Fintech for Underbanked: The Next M&A Hot Spot?

Think the onset of consumer protections laws stymied M&A for companies who serve the underbanked? You're wrong.

Between July 2012 and June 2013, there were 85 investment banking transactions involving companies in the financial technology and specialty lending realms that focus on consumers with low-to-moderate incomes, according to a study released Wednesday. The authors are the Center for Financial Services Innovation and Core Innovation Capital, a $50 million venture capital fund that specializes in the underbanked market.

The data show the acquisitions, initial public offerings and equity investments had a combined value of $5.2 billion in capital.

The study, which was sponsored by Morgan Stanley, was the authors' first on this topic, so it is unclear if the activity in the year leading up to June 30 rose or fell from past years. That kind of assessment is for next year — this year's report was about defining the size of the market, they say.

"This is a space we are newly defining," says Arjan Schutte, founder and managing partner at Core. "Take payments for instance. Payment overall have been heating up for years now. We are drawing a new circle in a Venn diagram across various types of companies that serve a similar customer base."

The low-to-moderate income market is a complex one for financial companies. Those involved tend to fall into two buckets — missionary or mercenary. The aim of the study is to attract participants from the middle ground between those two extremes, the authors say. They seek companies and investors who want to provide responsible financial products to underbanked customers while still turning a profit.

"We believe in a market-based system," says Rob Levy, director of research for CFSI, a research and consulting organization. "The [financial services] industry doesn't understand or value this market and that's why we did the study — to explain the need. Less competition enables the lower quality providers to own the space. The more good companies that get in, the more competition there is and the better the products will get."

A Morgan Stanley official echoed Levy's sentiments in an email. "By supporting research on the financially underserved, we hope to create opportunities to accelerate financial inclusion in innovative, market-based ways," says Audrey Choi, head of Morgan Stanley's global sustainable finance group.

In the years following the subprime meltdown, there has been an attempt to put in safeguards to prevent predatory practices — the most notable, of course, was the creation of the Consumer Financial Protection Bureau. Although the agency, given its sweeping jurisdiction, would appear to scare off companies from entering the mark, Schutte says it could actually inspire more M&A. The startups have been working with the agency since their inception; that existing relationship is attractive to a buyer like a big bank.

"It is tough for a big institution to change their product to be in-line with the regulatory changes," Schutte says. "But a new company that has been talking to CFPB since day one has cracked the code; that's attractive."

The types of companies involved in the transactions vary. The activity was broken down into three categories: specialty credit, which includes small-dollar loans, small-business loans, private student loans and subprime auto loans, made up 42% of the transactions; payments, which include prepaid cards, remittance and bill pay, made up 33%; and other financial technology, including personal financial management tools, alternate data analysis and savings products, made up 25%.

There were 71 equity investments, 11 acquisitions and three IPOs. The sector has piqued the interest of private equity; 84% of all the transactions involved PE. Its investments totaled $947 million.

"This might not get the attention of Twitter's IPO, but a lot is happening," Levy says.

For other players in the underbanked sector, the study's findings were a bit of a mixed bag.

On one hand, the study signals that despite the fighting over economic policy in Washington, "economic activity is rebounding in African-American, minority and low income communities," William Michael Cunningham, social investing advisor of Creative Investment Research, said in an email. "Unfortunately, this has attracted the attention of a group of hyper greedy 'private equity.'"