Interviewed By The Asian Banker Live
Mark Whitcroft, one of the founding partners of Illuminate Financial, shares the London-based venture capital firm investment strategies, why it invests in capital markets and early stage financial technology companies, and its funding targets in the next few years.
Yes, we are a venture fund. The first fund is $47 million (£35 million), which was our target for the first fund and we’re backed by a number of limited partnerships (LPs), including three strategic LPs that are multibillion dollar corporate. From the financial services sector, the two public ones are Deutsche Börse Group, who owns the German stock exchange in ClearStream, and IHS Markit, the NASDAQ-listed financial data and information company.
Illuminate Financial’s investments
Yes, so, even more specifically than that we invest in capital markets and early stage fintech companies, so all business-to-business (B2B) software solutions, enabling technologies. So, there’s a lot of talk in fintech about disrupted technologies. We’re actually investing in technologies that help exist in financial market participants, rather than try to take business away from them. We start with the thesis that we’re a once in a generational shift of market infrastructure within financial markets.
We think that has happened for three reasons. Firstly, significant industry de-leveraging post financial crisis, which you are familiar with. Multi-jurisdictional regulation and that has created a zero-tolerance environment for combined failures. We see that as really led to four new drivers around the adoption of technology of existing financial services firms, so the established market players that are cost, capital, control and compliance. So significant cost pressures in the industry; control whether it is of people or processes; and obviously a stricter compliance environment in which we operate. Capital which is very scarce these days in the sector.
The other C, so that’s the four Cs, is competitive advantage, and competitive advantage is probably the main adoption of new technology prior the financial crisis; whereas we think the other four Cs – cost, capital, control, and compliance are actually more important now than competitive advantage for adoption of new technologies. So, we look at technologies that really address a multitude of those five C drivers now. Yeah, you know competitive advantage is still a huge drive in the business, but we think the other four drivers are actually now in the environment of fixing and upgrading.
Sure, so let’s start with the last question because that’s the thirty thousand for you. So, in the last three and a half years that we have been operating we’ve seen about 1,500 start-ups, and those are all early stage capital markets financial technology (fintech) start-ups. I’d say somewhere between 60%-70% of those have a regulatory driver attached to them before their adoption. So, whether that’s method to, research and bundling, whether that’s best execution aspect, whether its fundamental review, of the trading book, whether its best execution, whether its Dodd-Frank, a whole multitude of regulatory drivers.
When we’ve seen 15 companies we had about ten categories that we broke them down into, but actually when you’ve seen 500, ten categories don’t cut it anymore. So, what we do now, we have a multitude of tag words that we ascribe to companies that come through the door, because what that means is - and we break that down to function, product, regulatory driver, technology driver… A company can come in through the door and might get eight tag words, it might get 15 tag words, it might get 30 tag words; but what that means is that we can slice and dice the data, either with our strategic LPS or our strategic bank partners, or our strategic buy-side partners, which allows us then to really hone in on the problems we’re trying to solve.
And I think that goes back to your first question. We actually say we are business solutions investor first, technology investor second, because the technology enables the product, but actually if you are not a solution that is solving a real business problem you can have the best technology in the world but you are not going to get adopted. Actually, from an enterprise software perspective, so B2B solutions, it is all about solving a problem for your client which means you’re going to get adopted. So, you know when we talk about categories of technology that is important we need to look up all the latest stuff about APIs, machine learning, artificial intelligence (AI)-driven solutions, or cloud adoptions. All of these things are important from a deep tech perspective, but actually the fundamental driver which we will look at is, when we’re validating potential investment opportunity, is who are the clients and why would they adopt us.
Our other underlying thesis is we’ll only invest if we can actively influence the outcome of the business. So, can we introduce them to potential end clients, can we introduce them to channel partners, whether that’s existing vendors they can partner with, whether that’s consultants who might help them from business development perspective, or who are the potential follow-on funders and that’s bringing to about a consortium around banks. A lot of market infrastructure in their space has been built up from the past in banks co-owning.
