Should Banks Acquire Fintech Firms?

JPMorgan Chase & Co. generated some buzz last October with its acquisition of WePay, a payments platform that works with companies such as GoFundMe and Constant Contact. The acquisition appears to be part of the banking giant’s focus on the payments space: Earlier in the year, it purchased payments technology from the merchant consortium MCX to expand its Chase Pay wallet. “When we think about fintech, we go through a ‘build/buy/partner’ evaluation to decide how we can get to market most efficiently,” said Jennifer Roberts, head of Chase Pay, in a release at the time. “This [acquisition] will help us get to market faster.”

At the time of the deal, New York-based JPMorgan reportedly paid above and beyond the $220 million valuation that WePay received in its 2015 fundraising round. JPMorgan has not disclosed the price it paid for its shiny new tech toy.

Bankers who in the past were wringing their hands in concern about the so-called fintech threat-and the cocky fintech founders who were certain their companies would topple the banking industry-have reached a detente of sorts. Acquiring customers is difficult, as fintech entrepreneurs have discovered, and partnering with banks makes sense.

Banks, on the other hand, need to adjust to better serve a consumer that now expects a more immediate digital delivery of products and services. New services fueled by technology can help add new revenue streams, and new processes can make traditional institutions more efficient. Many banks are now customers of, or partnering with, the fintechs that once promised to take them down. Banks are active investors in fintech companies, too. JPMorgan is a significant investor in the fintech space, with more than $2 billion invested in technology startups in 2016, including $793.5 million in wearable tech startup Magic Leap, a $60 million stake in blockchain provider Digital Asset and $30 million in cloud communications firm Cloud9. It also partners with fintech firms, such as marketplace lender OnDeck Capital-a partnership that both companies extended for another four years last August.

“Banks are making bets. They’re taking relatively modest positions without taking control,” says John Douglas, a partner at the law firm Davis Polk.

You won’t find a lot of banks acquiring fintech firms. Due diligence and integration can be difficult, due in large part to a cultural disconnect between old-school banks and new-school tech companies. And it’s hard to determine a fair price for a company with little history and almost no financial track record. But some banks-mostly but not exclusively the biggest banks-are strategically considering these deals. And some are making them work.

JPMorgan is just one of the banks that is including fintech acquisitions as part of its corporate strategy. Globally, commercial banks participated in 41 completed acquisitions of technology companies in 2016, at $14.4 billion in total deal value, according Pitchbook data as reported by KPMG. Capital One Financial Corp. has been an active fintech acquirer; its acquisitions include the mobile app Paribus, software developer Monsoon Co. and cybersecurity firm Critical Stack. The Spanish bank BBVA has been a notable global acquirer of fintech, purchasing Mexican payments platform Openpay in April 2017, Finnish digital bank Holvi in 2016 and Simple, the U.S. digital bank, in 2014.

More recently, smaller players have stepped up to the plate. San Francisco-based First Republic Bank, with $84 billion in assets, purchased the student loan repayment platform Gradifi in December 2016 to augment its student lending niche. KeyCorp, in Cleveland, Ohio, with $136 billion in assets, purchased the personal financial management app HelloWallet in July 2017, as part of the bank’s focus on financial wellness. But most banks are reticent to participate in these types of deals, according to Bank Director’s 2018 Bank M&A Survey, the results of which you’ll find on page 40. Just 7 percent of the directors and executives responding to the survey say their bank is very likely or somewhat likely to purchase a fintech firm by the end of 2018. When asked if the board and management team would be open to acquiring a fintech firm if the right target were available, just 23 percent answered affirmatively. The plurality, at 42 percent, are unsure.

So when does it make sense to take the leap and acquire a technology company, rather than continue as a partner or an investor? Banks are looking for strategic gaps where revenue opportunities could exist, says Tommy Marshall, managing director at Accenture. JPMorgan’s acquisition of WePay provides a more streamlined platform for the bank’s small business customers, for example.

Payments is a more mature area of fintech that is ripe for acquisition by traditional banks. Lending, wealth management and so-called neobanks-like BBVA’s Simple, which focuses on deposits and personal financial management-are more mature as well. Acquisitions by banks in next stage technologies such as blockchain and artificial intelligence are less likely until they have been developed into a viable product to benefit the bank. “They’re not at scale yet,” says Lex Sokolin, global director of fintech strategy at Autonomous Research in London.

