Any diligence process is challenging. Borrowers are usually juggling their ‘day job’ of running their business whilst simultaneously catering to investor needs for data and information. Investors on the other hand are fully focused on the borrower at this phase, ensuring their potential investment will be a safe and profitable one. Whilst we could discuss the metrics Investors typically use in their assessment, today I’d like to discuss red flags they look for, and how borrowers could potentially negate these if they are aware of them ahead of time.
Some aspects of fintechs are proprietary meaning the fintechs understandably will want to keep them secret. From a commercial point of view, if the fintech’s founders have discovered a new, better way to do things i.e. process some form of information into better decisions, then it is only natural to not publish this openly as they could give away their competitive advantage. On the contrary, there are aspects that should be openly and willingly shared with potential investors. If the fintech company is under an NDA and you are asking for millions of dollars from a potential investor, it is only fair that certain information i.e. finances, bank balances, default rates (more on this later), collections practices etc etc are shared. A legitimate company wants to tell its story, attract investors, and build trust.
Counter: If you as a borrower have legitimate concerns about sharing a particular type of information, share your concern openly with the potential investor. Usually there is a work around and by being transparent you build rapport.
Defaults and non-performing loans (NPLs) are inevitable in lending, but their numbers tell a tale. Consistently high NPLs, particularly if accompanied by weak explanations for improvement, point to a flawed business model or poor risk management. Conversely, beware of suspiciously perfect NPL rates. If NPL is zero, either you are not taking enough risk, or you are lying. Either way is a net negative.
Counter: Be transparent about your NPLs. If they are too high, have a thorough explanation as to why and what steps have been taken to ensure this doesn’t happen in the future. Early stage lending businesses can have high NPLs as they try certain segments or policies and this can be easily explained.
A company touting itself as an ethical, green lender with a portfolio stuffed with fossil fuel investments? Do you state you have 16 types of collateral but in reality only have 3? Alarm bells should be ringing. Such inconsistencies expose a disconnect between slogans and reality. Investors will be looking for the data to align with the statements in the pitch deck. If they don’t, they will walk away.
Counter: Ensure you can backup any marketing material during diligence. If you are not a green lender, then say so. There are investors available for myriad types of loans and industries. Misspeaking in your marketing to them will only ensure you waste time with the wrong ones.
Lofty projections are seductive, but base your decisions on grounded realism. Can a company realistically double its user base in a saturated market? Does their expansion plan defy industry logic? Is the user base going to outgrow the entire population of the country in which they operate? Note - I’ve seen this last point!
Counter: Make sure your projections are backed by some form of data and reason. Have expected clients/users and market penetration rates mapped out. I have witnessed fintech’s grow exponentially so lofty projections are not an issue if they can be backed by solid rationale.
Fintech may be tech-driven, but the core remains finance. Knowledge of lending practices, from underwriting to collections is a key driver of success for these businesses in their markets. Investors will always look for Borrowers who have a solid experience of doing their particular type of lending.
Counter: Is your management team lacking lending experience but you cannot afford to hire experienced former bankers? Several fintechs have solved this issue in their early stages by hiring strong part-time advisors who can help establish policies and procedures to get the business running. The added bonus is usually once you are ready to hire senior management, your advisor will likely have strong candidates from their network for you to choose from.
The goal for investors is to understand the rationale behind the red flags and assess their long-term implications. The quicker you can do this, the better your diligence process will be.
Lastly, whilst you will never see this written in an investment memorandum, a red flag you should be wary about is the investors gut feeling. The individual who proposes the deal to their internal investment committee is oftentimes taking some form of career risk in doing so. If a deal turns out to be a complete scam, the investment officer can have their employment terminated. And so, for an investment officer to commit to go through the weeks of work; interviewing, analyzing, modeling, writing reports and recommendations, they usually need to have a good feeling about the fintech. If you were in their shoes, would you waste your time with a borrower who gave you the heebie jeebies?