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One company has dominated headlines this week: Facebook. First its systems went down and then a former product manager, Frances Haugen, testified in Congress at a Senate hearing on consumer protection. Haugen highlighted problems at Facebook and called for greater regulatory oversight. “The severity of this crisis demands that we break out of previous regulatory frames.”

It didn’t attract as much media attention but the next day, four thousand miles away, in the Swiss town of Basel, financial regulators met to discuss how their own regulatory frames might be applied to Facebook and other big tech companies.

Facebook isn’t a financial company, at least not yet. Back in 2019, Mark Zuckerberg articulated grand plans to become one via a cryptocurrency called Libra. “What we’re trying to do with Libra,” he told lawmakers, “[is] rethink what a modern infrastructure for the financial system would be if you started it today rather than fifty years ago on a lot of outdated systems.”

We talked abo…

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Fifteen years ago – almost to the day – I sat in a meeting room at my London-based hedge fund, across the table from the management team behind the world’s biggest IPO. They’d come halfway across the world on a global roadshow to educate investors about their company. There was nothing fancy about this company, no cutting edge tech or innovative business model. It was a bank – the largest in China. After years of Communist party ownership, it was opening itself up to private capital.

The meeting itself was a formality. We wanted stock and they knew we wanted stock. An interpreter sat alongside the most senior executive and questions and answers were routed via her. They told us about their operational reforms, about their financial restructuring and about their strategy to grow fee income. But the investment case was simple: this was the biggest bank in China, home to almost a fifth of the deposits in the country, and an investment in it would grant exposure to the rapid growth of the …

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Turn on any TV or radio in the UK and after a while you will be confronted with an advert for a price comparison website. There are four of them: Moneysupermarket, GoCompare, Confused.com and Comparethemarket. Between them, they spend over £150 million a year on traditional media advertising and a lot more on other marketing. A few years ago, Go Compare’s TV advert – featuring Welsh opera singer Gio Compario – was voted the most annoying in the UK; Comparethemarket’s ad was not far behind. 

In some ways these companies are a precursor to the super app that is gaining increasing traction in financial services. This week, PayPal launched a one-stop shop allowing customers to access credit, savings accounts and other financial services from a single app. Like super apps, price comparison sites provide an interface between the customer and the market – a first port of call for customers to access financial services. But the mechanism is quite different, as are the economics. 

Price comparis…

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There’s a disconnect that sits at the heart of banking: the people with the highest demand for loans aren’t the ones banks want to lend to. More often than not, it’s because they don’t have collateral – and there’s nothing a bank likes more than collateral. A private bank will lend you as much as you want against the value of your stock portfolio; a mortgage bank will do the same against the value of a house. It’s more difficult if you haven’t got a brokerage account, or any real assets, or even a bank account. Globally, around 1.7 billion adults didn’t have a bank account when the World Bank last did a survey, in 2017.

One of the ways round this, if you want to avoid usurious interest rates, is to find a guarantor. 

Jonathan Swift – the author of Gulliver’s Travels – took up a sideline doing this form of lending in his home town of Dublin in the eighteenth century. He set up a small fund to lend to poor but creditworthy tradesmen who had projects that promised high returns on investmen…

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Welcome back to Net Interest, my newsletter on financial sector themes. I hope you had a good summer; I spent time in the Scottish Highlands walking hills and sampling whiskies. It gave me time to ponder the next steps for Net Interest, and I’ve decided to introduce a paid tier. Read on and I’ll explain...

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About a year ago, I wrote a piece on the equity research industry. It was a big industry once, but it’s been in decline. This year, asset managers will spend around $13.7 billion on traditional investment research globally, down from the $17 billion or so they spent in 2015. The era of the rock star equity research analyst passed a long time ago, yet revenues continue to fall. 

The reasons for the decline in the industry lie in its economics. It isn’t that demand for research product is waning; the amount of money active in seeking out investment returns around the world only goes up and the leverage such money can extract from a good piece of research is immense. Rather, the value chain that supported the traditional model is being rebuilt. 

One catalyst for this was regulation. At the beginning of 2018, a new regulation – MiFID II – took effect in Europe. Among other things, it forced asset managers to cover the cost of research themselves rather than pass it on to their clients inside trading fees. Unsurprisingly, this led to a reassessment of the value they place on research; it’s easy to try the lobster when someone else is paying. 

Many independent research-led brokers were hit hard. One of them was Redburn, a London-based firm with 200 employees. Revenues are down 25% from their pre-MiFID II peak and in its recently filed accounts for 2020, the company complains that “the aggregate equity research market wallet…remains under pressure… [I]t is proving challenging for the core business to generate meaningful growth in this market, given the market size headwinds.”

Yet while equity research providers gnash their teeth at the unbundling of research from trading, another unbundling has been taking place within equity research itself. Just as in related sectors like media, equity research offers a range of services which are increasingly being picked off by specialist providers. It’s this unbundling that explains the continued decline in investment research revenue. Services include:

• sharing industry knowledge

• facilitating access to company management and to industry experts

• publishing summaries and analyses of company filings like S-1s and earnings reports

• lending a sounding board for investors to bounce ideas off

• hosting company earnings models

• feeding consensus earnings estimates

• making stock calls

• maintaining oversight on company management

• building networks for institutional investors

• promoting their firm’s brand

• and much more, depending on research analysts’ entrepreneurial flair. 

Take access to company management. Equity research providers used to host grand conferences, taking over entire hotels to intermediate meetings between investors and corporate executives. As an investor I would routinely fly to New York or Florida to meet with CEOs in airless hotel rooms, paying Goldman Sachs or Credit Suisse for the privilege. Now, a lot of that can be done online at lower cost. Earlier this year, OpenExchange, a provider of virtual event solutions, raised $23 million in series D funding to fuel its growth. The company managed 4,000 meetings in 2019 but that jumped to over 100,000 in 2020 and 84,000 in the first half of 2021. 

Or take access to experts. Firms focussed on introducing investors to industry experts have been around for a while; indeed some of them became embroiled in an insider trading probe in 2010. But they’ve been showing strong growth recently, earning over $3 billion of revenues in 2020, with investment managers comprising some of their best customers. Gerson Lehrman Group (GLG) is the market leader [disclosure: I’m one of their experts] – they earned over $600 million in revenue last year – but lots of new entrants have come to the market, including Tegus, which retains a library of transcripted calls. The leading provider in China, Capvision, recently filed to go public in Hong Kong; it’s grown its revenues by 29% per annum over the past two years and now does close to $100 million in sales.

Across the whole spectrum of jobs to be done in equity research, new entrants are pecking away. Canalyst raised $20 million of series B funding in 2019 to do earnings models. Companies like Procensus offer a platform for institutional investors to share opinions and forecasts directly. Traditional data providers like Bloomberg are pushing up into research to secure positioning in their core market. And although not a startup, the Financial Times did more to bring Wirecard management to account than most research analysts. One analyst highlighted the conflicts that can arise from bundling when she told a German parliamentary inquiry: “It is an analyst’s job to sell ideas. Wirecard was one of my strongest recommendations.”

Finally, there’s industry knowledge. Traditionally this was sold at a very high price to a small number of clients. Redburn, for example, has no more than a thousand clients. But the low cost of internet distribution opens up a much larger potential market at a lower price point. A pioneer here is Ben Thompson, who offers tech industry knowledge and strategic insight via his Stratechery newsletter. He is estimated to have between 25,000 and 30,000 customers. His ideas have even been repackaged by traditional equity research houses and passed off as their own:

Ben Thompson @benthompsonIdeas are free but “Source: Credit Suisse” is a bit much

Alex Persson @PerssonAC

@benthompson Credit Suisse blatantly copying your work and not providing credit where credit is due. https://t.co/Wnplsl3gEz

August 8th 2018

89 Retweets880 Likes

All of which brings me to Net Interest. 

When I launched Net Interest in May 2020, I never really grasped the power of the internet. I had spent over 20 years in public markets, first in equity research and then as a partner of one of Europe’s premier hedge fund firms, analysing and investing in financial services firms throughout. At peak, my team and I managed $4 billion of assets in the sector, which we deployed, long and short, around the world. Although I’ve given up managing other people’s money, I maintain a keen interest, particularly in fintech, and thought it would be fun to write down what I was thinking about each week. 

Over 60 issues later, we are at more than 23,000 subscribers. Readers include CEOs and CFOs of some of the biggest financial institutions in the world, founders of some of the most exciting startups, and investors at some of the highest performing funds across venture and public markets. The email open rate is around 45%, which I’m told is quite good, and top posts are read by up to 50,000 people.

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The content isn’t equity research in the fully bundled sense. I don’t make stock calls nor do I publish earnings models. In addition, I write a lot about private companies whose securities don’t trade. But the industry knowledge is there, built on 25 years of experience. In fact, as an investor, I often observed a gap in the market for historical, contextual research – simple explanations for why an industry came to be and the longer term dynamics at play. Net Interest is my contribution to filling that gap in the financial services sector. 

From today, I’m adding a paid tier. The weekly long form piece will remain free, but paid subscribers will have access to three supplementary features:

• More Net Interest, in which we highlight breaking themes in the industry

• Instant access to the full Net Interest archive, complete with comprehensive search functionality

• Invitations to conference calls I’ll host on topical issues 

I’m excited by what Net Interest has accomplished over the past year and I’m ready to take it to the next level. I’m emboldened by some of the great endorsements I’ve received from some very demanding readers:

• After I wrote about Jamie Dimon in one of my first pieces, Inside the Mind of Jamie Dimon, I received a surprising email: “You did a very good job and I was impressed with your effort. It was fun for me to read...”

• After I wrote about Blackstone, the man who knows the company better than anyone wrote to say: “Your domain knowledge and specific knowledge about our firm is remarkable. You really understand how the business works and what the drivers are for our growth and profits.”

• And after I wrote about Indian fintech giant Paytm, its founder and CEO tweeted: “Super interesting read, even for me … It’s pleasure to read an article so well detailed and balanced, when we have never talked or interacted ever before!”

In addition, plenty more executives, founders, hedge fund managers and venture capitalists have written to say how much they enjoy Net Interest. One reader tweeted: “Very insightful, thought provoking, informative and his experience shows up in every one of his posts. @MarcRuby is part historian, part finance professor & 100% awesome.”

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That’s nice, but where’s the value for me? 

Net Interest provides three services to help operators and investors navigate the evolving financial services sector:

Frameworks. For beginners to the financial services sector and experienced professionals alike, Net Interest provides a series of frameworks to help analyse what’s going on. As well as looking at ways to think about traditional banking, we’ve explored the economics of fund management, how investment banking works and the shifting power dynamics between Wall Street brokers and global exchange groups. 

Teardowns. S-1 teardowns are great. I’ve contributed to a couple (Coinbase, Affirm) and I’ve written up a few here too (eToro, Wise) but pre S-1 primers of private companies on the path to going public are a step ahead of the crowd. Net Interest has published several: on Ant Group of China and on Paytm of India months before either filed their prospectuses; and on Revolut and Klarna which have yet to file. 

Calls. OK, I don’t make stock calls; I prefer to leave the last mile up to you. But I can get you close. On the long side, I’ve written up Square, Tinkoff and Irish banks. The stand out is Tinkoff, up 120% since publishing at the beginning of the year. It doesn’t always go as planned of course. I wrote up Galaxy Digital Holdings, the Goldman Sachs of crypto, in April, and its stock hasn’t recovered since. 

On the short side, the standout is Greensill. Steve Clapham and I laid out all the red flags nine months before the company’s collapse. Our piece was even highlighted at a UK Parliamentary hearing into the matter. As a private company, there’s not much most readers could have done with our analysis on the investing side. But we hope that some of the VCs out there took note when Greensill tried to raise fresh capital later in the year. More actionable may have been Evergrande, which we discussed in July; it’s down a lot since then. Again, though, it’s not all one way traffic. I was pretty sceptical of Robinhood’s prospects at IPO and that stock is up almost 20% since. 

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What will it cost?

The subscription price is $250 per year, or $25 per month. 

In addition, I am opening up just 25 slots for institutional members. These members will receive a more personalised service, where I will be available for quarterly one-on-one calls. The price for an institutional membership is $5,000 per year.

Compared to the tens of thousands of dollars that asset managers pay for bundled equity research, either of these subscription plans represents a very good offer. My pitch to you is that if this newsletter can help you make one better decision each year, it’ll pay for itself. And if it doesn’t, you can cancel anytime.

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When will this change happen?

The first subscriber-only post will go out next week, 10 September. 

There’s plenty in store for the months ahead. Coming soon is a write-up of M-Pesa, the original ‘digital wallet’ born in Africa. There’s a piece on the art market in the pipeline and also something on Chinese banks as well as continued explorations in decentralised finance. 

If you’ve gained any valuable insights from what you’ve read in Net Interest so far, I hope you’ll join me on the next leg of the journey and sign up as a paid subscriber. We won’t be breaking the equity research model, but if it’s financial industry knowledge you’re after, in an accessible format, then Net Interest is the place for you. 

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In the meantime, whether you’re celebrating Labor Day, Jewish New Year or a birthday (I am!) have a great week ahead,

Marc

Welcome to another issue of Net Interest, where I distill 25 years of experience investing in the financial sector into a weekly email. If you’re reading this but haven’t yet signed up, join over 22,000 others and get Net Interest delivered to your inbox each Friday by subscribing here 👉

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After Afterpay

Well, I said last week that I would be taking some time off over August. But this is a newsletter on financial sector themes, so when the biggest financial sector deal of the year is announced, it’s worth getting off the beach for!

Earlier this week, Square announced that it’s buying Afterpay of Australia in a deal (now) worth US$33 billion. We’ve touched on both companies here before – Afterpay in Online Lending: the Good, the Bad and the Ugly precisely a year ago (Afterpay was the Good) and Square in a write-up of the company (Hip to be Square) just before Christmas. They are both at the vanguard of fintech and share a distinctive feature. Unlike many fintech startups which create a lot of value for venture investors, these two have created most of their value in public. Square came to the market in November 2015 at a US$2.9 billion valuation and has created 98% of its value since; Afterpay came to the market six months later at a US$125 million valuation and has created 99.5% of its value since.

To understand the rationale of the merger, it is useful to delve into the background of Afterpay and the sources of its success. I am helped by the very timely publication of a new book, Buy Now, Pay Later: The Extraordinary Story of Afterpay, by Jonathan Shapiro and James Eyers, which came out not two days after the deal was announced. The authors write in their epilogue: “Writing a book about such a rapidly evolving subject was always going to leave us exposed to the risk that we’d be caught out by a dramatic plot twist.” They were right but it does mean they’ve written a complete account of Afterpay as an independent company, an account that Square shareholders may find very useful.

From eBay to Afterpay

Afterpay is a global pioneer in the growing Buy Now Pay Later market. It was founded in 2014 by Australian neighbours, Anthony Eisen and Nick Molnar.

Molnar had grown up in his family’s jewellery business in Sydney. It was a classic offline business with a store in Wynyard Station in the city’s central business district. Seeing the potential of the online market, Nick and his younger brother convinced their parents they could sell stock over the internet to supplement the store’s sales.

“I started to list a few pieces on eBay and it started to move quite well but I was in Year 11,” Simon Molnar told Fairfax. “I handed the keys over to [Nick] and he really ramped it up and became the top seller of jewellery for eBay Australia.”

That was when Nick was in college. He carried on selling throughout but was also attracted by a career in finance. He’d struck up a friendship with his parents’ neighbour, Anthony Eisen, who worked in investment banking. At the time, Eisen was winding down the investment portfolio of Guinness Peat Group, having previously worked as a corporate advisor at a number of firms including Credit Suisse. 

Through Eisen’s contacts, Nick secured an interview at a local venture capital firm. The firm’s founder, Mark Carnegie, was fascinated by Nick’s online jewellery business – so much so that he refused to give him a job, telling him to go away and scale up the business instead, and that they’d talk again next year.

