Altfi: whose lunch are fintechs eating?

This article was first published on Altfi: here.

Why do start-ups fail so often? Of course, execution is a big issue – but many start-ups are doomed to fail because of a fundamental issue with their business model.

For us, this is also a personal question. Two years ago we set up our own alternative finance credit business, PrimaDollar. At PrimaDollar we chose international trade finance, but we reached that conclusion after first considering many alternatives (no pun intended). This article sets out the conclusions that we reached about the alternative finance lending space (and maybe how to spot the winners).

The business plan

A business plan usually starts with a simple vision:

“The market is big, my product is brilliant.
This time next year, we will all be millionaires.”

Fintech lending sounds great. The market is huge! Banks are weighed down with many issues – so there are opportunities everywhere for alternative lenders to step in.

But amongst many things, building a new business means occupying and then defending a market space. Markets can be big, but what is the addressable market space – and who else is addressing it? Moreover, if there are existing players, are you eating their lunch – or making your own?

Addressable market space

Addressable market space is not just the total market. It is that part of the market:

(a) where there is a need for your product
(b) which you can realistically reach, and
(c) where sustainable business can be created.

Can you beat the banks at their own game?

For the alternative lender, the key question is whether it is possible to beat the banks at their own game – effectively, to eat some of their lunch – or whether the only viable business plan involves working in an “un-served” market space? The answer lies in an analysis of relative competitive advantages:

• Alternative lender competitive advantages include (a) being small and agile, (b) being new – so without the inflexibility and cost of legacy infrastructure (c) maybe smarter underwriting and (d) without high regulatory costs.
• Bank competitive advantages include: (e) low funding costs (f) they already have a lot of customers (and data) and (g) they can maximize lifetime customer value through up-sell and cross-sell.

Our conclusion was that the alternative lender has to find an unserved market space. This is because the funding cost disadvantage and the lack of customer retention tools outweigh the other advantages.

So are there large enough unserved market spaces? Are there creditworthy customers to whom banks provide a poor or non-existent service?

Of course, these customers are out there (near-prime consumer, students, certain SME sectors etc)  – but can we make a viable business out of them? Viability is not a question about the availability of institutional funds (see the article by Gabriela Kindert on this point Marketplace lending – viable or not?); this is a question of shareholder value and return on equity.

We concluded that the addressable un-served market spaces in domestic European credit markets are too small to support a viable alternative lender (except for maybe one or two niche champions). This is because in one country alone, the addressable market space is too small, and because scaling domestic propositions across multiple countries looks too difficult (because of regulation around customer rights). Moreover, because banks still do serve the mainstream well, un-served but creditworthy clients are hard to retain (such clients can quickly return to their old lenders – B2B, meaning perhaps “back to bankability”).

Therefore – the logical conclusion is that to be interesting, any new alternative lender focused on domestic credit markets (business or consumer) should include a strategy to take market share from the existing players (banks) and retain it. This leads you to the challenger bank model, as this is the only way to mitigate the funding cost disadvantage – and this is a boat that has already sailed.

What did we decide to do?

As I said, this was personal. At PrimaDollar we understood that we had to look outside domestic credit markets. We needed to find:

• a market space that we could occupy without eating anyone else’s lunch
• a business that can work easily in many different countries

Our business (international trade finance) has been being built in an unserved market space and is scaling up because it is easy to port across different supplier countries. Specifically:

• global supply chains are moving as buyers seek lower cost manufacturing locations; this is creating working capital gaps in many geographies which banks are finding hard to meet; and
• our model is portable because we finance cross-border transactions rather than domestic, and this avoids the need for local legal entities and local balance sheets.

For example, as China becomes increasingly expensive as a manufacturing location, buyers are moving their sourcing to other countries (like Bangladesh, India, Vietnam); these destination countries do not have banking systems that are geared up to support open account and deferred payment terms (which buyers increasingly require). Since our finance is provided from the UK and does not require in-country legal entities, we are already generating business across South Asia, proving the inherent scalability of the model.

Logically our plan should work – there is a clear path to scale and profitability.

Of course, there is still the small matter of executing the plan…