Listen: The Essential Podcast, Episode 88: The Fog of Fintech with Matt Harris of Bain Capital Ventures

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Nathan Hunt: This is the essential podcast from S&P Global. My name is Nathan Hunt. If you are an entrepreneur on the hunt for venture capital right now, I have some bad news for you. Chances are you already know the bad news. It's slim pickings out there. Funds are raising less and investing less. This is kind of a bummer, particularly if you look back fondly on the halcyon days of 2021 when money was abundant and offer sheets were founder-friendly. Where have you gone Masayoshi Son, a nation turns, it's lonely eyes to you.

My guest today knows this pain all too well. Matt Harris is a partner at Bain Capital Ventures in New York City and focuses on investments in financial technology and services. I learned about Matt from a video of a speech he gave recently at the FinTech CEO Summit in New York. Matt told this group of fintech entrepreneurs that 2021 was an anomaly. We won't likely see again for at least a decade. He said we were in a "fog of war" where uncertainty reins. He told these entrepreneurs that VCs would be looking for high gross margins, recurring revenue, committed customers and low credit and liquidity risks.

In other words, he metaphorically punched them right in the funding. This meet was funny, and it was honest. And it made me think this is a guy I'd like to talk to. So Matt, welcome to the podcast.

Matt Harris: I'm happy to be here. I do miss those halcyon days sometimes. I'll admit it.

Nathan Hunt: Matt, fog of war, which is a phrase you used in the speech, and it's also the title you gave it, is a phrase that is often attributed to Prussian general Karl von Clausewitz and I reference that because I know you are something of a military history buff.

He was referring to a lack of clear information on the battlefield, but a lot of people now a day is associate it with Errol Morris' documentary about Robert McNamara considered by many to be the architect of America's war in Vietnam. So I'm wondering if in using the phrase, you meant that fintech investing today is lacking clear information or if you meant it is like a land war in Asia?

Matt Harris: Well, I'm more of a Sun Tzu guy than either a Clausewitz guy or much less a McNamara guy but I actually meant it in a McNamarian sense, both the challenges associated with the Vietnam war and other land wars in Asia. But specifically, his -- he had many problems, the most problematic to me was fighting the last war.

He was a wunderkind during World War II applying all this systematic approaches from commerce, which he then deployed, of course, at General Motors, which then you tried to employ at Vietnam to incredibly poor results. So I think to me, that is a message that I want to get across. But mainly, of course, the audience I focus on, which is the founders that I work with. But if useful to the broader industry, which is the things that worked during the COVID bubble are surely not going to work in this new chapter and clinging to them is going to be a real problem.

Nathan Hunt: Digging into that for a second, the things that work, do you mean the things that worked for investors, for VCs? Or do you mean the things that worked for fintech entrepreneurs?

Matt Harris: I'd hesitate to be presumptuous enough to lecture my fellow investors, they're going to do what's best for them and play the game as they see the board. My job is to, from time to time, if not, certainly not lecture, but to give advice to the founders I work with. So that's really my audience, I have in mind here, and specifically thinking about things like burn rate, things like the reliability of that next funding round and access to and the cost of capital, equity and debt, both these things have just fundamentally changed.

And the phrase that I still hear is people saying things like, well, when the market returns or when this current depression or this current deflation of valuations, cures. And I just want to keep saying like this is normal. First of all, it's what exists now. So therefore, it is sort of prima facie normal, it is reality.

But secondly, it's much closer to, and in fact, in many ways more robust than historical valuations. And so if you were to look at it and say, are the odds higher that it goes up from here or down from here, I think you'd have to say down from here and living life expecting that the good days will come again versus dealing with reality is really a cardinal sin in the company building game.

Nathan Hunt: I'd like to ask you about your prediction that VC investing may take a decade to reach the heights of 2021 I don't want to say return to the heights because to your point, this is normal that was, in a sense, fairly abnormal historically. You tell an interesting story in your speech about different people giving different predictions of how many quarters it was going to take to return to 2021. You said 40, which is 10 years. What is driving that long time horizon for you?