For bank boards and management teams asking how to better deliver the services customers want in a more efficient manner, the answer increasingly lies in the use of technology. “That’s where you have to think about things like partnerships with fintech companies, and potentially, acquisitions,” says Jay Wilson, vice president at Mercer Capital. In an acquisition, “[the bank gets] more control over how the technology ultimately develops,” he says. Banks can gain talented employees as well.

While not a rule, technology acquisitions tend to start with a prior relationship, which could be an investment by the eventual acquirer or a partnership, as evidenced by First Republic’s acquisition of Gradifi and KeyCorp’s purchase of HelloWallet. If the partnership is thriving, bank management and the board will want to question whether they should acquire the partner, says Marshall.

But acquiring a fintech firm presents its own unique issues. Honing in on a fair price can be a challenge for bankers accustomed to buying other financial institutions. Integration can also be a challenge, due largely to the cultural differences between a traditional bank and a technology innovator. But these deals are still possible-and won’t necessarily be limited to the biggest banks, though purchasing a fintech firm will more greatly test and impact a smaller institution.

Partnerships can help banks gauge a fintech firm’s strategic fit with the company and ease the due diligence process. “We felt really strongly that [HelloWallet] had a market-leading product; we got to see and use it directly,” says Patrick Smith, an executive vice president who leads Key’s financial wellness initiative. He adds that HelloWallet’s focus on financial wellness aligned with Key’s strategic mission. “In terms of the product and what [HelloWallet] had to bring to the table, the talent and the culture-those are nice points of alignment that made an acquisition a really good option,” he says.

In another example of a partnership turning into an acquisition, First Republic started off by working with Gradifi to provide a company-wide student debt repayment benefit to its employees. Gradifi offers solutions that help employers contribute to their employees’ student loans or college savings plans, and facilitates student loan refinancing, a niche focus for First Republic. More than 300 First Republic employees enrolled within the first day the benefit was made available, said Executive Vice President Mollie Richardson in a January 2017 earnings call, adding that the positive reception made it clear that both companies share the same values.

Prior experience with each other may make closing the deal easier, but there are some key cultural concerns that should be vetted during the due diligence process. Technologists, in general, aren’t bankers. They might be unfamiliar with working with core providers-vendor relationships that are critical to almost every bank in the U.S. But perhaps more importantly, technology firms may not share a bank’s intensive focus on reputational risks and compliance, says Douglas. “There is a tension, because once [the fintech is] part of the bank, the bank is responsible for what it does,” he says. “And many times what the bank is after is the spark and innovation, but sometimes [that] might lead a fintech company to want to do something that the bank just doesn’t have the power to do.”

Douglas adds that acquiring banks will want to be sure that the firm owns the technology it is selling to the banks. “There’s a lot of [intellectual property] diligence that goes into this that wouldn’t necessarily go into the acquisition of another bank,” says Douglas. “IP is so important in these companies.” A bank doesn’t want to discover that an employee owns the technology, rather than the company it just acquired.

Another key differentiator between buying a bank and buying a fintech firm comes down to valuing the fintech firm, which points to another key difference, according to Sokolin. There’s a big disconnect between “cash-flow oriented, quarterly-earnings thinking, which drives how retail banks and large financial institutions are held for performance, versus [Silicon] Valley and the growth-oriented mindset on innovation,” Sokolin says.

Citi Ventures, New York-based Citigroup’s venture capital arm, regularly invests in the fintech space. Citi is seeking investments in startups that are operating well with talented teams, according to Arvind Purushotham, global head of venture investing for Citi Ventures. The startups need to execute on their business model, and on top of that, Purushotham says, Citi values firms that pay attention to operational details, including risk management and compliance.

The maturity of the company determines how valuation is approached. “In the early stage, it’s more of an art than a science, because you’re taking a look at what the company is and looking at the potential market opportunity for it, and frankly, your own risk-return profile,” says Purushotham. Later stage companies will have more history for investors to analyze.

Relying on an approach that’s more art than science is unlikely to suit most banks considering a fintech acquisition. “A lot of the early stage fintech companies aren’t quite to the level of maturity where the banks would want to acquire them and have them completely in-house,” says Jim Sinegal, an analyst for Morningstar. “They’re letting them build up on their own outside and when they reach a sort of critical mass, that’s when they become attractive as an acquisition candidate.”

