Here’s why the economic downturn is actually benefiting payments and lending startups
Conventional thinking suggests there are two types of companies that would be hit hard in a sudden recession: first, the ones with nowhere to hide because they have exposure to every part of the economy, like payment providers, and, second, the ones who lend to borrowers who can’t otherwise get a loan, since those borrowers are likely the first to default.
Both of these businesses are part of the fintech space, which has surged over the last decade as some industries moved online, brick-and-mortar stores shifted to a tech-enabled model, and big banks retreated from making small loans. If fintech companies are at the bleeding edge of finance, we’d expect them to get hit hard by a sudden recession.
But that’s not what we’re seeing. In recent days, payment processors have stepped up big time. Visa committed to no layoffs, SoFi made a splashy, billion-dollar acquisition. Stripe raised an additional $600 million capital, bringing it to a $36 billion valuation, and Robinhood is planning to raise money, too. Square founder Jack Dorsey donated a stunning $1 billion worth of Square stock to his foundation to fight the pandemic and is using Square’s Cash App to help people get stimulus payments. Square is not alone in the latter project, either. Challenger bank Chime offered advances on stimulus checks, and Plaid is building an app to make it easier for companies to apply for Small Business Administration loans.
Fintech companies spent the last 10 years building products, from payments to lending, that were designed around a fast, flexible, software-first economy.
In a financial crisis, we learn which abstractions turned out to be faulty: 2008 taught us that complex credit products were better at hiding risk than mitigating it; 2000 showed that while the internet was a big deal, that didn’t mean any given internet business was bound for success; 1987 demonstrated that “be the first to leave” is not a viable strategy if it’s everybody’s strategy. If this pattern holds, fintech — the union of two very abstract, meta industries — should be suffering right now during the sharpest economic contraction in U.S. history.
So why does fintech seem to be thriving? There are a few reasons.
Riding the e-commerce wave
The economic fallout of Covid-19 hasn’t hit everyone evenly. The businesses facing the most economic pain are the ones that involve face-to-face transactions, and face-to-face business is just about the only legitimate way to spend cash. While there’s been an absolute shift to lower spending, there’s been a simultaneous relative shift to more e-commerce, and that benefits payment processors.
For many businesses pivoting to e-commerce, this means turning to digital-first payment service providers like Stripe or PayPal. Changes in consumer behavior have hurt some online stores and massively helped others — and if you’re dealing with record-setting demand and complex logistics, the last thing you want to do is spend extra time implementing payment options or dealing with chargebacks, so easy-to-set-up, fraud-resistant payment products are a huge advantage.
Point-of-sale systems in physical stores should be the exception to general prosperity in the digital payments sector, and Square has announced a precipitous decline in gross profit — from 51% annual growth in January and February to a decline of 25% in gross payment volume for their retail-focused product in the 10 days ending March 24.
Tech-enabled loans to serve small businesses
The alternative lending space has seen explosive growth in the last 10 years. Large banks pulled back, burned by the financial crisis and crimped by post-crisis regulations. These new players are tech companies first and lenders second: They build a scalable process for sourcing borrowers and evaluating credit, then scale it with outside capital. This is in contrast to traditional banks. Banks are in a paradoxical situation: Since they adopted automation earlier than other industries, they have more legacy software, which means the cost of maintaining systems slows down the process of launching new features. A brand new lender may not have the deposit base, branch network, or underwriting experience, but it doesn’t have the liability of a COBOL backend.
LendingClub exemplifies this new breed, both in terms of what it does and in terms of how fast it adapted. The company was founded as a pure peer-to-peer lender: if users needed money, they’d borrow it from other users. The company has since evolved from a peer-to-peer lender to a conduit for loans from specialist credit hedge funds. It isn’t done redesigning its business, either. In February, LendingClub became the first fintech firm to acquire a traditional bank, giving it a stable deposit base to lend from rather than relying on flighty capital from funds. In a way, it’s going full circle; a peer-to-peer alternative to traditional banks has transformed itself into an FDIC-insured bank, showcasing the agility of tech companies to creatively troubleshoot its problems. It’s hard to imagine a traditional bank making that kind of pivot so fast.
With so many businesses desperate for capital, and so many people moving their spending from physical stores to e-commerce, the companies that can serve those needs well will prosper.