Matt Harris: Well, I have the benefit or the curse of having a fair amount of history under my belt in the venture business, having started at Bain Capital originally in 1995 and then in the start of my own venture firm in 1997. So I've seen a lot of cycles. The last kind of outrageous peak in the venture industry was in 2000 when $100 billion was deployed by the industry in North America, and it took 18 years to get back to that level. It took until 2018.

And so I think one factor in this prediction is just history that it takes a long time for limited partners who invest in these venture funds to forget and forgive and come back to the table. And I think that that's a good corrective method that capitalism has of curing ills of the past.

So I say that without complaint. But it has a powerful effect on what GPs or what venture capitalists is do and that has a powerful effect on how much money founders seek to raise and how many people choose to be founders, etc. So that corrective is working its way through the system now and the numbers are still declining 18 months after I made that prediction.

So I kind of stand by it based on that aspect of history and also what we observe about current levels, again, continuing to decrease. The other thing I'll say is, and this is the way I felt and many of us felt in 2002 and '03 and '04 after or sort of in the wake of the exuberance of the dot-com bubble. It was an element of nostalgia for how much money was possible to make in those days.

But I think for most of us, it was a feeling of relief, feeling of being more grounded in first principles analysis of being engaged and working with founders to build really important companies and focusing on the metrics that really matter. And so there's also a sense I think that's generally felt that despite you and I both referring to them as halcyon days, there's actually a lot of relief in those days having passed and a return to company building as perhaps it should be done.

And so that relief also is going to mitigate the return of those wild animal spirits. That again, are inevitable. And I don't know if it's 10 years or 18 years or it could be 8 years, but it's not immediate. And we shouldn't be too happy to see it come again because after every bubble there is a bust.

Nathan Hunt: Would you describe yourself as feeling relief right now to move beyond sort of some of the irrational exuberance of 2021? Do you feel relief in the kind of companies you're evaluating today or the approach that the founders you work with are taking?

Matt Harris: I feel comfort. There's an expression, one of my mentors used to use horses for courses. And it's about knowing what conditions are optimized for your particular temperament ,skill set. And to me, this is my kind of course. I think there perhaps less to mix sports metaphors, but there is perhaps less open field running.

There are certainly elements of three yards in a cloud of dust and blocking and tackling and kind of execution-oriented thinking versus the highly promotional days of Adam Neumann and SoftBank, etc. as you referenced in your open. But that's just what I'm suited to do. I'm suited to be a patient and calm adviser to a founder who's going through hard times.

And so in that sense, this course is suited to me quite well and that it's my comfort zone. I think the suspension of disbelief that is required to be a promoter during these wildly exuberant periods doesn't come naturally to me. I think the world to me has good things and bad things going on at all times. And I think the ability to soberly see both sides of that is whether it's a strength or weakness, it's who I am. And so I do better in more nuanced phases than in the sort of just pedal to the metal phase.

Nathan Hunt: Matt, we've had Sebastian Mallaby on the podcast to talk about his book, The Power Law. It seems to me like some of what you're talking about is a return to a form of venture capital, which was much more with VCs involved in their portfolio companies helping to guide them, sort of a prudence that sometimes lacks in, say, 2021 or 2000, as we both remember. When you read -- I'm assuming you read that book, you're in the industry. When you read that book, did you recognize yourself in some of the more classic VC stories?

Matt Harris: Well, I think there were many things that were dispensable about the classic VC model. I think one of the core observations of the book that resonates deeply with me is that venture capital and the technology-based entrepreneurship world that it supports is about exceptionalism.

And that exceptionalism leads to these power law dynamics in terms of exits and this sort of winner take all phenomena that we observe. And it suggests something that I've always held dear that the job of venture capitalist is to support exceptional founders not to be themselves center stage in the drama. And I think there was something about that classic VC model that privileged the VC too much, and you would see it in these term sheets that had all these elements of control to them.

