Executive Summary
In today’s rapidly evolving financial landscape, fintech stands as a transformative force, offering a myriad of opportunities for credit unions to modernize operations, diversify portfolios, and drive groundbreaking innovation. Yet, as we navigate this burgeoning field, a pivotal question arises: should credit unions invest directly in fintech startups or opt for fintech funds?
This comprehensive guide aims to dissect both avenues, meticulously unpacking the financial, operational, and strategic pros and cons to facilitate informed decision-making for credit union executives.
Over the years I have seen countless problems caused by credit unions, external auditors, or examiners asking questions. Well-meaning board, management, CPAs, all attempting to do the right thing for the credit union but based on the industry collective limited understanding of venture capital, fintech investing, multi-owned CUSOs, tax issues or valuation methods, these well-meaning folks sometimes cause more harm than good.
Ultimately, nothing is more problematic for your investment or the success of the CUSO you are investing in, than investor misalignment. Below is a summary of key things to consider when making your Fintech investments.
Direct Investment in Fintech Companies
There are advantages and disadvantages to direct investment in fintech companies. They include:
Direct Investment Advantages
Control and Influence
Direct investment is not merely a financial endeavor; it’s a strategic partnership. By investing directly, credit unions can wield significant influence over a fintech startup’s strategic direction, thereby ensuring alignment with their own long-term objectives. This influence often extends to the product roadmap, allowing for customizations that can be seamlessly integrated into the credit union’s existing operational framework.
Financial Upside
Direct investments have the potential to yield higher returns, especially if the fintech startup experiences exponential growth. These gains can far outstrip the returns from more diversified but less focused investment avenues like fintech funds.
Customization
The close collaboration that comes with direct investment often results in tailored fintech solutions. Such custom-built solutions can offer unique competitive advantages, differentiating the credit union in an increasingly crowded marketplace.
Tax Flexibility
The direct control over the timing of buy and sell decisions can be a significant boon for tax planning, allowing the credit union to optimize its tax liabilities effectively.
Direct Investment Disadvantages
Risk Exposure
One of the most glaring downsides of direct investment is concentration risk. By putting a substantial amount of capital into a single entity, the credit union becomes exposed to the specific risks that entity faces, be it regulatory hurdles, market competition, or operational challenges.
Resource Intensive
Direct investment is not for the faint-hearted or resource-strapped. It requires a rigorous due diligence process, ongoing governance, and a hands-on approach for monitoring the investment. This can be both time-consuming and costly. There is a high startup failure rate, although failures in credit union land are swept under the way less violently normally. Either way, startups almost always need more funding than expected. Credit Union boards tend to see additional capital (whether for growth or failed concepts) the same way, poorly. If new investors or brought in, they will expect existing investors to yield significant power, control and economics.
Also, Credit Unions have unique investing attributes where they can be quite helpful on collaboration and understanding market needs, they rarely have the skills to help with the operational issues of a for profit early-stage company.
Regulatory and Compliance Burdens
Direct investment in fintech startups involves navigating a complex regulatory landscape. Ensuring compliance with a myriad of financial regulations and standards adds another layer of complexity to an already intricate process. Regulations in this case could include NCUA, CFPB, FDIC, FFIEC, FASB, GAAP, and sometimes even the SEC.
Accounting Complications
The accounting practices involved in direct investment are far from straightforward. They often require annual valuations, which are not only resource-intensive but also carry the potential for valuation disputes, thereby complicating the financial reporting process. Depending on the level of direct ownership, consolidation may be required. Considering the profitability profile of startups, this will likely result in negative impacts on the Credit Union P&L and force its management to provide further reporting of pro-forma earnings. In a fintech fund, the arms-length nature of the investment avoids many of these issues.
Investing Through a Fintech Fund
There are advantages and disadvantages to investing in fintechs through a fintech fund. They include:
Investment Fund Advantages
Risk Mitigation
A fintech fund typically invests in a diversified portfolio of fintech companies, thereby substantially reducing the risk associated with the failure of any individual venture. This is particularly beneficial for credit unions that want to mitigate risk while still participating in the fintech ecosystem. If more capital is needed, it is not the sole burden of a few credit unions. The fund manager is motivated to limit capital calls to those that provide returns.