Nick was quick off the mark. He skipped his graduation ceremony to fly to an industry convention in Las Vegas and came back with the franchise to launch Ice Online, America's largest online-only jewellery retailer, into the Australian market. 

However, there were some fundamental differences between buying jewellery online and buying it in a store:

“We realised buying jewellery online was not like buying a dress,” Michele Molnar told The Sydney Morning Herald. “People were getting to the checkout and not confident to complete the transaction. We used to sit around the dinner table and work out how to make the transaction easy.”

Nick observed that only 1 out of 100 visitors to the website would convert at checkout. He toyed with the idea of introducing credit as a mechanism to smooth the process and discussed his ideas with Eisen. 

Buying on Credit

It’s not unusual for retailers to offer credit to facilitate sales. In 1807, a furniture store in New York named Cowperthwait & Sons was the first to allow its customers to pay in instalments: “Liberal credit is granted without extra charge, while cash purchasers receive a ten per cent discount.” Shortly afterwards, Isaac Singer introduced a credit scheme to bolster sales of his sewing machines. According to Harvard Business School, “Singer’s machines were neither the best nor the cheapest products on the market. But the firm’s innovative credit plan, inspired by piano showrooms near company headquarters, tripled sales in just one year.”

Others followed. Department stores introduced cards for their wealthier customers to defer payment and then smaller retailers banded together to form cooperative payment card systems. Visa and Mastercard grew from these roots, as we discussed in our piece on Dee Hock, the founder of Visa. But even twenty years after the launch of the first bank-issued card, Sears had more cards in circulation than Visa and Mastercard combined.

Extending credit to customers hasn’t always gone well. That very first bank-issued credit card –  dropped on the residents of Fresno, California in 1958 – suffered delinquencies of 22%, much higher than the 4% projected. Those losses cost its innovator his job. 

Managing the trade-off between retail sales and credit losses can still be a challenge. In 2014, Texas based furniture retailer, Conn’s, warned of major losses in its credit book. The company finances nearly 80% of its sales through an in-house credit business and deteriorating credit quality placed a drag on earnings. In the five years up to July 2019, Conn’s lost a cumulative $566 million in credit against profits in its retail business of $807 million before tax (a big price to pay compared with the 3% discount rate that merchants typically pay to accept credit underwritten by others).

The divergent skills required to navigate retail and credit led many stores to outsource their credit books. For smaller stores, there was also the issue of scale, which is how Visa and Mastercard got their impetus. Larger stores took longer to convince since their own cards incurred no discount fees and stores that allowed customers to finance purchases generated additional interest income, like in the case of Conn’s over the past twelve months where credit losses have stemmed and credit now contributes over 40% of the bottom line.

Dee Hock won over one of the largest stores, JCPenney, as a customer in 1979, but it took some doing. In the year prior, JCPenney’s credit volume amounted to 20% of Visa USA’s entire volume, so it’s not surprising the store came away with an attractive deal, one which precipitated Dee Hock’s exit.

Most stores now outsource credit. Signet, the world’s largest jewellery retailer, was one of the last to fall into line. In its year ended January 2017, it financed 62% of sales in its Sterling Jewelers subsidiary (which includes Kay Jewelers, Jared and smaller regional brands) which it underwrote itself. Since then, it has been selling off its financing business in pieces (amidst sexual harassment allegations and questions from the SEC over how it booked credit losses). In March this year, Signet finalised receivable purchase agreements with third-parties, representing the final step in fully outsourcing its credit offerings and removing consumer credit risk from its balance sheet. 

Growing Afterpay

Nick Molnar registered a new business, Innovative Payments, in May 2014. Six months later he and Eisen changed the company’s name to Afterpay. The idea was to allow customers a choice of two financing options: to pay in full, within 30 days, after receiving delivery of their item, or to pay in four equal installments over six weeks. The experience at Ice Online was that nobody used the pay after delivery option, so that was soon killed.

The pair did a deal with payments company Touchcorp to build the technology at a cost of A$13 million (paid in two cash installments – obviously – plus an equity stake of A$10 million). They hired a credit guy (Richard Harris) and a sales guy (Fabio De Carvalho) and set to work. In July 2015, they raised A$8 million of funding from 41 early investors, valuing the business at A$28 million. 

Early merchant customers liked the proposition. One of the first to sign up was Princess Polly, an online fashion brand. Afterpay soon grew to support one in five of its purchases, increasing its revenues by as much as 15%. General Pants came onboard next followed by Cue Clothing. In its first week on General Pants’ site, Afterpay accounted for 20% of sales. The company has retained a focus on fashion since, where there is greater demand for instant gratification and where ticket sizes are lower than in electronics, say, reducing risk. Merchants that add Afterpay at the checkout typically witness more conversion, larger basket sizes and higher repeat rates. 

Investors liked the proposition too. On a $100 sale, the merchant would pay Afterpay $4. After deducting $0.80 for Touchcorp to process the transaction and around $0.70 lost to bad debts and failed payments, around $2.50 would be left as a transaction margin. Because of the high turnover of loans (they were extended for six week periods) that margin could be earned multiple times over a year. And because Afterpay borrowed its funds – National Australia Bank would go on to provide a warehouse lending facility – the return on equity capital was even greater.

By the end of 2015, Afterpay had run out of funds. Rather than raise a venture round, it went straight to the stock market, listing in May 2016 at a A$165 million valuation. The public offering meant that venture funds didn’t get a chance to invest, with one exception – Matrix Partners, which came in later, in 2018, to finance expansion into the US. Not even Nick Molnar’s former job interviewer, Mark Carnegie, was given a chance to invest, although nor did he put any of his personal funds in. Years later, he was asked by a journalist whether he regretted not putting money into Afterpay. His response: “What do you fucking think?”.

At the time of its IPO, Afterpay had 100 merchants and 38,000 underlying customers signed up. After that, the company grew and grew. Its original pitch deck had projected A$677 million of underlying merchant sales in its third year of operations (2018 financial year); in fact it did A$2.2 billion. In the last financial year to June 2021, it did ten times that – A$21.1 billion – with 98,200 merchants signed up and 16.2 million underlying customers. 

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Along the way, Afterpay merged with its early technology provider Touchcorp (hence its stock ticker APT, as in Afterpay Touch) and expanded into North America and Europe (in Europe under the brand Clearpay because a Dutch company, AfterPay, got there first).

Expansion into the US was especially important given the size of the market – 25 times larger than the Australian market. In order to replicate a startup culture, Afterpay set up a separate company, Afterpay USA Inc, with US$15 million of funding from Matrix Partners in a deal that gave it conversion rights on 10% of the US business. Nick Molnar relocated to take charge. The first retailer to sign up was Urban Outfitters; it was soon followed by Revolve. Within nine months, Afterpay USA had signed up 900 merchants and attracted 300,000 users. And then, on Thanksgiving 2018, the Kardashian team reached out, wanting to onboard that very day to take advantage of Black Friday. 

“We tried every single angle to get in the door there, and one morning they filled out our contact form. They came inbound to us. And we were like, ‘The world is lovely,’” Molnar told The Australian Financial Review.

By the end of March, the number of users in the US had hit 1 million. In February 2020, the US overtook Australia by customer count; the number of users there is now 10.5 million. 

Regulatory Threats

It wasn’t all smooth sailing for Afterpay. Between 2017 and 2020, the company faced the glare of regulatory scrutiny; it has also been subject to intense competition. Regulatory scrutiny came in three waves.

First, the Australian Securities and Investments Commission launched an inquiry focused on the industry’s lending practices. Afterpay offers consumer credit yet doesn’t conduct full credit checks of customers as per national lending laws. Doing so would slow down the application process, removing the product’s attractions. The company says that regardless, it rejects 50% of attempted transactions by first-time customers. It has been able to circumvent credit checks because its loans are short duration and don’t incur interest and so fall outside the definition of credit products in the credit laws. When it filed its report in November 2018, the Commission agreed. 

Then there was a Senate committee inquiry into credit and financial services. A focus here was late fees. Afterpay charges consumers a fee if they are late with payments – the only revenue it extracts directly from consumers. However, the fee is capped and so doesn’t compound like interest. The company told the inquiry that only 5% of transactions incurred a late fee in 2018. Since then, the contribution from late fees has been coming down, to ~13% of revenue from ~20% in 2017 and 2018. 

Finally, the Reserve Bank of Australia probed whether Buy Now Pay Later providers like Afterpay should be allowed to stop merchants passing their costs on to customers, as they insist in their contracts. Such restrictions were banned in the credit card industry in Australia in the early 2000s. 

Afterpay argues that its model is increasingly analogous to an internet referral platform like Google rather than to a payments processor like Visa. Indeed, in the year to June 2021, Afterpay drove ~1 million lead referrals per day to its merchant partners, with 55% coming from consumers browsing the home page on the Afterpay mobile app. Since its early days, the company has shifted its focus from merchant-as-customer to consumer-as-customer. The merchant partner finances Afterpay’s customer acquisition, but then gets value back through referrals and repeat business. One analysis shows that leads from Afterpay convert 8x more than leads from Google; lead referral is a growing part of the proposition for merchants. 

The Governor of the Reserve Bank of Australia plainly agreed and in December 2020, indicated that he would not remove the no-surcharge rules that would have put Buy Now Pay Later on equal footing with card processors. 

Together with Square

There’s a widely held narrative that “Buy Now Pay Later companies are particularly popular amongst younger millennial and Generation Z consumers who came of age amidst the Great Recession and have a generally dubious view of credit.” It’s certainly true that Buy Now Pay Later, funded via debit cards (90% in case of Afterpay) is popular in that demographic – the average age of an Afterpay customer is 33. But it’s not clear whether a dubious view of credit is the reason. Robinhood, which we discussed a few weeks ago, has a similar demographic among its customer base (median age 31) yet sells a lot of margin loans (albeit its customers skew male while Afterpay’s skew female). 

Whatever the reason, Buy Now Pay Later is a useful way for merchants to convert debit-sized baskets into credit-sized baskets with no incremental risk and only slightly higher cost. Its popularity has bred a lot of competition. As well as Affirm and Klarna, Apple is launching a Buy Now Pay Later product in partnership with Goldman Sachs, and PayPal is investing heavily. The deal between Afterpay and Square recognises the changing competitive landscape, but it does something more.

As we discussed in our Square write-up, Square has built two independent ecosystems that are approaching critical mass – an ecosystem of merchants (Seller) and an ecosystem of consumers (Cash App). The holy grail is to connect them (the “third horizon” as management puts it) to capture all the value available when the two sides transact. Management tried in the past with Square Wallet, but they went too early, before the sides had critical mass. Looking back, the CFO said: “I think what we learned there and why we shut it down is if you tried to contain what a consumer wants to do, you effectively are removing utility from them.” 

Afterpay provides the glue to mesh the two sides together. As well as bringing in both more merchants and more consumers, Afterpay has proven how to combine them. Like Square, it started out with a focus on merchants but has shifted its focus to the consumer side. It’s also the case that across financial services, lending reflects the largest profit pool, yet growing a lending business while managing risk is hard. 

Combined, Square and Afterpay are worth more than Citigroup, which once harboured a strategy to become a financial supermarket. The modern equivalent is a super app and although that’s not a term Square management likes to use1, that’s what it’s becoming.

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More Net InterestBig Tech Doing Finance

The Bank for International Settlements (BIS) has been wrestling with how to respond to the incursion of big technology companies into financial services for some time. We highlighted some of the challenges in The Policy Triangle earlier this year. For years, financial regulators have contained themselves to managing the trade-off between competition and financial stability, with stability usually winning out. Big technology companies add a new dimension to the trade-off: privacy. 

This week, senior BIS personnel published a paper, Regulating Big Techs in Finance. They reckon financial regulators have a role to play, given “the potential systemic relevance of big techs and the need to introduce specific safeguards to guarantee sufficient operational resilience. That may be especially relevant for big techs offering systemically important payment services to a significant section of the population.”

Historically, regulators have taken an “activity-based” approach to non-banks entering financial services, i.e. that the specific activities they undertake need to be licensed, be they in credit or in payments or wherever. The scale of its non-banks has forced China to adopt a more “entity-based” approach, holding companies like Ant to higher standards. The BIS wonders if regulators elsewhere need to pivot, too: “[G]iven the unique set of challenges that are thrown up by big techs’ entry into financial services, a purely activity-based framework for regulation is likely to fall short of an adequate response to these policy challenges.”

Financial regulators have big technology companies in their sights. 

European Banks

European banks have had a good earnings season. Most of them have now reported their second quarter earnings and they have beaten Goldman Sachs estimates by 18% at the pre-tax profit level. A lot of the beat comes from lower loan loss provisions, but pre-provision profits beat by 6% with revenues performing 2% better than expected to grow 4% versus the same quarter last year.   

Capital also accumulated over the period, providing the fuel for higher dividends once regulators lift restrictions on 1 October. Last Friday, just after Net Interest went to press, the European Bank Authority released results of its bank stress tests which contained no major negative surprises, providing support for higher payouts. After eighteen months of lockdown, European banks are close to being released. 

Blackstone

I discussed Blackstone with Zack Fuss on the Business Breakdowns podcast this week – part of the Colossus group of podcasts that also includes Invest Like the Best. David Haber summarised the firm’s essence on Twitter as “Firm > Fund”. That’s exactly right; few firms have historically been able to optimise both. If you enjoyed the primer on the company last week, the podcast is worth a listen.  

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“I don’t know what you call that combination of all those things, but we call it Cash App, and we think it’s a new definition. We think it’s rather unique, and we’re going to continue to add surface area to it to make it something that people want to use every day.” — Jack Dorsey.

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Blackstone’s Moment

Asset management is a big topic of focus for us here at Net Interest. Over the months, we’ve tackled the industry from several angles:

• In Zuckerman’s Curse, we looked at the economics of hedge funds and why their returns tend to drop off when they get bigger;

• In The Private Equity Firms’ Private Equity Firm, we explored the origins of the private equity business model and the differences between owning an investment management firm and being a client of one. 

• In Other People’s Money, we examined the quest for permanent capital pioneered by Warren Buffett and increasingly being copied by present-day investment management firms.

Along the way, we’ve touched on many firms: Sculptor, Renaissance, Paulson, Blue Owl, KKR, Berkshire Hathaway, Markel, Bluecrest, Nomad and more. But we haven’t gone into any one of those companies deep.

This week we seek to redress that with an exploration of Blackstone.

Blackstone is the largest alternative asset manager in the world, which means it traffics in the kinds of investments that don’t fall into the conventional buckets of stocks, bonds and cash. There are around $250 trillion of securities in conventional stock and bond markets around the world; Blackstone is focused on the $14 trillion market of investable assets that sits outside them. It currently manages in excess of $650 billion of assets and targets a trillion. 

Last week, it overtook Goldman Sachs in market cap, making it one of the largest financial institutions in America. But for many investors it’s still an enigma. In this briefing, we look at:

• Blackstone’s beginnings

• The economics of private equity

• Blackstone’s expansion into real estate and beyond

• How Blackstone makes money

• Going public

• Blackstone’s secret sauce

Blackstone’s Beginnings

Blackstone’s roots lie in a two-person start-up founded 35 years ago in New York. This wasn’t your usual scrappy startup – its founders had pedigree. In October 1985, Stephen Schwarzman, a former head of global M&A at Lehman, and Peter Peterson, former Chairman and CEO of Lehman (and before that Richard Nixon’s Secretary of Commerce), established Blackstone as a private investment banking firm. Peterson had been ousted from Lehman a year or so earlier in a power struggle with the bank’s chief trader. Soon after, the firm ran into trouble in the European commercial paper market and Schwarzman was tasked with selling it. He did a deal with his next-door neighbour in the Hamptons and Lehman was sold to American Express. Schwarzman hung around for a bit but he knew he wanted out and began breakfasting with Peterson to brainstorm business ideas.

Although his business was M&A, Schwarzman had his eye on the burgeoning leveraged buyout (LBO) market. He’d been introduced to the market in the early 80s as an advisor on some high profile LBOs. The premise was simple: buy a company by putting up some equity and borrowing the rest. The company pays interest on the borrowed piece from its own cash flow; meanwhile, the investor improves the operating performance of the company with a view to selling it for a gain.

