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Most of the excitement around fintech as an investment theme is focused on the disruptors that are trying to destroy legacy financial providers. But the incumbents aren’t just standing still as the world evolves around them. In fact, many fintechs are providing technology and solutions that improve incumbent competitive positioning rather than trying to disrupt them. We think the incumbents’ efforts to maintain market share, and the fintechs that are facilitating their fight against disruptors, drive attractive investment opportunities.
The financial services industry’s technology infrastructure is old, innovation-stifling, and expensive to maintain. Though the need for upgrades predates the COVID-19 pandemic, the crisis has highlighted the many benefits of cloud infrastructure, including its adaptability, resilience, and ease of access versus legacy on-premises technology. Financial institutions with more modern technology have been able to respond better to a more digital customer and an increasingly remote workforce.
We believe legacy financial services companies need to continue to upgrade their technology to experience the improvements in innovation, security, and efficiency that can help them fight back against disruptive technology companies entering their end markets. As companies realize this need, we are finding intriguing opportunities fueled by firms that offer legacy financial companies more modern technology infrastructure, business applications delivered via the cloud, and more and more data-driven insights and analytics. In this piece, we explore this fast-growing opportunity set, the key markets driving the opportunity, and an example of the virtuous innovation cycle this technology can create.
A long and compelling runway for growth
For many, it may be surprising to discover just how long financial services firms have to go on their journey to modern technology infrastructures. Legacy companies have been hesitant to upgrade their technology because, though it offers substantial benefits, their existing technology assets make the transition complex, risky, and expensive. Figure 1 notes that over 50% of banks still have core IT systems built in the 1970s and 1980s. Moreover, more than 65% of “workloads” — data, computer processes, and business applications — are still on premises and not in the cloud. In our view, this presents a massive, long-term opportunity to capitalize on this transition.
The markets driving the tech infrastructure opportunity
In large, developed markets like the US and Western Europe, banks have had to spend tens of billions of dollars on technology and processes since the global financial crisis. Importantly, we believe this spending was primarily to satisfy regulators and clean up back offices. However, we are now at an exciting tipping point where banks in these markets are looking to compete with new fintech entrants. They are therefore beginning to redeploy that spending to drive growth.
In our view, incumbents in both developed and emerging markets will increasingly see the need to transition to cloud-based infrastructure to capture future growth opportunities and protect their business from disruptors looking to take share.
Technology infrastructure upgrades in practice: Data-driven innovation
We believe cloud-based infrastructure and advancements in analytics capabilities offer financial services companies the ability to fight back against aggressive disruptors entering their markets. For example, financial services firms have been able to lean on their relationships with credit bureaus to unlock more value from data and leverage modern technology to analyze their businesses in novel ways.
Data and analytics are in many ways the picks and shovels of the financial industry and we believe the credit bureaus own and operate some of the most valuable picks and shovels in the world. There are only three global scale credit bureaus in the industry. Each has a vast amount of unique consumer data that they leverage to provide insights to their customers. They are key providers of the tools that enable smart underwriting, effective marketing, and ongoing customer relationship management.
Credit bureaus have collectively spent billions of dollars on IT infrastructure to enable faster access to data for their clients. They have teams of data scientists that leverage the latest machine learning/AI technologies to find new relationships in the data and can sell those insights to their customers. In some ways, credit bureaus are extensions of these financial institutions’ data science and analytics departments, enabling them to better understand both their customers and their businesses. The bureaus’ ability to analyze data at scale and unlock unique insights has allowed them to expand their customer base beyond financial institutions to telecoms, utilities, health care companies, and even the fintechs that are disrupting their original customers.
When we are evaluating data services businesses, the two key vectors we analyze are the uniqueness and extensibility of their data. The three credit bureaus’ in-depth credit data files on consumers are incredibly distinct assets. And because of their core underlying data assets’ sensitivity, we don’t believe there will be another credit bureau created in the future. The uniqueness of that data, and the fact that we think this feature will endure, provides the credit bureaus with high barriers to entry and competitive differentiation.
In our view, the bureaus also rank favorably on data extensibility. We think their use of data can create a virtuous flywheel of growth over the long term. By offering new data and new insights to customers, the bureaus are able to harness new revenue streams to acquire or build other unique data assets. These can then be used to break into new verticals and add even more value to their existing customers. Employment data, telecom and utility payment data, and fraud/online identity data can all fuel the positive flywheel of adding value to customers, generating compelling returns based on that value add, and leveraging those attractive returns to reinvest in other high-return assets to drive the flywheel all over again.
Additional benefits: Greater security, more efficiency
Importantly, innovation and improved insight are not the only benefits to investing in technology. For example, in no industry is cybersecurity more important, in our view, than in financial services. And contrary to popular belief, companies with workloads in the cloud are more secure than those with data on-site.
Furthermore, using legacy on-premises technology built over 30 years ago is costly to maintain and inefficient for companies to use. Moving these processes to the cloud is helping banks automate tasks that were previously done manually, increasing straight-through processing and reducing both costs and errors.
Firms that make these investments can improve customer service, increase their understanding of their businesses, and ultimately drive better financial performance — all while improving security and efficiency.
Fintech infrastructure opportunities in 2021 and beyond
The COVID-19 pandemic highlights the importance of technology, data, and cloud-based company operations. Increased investments in cloud infrastructure and data analytics technology were trends that had enormous long-term potential before the crisis. But the largely remote workforce in recent months has accelerated those trends by highlighting the many benefits these technologies offer in an increasingly digital world.
Perhaps most intriguingly, we believe these technological transitions still have many years to run. There is still a huge portion of the industry operating on legacy technology and we believe incumbents will increasingly see the draw of cloud infrastructure’s data-driven innovation, security, and efficiency. The pandemic is only fueling the sense of urgency among financial services companies to invest to stay competitive, powering the growth of this trend.