And I think what was dispensed with in the most recent bubble was this idea that the venture capitalists were the center of the action. In fact, it's the founder. And in fact, it's the exceptional founder that makes all the difference. And so therefore, these elements of control, these participating preferreds, all of these tools that VCs would use in the past to bring out economic profit and to exert control, those went away, and I sincerely hope they don't come back.

I think of the venture capitalists as their proper role as an adviser, not as the person calling the shots. And so I'm hoping, I guess, for some sort of synthesis, which is to say, let's go back to the old style of company building, which is deploying resources when they've been proven to be effective, not just willy-nilly, blitz scaling.

And therefore, the opinion of a venture capitalist who's generally speaking, seen many more of these movies than any given founder has should be relevant. But let's keep an honor and maintain what we learned about what's possible when a truly exceptional founder manifests her vision in the world. and not go back to a world in which the Board full of VCs is actually calling the shots.

Nathan Hunt: Matt, you tend to take the longer view in general. In your speech, you talked about how net IRR changes over time, so that what can look like a good year like 2000 turns into a bad year and vice versa. I'm wondering if you can explain that process a bit to myself and our listeners.

Matt Harris: Yes, it's really interesting. Basically, the folks who track our industry, Cambridge Associates and PitchBook, etc., they have to measure IRR in any given year looking backwards. So right now, you can go look at this data. I'm sure S&P has an incredible version of this data as well. And look at the, for instance, 2021 vintage which is to say the venture funds that were raised in 2021 and how they're performing, you can look at that in the middle of 2023, and it will give you an answer.

That answer, of course, there was nonsense. Most of those funds haven't been invested yet, certainly not invested fully, and those companies are very far from having exited. And so what you get is a report based on paper valuations. And yet, it's all you have. And one of the things you observe then is as you look at it, not in 2023, but in 2025 and 2027, that same year, which had one number associated with it in 2023, will have a very different number associated with it in 2027.

So these IRRs, even though they're notionally historical data points they move around. By contrast with, for instance, a hedge fund. If a hedge fund posts a return for 2021, that's their return for 2021, but our asset class is quite different. And again, having lived through this in 2000, the initial reports, the early reports from the field where that was one of the best years of all time that the top quartile venture funds were earning 80% IRRs. That's how we looked in 2001, 2002.

At the end of the day, it ended up being a negative number that even the best venture funds in 2000 struggled to make a positive return. And so that wind shear of what it looked like in the near term and then what it ended up looking like is something that we can, with high degrees of certainty anticipate happening to some of the vintages around the COVID bubble.

And probably as far back as 2019 because the companies invested in, in 2019 and the funds raised then, were invested, of course, not just in 2019, but in 2020 and 2021, were the beneficiaries of huge markups and those markups have not come down yet, which is to say, if you think of a Series A company in 2019, they probably raised a B and a C during this period of massive exuberance, and they may still be held on the books of venture capital firms at the level of that Series C.

When in fact, multiples in the tech world have come down significantly since 2021, and in particular, in the late-stage venture capital world. So this is something that everyone knows intellectually, but it's quite different living through it and not knowing the magnitude of the drop but we're already starting to see it. Firms like Bain Capital who are not only in the venture business, but also in the private equity business as well as public equity and many other asset classes, we are registered with the SEC.

We run processes that are quite industrial strength. And so we mark our private companies to market fairly shortly after they raise an outside round. We have to look at their financial fundamentals and think about what they're actually worth, not just what somebody said they were worth in 2021. But those practices vary around the industry. And so this thing takes a long time to shake out.

Nathan Hunt: Matt, people who are perhaps more of an optimistic mindset like to talk about dry powder. And I hear the same thing over and over again whenever I look at venture capital or private equity I here, there is a huge amount of dry powder out there. We don't need to worry that much about valuations of private capitals because there's all this dry powder, right? And it's just looking for something to invest in. I know Bain Capital Ventures raised $1.9 billion in Q1 of this year, right? So far away from 2021 in the minds of your limited partners. So what do you think about the dry powder argument?