Schwarzman recognised that the LBO business was more scalable than the M&A business. “As M&A bankers, we would be running only a service business dependent on fees. As investors, we would have a much greater share in the financial upside of our work.” At Lehman, doing both was viewed as a conflict of interest; at his own firm, that could be managed. 

“The appeal of the private equity business model to a couple of entrepreneurs was that you could get to significant scale with far fewer people than you would need if you were running a purely service business… Compared to most other businesses on Wall Street, private equity firms were simpler in structure, and the financial rewards were concentrated in fewer hands. But you needed skill and information to make this model work. I believed we had both and could acquire more.”

In order to fund their LBOs, Schwarzman and Peterson needed to raise some money, so after a year or so of focusing exclusively on M&A, they hit the streets to raise their first fund. Anyone who has marketed a fund before will be familiar with the struggles they faced. Despite their reputations, they didn’t have a track record to boast and so prospective investors resorted to the age-old heuristic – social proof – to determine whether to invest. A fund is an interesting social structure: investors are much more comfortable participating if other investors are involved. In Blackstone’s case, a ticket from Nikko in Japan was the anchor to raise 2.5x that amount from other Japanese investors and a ticket from GE flushed out other investors in the US. Some investors were more explicit. MetLife came into the fund early but on condition that Blackstone could raise 10x that commitment from other investors. 

In total, Schwarzman and Peterson met 488 prospective investors; 33 invested (MIT isn’t the only allocator to pass on most of the emerging managers it sees). On 15 October 1987, they closed their first fund with $850 million of commitments. The following Monday the stock market crashed. Blackstone’s history is grounded in some lucky market timing.

The Economics of Private Equity

Blackstone’s first LBO was of the transport division of USX, which it renamed Transtar. It paid $650 million for 51% of the business, putting in just $13.4 million in equity (USX put in $125 million in vendor financing and Chemical Bank lent the rest). Within two years, Blackstone had made a 4x return on its investment and by the time the last piece of equity was sold sixteen years later, the return was 26x. 

Similar deals followed over the next six years. When that first fund (Blackstone Capital Partners I) was finally liquidated, it had returned 2.6x to its investors before fees. Blackstone took out a quarterly management fee along the way, of 1-2% of capital commitments during those six years and at least 0.75% afterwards. But most of its payoff came at the back end, on the exit of an investment, when Blackstone took a 20% cut of the realized gain after any preferred annual return investors were eligible for. Schwarzman likens the revenue model to farming:

“…We’re like farmers. When we buy companies and real estate, it’s like planting crops. You put seeds in the ground, you water, and the seeds start growing, but you can’t see the crop yet. Then they grow very high, and it will be a great crop, and you will be very, very happy.”

The 20% cut meant that that first fund yielded around $250 million for Blackstone and its handful of partners – a scalable business indeed. 

Since that first fund, Blackstone has raised fifteen more funds in corporate private equity as well as others focused on specific niches like secondaries (where it acquires interests in existing funds), growth equity, infrastructure and life sciences. It currently has $66 billion ‘in the ground’ in private equity and $63 billion of ‘dry powder’. Through its funds, Blackstone owns around 250 companies, employing more than 500,000 people. Each quarter, the valuations of these companies are marked to market based on their underlying operating performance, but it’s not until exit that Blackstone captures the value. In the past twelve months, valuations in corporate private equity are up 52%. Accrued performance fees that could be crystallised on a realisation event are up to $3.6 billion, but if all of those funds in the ground plus the dry powder can be invested at a 2.5x return, then the total payout could be more than ten times that. 

Blackstone’s Expansion into Real Estate and Beyond

In the early 1990s, Schwarzman became attracted to real estate. The real estate crisis at the time left many assets at distressed valuations and Blackstone decided to try its hand. In partnership with Goldman Sachs, it bid on a portfolio of garden apartments in Arkansas and East Texas at a government auction. But the two firms had differing investment styles. 

“Goldman wanted to bid as low as possible to avoid overpaying. For me, the biggest risk was not offering enough and missing out on a tremendous opportunity… You often find this difference between different types of investors. Some will tell you that all the value is in driving down the price you pay as low as possible… That has always seemed short term to me. What that thinking ignores is all the value you can realize once you own an asset: the improvements you can make, the refinancing you can do to improve your returns, the timing of your sale to make the most of a rising market. If you waste all your energy and goodwill in pursuit of the lowest possible purchase price and end up losing the asset to a higher bidder, all that future value goes away. Sometimes it’s best to pay what you have to pay and focus on what you can then do as an owner. The returns to successful ownership will often be much higher than the returns on winning a one-off battle over price.”

Blackstone convinced Goldman to increase their bid, and the deal went on to generate a 62% annualised return. The experience stuck with Schwarzman and coloured his investment philosophy across all asset classes through the rest of his career. It also convinced him to beef up the firm’s real estate efforts. Blackstone made a number of hires into the real estate unit and, in 1994, raised a stand-alone real estate fund (Blackstone Real Estate Partners I) that ended up doing a 2.8x gross return. 

One of the hires was a young Jonathan Gray. Recruited into Blackstone’s private equity business as a 22-year old from college, he transferred to the real estate unit in 1995. Ten years later he was running it. Most successful money managers have a defining key insight sometime in their careers; Gray had two. He was quick to tap into the commercial mortgage backed securities market to make bigger real estate transactions when they were relatively new. And he identified that public companies frequently have a lot of properties valued at less than the sum of their parts; if you can buy entire portfolios, you can often offload them piecemeal and extract strong returns, 

That second insight was the foundation for one of the biggest real estate transactions in history, when Blackstone bought Sam Zell’s Equity Office Properties on the eve of the financial crisis. By then, Blackstone had raised its fifth stand-alone real estate fund, Blackstone Real Estate Partners V, a $5.5 billion fund that started deploying capital in December 2005. It had a proven track record – the first three funds all did in excess of 2x – but Equity Office Properties was six or seven times larger than any real estate deal done before. In February 2007, Blackstone bought it for $39 billion and immediately went out to sell off many of its underlying assets. Within two days it recouped half of what it paid and within two months it had sold $30 billion of assets. 

The deal is indicative of the scale Blackstone operates at. Today, the firm has around $46 billion of capital ‘in the ground’ in real estate and a further $36 billion of dry powder to deploy. Some segments of real estate have struggled during the pandemic, but 80% of Blackstone’s exposure is to more resilient segments like logistics, suburban multifamily and high quality office (including life sciences). 

Blackstone diversified into other areas as well as real estate. It established a “fund of hedge funds” in 1990 for partners to invest their own capital, which it then rolled out to external clients. Today, Blackstone Alternative Asset Management is the largest discretionary allocator to hedge funds in the world; the hedge funds business makes up around 15% of Blackstone’s total assets under management. 

It also has a large credit business, which grew following the financial crisis. Blackstone acquired credit manager GSO Capital Partners in 2008 just at the time banks were pulling back from lending, creating more direct lending opportunities for private credit managers. Today, Blackstone is one of the largest credit-oriented managers in the world. Credit makes up around 25% of the group’s assets under management. 

How Blackstone Makes Money

Blackstone makes its money from two main sources: management fees and performance/incentive fees. Over the past few years, the mix has shifted more towards management fees. Across all of its business segments, management fees now rack up at around $5 billion per year. As Schwarzman identified at the launch of his firm, private equity fees are highly scalable. Around 35% are allocated to investment professionals and other employees but the number of staff does not ratchet up linearly with assets under management. Blackstone currently employs around 3,100 people, up 54% over the past five years, during which time its assets under management are up 84%. The margin on fee-related earnings has therefore been going up at a rate of around one percentage point per year; it now stands at 55%.

Performance/incentive fees are a lot more lumpy and, in the private equity and real estate business, contingent on exits. In the last twelve months, the firm released $2.1 billion of performance and incentive fees and right now there’s another $6.8 billion sitting on the balance sheet waiting for exit events.

One of the reasons for the mix shift in fees towards management fees is the higher weighting of perpetual capital managed by Blackstone. Traditional fixed term fund structures such as Blackstone Capital Partners I and Blackstone Real Estate Partners V are analogous to ‘single crops’, to borrow Schwarzman’s farming framing. Capital is raised, deployed and compounded, but it’s ultimately handed back to investors – an intensive process to repeat. Increasingly, Blackstone has been raising perpetual capital which, unlike fixed term funds, is under no obligation to be returned to investors. Right now, Blackstone has around $170 billion of assets under management across 15 perpetual strategies. The firm gets paid incentive fees on performance based on valuations as opposed to based on realizations in sales and often the base management fees are tied to net asset value as opposed to the amount of capital committed.

A major source of perpetual capital is the insurance industry. As we discussed in Other People’s Money, one of Warren Buffett’s career-defining insights was to pair up insurance with investment management. Lower interest rates have increased the pressure on insurance companies to seek out ways to earn higher returns and one solution is for them to get closer to credit origination, which several are doing by replicating Buffett’s strategy to partner with asset managers. Blackstone recently did a deal with AIG to manage $50 billion of its assets, rising to $92 billion over time. The deal will take the firm’s total insurance assets to $200 billion when fully phased in. 

As well as insurance, Blackstone has also been increasing its penetration in the retail channel. It estimates that there are $80 trillion assets sitting on household balance sheets of high net worth individuals around the world, which compares with $30 trillion in insurance and $60 trillion in its traditional institutional market. Retail allocation to alternative assets is currently very low, but Blackstone is seeking to address that via the creation of bespoke products and a support organisation. It is currently attracting retail assets at a rate of $4 billion per month.

Going Public

Blackstone went public in June 2007, just four months before the stock market peak as the financial crisis brewed (lucky market timing once again). The IPO provided an exit for Pete Peterson and floated a currency that could be used for employee retention and for acquisitions. The challenge for any asset management firm – as we discussed in Zuckerman’s Curse – is to strike a balance between the interests of the asset manager and the asset owner; add a third stakeholder into the mix – an equity owner – and it compounds the problem. Blackstone reconciled this problem with an intention to be “a different kind of public company”:

“We intend to continue to manage our business with a long-term perspective, to focus at all times on seeking to optimize returns to the limited partner investors in our investment funds and to retain our partnership management structure and culture of employee ownership of our business.”

Over the past fourteen years, Blackstone has broadly stuck to that. Its stock dipped to $3.50 in the months after it priced its IPO at $31 as the financial crisis took hold but it recovered subsequently and now trades at $115. Looking back on the past five years, economics have been shared between the three stakeholders as follows: limited partner investors have enjoyed returns of around $100 billion, employees have taken around $10 billion and around $15 billion has been left for shareholders (although these interests do overlap). 

In its first few years as a public company, investors were reluctant to place a high value on Blackstone’s performance fees. This led Schwarzman to complain publicly. He argued, in 2012, that public mutual fund managers traded at 16 times earnings while growing assets under management at a rate of 6% per year. At the time, Blackstone was trading at 10 times and growing assets under management at 27% per year.

Since then, Blackstone has been rerated – it now trades at around 30 times earnings. Part of that is due to the shift in business mix towards more fee-related earnings, coupled with the proven persistence of performance fees. Part is due to a change in corporate structure in 2019 which allows it to access a larger pool of potential shareholders.

Blackstone’s Secret Sauce

Blackstone highlights its ‘virtuous circle’ as a cycle consisting of three elements: investment performance, investor confidence and the power to innovate. The problem with such cycles in the asset management industry is that time lags can inject friction into them. Investment performance cannot be evaluated overnight – it can take three to five years to evaluate it; longer in the case of a fixed term private equity fund.

But Blackstone has been around for a long time now and has delivered robust performance across its strategies through different market environments (with the advantage that it has discretion to time its exits). Underlying its performance are three factors: process, scale and integration. 

• As an outsider it can be hard to assess any firm’s process, but at Blackstone there’s a clue in the investment style Schwarzman articulated when recalling his first real estate deal. Price is important, but what you do with the asset after you’ve bought it is more important. This was demonstrated when the firm bought Hilton Hotels at cyclically the worst possible time, just before the financial crisis, at a price that several months later looked too high; yet the deal performed well and ultimately made $14 billion for investors. 

• “Scale is our niche,” declares Blackstone. There are certainly very few firms able to execute deals on the scale of Blackstone. Scale allows the firm to own and invest in assets and businesses that have greater surface area for improvement. In several cases, Blackstone has used scale to create new business platforms. For example, in spring 2012, it began buying single family residential homes – it bought its first in Phoenix for $100,000. Within a few months it was buying $125 million per week and eventually it rolled its properties into a platform, Invitation Homes, which made $7 billion for investors.

• Integration is possible in part because of the firm’s scale: Blackstone sees almost everything and has a pool of capital somewhere in the group to exploit it. It also practices a thematic style of investing which lends itself well to integration. Blackstone identifies macro themes and executes them across its various strategies. In life sciences, it has a dedicated fund but it also invests in specialised property in its real estate unit. Current themes it is exploring across the group are: sustainability, logistics, digital infrastructure, housing and the post-COVID travel recovery.

“Information is the most important asset in business. The more you know, the more perspectives you have, and the more likely you are to spot patterns and anomalies before your competition. So always be open to new inputs, whether they are people, experiences, or knowledge.”

Conclusion

Jon Gray is now President and COO and designated successor to Stephen Schwarzman at Blackstone. But as the firm shifts from Black to Gray, it is unlikely to skip a beat. The Archegos episode at Credit Suisse (see below) highlights the importance of culture at any firm, not least one built on intangibles like knowledge and risk. Blackstone is small enough at 3,100 employees that its culture can be cultivated but big enough that its culture can be leveraged. Of course, the firm has benefitted from the tailwind of a supportive liquidity environment, but across all of its distribution channels and all of its investment strategies, there’s plenty more growth to go.

Further reading: Most of the quotes in this piece come from Stephen Schwarzman’s memoir, What it Takes. Blackstone’s 2018 investor day materials are also a helpful resource.

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More Net InterestArchegos

Matt Levine does a good job summarising the independent report commissioned by Credit Suisse on its Archegos failings. What stands out is that some people within Credit Suisse knew the risks they were running in their dealings with Archegos but they weren’t necessarily the right people and they didn’t necessarily do anything about it. 

Of note, Archegos positions were persistently in violation of internal risk limits. The maximum potential exposure limit was set at $20 million during 2020, yet actual exposure fluctuated between $200 million and $500 million during most of the year. Credit Suisse solved this problem by moving the account to a different unit within the firm where risk limits were higher! By 8 March 2021, gross exposure was up to $21 billion which was large enough to merit a discussion at committee, but the issue wasn’t escalated to the executive board for two more weeks. During that time, Credit Suisse even agreed to pay across some excess variation margin to Archegos even though it was trying to get Archegos onto a “dynamic margining” system that would have sent funds the other way – a system that would have been implemented if only Archegos had returned Credit Suisse calls (“the business scheduled three follow-up calls in the five business days before Archegos’s default, all of which Archegos cancelled at the last minute.”)

The whole sorry mess reflects a problematic culture at Credit Suisse, a difficult thing to repair. There was a lot of staff turnover leading up to the default, one of the proximate causes for its fallout, and there has been a lot since. But as we observed in our piece on the matter, “you can change the head multiple times, you can change the stick, but it stays the same broom.”

US Payments

A new paper asks, “Why is the United States Lagging Behind in Payments?” It is co-authored by the co-creator of Diem (formerly Libra, discussed here) – a technology looking to disrupt US payments – so it’s not exactly objective. But it makes some good points. It observes that transfers between major US banks incur fees ranging from $10 to $35 for same-day wires and compares this to the UK, where individuals and businesses have access to a free, 24/7 interbank payments system which settles within seconds and supports over 8m transactions per day. It goes on to outline the frictions that exist in the US in payments systems used by individuals, businesses and government. It suggests three ways to remove these frictions. 

