FINTECH CONSOLIDATION IN 2023: 10 THINGS
Shearman & Sterling
Consolidation will be an important foundation for the continued digital transformation of the financial services industry. The FinTech sector is maturing in profound ways, and the search for greater scale and diversification will be a critical driver for firms in the near term. In many cases, consolidation will be driven by a “flight to quality,” as potential investors and buyers, and even consumers, place a greater emphasis on FinTechs with strong legal and regulatory compliance records, including with respect to licensing, consumer data and operational resiliency. Consolidation will take various forms, from traditional M&A to strategic partnerships and investments. While transactions will vary in ways that are reflective of the diversity of the FinTech sector itself, here are 10 things that should be considered.
1. STRUCTURING ISSUES AND FUTURE PLANS FOR THE BUSINESS ARE CRUCIALLY IMPORTANT
The investment in or acquisition of a FinTech business may take a number of different forms, but in all cases, there will need to be thoughtful consideration on how a transaction is structured. Will it be in the form of a minority investment or full acquisition? Will the business be integrated into the buyer’s business or operated on a standalone basis? Are any parties sensitive to “control” issues under specific legal and regulatory regimes? Answers to these questions will drive a number of other important issues, including the appropriate due diligence strategy, the negotiation of certain representations and warranties, and other contractual provisions.
2. ASSESSING “COMPLIANCE CULTURE” AND ADAPTING TO A MORE ONEROUS REGULATORY ENVIRONMENT
Acquirers and investors need to understand a target’s existing “compliance culture” and its ability to adapt to more onerous regulatory requirements. An important task, as part of a larger due diligence effort, is to understand how a FinTech is tracking and complying with all of the rules and regulations to which it is subject. This goes beyond merely assessing whether it is in “good standing” in the jurisdictions where it operates. There needs to be an understanding of how the FinTech views compliance as part of its overall business, and how products and services are reviewed for legal and regulatory compliance.
3. ANTITRUST SCRUTINY OF FINTECH WILL BE INTENSE
As the financial services industry undergoes “massive transformation,” the US Department of Justice (DOJ) is taking on a “muscular” role for antitrust in FinTech. In October 2020, a senior DOJ official identified three areas where it is “leaning in.” First, the DOJ will strictly enforce existing antitrust laws to police the financial markets. Second, the DOJ is updating its modes of analysis. Structurally, it reorganized its Antitrust Division by creating a new “Financial Services, FinTech, and Banking” section. Substantively, it is focusing on two trends: a greater number of transactions involving acquisitions of nascent competitors in emerging technologies and an increasing number of vertical mergers that involve various financial products and services, such as data platforms and infrastructure that are potentially inputs to the acquiring firms’ products. Outside the U.S., the U.K. Competition and Markets Authority and the European Commission have also stepped up their scrutiny of FinTech M&A deals.
4. FOREIGN INVESTMENT RESTRICTIONS MAY APPLY
FinTech transactions may implicate foreign investment restrictions that can significantly delay or prohibit closing. In the U.S., the reach and authority of the U.S. government over what it considers to be “national security” concerns are broad, increasing, and often not subject to judicial appeal. The Committee on Foreign Investment in the United States (CFIUS) may review transactions for the protection of U.S. critical technologies, resources, and infrastructure. The U.K. has introduced new foreign investment restrictions that empower the U.K. Government to intervene in acquisitions in certain areas, including technology and cryptographic authentication. Foreign investment restrictions are not harmonized across the EU, but some EU jurisdictions have introduced regimes requiring tech-related businesses to seek approval
5. FOUNDERS AND OTHER KEY PERSONNEL NEED TO BE INCENTIVIZED
A critical consideration in many FinTech acquisitions will be how to incentivize and retain founders and key personnel. In structuring deals, acquirers should identify those individuals who are critical to the overall objective of the transactions. Incentivizing founders and other key personnel may entail the granting of equity compensation and using “earn-outs”, which make additional consideration contingent on the acquired company achieving certain financial or other performance metrics within an agreed-upon period. In addition, acquirers should consider the feasibility of “non-competes” and “non-solicits” for founders and key personnel.
6. VALUATION MAY BE MORE DIFFICULT FOR FINTECH TARGETS
While FinTechs once commanded significantly higher valuation multiples, as compared to traditional financial institutions, recent economic uncertainty and the prospects for a prolonged global recession have changed things considerably. Parties to M&A transactions should expect more intensive financial and market due diligence.
7. CUSTOMER DATA USES MUST BE EXAMINED CAREFULLY
FinTechs, and the innovative technologies and analytics they are associated with, generate or handle enormous amounts of data. For regulators, financial institutions, and customers, some very tough questions have emerged. Who owns the data? Where is it stored? What rights should customers have over their data? What laws and regulations are implicated when FinTechs interact with data? Careful attention needs to be given to these questions by banks, FinTechs, and private equity and venture capital investors when evaluating transactions. There are no easy answers.
8. SECURITY AND OPERATIONAL RESILIENCE ISSUES ARE PARAMOUNT
FinTechs that have access to personal and proprietary information are attractive targets for cybercriminals to steal valuable data and disrupt critical operations. Acquirers and investors need to probe these issues when evaluating FinTech transactions. Specialized diligence should be made into the history of data breaches and cyber incidents, as well as related governmental enforcement actions and private litigations, as these may materially alter the economics of a deal.
9. DUE DILIGENCE OF IP ASSETS AND KEY CUSTOMER RELATIONSHIPS IS CRITICAL
A FinTech’s value may be rooted in its IP and the strength of its customer relationships. These are two distinct areas that need to be given early attention in the diligence process. Adverse findings may significantly affect deal value. They can also delay a transaction’s closing until resolved or mitigated.
10. REGULATORY CONSIDERATIONS MAY AFFECT DEAL TIMINGS AND NARROW THE SCOPE OF ELIGIBLE BUYERS
FinTechs may engage in activities that are subject to specialized licensing and regulatory regimes. For example, if a FinTech engages in money transmission, lending, loan brokerage, loan servicing, or crypto-asset activities, separate licensing may apply. In any transaction, it is essential that a buyer or investor identify where a FinTech target is licensed.
If it is asserted that a license in a particular jurisdiction is not required, diligence should be conducted to understand how that assessment was made and whether it is correct. In addition, a buyer or investor should understand whether the FinTech’s business plan involves new activities or services that will eventually require licenses and in which jurisdictions.