Hello. My name is Frank Rotman and I’m a FinTech Junkie. I don’t say this lightly or in jest — I’m a flat out junkie. And by that I mean I resemble the classical definition of the word: “A person who gets an unusual amount of pleasure from or has an unusual amount of interest in something.” With more than 20 years of experience under my belt ranging from Big Bank P&L Roles to being a Founding Executive at a lending startup to becoming a Founding Partner at QED Investors with 25+ fin tech investments under my belt, I can say that my interest goes beyond the norm.
In my role as a FinTech Investor I talk to 200+ companies a year and find myself giving quite a bit of advice along the way. For anyone sitting in the same room with me day in and day out I might sound like a broken record at times, but this is a function of having well thought out frameworks for success (and failure) and realizing that many of the Entrepreneurs that I talk to don’t have the same perspective. I’m a product of my experiences and they of theirs. Not having these perspectives doesn’t make them bad Entrepreneurs, just ones with less gray hair and fewer scars than I do. Which brings me to this Blog. It’s my chance to rant and rave a bit about any and everything that I find interesting in the sector and hopefully impart a little hard-earned wisdom to my limited audience in the process.
Having just spent three hours with new businesses you might ask “what’s on my mind today?” I’ll tell you it isn’t about scrambling to pull a term sheet together or calling my Partnership to pound the table for a compelling company. What’s on my mind is cannons.
Let’s step back in history for a moment to the “Age of Sail”, a time in the 16th and 17th centuries when naval battles progressed from “grapple and board” combat tactics to battles resolved by “floating artillery.” The most advanced weapon of the time was the cannon and for nearly 200 years massive investments were made in its design and use. The reason for this is fairly obvious but worth stating. If one ship had cannons that fired a small percent farther than those of another, it should win ONE HUNDRED PERCENT of the battles between them. Minor improvements led to devastating advantage and therefore justified investment in continuous improvement. Rinse and repeat.
I bring up this concept because in the world we live in many products and services behave in the same way. This is undeniably true in financial services businesses for a host of reasons that become apparent when the drivers of success are picked apart. In lending businesses in particular, very small advantages can literally suck the oxygen out of a market and create havoc for the competitive landscape. Why? Simply put it’s because we live in a world of near perfect information and good customers behave rationally. It’s a crazy concept, isn’t it? Believe it or not, customers more times than not actually behave rationally when faced with perfect information!
And I can’t tell you how many times I ask Entrepreneurs this question each year: “If your product were put side-by-side with all the choices available to your target customer would they pick yours?” Guess how often the answer is an obvious “yes”? Not often (even though many Entrepreneurs will go down with their ship before admitting such). And guess how often they can define the critical dimension or dimensions that their target customer bases their buying decision on? Not often. For what it’s worth, I’ll have an entire post in the future about “primary vs. secondary terms” and how consumers make buying decisions but that’s a rant for another day.
So let’s take an example right out of the history books to show how powerful this concept is in practice. It requires going in the way-back-machine to a time when the primary method for acquiring a credit card was through the mail. Some of you can remember the days of opening up your mailbox to routinely find five or more credit card solicitations stuffed inside. Annual solicitation volume was in the billions, with some MONTHS exceeding half-a-billion pieces being delivered to households across the country. And guess where this volume was concentrated? Most of it went into the same thirty or forty million mailboxes that represented the best customers from a credit quality standpoint. Every issuer wanted the same customers and weren’t shy at going after them aggressively. A war was being fought with low priced products and headline pricing of 5.9% to 6.9% fixed rate APRs or long teasers that allowed customers to transfer balances at a 0% APR for twelve and sometimes eighteen months. The battle was intense.
So, to cut through the clutter and win in a crowded marketplace we wanted to financially engineer a product that stood out while still enabling us to make money. We needed to grab the attention of our target customer so they chose our product over the dozens of choices they had at any given moment. And we wanted to discourage our competitors from increasing their spend as an answer to the hyper-competitive environment. What did we do? We quickly tested and retested a crazy idea and it actually worked. The winning strategy was designed around a near zero margin profit product targeted so precisely that there wasn’t a prayer that the competition could follow without losing money. We did the unthinkable at the time….we launched a 4.99% product and won the war. And, we did it while still making money.
But the real story here is in the way the math played out (simplified of course) because it surprised everyone except those of us who had faith in the rationality of our target audience. For starters, response rates at the time were very low due to the competitive intensity in the marketplace. At $0.40 per piece of mail and response rates in the 50bps range, mail costs alone were a significant tax on the profitability of our customer base. And, even though losses were low in the population, they were a drag on profit running at 1.5% of active balances annually. With this backdrop in mind, the 4.99% product performed amazingly. In fact, almost magically.