• One is to bring deposits on a single ledger through a Central Bank Digital Currency (CBDC), so that transfers between banks are not limited by external liquidity constraints or third-party rails. 

• The second is to follow countries such as India and Mexico and increase the throughput of always-on real time gross settlement systems. This is the model the Federal Reserve is pursuing with the introduction of FedNow, targeted for 2023.

• The third is to facilitate the growth of interoperable, stablecoin payment rails by creating the right regulatory framework for these new types of networks to safely increase competition in payments.

Diem (formerly Libra) is a play on the third, although it is hedging itself by also embracing the first. The second is a solution worth watching.

Monzo

We discussed Monzo here a year ago in The Good, the Bad and the Ugly (Monzo was the bad). This week the company filed its accounts for the year up to the end of February 2021, and yet again auditors raise question marks around the bank’s capacity to carry on as a going concern.

“Our Directors have assessed our ability to continue as a going concern and are satisfied that we have the resources to continue for the foreseeable future. But, there is a risk we won’t be able to execute our business plan, which could impact our ability to generate a profit or raise enough capital to meet future regulatory capital requirements. Because of these obstacles, the Directors recognise there continue to be material uncertainties which may challenge our ability to continue as a going concern.”

The company also highlighted that it is under investigation by the FCA over anti-money laundering breaches with potential criminal as well as civil liability. 

The UK is home to several challenger banks including Revolut (discussed two weeks ago), Starling and Monzo. They’ve each trodden a different path and risen to the challenge of the pandemic in different ways. Starling embraced government loan schemes to boost its loan portfolio, Revolut diversified into trading, but Monzo looks to have stood still. Customer deposits more than doubled, to £3.1 billion, but the bank said fewer customers were using their accounts on a weekly basis – 55%, down from 60% – which it blamed on limited spending in lockdowns. Monzo is unlikely to be the first to IPO. 

Finally

Well, it’s no longer hot in London; now it’s raining. But I may still take some time off over August. If you have any ideas, opportunities, proposals, observations, or anything else you want to talk about, do get in touch by replying to the email or via Twitter or LinkedIn.

Welcome to another issue of Net Interest, where I distill 25 years of experience investing in the financial sector into a weekly email. If you’re reading this but haven’t yet signed up, join over 21,000 others and get Net Interest delivered to your inbox each Friday by subscribing here:

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Ever Grande

When I shut down my Bloomberg and exited the Mayfair office of my hedge fund for the final time a few years ago, one of the last prices I saw flickering on my screen was the bond price of a Chinese real estate developer called Evergrande. The price was part of my ‘canary’ screen. Evergrande is the biggest player in the biggest industry sector in one of the biggest economies in the world. It is also very highly leveraged. So when its bond price falls, it’s useful to take note. 

This week, its bond price fell. 

It’s not the first time it’s happened, which is why it may not have made it to the front pages of the newspapers. But that doesn’t make it any less significant. Its balance sheet is bigger now, at $356 billion, and it is the largest issuer of dollar-denominated Chinese junk bonds. The fall in Evergrande’s bonds was sparked by news that one of the Chinese banks had frozen some of its deposits. Piling on the woe came news that it had been asked to suspend new home sales in the city of Shaoyang due to a lack of funds in its accounts and that potential buyers were being refused mortgages by some Hong Kong banks. One line of its bonds fell to 49 cents on the dollar. 

China is a country full of paradoxes and one of them sits at the heart of the residential real estate market where Evergrande operates. Lest you forget, China is a communist state, and all land is owned by the state. In order to solve a funding problem, early reformers came up with a fudge. Zhao Ziyang, a former premier, describes in his memoir how he was introduced to the idea of selling land to raise funds:

It was perhaps 1985 or 1986 when I talked to Huo Yingdong [a Hong Kong tycoon better known as Henry Fok] and mentioned that we didn’t have funds for urban development. He asked me, “If you have land, how can you not have money?”

I thought this was a strange comment. Having land was one issue; a lack of funds was another. What did the two have to do with one another? He said, “If municipalities have land, they should get permission to lease some of it, bring in some income, and let other people develop the land.”

Indeed, I had noticed how in Hong Kong buildings and streets were constructed quickly. A place could be quickly transformed. But for us it was very difficult.

In 1988, the government changed the constitution to allow rights to use land – not to own, to use – to be bought and sold under long term leases. Residential use typically comes with a seventy year lease; commercial use with fifty years. No-one really expects land to revert to the government after that time, but the fudge serves a purpose. In the seven years between 2009 and 2015, the Chinese government collected 22 trillion yuan from selling land. By privatising this state asset, the government has been able to fund massive infrastructure investment on a scale that the taxpayer wouldn’t have been able to bear. 

The constitutional change paved the way for a commercial market to take root around residential property. But the real turning point came later, in 1998. At the time, most city dwellers lived in housing provided by their state employer. The problem was that state employers lacked the motivation and resources to build housing on sufficient scale. In 1998, the government introduced urban housing reforms that removed the obligation of employers to provide housing. People were encouraged to buy their homes from their employers, who sold them at heavily discounted prices. A massive transfer of wealth took place between the state and its people. That transfer of wealth seeded the growth in the residential housing market as homeowners reinvested their gains back in the market by buying bigger and better homes. 

(Ironically, having not been interested in investing in housing themselves prior to 1998, many state enterprises got heavily involved in real estate ten years later as the returns exceeded what they could get in their core business. In 2010, the central government mandated state companies to divest their property arms and return their attention to their core businesses.)

My interest with Chinese property developers began in the mid 2000s, soon after I had started at my hedge fund. Several developers had come to the market and I would visit them on trips to China. Plastic shoe covers on my feet so as not to spoil the newly laid floors, I would tour the sweeping developments springing up around cities like Beijing, Shanghai and Guangzhou. 

The investment thesis was simple: China was urbanising fast and that drove an insatiable demand for residential real estate. Developers could buy land from local government and turn it into aspirational accommodation at 25% margins. Back in my hotel room I would fire up my laptop and plug in values for the inventory of land and unsold homes sitting on developers’ balance sheets to gauge what their stock was worth. 

It didn’t take long for the market to get frothy. Demand for housing came not just for its utility but also for its investment features. Interest rates were kept exceptionally low and easy money boosted investment demand for housing. Since 2002, housing prices in China’s tier 1 cities, like the ones I visited, have risen more than six-fold (which compares with an 80% overall national increase in US housing prices between 2000 and 2005). With the market this frothy, analysts began plugging into their laptops the value of land developers hadn’t even acquired yet, but might. 

It was into that environment that Evergrande was listed, at the end of 2009. It was the biggest residential real estate developer of them all. At the end of the year, it had a total land reserve of 55 million square metres, giving it years of runway compared with the 5.6 million square metres of gross floor area (GFA) it sold that year. The company’s strategy was built around scale, affordability, turnover and brand. It adopted a standardised approach to its operating procedures. One of the bankers on the deal called Evergrande the McDonald’s of the Chinese residential property market. Its stock was 46 times oversubscribed in the retail tranche and it popped 34% on its first day of trading. 

Successful listing of the Group set the milestone in the corporate brand building. From the beginning of 2009, the Group quickly leveraged the gradual heating up of the property market, and immediately adjusted the business strategy, obtaining excellent results of RMB30.3 billion in contracted sales. Besides, the Group captured the best opportunity of the capital market and was successfully listed on the Main Board of the Stock Exchange on 5 November 2009. The Evergrande brand became a household name in China, the recognition and reputation of the brand reached an unprecedented level. [2010 Annual Report]

The IPO also helped Evergrande clean up its balance sheet. In the years prior to IPO it had operated with very high levels of debt relative to equity. Following its IPO, it sat on a net cash position.

That wasn’t to last. The company immediately geared up and started to expand in a literal land grab. The year after IPO, it grew its land bank by 75%, investing in a pipeline of developments across 62 cities, up from 25 the previous year. It took scale to a new level, building mini-cities rather than just apartment blocks that could accommodate as many as 65,000 people on a single site. The company raised cash from pre-sales, signing up prospective buyers years before completion. And it also raised debt: net gearing (net debt as a percentage of shareholders’ equity) rose to 52% in the year after IPO.

A couple of years later the company attracted the attention of short sellers at Citron Research, the team that would later give up short selling in the aftermath of the GameStop affair. They highlighted the risks creeping into Evergrande’s balance sheet. The company had grown its assets five times faster than peers in the past five years and was burning cash. Citron’s report made a number of other accusations about the company and its chairman, and Andrew Left, Citron’s founder, was eventually fined for market manipulation on the basis his report had been somewhere between negligent and reckless. But he was right about one thing: Evergrande was burning cash. 

In the ten years leading up to 2020, Evergrande has overseen RMB230 billion in cash outflows from operations. Its net debt currently stands at RMB536 billion, reflecting a 153% net gearing ratio. Excluding the revaluation of investment properties, that ratio is over 170%. Add in large accounts payable obligations (RMB829 billion) and the company’s liabilities are even larger. Much of this debt has been channeled into land acquisitions; the company now owns 231 million square metres of land across 234 cities (equivalent to four Manhattans). Over the past few years the company has been funding at rates of 8-11% via dollar-denominated bonds, but even these bonds were trading at higher yields before the recent bond price collapse.  

Over the years, the government has intervened numerous times to influence the residential real estate market in China. Using tax, mortgage rates, mortgage quotas, controls on secondary market listing prices and other tools, it has attempted to steer the residential property market between boom and bust. More recently it imposed some ‘red lines’ on property developers that require them to control their debt levels. Evergrande remains firmly in the ‘red group’. 1

Some people liken Evergrande to a giant pyramid scheme. There are periods in the cycle where real estate isn’t a cash flow business, it’s an asset appreciation business. As long as debt can be serviced, that can work, but problems emerge when it can’t. To address this, Evergrande has pursued two strategies.

First, it diversified into other businesses. It’s had a football team since 2010 which has gained success under coaches Marcello Lippi and Luiz Felipe Scolari. It operates theme parks, is involved in grain, dairy and mineral water businesses and has a cultural entertainment division. Its electric vehicle business is now worth $26 billion (down from $93 billion in April).

Second, Evergrande has made itself too big to fail – literally ever grande. Real estate investment is a very important driver of the overall Chinese economy. It has grown from a 5% share of GDP in 1995 to over 13% in 2019, of which over 70% is residential. Incorporating industries downstream and upstream of real estate, the sector makes up 29% of Chinese GDP (comparable internationally only to pre-crisis Spain and Ireland). 

Banks are particularly co-joined. Real estate loans make up around 28% of their loans and 40% of new loans. As a robust source of collateral, banks have an incentive to extend more loans to firms with land holdings. Incentives are similarly skewed in local government, where construction activity represents measurable economic output against which officials are assessed. Zhao’s economic realisation still drives local government budgets today. 

Because it’s too big to fail, Evergrande’s demise may be less a product of its financial position and more its political position. Recently, China’s financial regulator instructed banks to conduct a stress test around an Evergrande failure so the endgame could be getting close. How they choose to allocate losses will determine whether Evergrande bonds bleed out of the canary screen and onto the main screen. 2

Thanks to Byrne Hobart for pushing Evergrande up my agenda and for flagging Ken Rogoff’s recent paper with Yuanchen Yang on the Chinese real estate market.

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More Net InterestGreensill: Simply not Fintechery

The UK Parliamentary Treasury Select Committee released its report, Lessons from Greensill Capital this week. Our original write-up on Greensill was flagged at the hearings; the Committee now presents its own conclusions. In them, the Committee picks up on the red flag we raised about Greensill using an ‘appointed representative’ regime to meet regulatory requirements. Rather than seek direct authority, Greensill hid under the umbrella of a regulated firm called Mirabella Advisers. The Committee recommends that the Financial Conduct Authority and Treasury should consider reforms to the appointed representatives regime, with a view to limiting its scope and reducing opportunities for abuse of the system like this one.

The Committee also dismisses Lex Greensill’s attempt to deflect blame to the insurance industry. At his hearing, he said, “one of the real lessons from the failure of my firm and the impact it has had on the 1,200 employees that we had, is that a heavy reliance on trade credit insurance is dangerous. I urge you and the Committee to consider the manner in which that is regulated, because it is fundamentally [procyclical] in its behaviour.” The Committee is blunt in its response: “We do not think the failure of Greensill leads to any particularly strong evidence about procyclicality in the regulation of insurance markets.”

One other thing that stands out from the report is the cover that some companies receive from their association with the buzz around fintech. The Committee writes,

Mr Cameron may have been hoping to tap into an ongoing interest of the Government in supporting fintech. In 2014, George Osborne, then Chancellor of the Exchequer, stated at the launch of a new trade body for fintech that “I’m here today because I want the UK the lead the world in developing Fin Tech.” Lord Macpherson told us that “Every Government likes to be associated with success stories, such as the dotcom boom. Fintech is definitely the flavour of the month.”

Greensill paraded as a fintech company, but it wasn’t one. As Lord Macpherson told the Committee: “this simply was not fintechery.” Greensill is not alone here; many companies enjoy privileges they may not otherwise attain, through their characterization as fintechs. 

Circle

The noise around stablecoins is heating up now that they have over $100 billion of market cap and policymakers are taking note. We touched on the big ones here. Aside from continued questions over Tether’s balance sheet (see note 2 below), Circle has released disclosures ahead of its SPAC merger.

Circle management projects that the volume of USDC (its stablecoin) in circulation will grow from $35 billion in 2021 to $194 billion in 2023. It anticipates generating interest income on these balances of $40 million in 2021, rising to $196 million in 2023 (or $21 million to $88 million net of income shares and transaction costs). A rise in interest rates will boost these projections as Circle would be able to extract a higher yield on cash. A 100 basis point rise in interest rates across the yield curve would be worth an extra $470 million to Circle in 2022 and $1,110 million in 2023 before income sharing and transaction costs.

The company hints that it may seek out a bank license. It states that substantial investment in the business is required for a number of reasons, one of which is “regulatory capital required for appropriate license, operational and business model expansion.” Its interest rate sensitivity would make it one of the most asset sensitive banks in the sector.

Equity Research

As a former equity research analyst, a current newsletter writer and an intermittent consumer of investment research, the investment research industry is one I take a deep interest in. It was the subject of a Net Interest piece last year: The Cautionary Tale of Equity Research.

Earlier this month, Integrity Research completed a survey of asset managers to measure spend in the industry. They estimate that asset managers will spend $13.66 billion on investment research this year, down 4.5% on last year and almost 20% down from the peak ($19.98 billion) in 2015. 

Most of the spend gets channeled to the big sell-side firms, although independent research providers are expected to pick up $2.1 billion (a lower decline). The biggest chunk of this independent piece is primary research, which is projected to grow.

Classic sell-side maintenance research has been in decline for many years, but the budgets are still there for investors to reward value-added research. Last week, Byrne Hobart discussed newsletters that can move markets. The ones he highlights turnover a fraction of the $13.66 billion institutions spend on research. Either they are underpriced, or the price of investment research has further to fall.

Finally

It’s hot in London! So I may take some time off over August. But if you have any ideas, opportunities, proposals, observations, or anything else you want to talk about, do get in touch by replying to the email or via Twitter or LinkedIn.

1

Targets are: net debt/equity ratio below 100% by 30 June 2021 (company was at 153% at end 2020); cash/short-term debt above 1x by 31 December 2021 (company was at 0.47x at end 2020) and liability/asset ratio below 70% by 31 December 2022 (company was at 83% at end 2020).

2

@TheLastBearSta1 has an interesting theory that Tether (which we discussed here) may have invested customer funds in Evergrande commercial paper. Tether owns just under $30 billion of commercial paper, yet trading desks in Europe and New York have not had dealings with it. Evergrande, meanwhile, is one of the biggest issuers of commercial paper, with $32 billion outstanding at the end of 2020 (although consolidated number could be higher). 

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Revolution in the Air

As a finance newsletter, we touch on fintech here a lot. We’ve looked in detail at a host of new entrants into financial services – Wise, Tinkoff, Paytm, Robinhood – all of them attempting to disrupt the traditional way of doing finance. This week, we turn our attention to one I’m particularly close to: Revolut.

