Role of Capital Markets in Lending Programs

By Punit Dholakia, Global Head of Capital Markets, Pipe

Over the past few years, several fintechs have closed shop, some after being in business for a very long time. As we look at the years ahead, there’s a paradigm shift in the markets, where neutral rates are expected to be higher. History serves as a reminder to understand why capital-intensive fintechs (whose business model is lending to Main Street in some form) fail and take steps today to ensure a fintech start-up’s longevity.

Lower Pricing is not a Product

Several fintechs in the past decade have built and scaled similar products with lower pricing being the only differentiator. Assuming “lower cost equals product-market fit” is one of the most common mistakes founders make.

Fintechs are most sensitive to rates, and most businesses fail when rates rise unreasonably. However, the recent repricing of rates from 0% to ~5%, while fast, is still not unreasonable from a historical perspective. As inflation started heating up, prudent capital markets fintech teams differentiated themselves from the rest by stress-testing their portfolios and products. They ensured the business could work at higher rates either by passing on the cost to the customer or by partnering with entities that could offer consistently cheaper cost of funds. Those that couldn’t withstand this abrupt rise in rates have succumbed in the past two years.

Liquidity, Liquidity, Liquidity

Lack of liquidity is the single biggest reason why most fintechs and specialty finance lenders fail. A fintech can have everything in place – product, compliance, risk, etc. – but can still fail or be forced into a discounted acquisition or merger if it hasn’t responsibly managed its liquidity. As a general rule of thumb, given the ongoing bout of volatility, it’s prudent to have at least 18-24 months of liquidity to support your operational plans without the injection of any additional capital.

Relying on rapid growth and the expectation of perennial access to funding are common factors that result in fintechs failing. Effectively managing liquidity on a periodic basis and bumping it against roadmap expectations are critical at every phase of the company’s evolution. A common mistake inexperienced startups make is not adapting to the changing dynamics of the market. If the terms for a capital raise (debt or equity) have changed, holding out for those preferable previous terms to come back can lead to a downward spiral if market conditions deteriorate.

It can be painful in the short term to take these steps (i.e., accepting terms that look like you’re giving a bit away to the capital provider), but if it secures your company’s position and provides breathing room, it may be well worth the discomfort in the long term. If the capital isn’t needed, that’s great. But you don’t want to rush for capital when everyone in the market is scrambling for it. Hope is not a strategy. The best you can do is take steps today based on the market information you have at your disposal.

Overreliance on a single form of capital markets

In the past 15 years, two specific black swan events come to mind that caused significant business disruption. The 2008 financial crisis is long forgotten, but credit markets, and securitization markets specifically, froze for more than a quarter. The fintech space didn’t exist then, but most specialty finance lenders that relied heavily on securitization take-outs for continuous refinancings had trouble keeping the lights on.

While COVID might qualify as another such extreme event (since the Fed and Congress came to the rescue), for most fintechs, the sudden uptick in rates and associated financing costs in 2022-2023 has been more painful. In 2021, most fintechs, again, relied on securitization markets for their funding needs, pinned on the false belief that rates would stay low. Fintechs with a robust business model and product mix have since diversified into other forms of funding beyond public securitizations. Both events are a good reminder of what happens if a business fails to diversify beyond a single source of funding.

Role of capital markets and effective risk management

Just like any other business, when a fintech is first started, it’s inherently at its riskiest. However, as a fintech becomes more seasoned – with each passing year, each new product, and the scaling of existing products – the business risk should subside, and the capital markets strategy of the organization should shift to match.

If it were possible to summarize a good capital markets strategy in three bullets, it would be:

• Ensure sufficient liquidity for the business. While the runway might be short at the start, with each passing year, the runway should increase as the fintech stabilizes.
• Periodically model left tail events to determine the overall health of the portfolio, its ability to survive these shocks, and the impact on liquidity/runway.
• As the product scales and new products are launched, look to diversify your sources of funding to reduce counterparty and specific market risk. Look to diversify when times for funding are great – looking for capital when there is no urgency, provides companies not only with negotiating leverage but also the right partner.

Looking Ahead

When times are good, it’s very common to get complacent, and those who got complacent in 2021 were caught off guard. While broader metrics have improved significantly since then, it’s important to be cautious in the next 12-24 months.

A new administration and policies, debt ceiling limit, draining liquidity (as exhibited by declining reverse repo balance and quantitative tightening) coinciding with a refinancing wall across public and private sectors, and atypical rise in long-end yields after Fed rate cuts (reminding us of the UK gilt crisis of 2022) are all headwinds that can snowball individually or manifest turmoil in aggregate. Ensuring capital markets teams are using each tool in the toolbox proactively to navigate any volatility will be key to taking fintech to new heights.