I’ve spent a lot of (too much) time at fintech and insurtech conferences over the last month. I feel like I have had the same conversation multiple times with other VCs around ‘balance sheet’ fintech businesses but haven’t been able to fully expand on my points. This post is my attempt to do that.
By “balance sheet” fintech, I am referring to tech companies which secure a bank license or insurance license, that are then required by regulators to hold a certain amount of capital on their balance sheet. In banking in Europe the primary regulation is Basel III, in insurance in Europe it is Solvency II. Similar legislation exists in the US.
The argument I hear from some VCs is that they don’t like the idea of capital being tied up in financial balance sheets, where they worry that return on equity will be below the level they look for.
This is an interesting point of view given the huge amount of equity being poured into other companies requiring balance sheets by VCs right now: electric scooter fleets, eCommerce inventories, ‘dark kitchens’ etc etc. Maintaining an enterprise sales force with 12 month payback on CAC is also a significant balance sheet commitment. But I digress.
To the point in question, banks and insurers do have to hold regulatory capital and this does (mostly) need to come in the form of equity. Can an early stage investor still see a VC-like 10x+ return? Let’s work through a highly simplified example to find out.
Take an insurer “InsCo”. With extensive use of quota share and XoL reinsurance a solvency capital ratio of 35% of gross written premiums (GWP) is possible. So if they write €100 of business in a year they need to keep €35 on their balance sheet.
Assume that InsCo have a loss ratio of 60%, of which 80% is reinsured, the reinsurer takes 10% margin, expense ratio is 15%. Result is that InsCo can make £20 profit on £100 of GWP, with £35 of capital. Modelling this forward for a few years, starting with €10M of capital:
- Y1. €10M capital, €30M GWP, €6M gross profit
- Y2: €16M capital, €50M GWP, €10M gross profit
- Y3: €26M capital, €80M GWP, €16M gross profit
60% year on year profit growth. Impressive but not the 100%+growth a VC would look for in early years. Plus this ignores R&D spend and overheads that the company will need to pay for.
However, the important point is that the company has significantly de-risked in this time period. They will have proved go-to-market, unit economics and underwriting. They will therefore be able to raise new funds at a much higher valuation, with lower return expectations. Plus over time there is the option to use debt funding and other structures. Early shareholders will therefore be able to realise much higher returns leveraging the new capital coming in. This google sheet aims to model this out in more depth. Please have a play and let me know what you think.
Enough theory, how about reality? One insurance example is Admiral, a 25 year old insurer which IPOed in 2004. Their consistently high return on equity is above most VCs’ target IRR. Their RoE is significantly higher than other players due to extensive use of reinsurance, smart pricing and management of book. Another example is Hastings, with a return on capital employed of 49% in 2017. Their IPO in 2015 generated returns that any private markets investor would be happy with. Harder to find equity returns at this level in the banking sector, but challenger banks such as Aldermore and Shawbrook have shown ability to consistently realise return on equity in the 17%-22% range.
I am not saying that getting a banking or insurance license is the right option for every or even most fintech. There are significant downsides in terms of time to market, regulatory burden, and it does require raising more money earlier than an MGA or e-money approach. But in some cases it is the best or only option, and VC returns are still very possible.