Other fintech companies have moved into lending in a more direct way. Square Capital offers revenue-based loans to Square customers where you borrow upfront and pay back as you earn money. There are several good reasons for this: It aligns incentives, by encouraging the lender to help borrowers grow faster (if you expect your loan to get paid back in a year and it happens in six months, you’ve effectively doubled your return). Revenue-based loans like Square Capital’s are the ideal financial product for a crisis like Covid-19, when some companies see revenue go to zero, but the long-term value of the business is mostly threatened by the risk of foreclosure. In other words, revenue-based repayment means the lender automatically applies forbearance during temporary crises. Unlike traditional loans, these loans shift risk away from vulnerable small companies and onto bigger companies that are better equipped to handle it.
As long as Square itself doesn’t run short on cash, its alternative loans — originally designed so they’d be easy-to-understand and fit in nicely with the data Square was already collecting — turned out to be a perfect fit for the problem many of Square’s customers face.
Creating smarter loan products and services
Clearbanc is another prominent player in the new alternative lending space, and its model is quite clever. Instead of underwriting an entire business, it focuses on underwriting the ads. It finds small businesses that get a healthy return on ad spend and gets them funding to grow their ad budgets. One way to look at this is that it’s lending against less collateral than a traditional bank would. If a company can reliably spend $1 on ads and get $3 in gross profit, lending them that dollar means making a loan with $3 of collateral. Payment cycles tend to be fast, too, since the ads with quantifiable returns on investment are direct-response ads that lead to a quick purchase.
It’s not just a financial product, either: Alternative lenders can and do help borrowers better optimize their spending. If you’re lending a company money for ads on Facebook, Google, Twitter, and Snapchat, it makes sense to figure out which channel works best for them and focus on that — it also makes sense to see which specific ads are working and even to suggest pricing changes.
While there’s been an absolute shift to lower spending, there’s been a simultaneous relative shift to more e-commerce, and that benefits payment processors.
This is especially important considering that one of the long-term consequences of a prolonged Covid-19 recession will be an economic shift away from small business toward big companies that have high profit margins, lots of cash on hand, and relatively easy access to capital markets. Your local family-owned burger joint has a harder time raising money than McDonald’s, so your favorite hangout might turn into one more McD’s by the time the economy is back on track.
That’s not completely avoidable, but fintech companies are helping to mitigate this scenario by giving small companies the kinds of software tools big companies build. E-commerce titans invest huge sums in fraud detection, which an independent retailer can’t match. But Stripe can do all sorts of clever things to stop fraud and monetize them through the payment product. SMB-focused software gives independent companies a taste of big-company economies of scale, without forcing them to give up their independence.
One tricky problem with these loans is that they’re hard to backtest. Normally, the way banks build credit models is to look at history. If you’re lending against office buildings or factories, you could conceivably go back to the mid-19th century to see what a recession does to loan value. But if you’re lending to Shopify stores, mobile gaming companies, and A.I.-enabled CRM services, there is no meaningful recession backtest. You could go back to 2008, but in tech terms, that’s practically a different geological era.
Trial by fire
Only a few kinds of companies truly win in a recession. Payday lenders, dollar stores, and bankruptcy lawyers are some of the few who may view record-breaking unemployment as good for business. But every economic cycle resets the winners and losers. The online travel industry grew in the wake of the dot-com crash, when hotels were so desperate for business that they were finally willing to return calls from Expedia and Booking.com. Social media and search grew after 2008, when advertisers, who had cut their TV ad budget because of the crisis, realized that online ads were a better deal.
Given the relative youth of the fintech industry, one way they benefit from today’s brutal recession is that they finally know exactly how bad things can get. It’s a common truism in finance that stocks go down on vague bad news and then go back up when the news is quantified (last summer, Facebook announced that the Federal Trade Commission was fining it $5 billion — and the stock went up).
It’s hard for new business models to compete with legacy players because inertia is so strong, so anything that shakes up the entire economy necessarily benefits the forward-thinking winners over the legacy players. With so many businesses desperate for capital, and so many people moving their spending from physical stores to e-commerce, the companies that can serve those needs well will prosper.
Covid-19, and the ensuing severe recession, was not something anyone saw coming. Fintech companies spent the last 10 years building products, from payments to lending, that were designed around a fast, flexible, software-first economy. That meant they were designing products that were ideal for helping the lucky winners in the current crisis rise to the occasion, and at the same time absorbing some of the risk from the small businesses bearing the brunt of the economic shock.
As it turns out, the people who build the future are ready when the future suddenly arrives.