I first came across Revolut in 2016 when an early investor showed me around its app and the backend dashboard he had access to. I used to travel a lot and the opportunity to access cheap foreign exchange via a payment card was very appealing. I signed up as a customer and – as the app informs me today – went on to spend £6,438 on my travels through the remainder of the year. 

I knew that if I found the app useful, others would too; I was keen to invest. A short while later the company was out raising its series A and I got the opportunity to participate. 

This week, Revolut became the UK’s most valuable private tech company of all time. It announced a series E fundraising, valuing it at $33 billion. That puts it roughly on a par with NatWest Group, the bank where I had my first account as a kid. 

The massive growth of Revolut is clearly very exciting for me as an investor. But it also raises questions. Last year, NatWest did £11 billion of revenue; Revolut did £261 million. NatWest is on track to make £2.5 billion of profit; Revolut may or may not make a profit. Revolut has a few more customers than NatWest – 16 million versus 12.5 million – but what are those customers worth?

It’s time to sharpen my pencil and update my analysis of Revolut.

Personal Money Cloud

Revolut was founded at the end of 2013 by CEO, Nikolay Storonsky and his co-founder Vlad Yatsenko. Like the founders at Transferwise, discussed here a few weeks ago, the pair were fed up with the charges banks levied on foreign currency transfers. While Transferwise initially focused on making it cheaper to send money back home, Revolut focused on making it cheaper to spend money abroad. Storonsky recalls how he suffered around $2,000 of hidden foreign exchange transaction fees on a trip to the US from his home in the UK.

However you cut it, both markets are large. Revolut estimates that combined, the markets are worth £190 billion in the UK and Europe and ten times that globally. In the world before Covid, people used to travel abroad a lot and they spent money when they went. Revolut estimated that in its initial target market of the UK, more than three quarters of the population went away in the twelve months prior to launch, spending an average £220 per trip. The company’s proposition was that it could save these people from having to pay bank fees on their holiday spend. 

The focus on spend meant that Revolut needed to launch with a payment card. In July 2015, it came to market with a prepaid Mastercard issued by Paysafe. The card allowed customers to hold funds in GBP, Euro and USD, and to spend online and in-store with a globally accepted multi-currency MasterCard linked to their Revolut account. A virtual card was available for online purchases as soon as the account was set up and a physical card was dispatched shortly afterwards. Customer funds would be ring-fenced in accounts at Barclays. 

At that stage, Revolut was just an app – the infrastructure was provided by others like Paysafe, Mastercard and Barclays. But as an app, it offered an effortless and well-designed solution to multiple consumer pain points: transferring money across currencies, spending money abroad and tracking transactions. 

The revenue model was to exploit the spend side of the business to capture a share of the merchant interchange fees earned when customers use their cards. Initially, the company offered currency exchange and money transfers up to £500 for free. Later, it extended the terms of free currency exchange. However, the economics didn’t really add up. In Europe, debit interchange fees are capped at around 0.20% of the value of the transaction – not enough to cover the cost of free foreign exchange. So Revolut was on the hunt for new revenue streams. 

The original model had the hunt fulfilled by subscription fees. Revolut’s seed pitch deck projected £5.7 million of revenue three years after launch, of which over £5 million would come from subscriptions – enough for it to make a profit. It estimated that around 30% of customers would pay around £165 a year in subscriptions. Sure enough, it did launch a subscription product right about then. However, by this time, the strategy had shifted; the important thing wasn’t to hunt for revenue streams, it was to hunt for more customers. 

Global Money App

In its seed deck, Revolut projected 140,000 customers three years out. It got there in nine months. Through viral referral campaigns, Revolut was able to pick up customers very quickly. Media helped: the company featured in the press and on TV. It also moved into new markets early, with 10% of its customers coming from France very soon after it launched there.

Today, the company is in 35 countries and has 16 million customers. It’s a big number, but many of its accounts are likely to be dormant. Third party data (Apptopia) suggests that in June, the app had 3.4 million monthly users and 1.3 million daily users globally.

Revolut’s biggest market remains the UK (19% of monthly average users) where in 2020 it booked 88% of its revenue. Other big markets include Ireland (12% of monthly average users) where 1 in 2 adults is a customer; Romania (10% of monthly average users); and France (7.5%).

Revolut launched in the US in March 2020, and had seen 200,000 customers sign up by year end; total downloads are now running at more than twice that, but monthly average users lag at around 135,000 as of June. Its target market in the US is the 40-45 million people who aren’t originally from the US, who may have greater demand for a multi-currency account and are more likely to want to send money abroad. 

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The rapid growth in customer numbers has led to some growing pains at Revolut. Customers complain about funds getting frozen and accounts being closed as anti-money laundering systems pick up too many false positives while customer service is insufficiently resourced to pick up the pieces. In the first nine months of 2020, Resolver, an online complaints service, received almost 4,000 complaints about Revolut, after getting nearly 2,500 for the whole year before.

In addition, in 2019, Wired painted a picture of a toxic work culture where staff turnover was rife. That issue was tackled with a governance overhaul that led to the arrival of several new non-executive directors. The customer issue still rankles with many. 

Nevertheless, with customers come revenues, albeit still of the capped interchange variety and not sufficient to support the business. By the time of the series A round in 2016, the 2017 revenue projection had been upgraded from £5.7 million to £10.0 million. The actual outturn was £12.8 million. But yet again, profits were pushed out. The series A deck pushed breakeven back a year to 2018; three years on, the company has yet to report a profit over a sustained twelve month period. 

It claims to be getting close, though. In 4Q2020, Revolut reported an adjusted operating loss of £6 million, underpinned by profits in November and December. Subscriptions provide a ballast. In the UK, the company offers three tiers of subscription: plus (£30 per year), premium (£72 per year) and metal (£120 per year). They offer varying limits on no-fee ATM withdrawals, no fee currency exchange (the lower tier is limited to £1,000 per month), and the number of free international payments. Last year, subscriptions contributed £75 million to total revenue, with 14% of new customers taking a paid subscription. 

The biggest revenue upside is from new products. Revolut has been a machine at rolling out new products. In 2020 alone, it launched 15 new products and innovations for retail customers. These include interest-bearing savings vaults, open banking, gold and silver trading, junior accounts, cash gifting, rewards, bill sharing, subscription management tools, salary advance and new crypto tokens.

According to the CEO, shipping products fast is important:

“It’s our secret weapon, right, it’s how we compete with other companies. Because ultimately all… businesses, what they do, they give products to people and then the faster you can ship products, the faster you can iterate on products, so the more chances that you will win. As a result, [in the] last 5-6 years, we just perfected the speed – and we pay so much attention to speed and quality of the product – because ultimately, product wins.”

In its rush to deliver product, the company is not embarrassed to mimic others. Its salary advance product is based on a product offered by companies such as Salary Finance, Wagestream and Level Financial Technology [disclosure: I am an investor in Level]. It is in the process of rolling out social trading similar to what is offered by eToro (discussed here). In the future, it has ambitions to pull together its retail ecosystem with its business ecosystem (500,000 customers) to allow businesses and consumers to transact without intermediaries. Sounds a bit like Square. 

a.image2.image-link.image2-825-1456 { padding-bottom: 56.66208791208791%; padding-bottom: min(56.66208791208791%, 825px); width: 100%; height: 0; } a.image2.image-link.image2-825-1456 img { max-width: 1456px; max-height: 825px; } Source: White Sight via Aika’s [very good] Newsletter

The machine-like product rollout was just as well because the decline in travel during the pandemic was devastating for Revolut’s legacy business. International payment volumes declined by two-thirds compared with pre-Covid levels, leading to a 12% decline in overall revenues between the first and second quarters. Fortunately, stock and later crypto trading picked up the slack. For the full year, card and interchange revenues were up 28% to £95 million, but fees from foreign exchange and wealth were up 150% to £80 million.

Revenue per customer reached around £36 on an annualised basis in the first quarter of this year, up from around £21 for the full year 2020. Similar to Robinhood, which we discussed last week, the numbers are small. In US Dollar terms, the first quarter revenue run rate is equivalent to $50 per customer. This compares with around $90 per customer at US challenger bank Chime (2020) and $137 at Robinhood (1Q21). At incumbent banks, the numbers are larger. NatWest generates around $420 of revenue per customer and in the US, Bank of America and Chase generate over $500 per customer. 

The difference is of course that challengers can in principle scale at low cost. Revolut is still growing its customer base rapidly through referral, although it’s unclear what the return on a customer acquisition is when the referral incentive is £50 (even if the new customer does have to make three transactions to qualify). In 2020, the gross margin of the business improved from 29% in the first quarter to 61% in the fourth. Underneath gross profit, there’s £226 million of administrative expenses; right now that expense base is growing more quickly than revenues as the company invests in expansion, but at some point that will slow. Indeed, the company already employs more compliance personnel per head than major UK banks, so it may not need to invest as much there. Based on LinkedIn data, 16% of its headcount is employed in compliance compared with 8-9% at larger UK banks. 

Global Financial Superapp

Like other consumer fintech companies, Revolut has converged on the super app strategy. “One app for all things money,” is the lede on the company website. “We are building the world’s first truly global financial superapp.” Unlike others, though, it doesn’t have a core profitable business. Chime has unregulated debit interchange – it doesn’t suffer the cap that Revolut does in Europe. Robinhood has payment for order flow. Tinkoff in Russia has credit card lending. 

Revolut has two things going for it: it wants to be global and, unlike some of the others, it wants to be a bank. 

“Our vision is we want to build a global bank… sooner or later, someone will do it, and we want it to be us.” [Source]

Revolut is entering new markets at a rate of 5-10 a year. It typically spends up to two years on the ground before launch and invests between $10 million and $20 million in the process. Revolut reckons it can outgrow local competitors in the majority of countries it enters once it turns on its marketing campaigns.

It’s a tough challenge, though. There’s no real precedent for a global consumer bank. Citi and HSBC both tried, but retrenched from their global ambitions in waves. HSBC recently gave away its French business, but years earlier had given up on its slogan ‘the world’s local bank’. Citi is close to selling its retail banking operations in South Korea as part of its strategy to exit consumer banking in 13 markets across Asia and Europe.

At a recent investor event, the CEO of Tinkoff took a sideswipe at Revolut: “Our model that we’re thinking about at the moment is not a light model, where you skim off a few hundred thousand customers in 20 different markets. That’s not what we’re thinking about.”

Revolut also wants to be a bank. Right now it is regulated as an e-money issuer in the UK, although it has a banking license in Lithuania. It sits on £4.5 billion of customer funds (£310 per customer) which it needs to hold in cash at accounts at authorised financial institutions as a safeguarding mechanism. A banking license would bring three benefits. It would allow Revolut to invest customer funds more broadly, for example by offering loans. It would also provide customers with deposit insurance on their funds (although it’s not clear how much of an obstacle this is to gathering funds; Wise sits on customer funds averaging £2,300 per account without insurance). Finally, a banking license would give Revolut access to central bank facilities. As chairman Martin Gilbert said recently:

“​​The banking license would be pretty advantageous for us … at the moment, one of the big disadvantages we have is we might have £3bn or £4bn on overnight every night on negative interest rates, so you can see the drag on earnings that that has, because we have to safeguard clients money obviously because we’re not a bank.” 

In the US, SoFi is seeking a banking license and has indicated that it could add $200 million to $300 million per year to its baseline EBITDA projections over the next few years. Its business model focuses much more on the lending side than Revolut’s but it reflects the appeal of a banking license.

The downside is of course the cost. Revolut currently has to operate with only £63 million of capital. A banking license would ramp that capital requirement, which is one of the reasons it has just raised $800 million in its series E.  

There’s another downside, which is valuation. In the same interview, chairman Martin Gilbert said, “We don’t want to be perceived as a bank because banks are rated at a far lower rating than a fintech business, so we really do need to keep that advantage of being seen as fast moving and fee based rather than interest based business.”

That’s not something Revolut has to worry about for a while. It just raised capital at a valuation of 74x last twelve months’ revenue; that compares with NatWest at 2.3x. The question now is whether it can extract sufficient profitability from its customers to grow into that valuation.

Wise came to the market in the UK last week with an unbundled approach to financial services – isolate a product and provide it cheaper than the competition, with no cross-subsidisation. Revolut’s bundled model is different. Its newest shareholders, Softbank and Tiger Global, know that the revenues are out there; they are betting that by spraying products across markets, Revolut can capture some of them.

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More Net InterestBuy Now Pay Later

The Buy Now Pay Later market is hotting up with Apple entering the market in partnership with Goldman Sachs. (I have said before that the most formidable competitor in fintech could be Apple + Goldman Sachs.) Increasingly it looks like Buy Now Pay Later could be a feature rather than a business of its own. 

John Street Capital @JohnStCapital$AAPL & $GS are launching a BNPL service known as "Apple Pay Later" enabling Apple Pay users to pay across 4 payments every two weeks or across several months. $V & $GPN annc a similar product in Canada today. This + $PYPL & eventually $SQ make BNPL a feature & not a company

July 13th 2021

36 Retweets224 Likes

A good representation of this is in India, where MobiKwik recently filed to go public. The company started out as a mobile wallet in 2009. It now has 101.37 million registered users. In May 2019, it launched a Buy Now Pay Later product (MobiKwik Zip) that enables users to activate a Rs500 to Rs30,000 credit limit in their wallet which they can draw down, interest-free, in 15-day cycles. At the end of the cycle, the user is required to pay what’s due within five days, failing which late fees are applied (the user also pays a one-time activation fee). 

As at the end of March, MobiKwik had pre-approved 22.25 million users for the product, out of which 741,000 had activated. MobiKwik retains some of the risk (5-15%) but passes most of it on to financial institutions. Its advantage is that merchants are already signed up, via its wallet, and it has good data on its consumers via their purchase history. 

In the year to March 2021, the Buy Now Pay Later product contributed 21% to total revenue. A part of the investment case behind the IPO is that this will grow; it’s likely a feature other wallet providers will replicate. 

Loan Growth

A major issue overhanging US banks since the beginning of the pandemic has been the absence of loan growth. JPMorgan’s consumer and business loans were down 3% year-on-year in the second quarter as customer cash balances remain elevated leading to higher prepayments in mortgage and lower card outstandings. But the company is optimistic loan growth will resume. On his earnings call, the CFO said, “we are quite optimistic that the current spend trends will convert into resumption of loan growth through the end of this year and into next.” Bank of America provided a useful chart that backs up the assertion. It shows daily loan balances, with the trough having passed in March. Lending companies will be hopeful of a strong rebound in loan growth in the second half. 

a.image2.image-link.image2-308-500 { padding-bottom: 61.6%; padding-bottom: min(61.6%, 308px); width: 100%; height: 0; } a.image2.image-link.image2-308-500 img { max-width: 500px; max-height: 308px; } Source: Bank of AmericaAIG/Blackstone

Back in 1998, AIG took a 7% stake in Blackstone. Ten years later, AIG was in financial trouble and had to be bailed out by the US Government. Blackstone’s price was severely affected by the crisis, so the stake couldn’t be used to raise cash, but a few years later AIG was able to exit for a considerable gain.

This week, the two announced a reverse transaction. Blackstone will take a 10% stake in AIG’s life-insurance and retirement-services unit ahead of its IPO. Blackstone will also manage $50 billion of AIG assets, rising to $100 billion over six years. The move is the latest in the convergence of insurance and private equity as insurance companies seek to improve investment returns in their portfolios. It’s a theme we discussed in Other People’s Money – the latest application of a model Warren Buffett developed back in 1967.

Welcome to another issue of Net Interest, where I distill 25 years of experience investing in the financial sector into a weekly email. If you’re reading this but haven’t yet signed up, join over 20,000 others and get Net Interest delivered to your inbox each Friday by subscribing here:

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What is Robinhood?