Expert Management
Fintech funds are usually managed by seasoned professionals with deep industry insights and a solid track record. This layer of professional oversight can add an additional level of security and potential for returns. This can allow you to pick a type of fund manager that aligns with your interests. Some are very operationally oriented and have started or managed Fintechs themselves, Others are more traditional passive investors with strong investment knowledge but little operational expertise.
Simplified Accounting and Valuation
The accounting process for fintech fund investments is the responsibility of the fund and is generally simpler than that for direct investments. Funds provide reporting and portfolio companies valuation to its limited partners/investors. While Credit unions may opt for their own DCF or Comparable Company Analysis (CCA), they often rely on more suitable methodology provided by the fund itself, typically the Net Asset Value (NAV) of the fund, which serves as a straightforward valuation metric. Consequently, accounting for Credit Unions investing in a FinTech fund is much less of a burden and is limited to asset re/devaluation entries.
Regulatory Ease
The onus of regulatory compliance generally falls on the fund itself, significantly reducing the burden on the investing credit union.
Investment Fund Disadvantages
Lower Returns
Diversification, while reducing risk, can also result in diluted returns, especially if some of the fintech companies in the fund’s portfolio underperform. However, because it is a fund, the funds’ performance will be a function of the managers success in selecting the best companies and helping them succeed. Overall, a fund will likely have a more predictable return, but successes will be moderated by disappointments. As an asset class, venture and private equity funds are high performance vehicles.
Limited Control
When you invest in a fund, you cede control over which fintech companies become part of your portfolio. This lack of control can sometimes lead to strategic misalignment. Some Credit Union specific Fintech funds do allow for a louder and more collaborative voice from financial institutions.
Cost Factor
Fintech funds usually charge management fees, which can erode the net returns on investment. These fees are fairly standard, and can be lower than average returns, and lower for unproven managers. For proven managers, they tend to be higher and deliver higher net returns.
Valuation Methodologies and Their Impacts Over Time
When it comes to fintech investments, the choice of valuation methodology is not merely an academic exercise. It’s a critical decision that impacts not only the perceived value of the investment but also its actual returns over time. Whether you’re considering a Discounted Cash Flow (DCF) for its long-term perspective or a Comparable Company Analysis (CCA) for its market-driven insights, each methodology comes with its own set of implications over time.
For instance, direct investments often require annual valuations, which can fluctuate wildly based on market conditions, technological advancements, or regulatory changes. On the other hand, fintech funds, with their diversified portfolios, generally offer more stable valuations, although they are still subject to market risks and the fund manager’s expertise.
Choosing the right valuation methodology is critical for aligning the investment with the credit union’s broader financial objectives, risk tolerance, and investment strategy. For direct investments, methodologies like DCF or CCA may be more suitable, while fintech funds often rely on Net Asset Value (NAV) and Price-to-Earnings Ratios (P/E) as key valuation metrics.
Conclusion and Recommendations
The decision between direct investment and fintech funds hinges on a multitude of factors, including risk tolerance, resource availability, and strategic objectives. Credit unions with ample resources and a need for strategic alignment may find direct investments more suitable. Those looking to mitigate risk and simplify the investment process may prefer fintech funds.
In a landscape as dynamic as fintech, there’s also a compelling argument for adopting a hybrid approach, blending direct investments for strategic partnerships with fintech fund investments for diversification.
By understanding the intricate nuances, pros, and cons of each investment avenue, credit union executives can make informed decisions that not only align with their immediate needs but also stand the test of time, thereby ensuring a future-proof investment strategy. It is clear that collaboration between technology and financial institutions is increasingly important and is a unique market opportunity.
By delving deeply into each aspect of fintech investment, from financial implications to strategic alignments and from immediate gains to long-term impacts, this guide aims to serve as a comprehensive resource for credit union executives. It’s a complex journey, but one that holds the promise of transformative rewards.
Choose wisely.
** this article is for informational purposes only and is not intended as investment advice. Consult your financial advisor and legal counsel before making any investment decisions, as I am not a registered broker or investment adviser.
