Investors are increasingly unwilling to put funds into digital "challenger" banks unless they demonstrate a clear route to profitability, such as plans for growth via acquisitions, industry experts said.
Challenger banks such as Monzo Bank Ltd. and N26 GmbH — which are disrupting a banking space that has historically been dominated by large incumbent lenders — have attracted large amounts of investment in recent years, with U.K.-based entities receiving the most. U.K. firms in 2021 attracted €2.20 billion, up from €860 million in 2020, and far more than those in other big European countries, S&P Global Market Intelligence and Dealroom data shows.
In 2022, macro pressures have caused tech valuations to fall and investors have become more discerning. U.K. challenger banks attracted just €310 million between Jan. 1 and Sept. 20, although investment in other European countries picked up.
Venture capital firms and other investors are no longer willing to continue to provide large equity injections in challenger banks without seeing "a clear pathway to profitability," according to Hyder Jumabhoy, partner in the global M&A and corporate practice of law firm White & Case.
"There is mounting pressure on founders and challenger bank executive management teams to deliver on the promises of their business plans. That often requires a carefully orchestrated inorganic scale-up transaction, in the form of an acquisition of a performing portfolio or competing operating business," Jumabhoy told Market Intelligence.
There were eight M&A deals involving digital challenger banks as target, buyer or seller in major European economies in 2021, according to Market Intelligence data. This was down from the year before but above pre-pandemic levels.
Demand for revenues
Simon Low, partner at the retail and business banking practice of consultancy firm Oliver Wyman, said investors are becoming wary of giving cash to challenger and neo banks that might have a low cost base and provide a good customer experience, but which lack a clear revenue proposition. Many lack revenues because of having limited lending operations.
"Their issue is revenue," Low told Market Intelligence. "They have much lower cost bases, much better customer experience, but they don't have enough revenue because in consumer and small business banking, which is largely what they do, there are two ways to make money. One is lending and the other one is investments."
Many retail banking-focused challengers are still loss-making, despite rapid growth in customer numbers. U.K.-based Monzo has raised £956 million from investors since inception and has close to six million customers, but reported a loss of £119 million for the year ended Feb. 28, 2022. Germany's N26 raised €900 million in a funding round in late 2021, taking the total amount of capital raised to €9 billion. But it is yet to make a profit, reporting a €172.4 million loss, after risk provisioning, for the 2021 full year. Netherlands-based bunq BV, which launched in 2021, is also yet to hit profitability, and made a €13.4 million loss in the 2021 full year.
Growth begets growth
A flurry of recent M&A suggests that some challenger banks are using financial technology acquisitions as a way to achieve scale, generate revenues and drive profits, Jumabhoy said.
U.K. examples include Chetwood Financial Ltd.'s purchase of banking-as-a-service provider Yobota Ltd. in March this year, Tandem Bank Limited's acquisition of personal loans specialist Oplo Group Ltd. in January and Starling Bank Ltd.'s purchase of specialist buy-to-let mortgage provider Fleet Mortgages Ltd. in July 2021.
OakNorth Bank PLC is another challenger that has been on the acquisition trail. The British bank announced its bought a 50% stake in specialist lender A.S.K. Partners Limited in October. It came on the heels of its purchase of FLUIDLY Ltd., a fintech that provides cashflow management and forecasting tools for small and medium-sized enterprises, in December 2021.
The acquisition of A.S.K. Partners will allow the bank to grow its footprint among homebuilders, which is seen as a vital yet increasingly underserved segment of the SME market, said Valentina Kristensen, director, growth and communications, at OakNorth Bank.
"The U.K. needs to develop 300,000 new homes each year to deal with the housing gap, but during an economic downturn most lenders tend to retrench from the SME lending market," Kristensen said. "This purchase therefore comes at a vital time for the British economy as it will enable us to deepen our support for SME housebuilders and provide bespoke business loans to property entrepreneurs across the U.K. and through the economic cycle."
OakNorth differs from many of its challenger bank peers in that it became profitable quickly after inception. The bank launched in 2015 and had turned a profit just 11 months later. OakNorth reported a £134.5 million profit for the 2021 full year.
The picture in Europe
The trend for strategic fintech M&A is prevalent elsewhere in Europe, with Germany's solarisBank AG buying British payments processor Contis Group Ltd in July 2021 and Austria's bank99 AG buying the Austrian retail banking business of ING Groep NV.
Bunq completed two fintech acquisitions, namely Belgian expense management company Tricount and Irish real estate lending specialist Capitalflow Group DAC. Bunq had raised €193 million from the sale of a 10% stake to Pollen Street Capital Ltd. in July 2021, and according to media reports, the Capitalflow acquisition was part of the deal.
Commenting on the Capitalflow deal during a panel at the Fintech Talents festival in London in November, bunq CCO Gerald Gruber said that deal was motivated by a desire to grow the bank's lending book.
"It was very much a balance sheet-driven deal, driven by a focus on becoming profitable," Gruber said.