Last June, I wrote a piece in Net Interest called The Stock Market as Entertainment. It explored the explosion in retail trading activity happening at the time and suggested that one cause for renewed interest in the stock market was the cancellation of sport:

… a pivot from sports is a compelling explanation. The demographic of Robinhood’s customer base is similar to that of a sports bettor. Men aged 25-34 are the segment most likely to bet on sports on a regular basis. According to Deloitte 43% of North American men aged 25-34 who watch sports also bet on sports at least once per week, and that’s the same group that has flocked to Robinhood. The median age of a Robinhood customer has drifted up from 27 in 2017 to 31 now, and 80% of them are men.1

Indeed, Robinhood’s interface makes the transition between sports betting and trading seamless. The app has been compared to a mobile game (“Charles Schwab, meet Candy Crush,” according to an NBC News report) which users check ten times a day or more.

Robinhood customers also appear to be attracted to stocks for the same reasons they are attracted to sports events. In its S-1 prospectus DraftKings, a sports betting company, says that it delivers “betting experiences designed for the ‘skin-in-the-game’ sports fan – the fan who seeks a deeper connection to the sporting events that he or she already loves.” A look inside Robinhood portfolios reveals the sorts of companies that customers no doubt have deep connections to.2

One year on, it is clear that this explanation doesn’t suffice. Sport came back, but retail trading continued with enhanced vigour. Indeed, activity accelerated earlier this year, as Robinhood data attests.

a.image2.image-link.image2-338-594 { padding-bottom: 56.9023569023569%; padding-bottom: min(56.9023569023569%, 338px); width: 100%; height: 0; } a.image2.image-link.image2-338-594 img { max-width: 594px; max-height: 338px; } Source: Robinhood S-1

An alternative explanation is one promoted by Balaji Srinivasan: “Everyone is an investor now.” He argues that everyone being an investor is the natural endgame of the financialization of the economy, just as the shift from farming to manufacturing was the endgame of its industrialisation. “If in the 20th century, the 99% are labor and the 1% are capital, the flip happens this century where the 99% are capital and the 1% are labor.”

balajis.com @balajisFarming was the 1800s. Manufacturing was the 1900s. Counterintuitively, could investing become the most common "job" of the 2000s? Reason: crypto and fintech are turning everyone into an investor, just like the internet turned everyone into publishers. How far does that go?

September 22nd 2020

388 Retweets1,769 Likes

The idea is reflected in large white-on-green font towards the front of Robinhood’s S-1: “We are all investors.” Data from the Federal Reserve Survey of Consumer Finances shows US household direct ownership of stocks rising from the trough of 2013 and Robinhood reckons that will continue: “We believe democratizing finance for all is a one-way door, and these forces of change are more likely to accelerate than reverse.”

A Tavern on the Green

If there’s a synthesis between the two explanations, it lies in the conflation of gambling and investing. The two activities fall on the same spectrum and converge in the fuzzy area of financial speculation that sits between them. A few years ago, a group of researchers published a paper in the Journal of Behavioral Addictions looking at the relationship between gambling, investing, and speculation. Here’s how they frame the similarities and differences:

a.image2.image-link.image2-578-1456 { padding-bottom: 39.6978021978022%; padding-bottom: min(39.6978021978022%, 578px); width: 100%; height: 0; } a.image2.image-link.image2-578-1456 img { max-width: 1456px; max-height: 578px; } Conceptual similarities and differences between gambling, speculation and investment.

Ask any bystander of the industry what the fundamental difference between gambling and investing is and the response might be the role of skill versus luck in the outcome. But that wouldn’t be right. Many gamblers (for example Matthew Benham or Tony Bloom) show profound skill, and the role of luck in investing is well known. Rather, the key difference is that investing typically involves the creation or purchase of an asset with the expectation of long-term capital appreciation, which does not occur with gambling. In addition, in investing, the asset is never explicitly staked, whereas this always occurs with gambling – the best definition of gambling is staking money on an event having an uncertain outcome in the hope of winning additional money.3

Speculation captures the crossover of the two activities. Like investing, it takes place in a financial markets environment but it tends to be shorter term, higher risk and focused on generating gains from price movement with less regard for the fundamental value assets. 

There’s a class of financial instruments that lend themselves very well to speculation and they are financial options. Their fixed expiration dates make them more short term than owning their underlying assets, the leverage they carry heightens their risk and the premium you pay upfront is equivalent to a gambling stake. 

Which brings us back to Robinhood.

While Robinhood employs the investor narrative in its marketing efforts and claims “evidence that most of our customers are primarily buy-and-hold investors,” it makes the largest slice of its revenue from options. In 1Q21, it made $198 million of revenue from options, compared with $133 million from straight equities. Perhaps its options customers are subsidising its equity customers, allowing them to buy-and-hold at cheaper rates than otherwise would be the case. But given how much money Robinhood makes from options, its incentives are less around promoting stock ownership and more around promoting options trading. In 1Q21, it made $2.9 revenue per options trade, which compares with $0.4 on an equities trade (and $1.0 on a crypto transaction). Customers had only 2% of their funds invested in options, yet options contributed 14% to total trades and 47% to transaction revenues.4

a.image2.image-link.image2-388-596 { padding-bottom: 65.1006711409396%; padding-bottom: min(65.1006711409396%, 388px); width: 100%; height: 0; } a.image2.image-link.image2-388-596 img { max-width: 596px; max-height: 388px; } Source: Robinhood S-1

This set-up brings Robinhood closer to the contracts-for-difference (CFD) model popular in Europe. We discussed the model here in Net Interest back in March when we compared ETrade to eToro, just after eToro announced its intention to go public. CFDs are derivative instruments that allow traders to bet on the direction of an asset, either up or down. Unlike stocks, they don’t grant economic rights to the underlying asset. In some markets they bear tax advantages (for example in the UK, traders don’t have to pay stamp duty which they would be liable for on a stock purchase). As derivative instruments, they also embed leverage. 

CFDs are a lot closer to gambling than to investing (hence the different tax treatment). Customers can lose all their money. eToro’s general risk disclosure states: “CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 67% of retail investor accounts lose money when trading CFDs with this provider.” At Plus500, a competitor, the number is 72% – regulators insist on the disclosure.

So CFD platforms are in a constant hustle to acquire new customers to replace the churn. In 1Q21, Plus500 lost 16.2% of its customers over the quarter. They make up for it with high ARPU (average revenue per customer). In Plus500’s case, revenue was $838 per customer in the first quarter ($3,351 annualised).5

What about Robinhood?

Riding Through The Glen

Compared with Plus500, Robinhood’s churn rate is a lot lower. It is a more diversified business, and although it makes the biggest slice of its revenues from options, we don’t know what proportion of customers trade them. In 1Q21, it lost 4.8% of its customers, which is not as high as the CFD platforms but it is higher than Charles Schwab, where churn was 3.0% in the same period. Its ARPU is also a lot lower than Plus500’s, at $34 in the quarter ($137 annualised).

In really simple terms, those churn and ARPU numbers mean that Robinhood can expect to extract around $714 of revenue per customer over their lifetime, which compares with Plus500 at $5,200. Fortunately for Robinhood, its customer acquisition costs are commensurately low, at $15 in 1Q21, and all the free publicity Robinhood got in the first quarter actually pushed them down (from $20 in 2020).6

The analysis really is very simple though, because it assumes customers who stick around generate the same revenue contribution year-in, year-out. Robinhood expects that revenues from those customers may actually increase, and presents some impressive looking cohort charts to prove it. It’s true that as their assets appreciate, these customers will trade in bigger size, leading to higher revenues for Robinhood. The company estimates that as of the end of March 2021, its customers had seen appreciation of their assets of approximately $25 billion. Assuming this doesn’t include churned customers and only those currently active, it implies a 45% return on $56 billion of invested funds (given customers are currently sitting on $81 billion worth of assets). 

a.image2.image-link.image2-340-599 { padding-bottom: 56.761268781302164%; padding-bottom: min(56.761268781302164%, 340px); width: 100%; height: 0; } a.image2.image-link.image2-340-599 img { max-width: 599px; max-height: 340px; } Source: Robinhood S-1

The problem with this approach is that markets don’t always go up. As Robinhood’s UK risk warning declares, “Past performance is not a useful guide to future returns, which are not guaranteed. Your investments may go down in value.” And more importantly for Robinhood, transaction turnover may not always go up whatever markets do. In fact, Robinhood is IPOing off an extremely high turnover base. In 1Q21, its customers did an average of 30 trades each or 122 on an annualised basis, up from 84 last year and 54 the year before. That’s not as many as eToro, but it’s roughly twice the rate at Schwab. 

Sustaining that level of turnover will be quite a feat, which is why cohort economics make more sense for a steady subscription based business than they do for a cyclical transaction based one. 

a.image2.image-link.image2-639-1247 { padding-bottom: 51.242983159583%; padding-bottom: min(51.242983159583%, 639px); width: 100%; height: 0; } a.image2.image-link.image2-639-1247 img { max-width: 1247px; max-height: 639px; } Source: Robinhood S-1 and company reports

To frame just how unusual this current period is, take a look at the chart below which shows the average number of trades per quarter executed by customers of Charles Schwab going back twenty years. 

a.image2.image-link.image2-388-596 { padding-bottom: 65.1006711409396%; padding-bottom: min(65.1006711409396%, 388px); width: 100%; height: 0; } a.image2.image-link.image2-388-596 img { max-width: 596px; max-height: 388px; } Source: company reports

And with Schwab data, we can even zoom right in to the present day by looking at weekly trends. Brokerage activity peaked around the time of the Gamestop episode at the end of January and has been on the decline since. 

a.image2.image-link.image2-388-596 { padding-bottom: 65.1006711409396%; padding-bottom: min(65.1006711409396%, 388px); width: 100%; height: 0; } a.image2.image-link.image2-388-596 img { max-width: 596px; max-height: 388px; } Source: company reports

Finally, it’s worth looking back twenty years to see what happened after the last frenzy in retail trading activity in 2000. The chart below shows ETrade’s average daily trading volumes during the period (this one is not shown per customer, it’s across the entire ETrade customer base). After the peak in 1Q00, activity rates halved over the next eight quarters. It took a while to realise it, of course. On a conference call in March 2001, Charles Schwab, the man, talking about the performance of Charles Schwab, the company, admitted, “We’ve come through a highly speculative technology bubble. Maybe I should have been more emphatic about understanding that this was a temporary phenomenon.”

a.image2.image-link.image2-388-596 { padding-bottom: 65.1006711409396%; padding-bottom: min(65.1006711409396%, 388px); width: 100%; height: 0; } a.image2.image-link.image2-388-596 img { max-width: 596px; max-height: 388px; }

Perhaps we are all investors now – or speculators at any rate, doing 120 trades a year and checking our app ten days a day – but let’s not forget, “it’s a bull market, you know.” Robinhood customers are sitting on $25 billion of gains ($1,400 per account) and that ‘house money’ may sustain activity for some time. But when it’s gone, trading may lose its allure and Robinhood’s growth will have peaked.

Thanks to @FIGfluencer for great insights with this.

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More Net InterestBuy Now Pay Later

The Buy Now Pay Later (BNPL) market is getting increasingly competitive. As well as the pure play participants like Affirm, Klarna and Afterpay, there’s competition from PayPal (Pay in 4, which doesn’t charge merchants incremental fees) and legacy banks. Competition is particularly intense in lower ticket categories, where the credit decisioning process is simpler.

One response is to consolidate. The Australian Financial Review this week reported that Klarna (featured in Net Interest here) could be building up a stake in Australian company Zip Co which operates QuadPay, another player in the BNPL market. Given how much capital it has raised recently ($640 million at a $45 billion valuation) it makes some sense and explains why Klarna may have raised private capital so soon after a prior round, rather than going public. When it eventually does come to the market, it will be challenging enough to address regulatory risks; if it can show more stable competitive dynamics, it will be a much more compelling story. 

M&A

The quarter that ended last week turned out to be the strongest quarter for announced M&A ever. Deal volume of $1.56 trillion was announced, with $400 billion of that coming in June alone, pushing the quarter’s volumes 5% above the prior record. From a sectoral perspective, the strength was broad based, although technology, energy and healthcare saw particularly high volumes. A lot of the strength was domestic US rather than cross-border, and was centred among large cap companies rather than small or mid-sized ones. 

There’s a trend across many industries for the big to get bigger and M&A feeds that. There are many implications of that but for M&A advisory firms it’s a very profitable backdrop. 

Weather

We’ve covered some quite bizarre academic finance papers in More Net Interest over the months, all of them answering questions you never thought you had. For example, how earnings estimates can be influenced if analysts share the same first name as the CEO of a company they cover (spoiler: they’re more accurate, but don’t ask me about Salesforce.com). And how the accuracy of estimates correlates with how physically attractive the analyst is (spoiler: any benefit of an analyst being attractive diminished after Reg FD). 

A recent paper looks at the impact of weather. It examines how pre-announcement weather conditions near a company’s major institutional investors affect stock market reactions to its earnings announcements. The conclusion: that unpleasant weather leads to more delayed market responses to subsequent earnings news. Investors in California should learn to take advantage.

1

In its S-1, Robinhood provides an update of these demographics. The median age of customers is still 31, but “we continue to welcome an increasing proportion of women to our platform, having tripled the number of women on our platform at the end of 2020 as compared to 2019.” This would put the proportion of women in the customer base at around 23%. 

2

As of August 2020, Robinhood shut down the API that was used by Robintrack to collect data of stocks held in Robinhood portfolios.

3

Another notable difference lies in the variability of returns. Commercial gambling has a precise and mathematically determined negative return, whereas the magnitude and direction of monthly or quarterly changes in financial markets are much more variable and uncertain.

4

I’ve assumed 61 trading days in 1Q21 to calculate these numbers, which is right for options and equities, but crypto trades 24/7 in which case the revenue per transaction there is closer to $0.7. 

5

Plus500 disclosure puts ARPU at $753 for the quarter, but that is based on end of period accounts; I’ve used average accounts over the period.

6

The calculation here is ARPU divided by churn. It gives the perpetual value of a fixed revenue stream assuming a given level of churn. 

Welcome to another issue of Net Interest, my newsletter on financial sector themes. If you’re reading this but haven’t yet signed up, join over 20,000 others and get Net Interest delivered to your inbox every Friday by subscribing here:

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The Long Slow Short

It normally takes a lot less time to destroy a thing than to create it. That’s true on building sites, in careers and of reputations. “It takes 20 years to build a reputation and five minutes to ruin it,” said Warren Buffett. Such is the nature of entropy. 

Yet in business, the reverse can often seem the case. It’s never been easier to start up a new company. In the US, business formation is running at the highest level on record. Companies can be spun up from idea to $2 billion valuation in the space of fifteen months. And, at the larger end of the scale, Facebook is a reminder of how quickly value can be created – this week, it became a $1 trillion company after being around for just seventeen years (I have cardigans older than that!) These companies open new markets and/or promise to disrupt existing ways of doing things.

On the other side though, the incumbents they disrupt can often hold on for a lot longer than anyone thinks possible. Kodak, Blockbuster, Sears – they all took years to be put out of their misery. 

Warren Buffett makes the observation about autos that, “what you really should have done in 1905 or so, when you saw what was going to happen with the auto is you should have gone short horses. There were 20 million horses in 1900 and there’s about 4 million horses now. So it's easy to figure out the losers, you know the loser is the horse.” But you would have needed a lot of staying power to have been short horses. Historic horse prices are hard to come by but, using Buffett’s proxy, the number of horses stayed above 20 million for a further 25 years after he says you should have gone short. 

a.image2.image-link.image2-374-573 { padding-bottom: 65.27050610820244%; padding-bottom: min(65.27050610820244%, 374px); width: 100%; height: 0; } a.image2.image-link.image2-374-573 img { max-width: 573px; max-height: 374px; } The Demographics of the U.S. Equine Population, Emily R. Kilby

One of the reasons there’s a lot more money in venture than in short-selling is precisely because it can take so long for a business to destruct.1

A good example of this on the periphery of financial services is Western Union. I was short the stock once on the Buffett principle that it is easier to identify the loser than pick the winners – in this case in digital payments. I underestimated two things – one, how long the market shift would take to occur; and two, how much free cash flow Western Union would generate along the way.

