The chaos unleashed by the financial crisis of 2008 has created a host of new investment opportunities for venture capitalists eager to identify and profit from the ongoing shakeup in the financial-services industry.
Finance may not be what first springs to mind when someone mentions the phrase “venture capital.” These early-stage investors are better known for providing seed capital for high-growth technology companies like Google, or for seeking out promising biotech or clean-energy companies in their infancy. In contrast, the financial-services industry is typically seen as the domain of big banks, insurance companies, and asset-management firms—not the kind of businesses that need venture capital financing or where a VC can hope to turn a few million dollars into a few hundred million dollars in a couple of years’ time.
But that’s too narrow a view of both the venture capital universe and the financial-services business today, argue venture investors like Dan Rosen, a principal at Highland Capital. He has seen estimates that small but promising startups in this sector received a total of about $3.8 billion between 2002 and 2008, and that venture backers were able to pull out $19.4 billion in returns during the same period, divided almost equally between the profits from initial public offerings of those portfolio companies and their sale to larger businesses in M&A transactions.
Despite the slump in overall venture capital returns of late—as reported here earlier this week, the 10-year returns fell to a measly 4.2 percent in the first half of 2010, according to a study by Cambridge Associates—the financial-services arena continues to provide a ray of light for those venture investors, like Highland Capital and San Francisco-based FTV Capital, that are willing to place their bets in this market. Investments made in financial-services startups during 2009, for instance, have generated a mean of 35.89 percent in returns for their backers.
True, those are early days for venture investments, which can take five to 10 years to demonstrate how profitable they really are. But venture investors agree that there are tremendous opportunities for financial-service entrepreneurs in the wake of the crisis and the erosion of consumer trust in once-powerful brand names like AIG. “We don’t think the dollars going into this space will double or triple, but for people willing to take the time to understand this space, there are plenty of businesses, some based on long-term trends and some that are just now becoming clear, that are tremendously appealing,” says Rosen.
While the entrepreneurial part of the financial-services industry hasn’t generated as many home runs for venture backers as, say, technology, there have been and remain opportunities for payoffs. PayPal, for instance, generated big returns for its investors when eBay bought it for $1.5 billion in late 2002. Now, many venture investors are looking for big payoffs on another kind of payment system, prepaid debit cards such as those issued by Green Dot Corp. and NetSpend Corp. (which have won funding from premier venture firms Sequoia Capital, in the case of Green Dot, and Oak Investment Partners, in the case of NetSpend). Netspend went public last month at a price of $11 a share and closed Thursday at $15.23 a share; Green Dot’s IPO in July was a success, with the stock closing Thursday at $53.12 a share, up from the $36 IPO price.
Rosen sees these transactions reflecting one of four big trends in financial-services startups post-crisis: the effort by consumers to manage their financial lives. While prepaid debit cards like those offered by Green Dot and Netspend are typically pitched to the under-banked (those who rely on check-cashing outlets rather than banks), they are also being used by customers who want to take control of their spending habits and try to avoid depleting their bank accounts or running up hefty credit-card bills.
Another new business model is that of PerkStreet, a company in which Highland Capital invested during its Series A financing round. Rosen describes it as a next-generation online bank, offering FDIC-insured checking accounts, but that also offers customers cash-back rewards and other goodies for spending via their debit cards. “It’s all part of a new awareness on the part of Americans on finding ways to be smarter about how they spend their money,” Rosen explains.
Other venture dollars have flowed to companies whose business models reflect longer-term changes in the financial-services universe. For instance, companies like Blippy and Swipely bring social networking to shopping, offering consumers who choose to share information about their purchasing habits access to specially targeted offers. (Backing these business models isn’t without its risks: Blippy accidentally made the credit-card numbers of some early users public.)
Social networking and gaming are also fueling the demand for new kinds of payment systems that aren’t dependent on Visa, MasterCard, or even PayPal. For instance, if you want to buy a sword to better compete with rivals in cyberspace, you’re buying an object with no inherent value—something traditional payment systems haven’t yet been able to address. A firm like Boku Inc., however, offers gamers and others the ability to pay for those with a smartphone or other mobile device.
Indeed, mobile-oriented payment systems are now emerging as the holy grail for investors in entrepreneurial financial-services companies. “There are new ways to do traditional transactions, like using handheld devices to check out while you’re standing in a line in a store,” says Jim Hale of FTV Capital. “I still haven’t found a way to invest in that yet,” he says, but adds that it’s just a matter of time before a handful of companies find a way to make that work smoothly and begin battling for market share.
In the meantime, Hale is finding all kind of opportunities to back new businesses that develop low-cost financial products for consumers. PowerShares Capital Management LLC was founded in 2003 and launched a whole array of cutting-edge exchange-traded funds that go beyond passive index investing, including the first active real estate ETF. PowerShares was acquired by Invesco Ltd. three years later, but Hale hopes that a London-based firm in which his fund is an investor, ETF Securities, will be another big coup when it comes time for him to sell.
There are already plenty of opportunities for startup businesses to win venture capital backing in these areas, VCs agree. What remains unclear is the extent to which a bigger shakeup in the financial system may yet produce new and undreamed of opportunities for entrepreneurs.
For instance, it’s becoming clear that the economics of traditional banking have become more difficult. A big bank can’t use the profits from proprietary trading to help cover the costs of maintaining a big branch network any longer, nor can it charge the kinds of overdraft and other fees that once helped subsidize networks of tellers and branch managers. So what happens next? Will banks pull back from street-front lending? Will there be room for new businesses to emerge, offering peer-to-peer lending via the Internet?
Those are some of the questions on the minds of venture investors as they continue to scour the landscape for fresh ideas. “This is probably the most wide-open landscape that we’ve ever seen,” says Dan Rosen. “True, it’s still a regulated industry, and some investors don’t want to deal with that.” But those willing to make the effort believe they’ll be richly rewarded and that the one-year returns made public by Cambridge Associates might just be the beginning of a prolonged boom.