Fintech companies fill the gaps that banks left open, said LMP’s Steve Pierson

Lovell Minnick Partners has invested in the fintech and tech-enabled services markets for over 20 years. Last month, the Radnor, Pennsylvania-based private equity firm made a significant investment in STP Investment Services, a tech-enabled investment operations service provider. PE Hub asked LMP managing partner Steven Pierson to share his thoughts on the STP deal in particular and on investing in fintech companies in general. Pierson joined LMP in 2016, chairs the firm’s partner committee and serves as a member of the investment committee. He came to LMP from UBS, where he served as the head of FIG investment banking Americas and global head of financial technology and services.

What’s driving private equity-backed deals in fintech?

If you look at the financial services market 20 years ago, you’ll see that it was centered around and controlled by banks delivering proprietary technology and services to the marketplace. Due to the financial crisis, followed by capital constraints and decreased tech spend, banks have struggled to make notable improvements to their tech and tech-enabled services. This inability to adapt, while other sectors have dramatically raised consumer expectations, has left the door open for innovative software developers and fintech platforms to fill the gap by providing a better solution to the end client, as well as complete internal tasks far more efficiently than in the past.

Alongside the rise of innovative technology and market participants outside the banks, there is a continued trend to outsource non-core functions to specialized service providers. This outsourcing trend can be attributed to incumbents wanting to focus on their core offering, stringent regulatory requirements requiring specialized (often quite expensive) knowledge, and internal efficiencies/margins that can be gained from outsourcing.

Today, financial services represents just 10 percent of US private equity investments, but players in the space are increasingly seeing this technological transformation occur across the entire fintech value chain and backing businesses sitting in the middle of these trends, while also benefiting from an extremely large total addressable market.

What is LMP’s investment thesis in fintech?

We have been investors in the fintech and tech-enabled services markets for over 20 years, which has allowed us to witness first-hand the aforementioned transition in the industry. We back income statement-driven and asset-light fintech companies that are offering a mission critical Business-to-Business (B2B) services. When exploring investment opportunities, we look for businesses that have strong growth fundamentals including sustainable revenue growth, scalable gross margins, and profitability. For example, we average ~25 percent YoY revenue growth at entry for Fund V portfolio companies and almost all of them have very material recurring/re-occurring revenue models.

The ultimate driver of a fintech business is very much dependent on the end-industry and because of how large the fintech ecosystem is, investing requires in-depth sector knowledge and a laser-focus on certain sub-sectors to build theses and properly appreciate the drivers of growth. We believe our vast experience and network across the payments, asset/wealth management, insurance services/insuretech, and capital markets tech spaces allow us to identify market leading fintech companies in these respective industries that are set to benefit from market tailwinds.

Our primary focus areas are payments companies, vertical software with a back-office angle, mortgage/real estate technology, data and analytics businesses, risk and compliance companies, and technology for the wealth/asset management ecosystem.

How does the recent acquisition of STP fit the investment thesis? 

STP is an end-to-end, technology-enabled investment operations service provider that fits squarely within our fintech and business services investment thesis, focused on the adoption of outsourcing non-core functions for asset and wealth managers. Other investments that have fit this theme include AssetMark, ALPS, Deep Pool & Foreside.

Having invested in over 30 asset managers, wealth managers, and technology and outsourcing providers serving the investment product value chain, we have a deep appreciation for the operational challenges that investment managers face in today’s market environment. Fee pressures, compliance burdens, increasingly complex and competitive operating environments, and the rising penetration of outsourced solutions all represent tailwinds for further adoption of the technology-enabled services that STP provides.

How does LMP expect to grow STP?

LMP is focused on growing STP through both organic and inorganic strategies, including expanding the sales and marketing functions to meet the opportunity of a large addressable market and M&A. The company has made four acquisitions to date without institutional backing, so we are thrilled to work alongside the team to support their acquisition strategy and help add new capabilities and clients.

What are the exit opportunities for fintech companies today?

Given the robust interest in the space, there are a number of exit strategies for fintech companies. Larger fintech strategics who are looking for new technology solutions to expand their product set or enhance their client roster may acquire a smaller fintech company. Banks are also becoming more aggressive acquirers of fintech companies given that the industry has traditionally underinvested in technology for the last 20 years.  Private equity funds, of course, are also highly focused on this area, and sponsor-to-sponsor trades are relatively common these days. Finally, there’s the IPO route, which we’ve seen used more in the last year and a half.

At LMP, we invest in mid-market companies, so we typically exit fintechs by selling to larger fintech strategics or another private equity fund that can help lead the company through its next phase of growth. For example, we recently had a partial realization of Inside Real Estate, which saw Genstar join LMP as an equal financial partner alongside us in the company.

How are rising interest rates, record-high inflation, supply chain shortages, labor challenges and the invasion of Ukraine affecting LMP’s portfolio companies?

Our portfolio doesn’t have any direct exposure to Russia or Ukraine, so the macroeconomic environment plays more of a factor in our strategy and how our companies perform.

Candidly, inflation and rising interest rates generally have a slightly positive effect on our portfolio in a direct sense, as higher prices mean higher volumes and thus higher processing revenue, particularly for our payments businesses. Further we have businesses in the portfolio that are biased to raising rates. Leverage is generally not a contributor to returns for us and most of our companies are materially under-levered relative to what is typically available so a rising cost of debt is not typically a concern with the majority of our companies.

Supply chain shortages also don’t have too large of an impact as our portfolio companies offer software, tech-enabled or human capital delivery models and do not have an inventory cost of goods sold. One of our businesses, LSQ, provides invoice and supply chain finance tools to enterprise and mid-sized companies that help free up trapped working capital, which has become more important in the current environment.

The labor challenges (both rising costs and tight hiring markets) that have persisted have had the largest impact on LMP’s portfolio companies over the past 12 to 18 months, but our portfolio companies have been able to successfully combat this by hiring in smaller markets, moving software development to offshore locales and enabling a more hybrid remote working approach.

Going forward we’ll continue to invest in growth orientated fintech businesses that exhibit strong financial fundamentals, have a large/expandable end-market, provide a mission critical tool set and offer an opportunity for consolidation. These types of businesses have served us well in our 20+ year history in the financial services sector.