Actually, there was a third factor that I’ve only recently understood: this is a company that peaked in 1878. My short wasn’t exactly a novel idea! Faced with disruption from the telephone, the fax, the personal computer, the internet, and now digital payments, Western Union has been on a steady decline for over 140 years. When it comes to operating in markets that are collapsing around it, Western Union has form. And yet it's still going. 

This is the cautionary tale of Western Union

What Hath God Wrought?

When Samuel Morse, inventor of the Morse code, sent the first telegram from Washington to Baltimore on May 26, 1844, he ushered in a new communications age. That first telegram read: “WHAT HATH GOD WROUGHT?”

Several companies sprung up around the US to capitalise on the new technology. In 1856, two of them got together to form The Western Union Telegraph Company. The new company snapped up smaller competitors, consolidating its position across the country. Demand for its services boomed and in 1861 the company opened the first transcontinental telegraph wire, allowing messages to be sent near-instantaneously from coast to coast. Before even the railroads, Western Union became America’s first industrial monopoly.

Between 1858 and 1876, Western Union’s capitalization rose from $385,700 to $41 million. Along the way, it introduced the first stock ticker – designed by an employee called Thomas Edison – and launched a money transfer service. When Charles Dow compiled his stock index, Western Union was one of the original eleven constituents. 

But it was all downhill from there.

Things started going awry in March 1876, when Alexander Graham Bell patented his telephone. To bring it to market, Bell sought funding from angels. His father-in-law pitched Chauncey Depew, a senior executive in the Vanderbilt railroad group. Here’s how Depew recalls the pitch (emphasis mine):

One day he said to me: “My son-in-law, Professor Bell, has made what I think a wonderful invention. It is a talking telegraph. We need ten thousand dollars, and I will give you one-sixth interest for that amount of money.”

I was very much impressed with Mr. Hubbard’s description of the possibilities of Professor Bell’s invention. Before accepting, however, I called upon my friend, Mr. William Orton, president of the Western Union Telegraph Company. Orton had the reputation of being the best-informed and most accomplished electrical expert in the country. He said to me: “There is nothing in this patent whatever, nor is there anything in the scheme itself, except as a toy. If the device has any value, the Western Union owns a prior patent called the Gray’s patent, which makes the Bell device worthless.”

When I returned to Mr. Hubbard he again convinced me, and I would have made the investment, except that Mr. Orton called at my house that night and said to me: “I know you cannot afford to lose ten thousand dollars, which you certainly will if you put it in the Bell patent. I have been so worried about it that contrary to my usual custom I have come, if possible, to make you promise to drop it.” This I did.

Depew was clearly not familiar with Chris Dixon’s idea (from Andreessen Horowitz) that the next big thing starts out looking like a toy. If he had been, he could have been very rich. “...if I had accepted my friend Mr. Hubbard’s offer, it would have changed my whole course of life. With the dividends, year after year, and the increasing capital, I would have netted by to-day at least one hundred million dollars.”2

Internally, Western Union dismissed the idea, too:

“This ‘telephone’ has too many shortcomings to be seriously considered as a means of communication. The device is inherently of no value to us.” — Western Union internal memo, 1876.

So Bell and his father-in-law brought the product to market by themselves, creating the Bell Telephone Company in 1877. Before long, Western Union saw the potential of this new technology and went after it too. But amidst a patent infringement case, it pulled out, giving up telephone rights to Bell. (Orton wasn’t just wrong about the toy, he was wrong about the validity of his prior patent.)

Meanwhile, demand for telegraph technology stagnated. By 1909, Bell, now known as AT&T, dwarfed Western Union, and that year acquired it to form an integrated telecommunications company.

Clayton Christensen cites the case as a classic in his theory of disruption:

Alexander Graham Bell’s telephone was initially rejected by Western Union, the leading telecommunications company of the 1800s, because it could carry a signal only three miles. The Bell telephone therefore took root as a local communications service that was simple enough to be used by everyday people. Little by little, the telephone’s range improved until it supplanted Western Union and its telegraph operators altogether.

We’re Not Telegraphers

AT&T only owned Western Union for a few years. Under threat of antitrust prosecution, it spun it back out in 1913. 

Shortly afterwards, Western Union stumbled across the consumer charge card, years before Diners Club and American Express would popularise them. Customers could pop into any one of Western Union’s numerous locations and pay for a telegram on their centralised account. In order to identify the customer to the billing system, Western Union issued them with a small rectangular piece of card, containing the account number, the name and address of the person or company responsible for paying the charges, and a signature line. The card identified the billing account, and the signature could be used to authenticate the cardholder.

Unfortunately for Western Union, it didn’t spot an opportunity to monetise its charge card, even while telephone continued to eat away at its core telegram business.

Domestic telegram traffic dropped from 234 million messages in 1929 to 212 million in 1930 and down to 192 million ten years later in 1940. There was a brief uptick during World War II from military communications, but demand subsequently resumed its decline, falling to 179 million messages in 1950. After the war Western Union struggled to turn a profit.

a.image2.image-link.image2-377-578 { padding-bottom: 65.22491349480968%; padding-bottom: min(65.22491349480968%, 377px); width: 100%; height: 0; } a.image2.image-link.image2-377-578 img { max-width: 578px; max-height: 377px; } Historical Statistics. Notes: Western Union messages 1870-1910; all telegraph companies, 1920-1970.

That didn’t stop Western Union from trying. Under its post-war leadership, the company developed a number of new business lines (oh, but for charge cards): 

💡 The Telex. In 1931, AT&T introduced a teletypewriter exchange service that allowed customers to send and receive messages directly from a machine installed on their premises. Western Union launched something similar, called Telex. The service was a lot less labour-intensive than its core telegram business, allowing Western Union to cut costs. Western Union ultimately acquired AT&T’s service to consolidate the market, taking its footprint from 26,000 terminals to 66,000 terminals in 1968. By the late 70s, Telex took over from telegram as the largest source of Western Union’s revenues. 

💡 Leased communication systems. The company looked to leverage its communications infrastructure by offering turnkey communications networks for government and industry. In 1950, it set up a teleprinter network connecting nearly 200 major banks. By 1960, about 2,000 companies were leasing turnkey communications networks from Western Union. 

💡 Information processing. In the late 1960s, Western Union redefined its market. Its CEO at the time declared about his team, “we’re not telegraphers,” and explained: “We are in the communications service business, but this entails a new concept of communications. We have to broaden communications to include the processing of information as well as the handling of it.” His plan was to install computers at key locations across the country; these computers would integrate telegram and Telex services into a single system, with excess capacity offered to customers to perform real-time information services. 

Underpinning all of this, the company upgraded its legacy pole lines with a network of microwave towers. Later, it launched a series of satellites as well. However, the legacy telegram business did not provide sufficient cash flow to finance the infrastructure build. By the end of the 1970s, the company’s debt exceeded its equity. Meanwhile, one by one the new business lines stumbled.

The strategy to go after information processing was always going to be challenging given the number of competitors. Hundreds of firms from IBM down were addressing the same market. Consumers, where Western Union had an edge, were not that interested and the market didn’t grow that big. The entire online data processing services industry was worth $1.3 billion in 1975, against the $569 million that Western Union was earning in revenue from its core business. Nor were regulators that comfortable with the strategy. The Federal Communications Commission (FCC) wanted Western Union to park the new business in a separate entity and imposed demands on the company in keeping with its monopoly position in domestic telegraphy. In 1976, Western Union's on-line data services revenue amounted to just $64 million.

As for the telex, who remembers those? Subscribers peaked in 1981 at 141,000, the same year IBM released its personal computer. A personal computer plus printer plus modem could replicate the telex and offer so much more. For smaller users, the growth of inexpensive fax machines provided an alternative (but who remembers those?)

Moving Money

Western Union lost money over 1983, 1984 and 1985, partly from investments in an email platform (yes, it was still trying), partly from write-downs on legacy infrastructure. In 1987, investor Bennett S. LeBow acquired control of Western Union through a complex leveraged recapitalization backed by Drexel Burnham Lambert. Over the next few years, Western Union’s management sold off capital assets including the satellite network to Hughes and the Telex network to AT&T.  By 1990, all that remained was a money transfer business, which, in 1994, got sold along with the Western Union brand to First Data Corp.  

The money transfer business had been a sleeper through most of Western Union’s existence. The company processed its first money transfer in 1871. Interestingly, although the cost of telegraphy has come down significantly since then, the cost of money transfer, less so. A copy of an early Western Union transfer for $300 shows fees of $9.34 or roughly 3%. Credit card fees can be as high as that today, and money transfer fees can be higher. 

a.image2.image-link.image2-468-648 { padding-bottom: 72.22222222222221%; padding-bottom: min(72.22222222222221%, 468px); width: 100%; height: 0; } a.image2.image-link.image2-468-648 img { max-width: 648px; max-height: 468px; } Western Union money transfer from 1873

It wasn’t until the mid 80s, when deregulation allowed a previously domestic service to expand internationally, that the business took off. Before that, Western Union never developed sophisticated-enough security – cryptography, identity verification and the like – to make money transfer services core.

First Data spun Western Union back out as a public money transfer business in 2006, a few months after it dispatched its last telegram. Its business model was straightforward. Consumers could take cash into any one of its 270,000 agent locations around the world and have someone else, say a family member, pick it up in another location. Most of the agents are independent businesses authorised to offer Western Union’s services. They provide the physical infrastructure and staff required to complete the transfers and get paid a commission based on a percentage of revenue (shared between the “send agent” and the “receive agent”).

Today, there are 550,000 agents in 200 countries (although 35% of them are dormant). However, while it has broadened its reach, revenues haven’t really gone anywhere. In fact, Western Union came back to the market in 2006 on the back of peak revenue growth (12.5% in 2004 and 2005). Since then, revenues have grown at a compound rate of 0.6%.

Part of the reason for flatlining revenue is price; average revenue per transaction has come down from $28.0 in 2005 to $14.40 in the first quarter of 2021. That includes around a 15% pricing premium versus the market across the entire footprint. But the company is also losing market share. Using World Bank global personal remittance data, Western Union’s share of cross-border money transfers has fallen from 17% in 2008/09 to 14% in 2020. 

And the reason it’s losing share is that yet again, Western Union is being disrupted – this time by digital payments. Wise (formerly Transferwise) lists in London next week (we discussed it here two weeks ago). Although both companies do international money transfer, Wise doesn’t categorise Western Union as a competitor because Western Union deals mostly in cash. The problem is that cash is going the way of the telegraph. 

As before, Western Union is trying. It now does 23% of its business from digital and is on track to do $1 billion in revenue from digital this year. However, although they are digitally initiated, most of these transfers pay out at a retail location so it’s still fundamentally a cash business. 

When Facebook launched Libra in 2019 (now Diem, discussed here) it had its sights on the global remittances market. Its ambitions have been tempered somewhat but whether it’s Diem or other stablecoins or central bank digital currencies (discussed here) or digital wallets, the forces against cash are mobilising. But this is a movie Western Union has seen before. It took thirty years for the volume of telegram transactions to halve, and the same amount of time for the number of horses to halve. It’s a long, slow process. 

Christopher McDonald’s piece, Western Union's Failed Reinvention: The Role of Momentum in Resisting Strategic Change, 1965-1993 was helpful, as was David Hochfelder’s, Turning an Elephant around in a Bathtub. I was told Joshua Elias Lachter’s senior thesis, The Western Union Telegraph Company’s Search for Reinvention, 1930-1980 is good but I couldn’t get hold of it online.

More Net InterestRobinhood/Distressed Investing

When Robinhood received a margin call from the DTCC earlier this year (discussed here), it was forced to raise emergency funding. At the beginning of February, the company issued $3.55 billion convertible notes in two tranches. Of the company’s existing investors, Ribbit Capital was at the forefront of the the rescue, taking down $502 million of the issue, equivalent to 14% of the total; two other investors (Index Ventures and New Enterprise Associates) took another 4% between them. 

When the company goes public, investors in this emergency round will get a large payoff. If the IPO prices below $54.70, the notes they bought convert into Robinhood stock at a 30% discount. One tranche of notes had warrants attached, which exercise at a 30% discount. If Robinhood prices above $54.70 then the notes convert at a fixed price of $38.29, so an even higher discount (in the case of the larger tranche; the maximum conversion price on the other tranche is slightly higher). The notes also carry accrued interest, payable in kind, at a rate of 6%, which adds to the payoff. 

As at end of March, no more than eight weeks after the securities were issued, these securities were fair valued on Robinhood’s balance sheet at $5.04 billion. And that’s with a 10% discount built in. On the day of the IPO, they will be valued closer to $5.8 billion, assuming an IPO price below $54.70. That’s a 62% return over a six month holding period, or $2.2 billion in real money. 

Distressed investing is high return and venture investing is high return, but when the two come together, the returns can be very high. 

Banker hours

In November 2013, Goldman Sachs sent out a memo to its banking staff:

All analysts and associates are required to be out of the office from 9PM on Friday until 9AM on Sunday (begins this weekend)

Earlier this year, in response to complaints from junior bankers, CEO David Solomon recorded a voicemail for staff in which he committed to step up enforcement of the rule.

Now, some researchers have looked at the impact bans like this have on bankers’ work-life balance. Using data from 16 million taxi rides from ten large investment banks to residential destinations, they compare late-night and weekend rides from banks that have adopted such rules to those that haven’t. 

Their conclusion is simple. Bankers who don’t work on Saturdays simply make up for it by staying later during the week. The effect is particularly marked over the summer when interns are on site. At one level, this reflects a classic problem of unintended consequences in regulation, where the response to the regulation is not taken into account in its design.

At another level, it reflects a problem in certain jobs where it is difficult to model individual contribution. Banks have historically used a willingness to work long hours as a proxy for some valuable, yet hard to observe, characteristics of employees. The long hours also create a barrier to entry which solves a selection problem. As Mike Dariano, who alerted me to the paper, notes, “Long hours in investment banking are the Peloton Christmas commercial: not for you. Unless it is. Then it’s really for you.”

Compound Treasury

As you know, I’m being slowly drawn into the web of decentralised finance (DeFi). A few weeks ago in My Adventures in CryptoLand, I wrote about a protocol called Compound. More recently, in Reinventing the Financial System, I wrote:

We spend a lot of time at Net Interest thinking about fintech, which is largely the front end of financial services. Entities like Maker DAO innovate at the back end. When they meet in the middle, interesting things will happen.

This week, Compound launched a new product called Treasury, designed for businesses and financial institutions to access the features of the Compound protocol without dealing with the complexities of crypto. It has already been picked up by neobank Current to offer customers 4% APR on cash balances. In the UK, Ziglu offers consumers something similar (5% on sterling deposits) but it solves the back end by itself. By making the back end easy for all institutions, Compound Treasury is a step towards the convergence of DeFi and traditional finance.

1

One example of a sudden corporate decline (outside of fraud) is the case of Ratners, a chain of UK jewellery stores. In April 1991, its chairman, Gerald Ratner, made a speech where he said, “People say, ‘How can you sell this for such a low price?’, I say, ‘because it's total crap.’” He went on to say that one set of earrings on sale was “cheaper than a prawn sandwich from Marks & Spencer’s, but I have to say the sandwich will probably last longer than the earrings.” After the speech, the value of his company fell by around £500 million and never really recovered. However, the episode occurred during a recession when consumer spending fell at its highest rate in at least twenty years, so it is difficult to isolate just how much of the demise was caused by Ratner’s comments.