Few fintech firms are publicly traded, meaning data is more limited, even for a more mature firm. “It requires having a skilled valuation and advisory team that understands the space and the market potential,” says Wilson. Multiples for North American fintech firms hit a high in 2017, at 10.6 times earnings before interest, taxes, depreciation and amortization, according to the data and research firm Pitchbook. Multiples have risen every year since 2012.

Meta Financial Group, a Sioux Falls, South Dakota-based holding company for a savings bank called MetaBank and an electronics payments business, has acquired mature technology firms-four in the past three years. They include EPS Financial, a payments provider for the tax industry that Meta purchased for $21.3 million in 2016, and Fort Knox Financial Services Corp., a tax refund service better known as Refund Advantage, purchased for $50 million in 2015. The deals were a strategic fit due to the $4 billion asset Meta’s focus on the electronic payments arena, which also made the company uniquely positioned to evaluate these deals. Still, “we try to be a very disciplined acquirer, so when we look at acquisition opportunities, we focus on the numbers, [and] we focus on the risk,” says Meta CEO J. Tyler Haahr.

Price matters to fintech companies, but it’s important to note that fintech founders are also looking to grow and reach the masses. They want to get their product out there, and banks have the customers. “The prospects of having a million users of your cool app-it’s really compelling,” says Sokolin. “That’s the reason entrepreneurs start companies in the first place. That is far more compelling than retention bonuses [or] vesting.”

First Republic may not be a national player, but the bank is investing in promoting Gradifi outside of its footprint, says Aaron Deer, an equity research analyst with Sandler O’Neill + Partners who covers the bank. (First Republic’s branches are mostly located in California, with a few on the East Coast and one in Portland, Oregon.) First Republic has provided Gradifi with capital and resources that it likely couldn’t access as a private startup. “[The bank sees] a correlation between the kind of service that they want to offer customers and the product that Gradifi provides,” Deer says.

Gradifi has maintained its own brand-another unique aspect of many fintech acquisitions by traditional banks. “[Gradifi] had other banks that they were working with, and so the natural inclination would be for First Republic to buy [Gradifi] and shut down those other deals, but that’s not happening,” says Mitch Siegel, head of strategy for financial services at KPMG. Instead, First Republic, through Gradifi, can keep their competitors as customers. Keeping the fintech firm separate, with its own culture and brand, can also be a way to prevent a culture clash between the more traditional bank culture and that of the fintech firm.

Partnerships, rather than acquisitions, will likely continue to define the relationships between most banks and fintech firms, but more financial institutions will consider these acquisitions to strengthen strategic areas. It’s a natural fit. “If I’m a fintech entrepreneur, I am building this so I can realize the value of it one day, and just as is the case with banks, oftentimes the best way to do that is to sell it,” says Jonathan Hightower, a partner at the law firm Bryan Cave. “There’s no reason that banks shouldn’t be the to-go buyers for fintech firms.”

Banks could face competition from other industries in their pursuit of a fintech deal, including from digital payments providers like PayPal and Square, and tech giants such as Google, Amazon and Facebook interested in providing services that help grow their own businesses, whether that’s in the form of small business loans that Amazon offers its client vendors or Facebook’s use of peer-to-peer payments in its Messenger app.

Most deals between banks and fintech firms are expected to be completed by bigger banks, due to the outsized impact these deals would have on a smaller institution-both financially and culturally-and the lack of capability and expertise to conduct due diligence and digest such a deal. “[Big banks] can put the company in a little division, and they can have their innovation silo, and it doesn’t bleed over to the rest of the bank,” says Hightower. “For most banks that are in the middle, it requires some thought-but it absolutely can be done.”

Boston-based Gradifi operates as a separate subsidiary of First Republic, and Meta has taken the same approach with its tech acquisitions. Key, however, plans to fully integrate HelloWallet into the bank’s brand. “Our object is to have HelloWallet be a fully integrated component of KeyBank,” says Smith. But Key is taking its time in integrating the startup’s talent into the organization, as well as the product and its clients.

“Let’s not try to make this harder than it really is-it’s still an M&A deal at the end of the day, and the financials need to work, the strategy needs to work, and the culture needs to work,” says Hightower.