For the past five years, banks have transformed by, in part, focusing on bank-to-bank mergers. However, the surge in banking M&A will shift from traditional acquisitions as banks clamor for disruptive technology and differentiated client experiences to defend profit pools that are under attack. In a soon-to-be-published study of banking and payments M&A and private placement transactions, Accenture found that “ecosystem deals” (where the buyer acquires outside of the core industry to improve the business) delivered 3.4x more value in the long run than “builder deals” (where the buyer acquires to build onto an existing portfolio). This supports the value creation attractiveness of fintechs.
In the first three quarters of 2021, US banks made 62 equity investments into fintech companies — more than the 2020 full-year total and nearly back to the 67 of 2018 and 2019. Fintech acquisitions are now at the forefront of capability-driven plays and allow cash-laden banks to boost competitive positioning by addressing changing consumer demand, tackling regulation, expanding markets, and augmenting scale and digital capabilities — all of which signal robust activity:
- Escalating valuations due to the proliferation of cash, resulting in fewer traditional banking targets and more attractive fintechs.
- More fintechs applying for banking charters to challenge industry stalwarts. To combat this competition, banks are acquiring fintechs that enable them to address their digital customer base.
- Banks are divesting non-core assets to free up capital and focus on core capabilities and markets; fintechs are viable options, given their broader capabilities and markets.
- Rising inflation may drive banks to re-evaluate future strategies, and either target fintechs with access to new revenue streams or enter new markets.
Fintech acquisitions will play a bigger role in banking transformations.
As we’ve seen in other market downturns, valuations may flatten and result in more attractive fintech targets. Fintech integrations are uniquely challenging: A stunning 80% of tech acquisitions fail compared to 50% of other M&A transactions. Merger success is as dependent on the art as it is on the science of integrations across three key areas: setting the deal thesis, conducting due diligence, and planning and executing integrations.
Investment / Deal Thesis: Acquiring a fintech is quite different than acquiring a traditional bank. Typical value drivers like economies of scale and geographic expansion are less relevant. Rather, acquirers need to assess the outlook of target markets, changes in customer needs, the dependency on players in the ecosystem and advancements in technology. When calculating the value potential, acquiring banks also need to be realistic about the speed at which they can fuel growth, which is often correlated with the level of modernization of their technology. The internal rate of return, which is tracked by banks to measure the success of their acquisitions, contrasts with fintechs’ laser focus on market share, product and consumer growth. Banks should consider aligning their metrics to the deal thesis to maintain value, as a lack of clarity could erode value after the deal has been closed.
Due Diligence: Pre-deal diligence should focus on the “new” elements of the investment thesis. These include both broad IT and specific platform implications; customer segment preferences, size, and growth; competitive dynamics; as well as traditional elements like risk and potential tax and legal liabilities.
In the case of technology diligence, in a fintech acquisition the technology platform is core to the deal case. A platform-centric diligence that assesses the business fit, future roadmap, development capability, technology maturity and flexibility, stability and performance, scalability, data security, supportability and ability to integrate into the rest of the ecosystem will provide key insight to finalize the deal decision. This allows acquiring banks to increase precision on the value of the technology, as well as understand where the market is headed. Technology fluidity requires a meticulous review of market movement.
Beyond the products themselves, an acquirer should also look at how customers are evolving and adopting new products and services; and how competitors are increasing and shifting their investment in technologies, channels, services, etc., to meet constantly changing customer demands. Teams must also understand and clarify the organization’s talent strategy to acquire and retain key skills, as well as drive a focus on culture.
Integration approach: Speed is critical, as the pace of technology advancements could render a once-attractive target obsolete. But before plowing ahead, to define the best integration approach, banks must understand how the fintech acquisition will support their long-term growth strategy. That is, is it an acquisition to gain more scale in an existing market or is it an acquisition into new markets and/or to develop new capabilities? This will define the type of integration: buying the IP, tuck-in, stand-alone, joint venture, culture of cultures (holding company), or fully integrate while sustaining value, growth potential and culture.
There are three elements of the integration approach that need to be considered:
People: Fintechs need to retain and continue to recruit key tech talent to sustain their growth. To hold onto their new acquisition’s talent, banks need to maintain or improve the employee value proposition and carefully define the culture of the combined entity. This is accomplished by assessing both cultures to identify the key characteristics for the combined entity (e.g., entrepreneurial, fun, risk-taking vs. averse, etc.). Furthermore, the combined entity will need to identify the biggest talent gaps and come up with a strategy to close it through internal development, recruiting, or outsourcing (“build, buy, borrow, or bot”:
Build – develop the skills and capabilities within the workforce
Buy – across all the pools of talent and skills to hire in the skills needed
Borrow – bring in freelancers, consultants, agencies or other service providers
Bot – automate tasks or roles
Technology: Historically, banks have been slow to modernize their core infrastructure, making it harder to integrate modern tech stacks. Accenture research shows that 47% of banks have “a high degree” of their workloads in the cloud; however, only 35% have captured the full value they expected. By identifying differences in the tech stack, technology organizations can plan effectively. A holistic technology strategy should assess the age of the systems, mainframe and data centers. Considerations for the technology operating model include governance, architecture, delivery practices, and operating norms: how quickly decisions are ratified, contracts executed, and product enhanced. All of this could impact value realization.
Governance: Fintechs generally operate in a deregulated sandbox and may be inexperienced at complying with regulatory requirements, obtaining licenses to work, and meeting other DOJ, FDIC, Federal Reserve and internal audit requirements. Creating the infrastructure to help these fintechs conform with mandatory requirements while not stalemating growth is a critical balancing act. By their nature, fintechs operate in an agile manner and are not accustomed to complex policies, processes, and procedures. Designing “minimal viable thresholds” for fintechs can help eliminate costly and frustrating roadblocks.
In subsequent blogs we will provide a deep dive on talent, technology, and governance within the context of de-risking fintech mergers. If you’d like to talk about your bank’s M&A strategy, please get in touch.
Thanks to Seth Van Winkle, Coco Chalfant and Samantha Ngu for their contributions to this post.