Our business models about entry points and exists, so most sides of that are important. So, it is a journey and the exit landscape in our space is consolidation driven exits by trade sales to market participants or existing vendors, versus traditional tech where it tends to be the Google’s, the Facebook, the Yahoos, the Bing, these companies. So, there’s a huge spike of the front-end and then there’s quite a short tail of potential acquirers afterwards. In our space there’s a huge long tail of potential acquirers afterwards, whether it’s existing lenders, whether its market participants. We spend a lot of time thinking about who are the potential acquirers of our businesses when we go into them. Going back to your question around consortium, there are plenty of examples of where consortia haven’t worked well right?
It is very challenging when there are so many parties around the table with different drivers. Each of them doing their own thing, not necessarily aligned with what is best for the company. Now, so there are plenty of examples where consortia failed. Actually, my business partner, his entrepreneurial journey was setting up a platform, his name is Mark Beeston, he was setting up, he came up as a president of a firm called T-Zero, which was an independent subsidiary of Creditex, the broker, and they were solving a problem of affirmation and confirmation in the CDS market. So, there was a real documentation crisis in the mid-2000s around CDS settlement, and it was very difficult to understand what your exposures were to different counter parties in the market, so they were addressing that problem. They were actually going up against market consortia that was trying to solve the same problem, T-Zero over four years grew up to be the market standard with over 200 participants on the buy side, and I think 15 to 20 dealers using the platform. That was then sold to ICE along with Creditex in 2009, and they were able to become the market standard, which is now ICE Link T-Zero. That was able to become the market standard and run faster than the consortia, for all the reasons that you alluded to earlier. Now, having said that there are examples of like Markit. So Lance Uggla who built Markit from Canadian guys in a barn solving a CDS problem up to an 11-year journey of IPO, which was a consolidation of over 25 or 30 small companies. So again, the consolidation play coming into effect there and in terms of exits. The market is owned by multiple banks, right, but he had the type of personality that could herd the cats as you indicated, and was a successful IPO. IPOs aren’t necessarily the exit trajectory in our space, so you can make it successful in a consortium, but there are plenty of examples where it hasn’t worked well and I think there are different government models that we see now that play into effect with maybe rotating more seats amongst bank ownership. You’ve also got issues around if it’s not a separate corporate venture unit. Banks also have a certain percentage of your companies that they can own which is, you know when it comes to capital allocation holding rules and Dodd-Frank with its 4.9% of the voting stock. So, banks can only own a certain percentage of these companies anyway, but if you can address government aspects of consortium there can still be benefit of having banks in your share cap table but it has been an issue that has been managed carefully.
A consistent feedback link
So, in the fund model that we’ve created, we’ve tried to provide a pretty consistent feedback link, whether that’s validating potential investee companies that come through our doors with our partners on the buy side, on the sell side, on our strategic investors as well. So, there’s a consistent validation circle that goes on in there, but also, we care a lot of the problems that people are trying to solve. So, we spend a lot of time in our network, trying to find out what the business problems are, because if you know what the problems are you can then go source the solutions. So, you know, I think that’s a big part of vendor success. I think then it’s about your route to market. Are you going to go and sell each account one-to-one or is there another start-up, or is there anestablished vendor that you can partner with to ride their MSAs.
So, we’re a team of twelve, and we’ve got six in the investment team. We’re London-based, but we invest globally. My business partner spends every second week in the States; and we’ve got people who spend time in this region as well, and we’ve invested in a number of different centres throughout around the world.
Yeah, we care most about potential capital that wants to invest in this sector, we care about potential investee companies that come in through the door, and we also care about potential clients of those customers and of these investee companies as well. So, of our pipeline we see somewhere between 130 to 150 companies a quarter, early stage companies coming through the door, and somewhere between 70% to 75% of those are referred into our network, or referred in via our network because we try to position ourselves as strategic independent capital. And to your point about consortia earlier, right, we’re trying to provide independents but at a Series A bucket where it’s beyond the angel ability, the angel investor’s ability of friends and family around gathered to support the companies. Whereas traditionally before where private equity and potential banks come in and play. So, we’re helping that sort of growth phase of the company, then whether you can partner an early stage company with a traditional vendor rather than going one-to-one. You may actually get access to potential 200 clients, so we think partnerships are a core part of the proposition in this sector.