Matt Harris: Well, I think the -- even one layer down in the sort of ontological chain would be the belief in technology. And that is the reason we were able to raise capital, and we're incredibly grateful to our limited partners for their faith in us. But notably, nearly 20% of that capital comes from us as the partner. So it's not just third-party capital. It's really a high conviction and a highly aligned conviction that technologies work is not done that technology is in the middle of reshaping the global economy and the way everybody lives and that it has this wave like shape to it.

And this is where even a balanced person like myself has this great optimism as well that fuels my career and fuels my life is that the next wave has always come. And the period of time between waves can vary and the height of the waves can vary, but technology has this Procopio-like quality of ever refilling itself with innovation.

And so shortly after or right at the moment that we raised this fund, you see generative AI burst on the scene in this dramatic fashion. And it was validating in a sense to this core belief that actually the human capacity for invention and creativity is far from exhausted. Now more mechanically, this shows up in, as you note, in our fundraising and others, limited partners having an ongoing interest in the asset class.

It is, of course, dampened and tempered by their own concerns about being over allocated to various asset classes, being concerned about return profiles going forward versus history. And all those matters which are important to allocators and asset owners as they should be. But at the end of the day, when you press them on their beliefs and the importance of technology generally hasn't waned.

They may go out of favor on any particular technology, but they continue to believe that growth and relatedly alpha comes from innovation and dynamic founders, power law dynamics and those things which have not actually gone out of fashion fundamentally. And then that leads us to this question of like the abundance of capital and dry powder, as you note.

I think dry powder, I mean, empirically is a real phenomenon. We still see hyper competitive financing is happening even in what is overall an environment where valuations are down and deal activity is down. But for the right founder in the right space, with the right set of conditions, which is to say the right idea, the right demonstrated traction, financial or otherwise, we're still seeing multiple term sheets aggressive valuations, aggressive timetables.

And so I think the dry powder argument is real, and it's up and down the stack. It's true at the seed in early stage, and it's through at the private equity stage. And so great companies are not going to suffer lack of equity capital funding, which is good. I mean I do think capitalism depends on that. If we went into a vast desert of capital, which is indeed how it felt in '02 through '06, it has a way of stifling innovation, it has a way of, frankly, increasing efficiency, there are good things about it. But we're at a point, if you just focus narrowly on the United States where I actually think we have innovations that need funding.

If you look at climate, if you look at artificial intelligence and the need for that to be developed responsibly. If you look at deeper technologies like semiconductors, telecommunications infrastructure, quantum computing, these are areas where, from a national competitiveness perspective, we have, I would say, new and very real concerns about our ability to continue to be the leading technology economy in the world. And funding is a part of that answer.

Obviously, talented entrepreneurs are the sine qua non of that, but funding is an ingredient. And so while I don't look forward to competition and dry powder creates competition, as a citizen and as a believer in technology, I'm glad it exists.

Nathan Hunt: You talked about 02 to '06 and sort of the funding desert and that leading to greater efficiency. In the speech, you also -- and here you were talking to fintech CEO, founders, you talked about resilience, right? And how entrepreneurs now need to strike the right balance between the highest chance of winning and the strongest chance of survival. So I was an entrepreneur once upon a time. And as a former start-up founder, I want to ask how the heck am I supposed to do that?

Matt Harris: Well, we did a study, my partner, Sarah conducted a study of the fintech companies that went public. And here, I think there are lessons for all kinds of technology companies. But fintech, in particular, was kind of the poster child of the bubble. There were well north of 100 IPOs in fintech alone during the COVID bubble. And it was characterized by some of the highest valuations and it happens to be my field of endeavor.

So we went and studied what happened to all those companies. And in particular, what happened between the peak in November 2021, and we got lucky on this, we actually picked the actual trough at least so far, which was about 10 months later in September of 2022 for this universe of fintech companies. And our question was what drove both resilience, which is to say the least peak-to-trough compression in multiple and then also just remaining value. So where are valuations persistently the highest?

And we found a very strong R-square around a set of variables, which we think of as sort of the hallmarks, thankfully of our investing strategy so far, but certainly validated them going forward, which is to say the companies that were focused on B2B and generally speaking, kind of middle market and enterprise customers versus small business, companies that were focused in recurring revenue segments like payments and wealth management, companies that had high gross margins and had a lot of software.

