Impact of reversal in interest rate cycle on Fintech investments
What prompted reversal in interest rate cycle?
With an intention to minimize the economic impact of the COIVD pandemic, central banks around the globe, through various fiscal and monetary measures, kept up an extended period of favorable interest rates, ample liquidity supply and an overall accommodative stance[1].
However, there are factors beyond the reach of Central Bank’s actions which are playing spoilsport. For example, there are supply side disruptions caused due to raw material shortage and global supply chains getting impacted due to the pandemic, resulting in a demand-supply imbalance. There are also views that relief packages such as the American Rescue Plan Act has put too much money in the hands of people, driving demand for products in a big way, further stressing such mismatches. Geo-political situations such as the Ukraine war have also pushed up prices of commodities such as the oil.
All these led to a situation of inflation (‘general price rise’), impacting the common man in terms of his/her ability to buy basic goods such as groceries and food. As an illustration, US inflation hit the highest level in 40 years as prices rose by 7.5% in 2021[2]. This has also put a lot of political pressure on the ruling governments to control the runaway prices.
Central Banks are under a pressure to ‘tame’ the inflation and provide a ‘soft-landing’. As interest rate hikes are one of the established weapons in a central bank’s armory, the hikes are being resorted to, starting later part of Q1 2022. For example, US Fed Reserve increased the interest rates by half percentage point, likewise Reserve Bank of India followed it up with a 40 basis point hike.
How could it impact the VC investments, especially into Fintech?
Global Fintech investment was estimated to be at a record USD 141 billion in 2021, almost tripling from 2020 levels of USD 45 billion[3]. Another report suggests that $1 in every $5 of global venture funding went to Fintech in 2021.[4] This trend is expected to undergo a sharp correction in the coming year for the following reasons:
* Impact on profitability: Many fintechs have taken debt on their books, as part of their fund raising. For example, Block Inc had 4.5 billion dollars of debt as of December 2021. An increase in interest rate would be mean higher interest outflow, ultimately impacting the profitability.
There could be a double whammy impact on fintechs which are into the lending business. On one side such fintechs could see a compression of net interest margins (interest inflow minus interest outflow), while on the other side there could be higher bad loans as well, especially in segments such as retail.
* Impact on customer demand: Again, fintechs which are into the lending business are measured by metrics such as loans disbursed, especially in the retail segment, could face a subdued demand due to higher interest rates.
* Impact on valuations: Stocks of US Fintech lenders were down 30% during Q1 of FY 2022. Likewise, valuations of some of the large listed fintech players like RobinHood, PayPal and Block were down by more than 20% during the same period. Arguably, this is the after effect of impending rate hikes which the market is factoring in. This could translate into depressed sentiments for any further fund raise for existing as well new firms. Getting fresh funding could prove tougher as investors would raise the bar for deploying funds in a depressed market.
* Alternative Investments: With increase in interest rates, alternate investments such as fixed income may be become more attractive, given a risk-reward expectations and investments may get channeled towards such instruments.
In the coming year, the optimism/over zealousness displayed by the investor community is expected to temper down. They can be expected to take a very cautious approach. This may not impact fintech players with proven track record; but the ones with unproven capabilities/business models can be ones who would get most impacted.
References:
[1] https://www.federalreserve.gov/supervisory-regulatory-action-response-covid-19.htm
[2] https://www.theguardian.com/business/2022/feb/10/us-inflation-reached-highest-level-40-years-january
[3] https://ftpartners.docsend.com/view/x3bgig5qz43f2pd5
[4] https://www.cbinsights.com/research/report/fintech-trends-2021/