We’re early in the journey so no exists yet, but one of our companies Privitar, does data privacy engineering, earlier this year they raised $16 million equivalent from follow-on investors like ourselves, but also three new investors as well. Every fund from a venture perspective marks the market based on last valuation so that is an uptick. CloudMargin, I think is a great example of a new market infrastructure play. So, they do collateral management. They’re in the collateral management space, and they are a workflow tool that helps market participants in that space. That is an area that is still very manual on a lot of aspects of this industry. So, it’s still involving a lot of phone calls, emails, and faxes. The founders were a bunch of market participants who realised there was an opportunity here for providing a tool to the sell side. Until that time was very much excel-based, and with email regulations coming into effect next year you have to put more robust to surround that process. So, this is a SaaS solution, cloud-enabled, which price is based on how many CSAs you have. If you’re small fund its very cost effective, if you’re a big fund you could be live and up running very quickly with that tool.
That is a company that we were in very early, and they have expanded into the States, into Asia, and has a lot of clients in Europe, so they’re now global with some of the biggest fund managers in the world using their platform. They also have a public partnership that’s been announced with IHS Markit as well to plug in to. IHS Markit is one of the investors in the fund, therefore, we have an alignment with them in terms of understanding what they’re solutions are and how there might be wins on every side, because that’s the way partnerships only work if both sides are winning. CloudMargin came through the door through parts by network.
The aspects of data
I think if we look at the buzzword of big data, we’re still very much on the hype cycle of big data. This was actually in many ways our thesis around our investment in Privitar, because everybody wants to gain thematic insight from the data they have; but the problem you’ve highlighted is how do you know what data is actually useful, and on top of that how do you ensure that you know the providence of that data? The lineage of that data? How do you ensure that data in usable in a normalised fashion? In and around that, if you look at all the talk about machine learning and AI now can shift the quality of your data to begin with. Going into your AI algorithms is no good, it doesn’t matter how good your algorithms are, and you’re going to get rubbish at the back-end. So, we think data has a huge impact on every aspect of capital markets that we look at. The entire trade line, whether its pre-trade, point-of-trade, or post-trade, and we make investments across that entire life cycle; and we think data hits nearly every attribute of the investments that we look at. Whether that’s data visualisation, whether that’s workforce solutions, whether that’s the likes of TickSmith, which we’ve invested in, which is capital market data lake. They work with a number of providers, one very big exchange globally. They power the entire back-end of their selling of market data. So again, there’s the monetisation aspect of data as well, not just the usability aspect. To address your question, we think this impact nearly every aspect of the investments we look at.
Totally, a lot of the biggest banks in the world have thousands of systems that don’t interconnect, and on top of that, often they’re in legacy languages in terms of what they’re written. COBOL is well known as one of the languages of the 70s and 80s, where there are not that many programmers around these days that actually, you have to pull people out of retirement to help with this stuff. Core architecture within banks is definitely something that over time either doesn’t ever get changed, with band aids put on this stuff, or with new architecture that we look at. It’s about the connectivity of existing systems to ensure that you end up with a date to do something with.
Generating more funds
Our cheque sizes tend to range from kind of quarter of a million dollars to $3 million, and we’ve deployed both ends of the spectrum across our entire portfolio. We think there’s a significant Series A hole in terms of funding in the space, which is where we operate. Traditional venture firms don’t tend to look at capital markets and fintech, some do but most don’t, because the exits aren’t significant IPOs of 500 million, billion dollars. It tends to be exits in terms of asset sales or trade sales to existing market participants. If you have a $500-million fund you have to look at everything as a potential fund return and capital market and fintech may not look that attractive. I think money in this space, right at the front end tends to come from angels and we all know that financial services tend to be well remunerated in history, so actually there tends to be a lot of market participants, you know fintech angels out there. We then have a bucket in Series A which is in particularly well filled; which is where we in particular operate in fund one, and then beyond that kind of Series B and C, and beyond is a mixture of private acting money, which is very focused in financial services, and capital markets, banks, and there is also a well-publicised uptick in terms of corporate venture units as well.
Well fund one was $47 million (£35 million), which was our target, and that is what we raised. We will look as any venture investor to raise another fund once we’re at the point where that makes sense, and obviously we will be targeting a bigger fund. So, more assets under management is clearly something we look to in our own future.