Enough Equity Financing: Why the Future of Impact Fintechs Depends on Private Debt
Impact investors are no strangers to private debt. But are they too shy about these instruments, right when impact-focused fintech companies need them most?
It’s a reasonable question for any institution, family office or high net-worth individual intrigued by financial technology companies serving underbanked populations in developing markets. Having gained traction over the last half-decade, these pioneers in responsible digital finance are ready to scale. Yet another equity-led capital raise isn’t the most efficient way to get them there. Private debt is.
Impact-focused fintech companies have played a pivotal role in promoting financial inclusion, alongside microfinance firms, development finance institutions and others. Primarily, these companies have devised innovative methods to connect debtors and creditors using traditional underwriting techniques, as well as transforming the rules of underwriting altogether. Their emphasis on technology has solved many of the inefficiencies that have prevented financial services from reaching worthy individuals and businesses.
The financial impacts of these companies are measurable; the societal benefits they provide are immeasurable. One company MicroVest has worked with is NeoGrowth, a fintech company operating in India. NeoGrowth utilizes a technology to offer loans to small companies for working capital and modest capital expenditures. These companies are typically small stores and restaurants serving their local communities that are effectively shut out from the Indian banking market because they lack collateral. Through its technology, NeoGrowth tracks and forecasts sales and cash flow that it then uses as the basis for financing the small company.
For NeoGrowth and other first-generation impact fintechs, the business model has been proven. The technology and infrastructure are in place. To further bridge the divide between the underbanked and low-cost financial products, they need the financial capacity to expand their services and their user base.
Most impact-focused fintechs have relied on Series A and B fundraising rounds to secure capital. Given the relative success of these fundraising efforts, it’s tempting to say that this capital can serve two objectives: growth and scale. But it can’t.
Ultimately, equity capital is best deployed to spur growth and achieve efficiency. To attract and support new users, capital must continuously be going into marketing, bolstering credit teams and technological development. Without new innovations and operational efficiencies, the costs of lending become too high for these companies to sustain their business model.
In contrast, what private debt provides is the liquidity needed for loan making. It also happens to be an untapped reservoir of potential for impact-focused fintech companies. At MicroVest we see that most fintech balance sheets are free of borrowing or leverage. This comes as surprise, because according to an April 2018 report from the Global Impact Investing Network, private debt is the most popular asset class in impact investment portfolios.
Upon review, though, there are some perfectly logical, if sometimes inaccurate, reasons behind this. Impact investors might be nervous about the ability of fintech companies to ascertain the credit risk profile of individuals or businesses in developing markets, making them hesitant to provide the capital to fund loans. For many fintechs, however, the opposite is true. Though some fintechs are focused on alternative credit lending models, many are simply using technology to deploy tried and true underwriting methods more efficiently. The underwriting models being utilized by this latter group, and the very short duration of loans, means that the balance sheet risks are far better managed than people might realize. And the business models behind these firms – often cultivated by former banking professionals who saw the potential of serving underbanked populations in more ethical and efficient ways – are solid.
Just like impact investments themselves, private debt comes in a variety of structures, suited to an array of risk, return and impact appetites. One approach to boosting private debt financing could involve lending through master trust structures, where capital is deposited straight into the trust and consumer or business loans are distributed straight from it. Other structures could involve revenue sharing and bridge financing between equity rounds.
The abundance of flexible investment opportunities such as these should intrigue many impact investors. But what should really motivate these investors into embracing private debt is the opportunity at their feet: turning a nascent marketplace for impact fintechs into a thriving one.
It’s up to investment firms to accelerate the pace of providing financial services, in order to give fintech companies a means to achieve the financial and societal impact we are all seeking.
The industry is starting to realize this – hence, more streamlined access to capital was among the International Finance Corporation’s guidelines for responsible digital finance, an initiative developed and launched earlier this year by over 50 co-founding signatories, including MicroVest. The more impact investors embrace private debt as a catalyst for scale, the more fintech companies will succeed in their mission to promote financial inclusion across developing and frontier markets.
John Beckham is the Chief Investment Officer at MicroVest Capital Management.
Image: A small businessman supported by NeoGrowth, an impact-focused fintech in India. Image credit: NeoGrowth