Banks’ investments in fintech ventures

Journal of Banking & Finance
Volume 149, April 2023, 

Banks’ investments in fintech ventures

Author links open overlay panelEmmaLi^bMike QinghaoMao^bHong FengZhang^bHaoZheng^a
https://doi.org/10.1016/j.jbankfin.2022.106754

Abstract

We investigate the patterns and performance of banks’ investments in fintech ventures in the United States. We document that banks, as compared to independent venture capitalists (IVCs), invest a larger proportion in fintech startups and achieve a higher IPO exit rate. The better exit performance is neither explained by banks’ tendency to invest in later-round or larger deals, nor contributed by banks’ following successful peer IVCs. Banks’ outperformance is mainly concentrated in fin-native fintech startups and those whose business operations overlap with banks’ core business segments, which is consistent with the corporate venture capital (CVC) literature and the conjecture that banks possess unique industry expertise that facilitates their selection of fintech startups. In addition, banks participate more on the boards of fintech startups than of other ventures, implying that the better investment performance is not purely driven by selection.

Introduction

The role of banks as equity investors is an important topic for financial economists and regulators (e.g., James 1995, Jiang et al. 2010). Recent studies investigating banks’ investments in the venture capital market document that banks do not outperform independent venture capitalists (IVCs) in general venture investment. Rather, banks primarily pursue strategic purposes, such as building lending relationships with startups (Hellmann et al., 2008), or cross-selling other banking services to them (Fang et al., 2013). While prior studies mainly cover banks’ investments in general technology startups (e.g., information communication technology (ICT) or biotechnology), we focus on their investments in a particular group of targets, i.e., financial technology (fintech) startups, which are established to either substitute for or complement banks’ functions in the financial markets. Based on the corporate venture capital (CVC) literature (e.g., Gompers and Lerner 2000), banks’ industry knowledge in fintech startups could potentially help improve their venture investment performance and therefore can serve as an additional motivation for why banks invest in fintech ventures.
Advances in fintech during the past decades have dramatically reshaped the traditional banking sector. For example, the introduction of Internet banking in the 1990s and contactless payment in the 2000s have improved banks’ operational efficiency and made banking services more accessible. These fintech advances are mostly complementary to banks’ existing functions. Conversely, other fintech innovations potentially trigger substitutes in banking and therefore bring disruptions to the incumbent banking sector. In particular, large tech firms are increasingly expanding their products into traditional banking services, while technology-focused startups are also entering the financial industry at an unprecedented speed (e.g., Vives 2019, Allen et al. 2021, Boot et al. 2021). According to Crunchbase Industry Spotlight, total funding of fintech companies has grown more than ninefold since 2010, with US$43 billion of fintech investments reported in 2019 alone.¹ Notably, large banks such as Citigroup and JPMorgan Chase & Co. have all ramped up their investments in fintech startups.² According to a recent S&P Global report, even during the Covid-19 pandemic, major European banks have continued their investments in the fintech space, while the overall financing from general VCs have dropped.³ The booming interest from major banks in investing in fintech startups calls for a better understanding of banks’ equity investment in this particular type of startups.
Our paper is one of the earliest studies on banks’ interaction with fintech startups through the venture capital market. Bellardini et al. (2022) investigate how banks finance fintech startups in advanced economies. They examine banks’ choice of equity versus debt in financing fintech startups and its determinants such as startups’ specialization. Hornuf et al. (2020) use non-U.S. data and find that, in response to the growing fintech market, banks choose to form alliances either through investment or product-collaboration with fintech firms. Different from these two studies, our paper is focused on banks’ venture investment performance, which is still one important missing piece in the literature. On the one hand, the CVC literature would predict banks’ use of industry expertise to enhance fintech investment performance (Gompers and Lerner, 2000). Prior to the advent of many fintech startups, the industrial nature of traditional tech-oriented startups may limit banks’ ability to utilize their expertise to improve investment performance (Da Rin et al., 2011; Bertoni et al., 2015). On the other hand, prior studies show that banks’ investments are mainly for strategic purposes rather than for financial gains and the exit outcome of bank investments in general startups is no better than that of the investments by IVCs (Hellmann et al., 2008; Fang et al., 2013). It is also possible that traditional banks may strategically take equity stakes in fintech startups as a future-proofing strategy in reaction to the competition in fintech investments when big tech companies become new entrants to the financial industry (Stulz, 2019; Vives, 2019). Our study aims to address the tension between the two hypotheses and shed light on banks’ motivation to invest in fintech startups.
Using the Crunchbase datasets for startup financings from 2000 to 2018 in the United States and restricting our sample to only first hand-shake equity investment by an investor in a startup, we compare the average investment portfolio of a bank with that of an IVC. We find that around 10% of banks’ investment targets are fintech startups compared to only 6% for IVCs. Following the VC and entrepreneur financing literature, we measure investment performance using IPO exit rate which is widely accepted as the best proxy for financial returns of venture investments (Barry, 1994; Black and Gilson, 1999).⁴ Univariately, the IPO rate of banks’ investments in fintech startups is about 10.9% compared to only 3.6% for IVCs. In a multivariate setting after controlling for investment-level characteristics and investor experience, we find that banks’ investments in fintech ventures are associated with around a 4% higher IPO rate compared to IVCs’, while banks do not differ from IVCs in the performance of general venture investment (e.g., Hellmann et al. 2008, Fang et al. 2013). The results are economically significant, given that the average IPO exit rate in our whole sample is around 7.5%. Our findings demonstrate that the rise of fintech startups could bring new investment opportunities to banks as venture investors and highlight that the superior investment performance can be another motivation in addition to strategic reasons previously documented.