They weren't just manufacturing financial products they're actually building beautiful data-rich, sticky software and then embedding financial services in that software. Those were the companies that had the highest resilience, the least in the way of a peak to trough fall in stock price. And then when the dust settled, those are the ones that had the highest valuation multiples even after these big drops.

So when I think of resilience, those are the elements I think of. Do your customers tend to stick around? Do they pay you a price that is much, much higher than your input costs such that you can earn high gross margins. Are they rational decision-makers who don't tend to go out of business? And are you taking a bunch of other risks like, for instance, balance sheet risks.

If you think about the companies that were most dramatically out of favor, they included companies like PropTech companies. So companies, for instance, that went around buying houses, I would submit to you that's not really a technology company thing to do. And it creates all these exogenous perils around funding, of course, but also around the transactional nature of that business. That's not a recurring business.

That's a -- I hope, tomorrow goes well business. And of course, the directional risk of the value of those homes and the regulatory risk of it being so deeply involved in consumer financial services with the incredible focus of regulators on the consumer financial protection. So it really did separate the fintech world into those companies that had those hallmark elements of resilience. And those companies that as we look back we can't help but think were driven by 0 interest rates more than by fundamental economics.

Nathan Hunt: Matt, let's dig into one of those sticky technologies, which you have written about, talked about a lot in the past, which is generative AI. In a recent blog post, you made an analogy between generative AI and Attila and Hun. So let's play this one out. If Attila is generative AI, who is Rome? And just to throw some military history at you, is a Battle of the Catalaunian Plains possible between whoever is Attila and whoever is Rome?

Matt Harris: Well, in this example, generative Attila the Hun, of course, is the till of the hunt. And sadly, regional and local banks are the Western Roman Empire. The analogy here rests on not just generate AI, but two other technologies, all three of which are kind of coming to maturity, some level of maturity at the same time.

And the three technologies are open banking, faster payment rails and generative AI. All three of which have been worked on for decades but are newly commercially relevant. What that means is superpowered customers of banks. Banking is one of those industries where unfortunately, most customers are getting a raw deal. The fundamental fact of it is, if every customer of the average bank knew exactly what else was on offer to them and had a frictionless way of availing themselves of those offers, 80% to 90% to 100% of the customers would leave. That's just the nature of banking.

It's historically been filled with friction, and that's been the only reason that banks have been able to do things like create "deposit"" franchises, which is something people brag about, but I find quite curious, what it means basically when Wells Fargo says they have a deposit franchise is prevailing interest rates right now, 400 to 450 basis points in the economy. So any one of our customers could go get that.

But we only have to pay them 80 basis points. Isn't that fantastic? The degree to which we're taking advantage of our customers and their ignorance or the friction that exists between them and the deal they should be getting.

Nathan Hunt: Matt, I want to stop you there because I literally pulled a quote from one of your blog posts. I loved it so much. One of the most obnoxious terms in banking today is deposit franchise. I just thought it was a great quote.

Matt Harris: I'm glad you liked it. I'm hoping it goes out of favor. Well, I predict it goes out of favor either because people recognize how obnoxious it is or because deposit franchise ceases to exist as a concept because as we observe, it's just much easier to move money out of banks. And we have this shock, which is all of a sudden, there's a reason to move money out of banks, not just, of course, the concern about bank weakness, but also the offers elsewhere in terms of interest rate availability.

So we've had this disruptive shock in terms of higher rates that comes at a time when it's easier than ever to programmatically move your money through open banking and faster to move your money because of real-time payments and FedNow, which launches this month. And then the kicker, the real Attila, the real thing that's going to shake things up is generative AI, which introduces not just the possibility, but the inevitability of autonomous agents.