2

Despite missing out on at least one hundred million dollars, Chauncey Depew imparts great advice: “I have no regrets. I know my make-up, with its love for the social side of life and its good things, and for good times with good fellows. I also know the necessity of activity and work. I am quite sure that with this necessity removed and ambition smothered, I should long ago have been in my grave and lost many years of a life which has been full of happiness and satisfaction.” — Depew, Chauncey M. (Mitchell), My Memories of Eighty Years, Published 1922

Welcome to another issue of Net Interest, my newsletter on financial sector themes. This week’s issue is a bit different – it’s a guest post by Bruce Packard. Like me, Bruce is a former equity research analyst; in fact we used to work together at Credit Suisse. I’ll introduce him properly below. In the meantime if you’re reading this, but haven’t yet signed up you can do so here:

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Litigation Finance

An occasional theme here at Net Interest is the study of new asset classes. There’s something quite fascinating about them: how and why they emerge, why some endure and some don't, the types of people who pioneer them and the money they make and lose doing so.

It's hard to believe now, but equities were once a new asset class, at least in institutional eyes. A few years ago some finance professors conducted an appraisal of John Maynard Keynes’ performance as manager of his Cambridge college endowment from 1921 to 1946. Keynes’ top-down macro approach generated disappointing returns in the 1920s, but when he switched to stocks – not permitted by many other colleges until later – his performance improved. “Keynes’ great insight was to appreciate the previously overlooked attractions of a new asset class for long-term investors, namely equities.” 

Since then plenty of new asset classes have sparked institutional interest. We’ve discussed here some contemporary ones – crypto of course, and also revenue contracts; we’ve also discussed one that didn’t endure – supply chain finance. With interest rates so low, the demand for alternative asset classes offering i) higher returns and ii) uncorrelated risk has never been higher, making this a ripe environment for new asset classes to incubate. 

This week, we take a close look at another new asset class – litigation finance. And there’s no-one better to introduce us to it than Bruce Packard. A couple of years ago, Bruce spent some time working with a mutual friend who was setting up a litigation finance crowdfunding platform: Axia Funder. Today, he writes a weekly column for Sharepad. 

Over to Bruce.

Size of the market

The size of the legal market is huge. The top 30 law firms have $2 trillion of pending arbitration claims; annual law firm fees are $860 billion globally (of which just over half is in the US). Both corporates and law firms expect the market to grow further as disputes rise following the pandemic, according to a research survey published by Ernst & Young.

One such dispute is the case between Tatiana Akhmedova and her son, Temur. The case erupted after Temur had conspired with his father to hide assets following his parents’ divorce. In April this year in London, a High Court Judge, Mr Justice Knowles ruled in favour of Tatiana. Temur was ordered to pay his mother £75 million. The court heard how Akhmedov senior transferred assets such as their superyacht, Luna (worth around £340 million) and an art collection (worth around £110 million) into the ownership of trusts in Liechtenstein in order to prevent his ex-wife receiving £453 million that she had been awarded following the couple’s divorce.

Burford Capital, a new type of law company that funds court cases, is helping Tatiana recover these assets from her ex-husband and son. Disputes like this should be uncorrelated with other asset classes such as Government bonds or equities, which all respond to economic cycles. Indeed disputes tend to be unique in nature, and should be uncorrelated with each other. There’s little to suggest the pursuit of the Akhmedov yacht should be correlated with another of Burford’s claims – against the Argentinian Government over the expropriation of an oil company (YPF).

What are legal assets?

For industrial companies, property, plant or equipment make up the bulk of assets recorded on their balance sheet. But financial companies’ assets are more abstract, such as loans like mortgages or bonds, with the debt often secured on tangible assets like property. Companies like Burford take this one step further, and offer non recourse funding of legal claims in return for a share of the money recovered when the dispute is settled. This is inherently risky – court judgments can go against you, even if your lawyers believe you have a strong case.

If the claimant loses, they (and the litigation funder) receive nothing and may have to pick up the other side’s costs. Therium, an unlisted litigation finance company, has suffered a couple of high profile losses. One involved a drunken bet made in the Horse and Groom pub between Sports Direct owner Mike Ashley and banker Jeffrey Blue; Jeffery Blue lost and had to pick up Mike Ashley’s costs. Another was the case brought by Amanda Staveley against Barclays over the bank’s 2008 fundraising. Both cases highlight the risk in litigation finance: the outcome tends to be binary – either a large gain or zero. 

Burford says that they lose just 10% of their cases. They win 29% of their cases in court, but the majority of cases, 61%, are settled before going to court. Burford doesn't own the case, they provide the funding, so it is the plaintiff’s decision whether to settle out of court for less money, or go to court and receive a likely higher reward, but at the risk of losing, and receiving nothing. 

Tatiana Akhmedova and her attempts to impound Luna reveals that litigation finance isn’t just about the judge ruling in a claimant’s favour. Defendants often hide assets overseas to evade court orders and some jurisdictions are friendlier than others. Imagine trying to enforce an English court’s award against a Russian oligarch in a Russian court. Asset tracing and recovery are therefore also integral to successful litigation finance.

Burford is the only major litigation funder to keep an asset tracing and recovery team in-house; most funders outsource this activity to firms run by ex-intelligence agents and private investigators. Christopher Bogart, Burford’s CEO, says: “Enforcing judgments is core both to the integrity of the legal system and the success of a litigation finance business. In some cases, scofflaws try to evade payment of court judgments and their obligations.” (I had to look up the word “scofflaws” but it is a word, meaning: a person who flouts the law, especially by failing to comply with a law that is difficult to enforce effectively.)

Sometimes asset recovery can lead down unusual paths. Harry Sargeant, a US billionaire, accused Daniel Hall, who works for Burford, of illegally accessing highly personal materials, stored on a corporate server belonging to the family business. Burford was trying to enforce a $29 million judgment against Sargeant and presumably Hall believed that this would be more likely if he had obtained a compromising video tape of the billionaire.

Returns

Common sense would suggest you don’t see high returns without any risk. At first glance the numbers look very attractive in a low yield environment. Burford reports that on $831 million worth of disputes that they have funded with their own balance sheet since 2009, they have generated a ROIC of 92% and an IRR of 30%. A competitor, Litigation Capital Management reports an even higher ROIC of 135% and an IRR of 78% over the last 9.5 years.

As you would expect, high returns attract new entrants. The Association of Litigation Funders lists 13 members, including Burford, Harbour, Vannin and Therium. Most firms remain confident that competition should not drive down returns, as this is a relationship based business, with law firms tending to recommend the funders who they have successfully worked with in the past. 

That may be true, but it’s rare to find an industry where a large inflow of capital does not alter the economics of returns. Like banking and insurance, there will be several years’ time lag between new business written and rewards (or losses) reported. Litigation funders that are writing business based on optimistic return assumptions can do so for several years before the chickens come home to roost.

Accounting

A separate criticism of high reported ROICs, is that the returns are illusory and the sector has opaque accounting. It is important to understand that c. 100% ROICs that funders report is not comparable with the mid to high teens returns that companies like Unilever report. The litigation finance companies report the ROIC on a portfolio of completed cases and exclude i) cases where money has been invested, but have not yet settled and ii) allocating their group operating costs.

Importantly, Burford and its critics do not disagree on the numbers, but how the numbers are presented. By way of example, Burford’s 92% ROIC calculation is based on $831 million capital deployed in completed cases, from which they’ve recovered $1,597 million. Simple. Yet if we sum up all of the capital deployed using the table on page 45-46 of the 2020 FY Annual Report, the sum comes to $1.8 billion. The roughly $1 billion difference represents those cases that have yet to be completed. Should the “Invested Capital” denominator include all capital that has been invested, or just that from completed cases? I think that you can make the case for both calculations; what is important to understand is that the high ROIC figures reported by litigation finance companies are not comparable with what companies in other sectors report.

Burford has a market cap of $2.4 billion versus a total portfolio of $4.5 billion of disputes, though that contains both funds managed for third parties not on their balance sheet and cases that have been written up using Fair Value accounting. Critics have suggested that Burford is quick to write up gains with Fair Value accounting, but slow to recognise losses. Originally Burford management were not keen on Fair Value accounting, in 2010 they said:

“[We] believe strongly that litigation and arbitration returns are inherently speculative and are most appropriately accounted for by holding investments at cost until a cash realisation has occurred, as opposed to taking unrealised gains into income before a litigation resolution has occurred. Moreover, the appropriate metric, in our view, for Burford Capital’s share price measurement is its relationship to net asset value based solely on actual cash realisations. Thus, for the guidance of investors, we publish a cash NAV figure alongside the requisite IFRS-based NAV, and we encourage investors to consider the cash NAV as the appropriate valuation metric.”

Then something changed. In 2011 Annual Report, Burford stopped publishing cash NAV, claiming that:

“We have also historically published a “cash NAV”, but that measure has not been embraced by analysts and investors, and given the increased complexity in its computation following the Firstassist acquisition and the relatively modest and clearly identifiable unrealised gain in the portfolio, we do not intend to continue to use or publish it after this set of accounts.”

Study silence to learn the music

Voluntary disclosure – what companies choose to tell investors – rather than what they are required to reveal, is a fascinating area. And very often when companies change their mind and withdraw disclosure it’s even more significant, though harder to spot. When you walk around the City of London and see large cranes and a new building going up, it’s often hard to recall the building that previously stood in the space. Similarly, unless you are reading corporate results laid out with the previous year’s results in parallel, it’s hard to see what is no longer there. Or, as the Finnish Operatic Metal band Nightwish sang: I studied silence to learn the music.

Perhaps a coincidence, but around this time is when Selvyn Seidel, the co-founder who lived in the village of Burford, left the company. The other co-founder was the current CEO, Christopher Bogart, previously General Counsel for Time Warner and before that Cravath, Swaine & Moore. 

Burford’s IPO in 2009 was backed by Neil Woodford, while he was still at Invesco Perpetual. He bought 45% of the share capital when the shares IPO’d at 100p, which required a special waiver from the Takeover Panel, as over 30% would normally require a mandatory bid for the entire company. This valued Burford at £80 million market cap in October 2009. Other institutions with disclosable interests were Baillie Gifford, Fidelity, Eton Park and Scottish Widows. Most of those investors have sold out now, Woodford’s fund has been wound down, Invesco owns just 6% and currently the largest shareholder is Saudi Arabian fund, Mithaq Capital, with 10.5%. 

Short selling attack

By October 2018, Burford’s share price had risen from its 100p 2009 IPO price to almost £20, and the company raised £192 million (or $251 million) at 1850p per share. Canaccord published a sell note in April 2019 and in August 2019, Carson Block of Muddy Waters led an attack on the company, calling it “a perfect storm for an accounting fiasco.” Block has made a name for himself shorting Chinese frauds: Orient Paper, Sino Forest, Luckin Coffee. He has been aggressive and he has been right. In his report he compared Burford’s accounting to Enron. Block also highlighted the fact that Christopher Bogart’s wife, Elizabeth O’Connell was the CFO, though she has since been replaced by Jim Kilman, formerly Burford’s investment banker at Morgan Stanley.

Muddy Waters can claim victory in their battle: Burford’s share price fell back below £3 in March 2020, helped by a broad sell off in markets due to the pandemic. Following the attack, Burford disclosed that they have written up the value of their court case against Argentina for expropriating the oil company YPF to $773 million. The firm’s rationale is that there is a secondary market in this large claim; they sold 39% of their interest in the proceeds of the YPF/Petersen claim for $236 million in cash in a series of third-party transactions from 2016 to 2019. Burford management says that Fair Value accounting requires them to write up the value of the asset. 

Many twists and turns

Burford’s share price has now recovered to 780p.  Last week they announced that they had bought back £24m of bonds yielding 6.5% due 2022, which does not appear to be the actions of a company that is worried about its financial position. It’s possible that they do recover a significant sum from the Argentinian Government in the next few years, which would justify management’s accounting. The case against Argentina will be heard in New York, probably at the start of 2022. Lawyers with large value disputes are tenacious, many of their cases take years to come to judgment, with many twists and turns. The jury is still out.

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More Net InterestStress Tests

US banks have a lot of catch-up to do. Last year they were restricted from increasing dividends and doing share buybacks as regulators encouraged them to preserve capital. This week, they all passed their stress tests, with ample buffers against regulatory capital minimums. In aggregate, the banks that participated in this test have around $175 billion of excess capital, equivalent to around 10% of their market cap. Compared with their own capital targets, which are typically more conservative than regulatory minimums, they have around $100bn of excess capital.

Although the stress applied to banks in these tests was not as severe as last year, when the outlook was more uncertain, it remains a pretty severe test. The Fed stressed credit card loans at a loss rate of 16.2%, much higher than what was incorporated into stress tests five years ago (13.4%) and a big gap versus the rates currently being realised. In commercial real estate, where risk might be more apparent today, losses were estimated using a 10.5% loss rate, which is the highest ever used in a Fed stress test (last year a rate of 6.3% was used). Yet the banks are quite well covered and already have a large stock of provisions to absorb such high losses; the top seven banks have sufficient provisions to cover around half of their stress-case losses before capital even has to be tapped into (last year that coverage was only around a quarter). 

Banks will report capital plans on Monday (28 June). They will be eager to disgorge their excess capital to shareholders. 

Revolut

I’ve discussed Revolut here a few times before, and I’ve been remiss – I should have disclosed that I’m an investor; I participated in the series A back in 2016. However, first and foremost I’m an experienced analyst and that stops me being starry-eyed. This week the company filed its 2020 financials and they are a bit mixed. 

The company lost £168 million on revenue of £261 million (including fair value gains on cryptocurrencies). Between those two numbers, there’s a lot of cost. Much of that is linked to risk, compliance and control enhancements. Based on LinkedIn data, around a sixth of the company’s workforce (of ~ 2,500) now sits in some sort of compliance function. The good news is that those costs are largely fixed and don’t have to scale with the company. Nor do the total costs include much marketing. The company halted marketing and discretionary spending during the year, yet continued to win new customers largely by referral (customer count is 15 million as at March 2021, up from 10 million in February 2020). 

Revenues have diversified. Just over a third of revenue now comes from card and interchange, compared with just less than half in 2019. Crypto picked up the slack which may now be taking a hit, but the company also opened up a source of income via subscriptions which now contribute 29% to revenue. Subscriptions are good because the rest of the revenue base is very transaction oriented; there’s no interest income here. In fact, average deposits per customer stand at around £300, much less than at Wise, where they stand at £2,300, so scope to earn substantial recurring revenue from them is limited (notwithstanding the current level of interest rates). Average revenue per customer of £21 for the year is not great, although there is likely a distribution around that number (how many of the 15 million customers are not active?)

Despite the company’s grand ambitions to expand globally, most revenue still comes from the UK – 88% of statutory revenue in 2020 (i.e. excluding the mark-up on crypto). By the end of the year, Revolut had 200,000 customers in the US, where it intends to make a push. 

Press reports indicate that Revolut is looking to raise capital. Part of this may be to fund regulatory capital to underpin the bank licenses the company has applied for in the US and the UK. Klarna has been regulated as a bank since 2017 and has had no trouble raising capital, but its core product is higher return than Revolut’s. Key will be whether Revolut can use its banking licenses to win more deposits and introduce more products. 

Tink/Visa

Visa announced this week that it would acquire Tink, a European open banking platform, for $2.2 billion (versus its last valuation of $825 million in December). Founded in 2012, Tink offers customers access to underlying consumer financial data via a single API. It reaches over 250 million consumer bank accounts across 18 markets in Europe via integrations into over 3,400 financial institutions (versus ~11,000 market total). It offers five key products: Transactions, Account Check, Income Check, Payment Initiation and Money Manager. 

Account-to-account payments are growing as a credible alternative to payments made via card networks, particularly given the support of unified protocols such as Open Banking in the UK. This deal gives Visa a foothold in the segment. Open banking payments are better suited to large ticket items since fees do not scale with transaction size, and to transfers between a consumer’s various accounts (e.g. bank to fintech). They may also be better suited to variable recurring payments compared with cards kept on file. Depending on the underlying payments network, settlement times can also be faster, such as in the UK under Faster Payments. 

Visa was exposed by the DOJ when it tried to buy Plaid. It is unlikely that there will be an incriminating email trail this time (or back-of-the-napkin doodles of volcanoes) but the motivation is similar: to own control of the disruptive play rather than look on passively.