To better understand the mechanisms behind the outperformance of banks over IVCs in fintech investments, we explore several alternative explanations. First, banks could appear to be more successful simply because they tend to initiate investment in later-round and larger deals. We rule out this explanation by documenting robust results when restricting our sample to only later-round deals and to only larger-amount deals. In other words, banks’ outperformance is not likely to be driven by their unique investment patterns. Second, banks could follow other successful IVCs in selecting fintech startups. To examine this possibility, we restrict the comparable IVC benchmarks to those who have jointly invested with at least one bank in at least one fintech “first hand-shake” investment round. The results remain robust, which suggests that banks’ outperformance is not because they mimic or follow equally successful IVC investors’ investments. Third, we conjecture that banks’ industry-specific expertise could contribute to their superior performance in fintech investments. Consistent with this, we show that banks’ outperformance is mainly from the investments in fin-native fintech startups that specialize in financial services. Besides, we also examine other forms of investment exits. We find that fintech investments by banks are less likely to exit via acquisitions and find little difference in the write-off rates between banks’ and IVCs’ fintech investments.
In addition, we examine whether banks act beyond simply being an investor in the fintech startup space. Naturally, one may predict that banks favor fintech startup investments because they can actively engage in the management of fintech startups. Based on our subsample of startups that were invested in by banks and eventually went public in the U.S., we compare banks’ probability of taking a board seat, becoming a principal shareholder, or serving as an IPO underwriter between fintech ventures and other startups within their investment portfolio. We find limited evidence that banks are more likely to join the board of fintech startups than that of other startups, demonstrating that banks take a more active role in monitoring and assisting the fintech startups. Taken together, our evidence suggests that banks are more likely to extend their industry expertise to the fintech VC market, which facilitates their investment performance.
Our study contributes to several strands of the literature. First, our findings complement the studies on the incentives of banks for making venture investments. Before 1990s, equity investments by banks were subject to strict regulations.⁵ In 1999, the Gramm-Leach-Bliley Act was passed to allow banks to engage in private equity investments. In 2020, the Volcker Rule was relaxed to further ease banks’ venture capital investments. The role of banks as both traditional lenders and, more recently, as equity investors is an important topic because banks play a critical part in the operation of the financial system. Prior studies document that banks enter the VC market to expand business opportunities. Gompers and Lerner (1999) investigate the conflicts of interest when investment banks are also pre-IPO investors of their underwritten firms. Hellmann et al. (2008) find that banks use venture investment to build the subsequent lending relationships. Dimov and Gedajlovic (2010) compare different types of VCs and suggest that bank-backed VCs have the most diversified portfolios and are more concerned with the benefit they can get by leveraging their business opportunities into venture investment. Fang et al. (2013) show that banks are more likely to be involved in the private equity market during credit booms so that they have more cross-selling opportunities. Our study is the first, to our knowledge, to show that banks’ performance in fintech startup investments is different from that in general venture investments. Consistent with the CVC literature, banks’ industry insights facilitate them in selecting successful fintech startups, which provides one potential motivation why banks show strong interest in this venture market.
More broadly, our findings add to the discussions on the challenges and the opportunities to banks posed by fintech firms (e.g., Stulz 2019, Vives 2019, Thakor 2020, Allen et al. 2021). Fintech firms compete with banks for market share in banks’ traditional business areas. For example, fintech lenders have technological advantages in processing non-traditional information and accessing a broader customer base, while facing less stringent regulations (e.g., Buchak et al. 2018, Tang 2019, Berg et al. 2020, de Roure et al. 2022). Fintech payment providers disrupt banks’ established payment business through payment innovations and weaken banks’ information advantage about consumers (e.g., Rysman and Schuh 2017, Parlour et al. 2020). Robo-advisors are widely used as a low-cost substitute of traditional human financial advisors (e.g., D'Acunto et al. 2019, Hodge et al. 2021). On the other hand, fintech firms prompt banks to speed up their adoption of new technologies and to enhance their existing products and services (e.g., Navaretti et al. 2017). Our study adds evidence to this literature by documenting that the rise of fintech startups presents banks with the unique opportunities to finance and benefit from the growth of fintech startups. With a vast number of digital entrants into the banking industry, banks can leverage their competitive edge in their core business segments to invest in the fintech startups with high-growth potential.
Finally, our study contributes to the growing literature focusing on the impact of non-traditional investors including CVCs, BVCs, mutual funds, and hedge funds in the VC market (e.g., Gompers and Lerner 2000, Hellmann et al. 2008, Aragon et al. 2018, Kwon et al. 2020, Chernenko et al. 2021, Huang et al. 2021). Prior literature documents that CVCs can select and add value to investees, especially when strategic alliance presents between the company and its start-up portfolio firms (e.g., Gompers and Lerner 2000, Maula and Murray 2001, Ivanov and Xie 2010). In line with this literature, our paper shows that banks can select better fintech start-ups based on their industry expertise. Besides, banks also add value to fintech start-ups through monitoring via participating on the board of fintech start-ups. Other non-traditional VC investors also demonstrate various kinds of strength in their investment. For example, mutual funds enable companies to stay private longer and therefore postpone many of the costs associated with public listing. They also earn positive abnormal returns by investing in private firms (Kwon et al., 2020). Documented by Aragon et al. (2018), hedge funds’ industry-specific investment experience in the public market helps enhance the performance of their venture market investments. In addition, Huang et al. (2021) find that institutions' ownership in startups reduces IPO under-pricing, which facilitates VCs’ exit in the secondary market. Our study complements this strand of literature by underlining banks’ specific industry expertise in enhancing their performance in fintech startup investments.
The rest of the paper proceeds as follows. In Section 2, we describe the data and variables. We present the findings in Section 3. We conclude in Section 4.