#Venture capital#Fintech#Risk management

Risk management: funding an optimal vision of fintech

Market, technical and regulatory factors are integral to good risk management in fintech. Here, we explore best-practice for venture capitalists

|Oct 12|magazine16 min read

Venture capital (VC), whether conducted by individuals or firms, can provide opportunities for some of the newest and most exciting tech-based companies in the world to get a foothold in the market and drive fast-paced expansion across the globe. 

Companies like Alibaba and Chinese fintech Qudian break the mould by driving both anticipation and engagement with their platform and subsequently delivering significant returns to investors within a relatively short time frame - Qudian managed to raise USD$900mn after going public in 2017, an impressive feat for a company founded only four years prior. However, while fintechs can sometimes exceed all expectations, this isn’t to say that VC doesn’t carry inherent risks. 

After all, startups by their very nature are often helmed by inexperienced entrepreneurs, initially have little to no market recognition or sales traction and usually require careful guidance to lead their product or service from conception to implementation. Despite this, VCs can still be captivated by an enticing idea or proposition and commit potentially millions of dollars to developing it. As such, strong risk management practices are essential to ensure that firms deploy their funds in the most optimal way. 

Know operational regulations

“For us, no idea is too early: our door is always open. We want to be your partner in the first round. Then be there for multiple rounds. We’re long-term, patient partners. With you through the cycles,” says Australian VC firm AirTree, which recently provided startup Open with AU$3.1mn (US$2.2mn) in top-up funds. Getting involved with prospects at an early stage and in a holistic manner can be an effective method for stymieing elements of investment risk, particularly in the highly regulated finance and insurance sectors. 

Moreover, in its article ‘Value and resilience through better risk management’, McKinsey & Co adds that a comprehensive understanding of the regulatory framework within which a company operates stands the investor in good stead to anticipate larger issues: “Geopolitical uncertainties alter business conditions and challenge the footprints of multinationals. Corporate reputations are vulnerable to single events, as risks once thought to have a limited probability of occurrence are actually materialising.” 

Regarding the latter point, policy and necessary operational changes resulting from the COVID-19 pandemic could be cited as an example. In such eventualities, BCG cites the importance of capturing and analysing market data constantly in order to gain insights into what new products and services are experiencing positive gains. Such an approach could require additional VC investment in AI (artificial intelligence) or ML (machine learning) data analytics tools, which, although initially incurring upfront costs, could ultimately save money through better market forecasting and less negative investment.

BCG’s ‘10 principles of risk management

  1. Risk management should start with senior executives
  2. Risk management is a collaborative process
  3. Avoid overreliance on complex metrics or models
  4. Strategy and risk management should be interchangeable
  5. Far from just being corporate policy, risk management should be crystallised in a company’s culture
  6. Information should be freely available to facilitate a fast response
  7. Active discussion is better than reliance on ‘reports’
  8. Rather than seeking an end goal, risk management should be viewed as a never-ending journey requiring constant development
  9. It is possible to prepare for unknown risk factors
  10. Plan for the worst but hope for the best - i.e. don’t be entirely dissuaded from an investment specifically because there exists some element of risk

Scale appropriately

In July 2019, ‘impact investment’ startup Swell Investing officially announced that it was closing after just two years in operation. The company’s official statement declared that it had failed to “achieve the scale needed to sustain operations in the current market." Investors were subsequently given until mid-August 2019 to withdraw their funds. According to CBInsights, VC Pacific Life Insurance had already invested $30mn into Swell prior to its closure. Given the company’s own admission that scaling issues were at the heart of its problems, VC firms should consider the principle value drivers of their investment, such as products addressing a common FSI (financial service institution) tech problem, services of relevance to changing market conditions, or the ability to provide an exceptional customer service experience. 

Recognising opportunities for collaboration and developing partnership networks within fintech can redress the balance for those experiencing issues with scaling. PwC’s 2017 Global FinTech report, which it revisited in 2019, highlighted that symbiotic collaboration within different elements of finance has grown because “startups realised they didn’t have the scale or customer trust to compete with long-established FS (financial services) organisations head-on, while FS looked to fintech partnerships to help strengthen operational efficiency and boost innovation.” 

Understand the technical risks

Although a desire to invest in the latest technology and digital tools is often what motivates most VCs, they must nevertheless be careful to thoroughly understand the methodology and application of innovations instead of just their potential benefits. Has the tech startup created a product or service which fulfils a core need in the market or is it simply working with an exciting but currently impractical technology? Additionally, when innovations are genuinely disruptive they can fundamentally alter FS norms and therefore must be scrutinised for weaknesses, regulatory compliance breaches or implementation issues..

This has particular relevance to banking, specifically digital banks (neobanks, challenger banks, etc) like Revolut, N26 and Monzo, although it is also invariably true of traditional banks upgrading their tech infrastructure. Posing enticing targets for cybercriminals, VCs must consider that banking startups need solid system architectures. 

McKinsey states in ‘’The ghost in the machine’: Managing technology risk’: “Many banks now find that [new software and systems] are involved in more than half of their critical operational risks.” When attacked, the consequences can be severe for the bank, its customers and stakeholders; common targets include “the disruption of critical processes outsourced to vendors, breaches of sensitive customer or employee data, and coordinated denial-of-service (DDoS) attacks.” 

No investment is without risk; in fact, it is the ‘untested’ nature of some fintechs which makes them such an exciting prospect. However, VCs must always be cautious and thoroughly consider the appropriate technical, regulatory and market considerations before funding commences. Doing so not only protects the firm and saves money from being lost but ultimately ensures that consumers are receiving optimal financial services experiences. VCs can be pivotal in shaping the trends of the fintech landscape as it gradually adjusts to a post-COVID-19 world. Adequate VC risk management will help ensure that, whatever tech-enhanced vision of financial services emerges, it is a profitable venture for everyone.

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