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Picking winners in a fragmented market

Picking winners in a fragmented market

Source: Finextra interview

Stewart Foster recently set up private equity firm Third Financial after leaving Financial Objects. He spoke with Finextra about where he sees the opportunities for investing in small-to-mid-sized fintech companies, and the role of offshoring in his investment plans.

Q. You’ve just launched Third Financial as a private equity firm looking to invest in the financial technology space. What’s your view of the current state of the market, where do you see the opportunities and how do you plan to take advantage of them?
A. We’re absolutely going to focus purely on the financial technology market because that’s the market we know. We intend to buy one or more controlling interests in the next few months. We’re doing a search of the market for opportunities and definitely want to get going by the end of the year at the very latest.
We’re looking at firms in the £1 million to £10 million range, but obviously if it’s bigger than that we will partner with another private equity or VC firm. Ideally we’d look at privately held companies, but we’re not ruling out public listed companies.
It could be in our core space of wholesale/retail or the asset management space, but it could also be in something like risk management or compliance. I think the type of market we’ll go for will dictate the turnaround strategy and the management resources I’m going to bring in.
The asset management space would be an ideal place to find companies – we see all the predictions that the amount of money under management will grow by about 8% to 9% every year for the next decade. This is pretty consistent across every continent. So we see it as having good long-term growth and the UK market is also particularly strong. We don’t think small to mid-sized companies in this market would be at a significant disadvantage. If we can find something in this sector and rapidly grow it or turn it around, we’d be looking at a 3-5 year time frame before exiting.
Q. What about the core banking space?
This is a market we know well and have a pedigree in, but it would be a different kind of acquisition. If it’s in the core banking space, it would be a turnaround situation. It’s a very fragmented market. There are lots of smaller companies out there, and it’s quite dominated by i-Flex and Temenos. If you look at the banking league table there’s probably another 30 companies that each have one or two sales a year each. They may have some blue chip clients, but they’re small. If we were going to acquire one of those we wouldn’t be doing it with an eye to rapid growth. Because why would we be able to come in and suddenly grow it in a global market? But if it was one or several of those that needed turning around to improve performance, we could do that and then sell on to a bigger company. That’s something we could do.
In the asset management space we do have a preference for front and middle office because from experience we know that implementing and looking after clients is easier in the front and middle office and that if you’re a small or mid-sized IT company in this space, it’s easier to sell. There’s less risk to the buyer. But if you’re selling a back-office system, that is high risk for the buyer and they tend to look for big companies to buy from.
Q. There’s been some recent consolidation in this front-office buy-side area, with Fidessa buying Latent Zero.
A. Yes, there has been, and also in the private client space with eXimius being bought from Business Architects by Thomson Financial. Just like we know in core banking there’s consolidation, in the wealth management space bigger companies are trying to buy smaller companies that have a client base so they can get into the game. I think everyone sees that it’s going to be a higher growth market than core banking over the next 10 years.
Wealth management is interesting not only because there are software companies looking to get in, but also because there are an increasing number of new entrants to the wealth management business itself, with lots of bankers leaving UBS and other large banks and setting up on their own and taking private clients with them. These new small organisations need software to comply with regulations and will have no choice but to buy solutions to run their service.
Q. There is lots of private equity money out there looking for opportunities. Is this making it more competitive to find potential companies to invest in?
There is a lot of competition and a lot of money out there. We know that the problem bigger private equity firms have is finding opportunities. We don’t think that’s a problem for us because we’re not into the really big software companies – of which there are far fewer. But in the £1 million to £10 million range we believe there are many potential investment opportunities, and far fewer private equity firms operating in this space – particularly ones that have management experience in the sector.
Q. Are you focusing just on the UK? What about internationally?
We’re looking mainly in the UK at first because that’s where we’re based. But Roger and I both see Bangalore very much as part of the future. Having been successful in setting up offshore operations, where many others have made a bit of a mess of it, we see that as part of turning around an acquisition, Bangalore is likely to play a role. Maybe even as part of that we could be offering services out there as well.
Q. Have you encountered any issues with capacity in Bangalore? I’ve heard that the infrastructure isn’t coping well with the rapid growth there and that wage inflation and staff turnover rates are very high and growing.
That’s absolutely correct. The Indian economy is still overheating, growing at 9% a year, but they’ve got inflation down to 5%, which is amazing. Those challenges you mention were there when we set up out there with Financial Objects three years ago and they’re still there. But there are things you can do to overcome the challenges, and the key is to get a good local manager you can trust. There’s still lots of local talent out there and attracting and retaining them isn’t too hard if you can offer them something interesting.
And there’s still a big price advantage with the rupee against the pound, which enables you to provide more resources and better service for your products and customers. If you’re a huge company you probably wouldn’t set up in Bangalore now, but any company we invest in will be relatively smaller so it’s still a good fit.

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