This next chapter of AI, where it's not just the ability to read and write the ability for you to prompt it to write a birthday card for your wife and the style of Shelly. But the ability to do things like consider my financial situation at my bank, consider the options available to me at all times and take action on my behalf when there are higher deposit rates available and lower lending rates available and any sense that there may be a fee coming and avoid those fees, capture those rates and reduce my lending rate, you could refi me once a day, if you want. I don't have to even -- I'll get an e-mail telling me that I got refi, not just in mortgage but in all of my liabilities.

So that ability for every customer, consumer or business to constantly be optimizing their own cost of debt, their own returns on deposits and minimizing fees to 0. That takes the average bank income statement and squishes NIM and reduces fee income and -- and so that's a scary dynamic that will play itself out over 5, 10, 15 years.

But the analogy to the Attila example is it's not actually that Attila's going to come in and kill these regional banks. It's not that people are going to sign up, leave their banks for some generative AI-based banking solution. What Attila did as it relates to the actual Western Roman Empire, as you seem to know quite well, is Attila of the hunt just spooked the barbarians.

Atilla did not stride into room himself or with his troops, but rather the Vizigoths and other "Barbarian tribes" who've been living in basic piece with Rome had this new threat on their eastern flank that caused them to stampede into Rome. And so indirectly, Attila the Hun and did the Roman Empire. And indirectly, generative AI is going to create a stamp head of bank customers seeking higher yields on their deposits and lower cost of capital on their loans and the reduction of fees to 0, and that's a scary result for most financial institutions.

Nathan Hunt: So we sit in different places in the larger financial market, you’re funder of fintech entrepreneurs, and I am at S&P Global. So I'm going to have to play a bit of devil's advocate here, hopefully not actual devil's advocate, but -- you are describing this new system as frictionless. And again, I get that you're talking to fintech entrepreneurs and frictionless is a good thing to them. But some of the frictions have played a pretty important role in our financial system up till now. So should frictionless be the gold standard, aren't sticky deposits good for freeing up capital and investing.

Matt Harris: Well, to be very clear, I regret this turn of events. I'm not advocating for this because banking is alchemy. It actually benefits from some of the obscurity of how it works and certainly benefits from friction. And while any individual consumer might do better in terms of their assets and their liabilities by this frictionless, automated agent style, we all depend on the banks.

So there's a collective benefit of a healthy banking system. But this is another one of those classic human situations where everyone's individual incentives and prerogatives are going to lead to a real collective problem in the U.S. banking system. So I'm not advocating for this.

I am anticipating it. And by anticipating it, I hope to generate somewhat of a clarion call for the industry. And in particular, if I'm honest, for the regulators. The regulators have stood athort the 4,500 local and regional banks and protected an industry structure that has preserved that. And that doesn't make sense in this world. And if they do nothing, we will have lots of failures and we'll probably end up with four too big to fail banks. I prefer a world in which we had 25 too big to fail banks.

But that requires regulators to have an enlightened perspective on mergers, one that encourages them and not one that default discourages them until and unless a bank fails and then they try to get it done over a weekend. So I think for the next 30 years, we're going to have thousands of banks and credit unions in the United States, and that reflects our national character and I'm a fan of that.

But as things get more precarious, I personally think the regulator should be more willing to allow and in fact, encourage mergers that create more scale, scale that allows for technology innovation, which is required to compete in banking. And recognizes the fact that geographical franchises, which is the reason we have thousands and thousands of banks, it's just not the dimension of competition anymore. And once you recognize that, you take a different perspective on what actually drives competition and how to encourage it.

Nathan Hunt: Matt, I'm going to ask one final favor, which is when you inevitably write your book on financial systems and military history, I'm going to ask that you come back and let me interview you again.

Matt Harris: I would be thrilled, Nathan. This has been terrific. I really enjoyed this conversation. And so that will encourage me to get off my duff and write that book.

Nathan Hunt: Thank you so much.

Matt Harris: Thank you.

Nathan Hunt: The essential podcast is produced by Patrick Moroney. At S&P Global, we accelerate progress in the world by providing intelligence that is essential for companies, governments and individuals to make decisions with conviction from the majestic heights of 55 Water Street in Manhattan. I'm Nathan Hunt. Thank you for listening.

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