The choice is no longer whether to invest in innovation, but how. The best approach for most banks is to transfer the risk and challenges of producing operational and financial returns to an external strategic investor. The other reason to partner with a strategic investor also happens to be one of the most important measures for how you evaluate a fund: strategic fit.
As discussed in the first post, strategic investors are complements to innovative banks, but only when the fund’s strategy complements the bank’s strategy; and that only works if the bank has actually defined its strategy. Assuming that is the case, the fund should be in sync with the bank to understand its needs, opportunities, and vision of the future. This sets the fund up to generate quick wins for their investors (LPs) and portfolio companies and demonstrate value to all stakeholders.
The risk for strategic funds is a bit ironic; it comes from being too aligned with their bank LP needs. It also comes from being overly reactive to today’s market challenges. If a strategic fund acts too much like an internal innovation group or corporate venture team (CVC) they may end up over-indexing on companies that are great bank partners, but less great investments.
Executive teams at banks are planning on 1, 3, and 5-year strategic horizons, whereas most VC funds are taking 7, 10, or more years to fully return capital. A strategic fund cannot exclusively operate on the same time horizon as banks and must take a longer-term view of the market when making investment decisions, accounting not just for the current state of the industry and technology, but where each may be going.
So how can banks capture strategic value and financial returns from a fund that is in structural misalignment? Achieving both comes down to good portfolio construction.
Diversifying a Strategic Portfolio
The first lesson of Investing 101 is building a diversified portfolio. This doesn’t just come from investing in thirty different companies tackling thirty different products, spanning regions, sectors, and verticals. Diversification requires intentionality, tied to your vision of the world and the strategic position you occupy.
Within Alloy Labs, our vision is influenced by the waves of technological trends and the timing for their potential impacts on the banking industry. The more immediate the impact of the technology, the more operational the opportunity. On the other hand, opportunities with delayed impact require a much longer lens on the market and must be made with firm expectations on the future needs of the organization, customers, and the market. These are the exploratory opportunities at the furthest point on the horizon. These are the investments in frontier technologies and experiences that live in a future that could become reality. These opportunities require higher conviction because there will be much less consensus and guarantee around the future application of these technologies.
The waves we focus on overlay with these time horizons:
First Wave: Digitizing the Bank
Today’s bank problems are real and aplenty. There is no shortage of processes that need to be automated and systems that need upgrading. Data silos exist across the organization. Cores are difficult to build atop. Digital banking experiences lag their fintech counterparts. These are problems that banks will pay to solve right now.
Digitizing the Bank solutions are the best examples of products that can become great partners but not great investments. Though these solutions can cut costs and accelerate growth, they tend to not be transformational. The value they deliver is tangible, but is the impact limited? They solve today’s problems, but can they solve tomorrow’s? Winning investments must do both.
Second Wave: Future of Banking
In order to remain competitive, banks will need to evolve their value proposition to match their customers. Retail and business clients continue to expect more from their financial institutions, especially as fintechs force their hand with novel and innovative experiences. The winning banks will be those that choose to no longer compete on the same playing field as before. They will leapfrog the market and move in directions that will completely shift and expand their customer value proposition, offering services at the Edge of Money.
Investments in the Future of Banking are more strategic than operational bets. While there is tremendous value in being an early adopting partner with these companies today, in the future, banks won’t be afforded the choice. Banks will have to adopt these technologies if they want to remain relevant.
Third Wave: Embedded Finance
The way financial services are delivered continues to evolve. Financial services delivery has exploded and isn’t limited to neobanks; Starbucks is one of the world’s biggest fintechs. Now digital wallets, accounts, payments, lending, and investments are being pushed through all types of brick-and-mortar and digital companies.
The banking-as-a-service (BaaS) ecosystem that underpinned much of the explosion of embedded finance and reimagined financial services delivery has retraced due to – warranted - regulatory pressure. The market will gain firmer ground on the back of these actions as the compliant, operationally sound banks rebuild with more clarity on regulatory expectations. The recent actions only cement the need for RegTech and BaaS infrastructure companies that enable banks to become the hubs for financial services delivered through these third parties. Just like the Future of Banking, we consider investments in Embedded Finance to fall on the strategic timeline.
Horizon: The Finance Frontier
The fourth wave is on the horizon. The place where banking and finance are being reinvented entirely. This includes the creations of new asset classes; the deconstruction and rebuilding of financial services; the developed of new forms of “value” altogether, with and without the need for financial institutions.
Innovation is obvious in retrospect but impossible to forecast far in the future. The technologies are easy to see coming but the ways in which they get adopted are not as predictable. Frontier concepts often become nothing, but they could become threats for incumbents or harnessed to create new customer value. It is important to understand how these frontier technologies are being experimented with in order to forecast future market shifts and position organizations appropriately.
Constructing a Portfolio
Constructing a diversified portfolio that achieves your strategic and financial goals requires that you invest across all fintech waves. The Alloy Alchemist Fund aims to build a portfolio that is heavily weighted on strategic opportunities with targeted operational and frontier investments. The ideal distribution, in our opinion, looks a little bit like a bell curve:
This approach to portfolio construction is how we aim to deliver on all the promises of a strategic fund: deliver financial returns, create operational impact, develop unique strategic insights, and be a complement to our LPs’ and members’ innovation activities.
The reason that we have the mandate to invest like this is because our banks operate with a strategic lens on the future. Alloy Labs members aren’t simply focused on the table stakes technologies that need to get stood up across the bank. Over time, they became increasingly open to exploring concepts together that push the envelope. Now, they expect it from us.
Banks, you should have the same expectations of your strategic investing partner. If you’re currently searching for a strategic investment partner, use the criteria above to evaluate a fund’s approach. The wrong partner will generate poor financial results and bland insights. Most importantly, it’ll tie your bank to a strategy unprepared to win the future.
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