Investors in European financial technology are set to become pickier in 2023, focusing on profitable companies with simple operating structures, and consolidation in the space is likely.

European fintech companies received €13.7 billion from investors in the first 11 months of 2022, with the largest deals coming in the early part of the year. A worsening macroeconomic picture has since caused tech stocks to slump and altered investors' priorities.

"Number one is cleanliness of group structure and regulatory footprint," Hyder Jumabhoy, partner in the global M&A and corporate practice of law firm White & Case, told S&P Global Market Intelligence.

'Spaghetti structures'

After a burst of funding from enthusiastic investors in recent years, many fintechs grew as fast as possible, experimenting in different markets and pivoting to others — or pulling back — if things did not work out. That has left some with tangled internal structures and complicated relationships with regulators that create inefficiencies and make consolidation transactions more difficult, Jumabhoy said.

Those without these "spaghetti structures" are more likely to attract investment in the current environment, Jumabhoy said.

Fintechs need to prove they can function with leaner operating models, be disciplined in terms of hiring and marketing spend, and show a "results-oriented mentality" to instill confidence in investors, according to Jordan McKee, director, fintech research & advisory group at 451 Research, an S&P Global Market Intelligence company.

The era of low rates where borrowing was cheap and investors were spurred by a "fear of missing out" is over, McKee wrote in a Nov. 30 report. Heightened risk-aversion, prompted by the Russia-Ukraine war, is a key downside risk for the global economy, S&P Global Ratings wrote in a Dec. 9 note.

Different investor priorities

The largest investments in European fintechs this year were €1.23 billion in wealth management service provider FNZ (UK) Ltd and €875.4 million in Checkout Ltd., a payments processor that operates as Checkout.com. Both took place before the breakout of the war, which spooked markets and accelerated inflation.

In the new macroeconomic environment, investors need a clearer view of how and when their investments will pay off, McKee said. Fintechs must show how they differentiate themselves and demonstrate an ability to drive sustainable growth. Those focused on embedded finance — offering banking as a service, for example — may continue to attract investment due to their inherently sticky customer relationships and less capital-intensive business models, McKee said.

Private equity or venture capital firms are far more likely to invest in already-profitable companies than those that promise profits in a year or two, Jumabhoy said.

In this context, investment is likely to flow more toward the business-to-business subsector of fintechs. The flashier business-to-consumer market is saturated and has been chopped up into niche segments such as freelancers, buy now, pay later, automotive finance, trade finance and receivables finance, each of which has been filled, Jumabhoy said.

In the less-crowded B2B market, it is easier to build scale, and there is less scrutiny from regulators because the counterparties on both sides have sophisticated financial knowledge.

Consolidation

The difficult funding environment and large number of extant fintechs is set to spur a wave of consolidation, leading to fewer but stronger companies, according to Amsterdam-based venture capital firm Finch Capital.

There are more than 250 fintech companies in Europe focused on know-your-customer compliance, and more than 300 offering expense management software, Finch Capital said in an October 2022 report.

"With investors becoming more cautious about where they put their money … we are likely to see a period of consolidation in the fintech space as many verticals are highly fragmented," Finch Capital said.

Railsbank Technology Ltd., an embedded finance fintech that acquired assets from Wirecard AG after a fraud scandal at the latter, is exploring a sale, Sky News reported in November. The company, which operates as Railsr, has raised $146 million in funding since 2019, most recently in an October 2022 funding round that included contributions from U.S.-based Anthos Capital L.P., China-based CreditEase Corp. and Singapore's Mars Growth Capital, Market Intelligence data shows.

There will definitely be more consolidation in 2023, but deals carry risk, according to Jumabhoy. For example, fintechs that raised money via crowdfunding, and thus have thousands of shareholders, must bear in mind that tie-ups may be expensive and carry more execution risk than normal consolidation transactions.

* Access profile and funding round details for Checkout Ltd. * Access funding round details for Railsbank.