNow, but that is still years from ubiquity.

A similar story could be told for Apple Pay, ACH Processing, ATM processing and other technology solutions that converged on a dominant provider. But this post is already getting too long. The lesson is to ensure a partnership doesn’t lead to loss of influence.

2. Who owns the customer?

In most cases, banks control the brand in third-party partnerships, but sometimes the Fintech does. Think of Apple Pay or Fiserv’s Clover. Zelle emphasized bank brands over the Zelle brand at formation – but it was a debate. The Zelle brand became a network mark, denoting connectivity.

Sometimes, larger banks can keep brand while smaller banks cannot. That is happening with BILL where JPM & BAC have branded versions while most other banks use the BILL brand.

If the bank owns the brand and the customer, they control cross-sell while if the Fintech controls brand, the Fintech does. As one example, Apple owned the Apple Pay customer and pushed the Apple Card at the expense of incumbents. Clover is another example. Fiserv controls the brand and has started lending to merchants with Clover Capital. This is not really competitive as banks generally weren’t lending to small merchants anyway, but it is a borderline case.

In any Fintech partnership, the bank should try to keep branding and customer ownership.

3. What happens if the Fintech fails or exits to a rival?

Even if a Fintech partnership is balanced, stuff happens. If the bank makes customers reliant on Fintech functionality, it is hard to uncouple. There is no way to mitigate this. Software can go into escrow, but without the team to manage it, that isn’t worth much. In short, make sure any Fintech partner is solvent and have a credible exit strategy in case they sell themselves to an unwelcome buyer.

Conclusion

Banks rarely buy payments Fintechs for very good reasons. The two business models don’t mesh well so the result is usually disappointing. The Fintech product loses competitiveness as key staff leave and necessary bank policies slow down growth. Partnering is a better solution provided contractual terms account for foreseeable downsides.