By cutting 100bps out of the headline rate, a massive percentage of the active shoppers in the space that we solicited chose our product. Instead of delivering a 50bps response rate, the 4.99% product delivered a massive 200bps response rate which cut our acquisition costs and payback periods significantly. But here’s where the cannon battle analogy kicks in — the more important insight was that the incremental responders were just about pristine from a credit perspective (i.e. – zero defaults) and spent a significant amount more on our cards than the base responders. Balances from everyone else’s cards came flowing into the product and spend that was historically split across an entire wallet of cards found itself on a single product — the 4.99% fixed rate market killer. The combination of reduced acquisition costs and incremental spend from near zero loss rate customers clawed back the 100bps reduction in margin and effectively dominated the marketplace for quite some time. The competition didn’t follow because they didn’t understand how the math would play out nor did they have the targeting capabilities to ensure that the offer would only go to the best-of-the-best customers. While we were enjoying the benefit of lower loss rates and higher spend-per-customer they were seeing the opposite. And guess what they did? Many did nothing. But some raised price trying to make up for the reduced profitability through increased margin. And as could and should have been predicted, it didn’t work. Our cannons shot a little bit farther than our enemy’s and we won the war.
I’ve observed the same effect time and time again in my career and I can say without a doubt that the cannon effect holds true. For instance, one of my jobs in a former life was to fix broken business units that at one time performed quite well and been in market leadership positions. My approach was always the same. Step #1: Figure out if the products and services being sold by the unit were the best choices for the target customer base. If the answer happened to be “no” then I didn’t need to go to Step #2, I knew a major area of focus for the turn-around. And, in the case of more than half the broken business units I fixed over the years the story was simple. At one point the business was offering great products to customers but the market had changed without the business adapting. Attrition from the existing customer base started to pick up at the same time that the cost of acquiring new customers was rising which were both signs of being on the receiving end of a superior cannon. The result was a troubled forward looking financial statement which led to a replacement of management and a re-thinking of the business (and job security for me).
Which brings us to the moral of the story. If you can’t definitively say that a rational customer would pick your product when faced with perfect information then you might as well give up before you start. Why get into a battle you know you can’t win?
Frank – glad you finally started this blog 🙂 love the post and even more, love the cannons example. Cheers
Great post Frank, look forward to reading more insights. At my current company we are trying to define our product focus (suffering through the classic wanting to be all things to all people syndrome) and the customer choice analogy is one I am sure to use as we continue to refine and focus.
Great first post, Frank. Sets a very high bar for entrepreneurs, but most of the hugely successful innovations in consumer finance do involve unique product features, consumer experience and/or brand appeal. I look forward to reading more.
Very nicely done. I’ve seen your work in real time so I know you speak the truth. I look forward to the next post – and the next lesson.
You crafted an amazing piece that encapsulates a decade of insight based on your real world experiences…. working alongside other VCs, helping entrepreneurs by rolling up your sleeves, navigating the corporate world and being an entrepreneur yourself. You have carefully observed and are so willing to share your advice. Your contribution daily to those entrepreneurs and collaborative style with teaming up with fellow VCs coupled with your pinpoint clarity of thought makes you a true renegade in the fintech space. Bravo!
Hey Frank – I really enjoyed the white paper..great job! I asked this question on Lend Academy where I first saw it and would like to get your take as well:
You astutely note that HELOCs crowded out personal loans pre-financial crisis. Since home values have risen, why aren’t banks aggressively marketing HELOC/HEL products, particularly to home-owning LC/Prosper borrowers who can refi into a much lower rate?
Michael – Glad you enjoyed the paper!
As for your questions about HELOCS the answer is pretty simple. The standards for underwriting HELOCS have increased dramatically since the last HELOC boom. It used to be the case that your Bank would hand you a checkbook with a new mortgage and say “here’s your HELOC” (overstatement to make a point). The standards were closer to underwriting unsecured credit and/or just a piggyback on the primary mortgage process.
But today, to make a HELOC a Bank has to go through nearly the same steps they use to underwrite a conventional mortgage. To make a small amount of equity available to a consumer comes with a very expensive process. The result is obvious — Banks are struggling to figure out how to make HELOCs work again.
Some Banks will figure this out over time….but for now it’s a good assumption that the category isn’t going to bounce back anytime soon. Happy to chat more in person….come find me at LendIt!
Hi Frank – I’m glad I found this blog!
Re: this HELOC conversation:
I have been tracking every single mortgage loan (refi, HELOC, purchase) for condos in New York City for the past few weeks. I know this is not reflective of the overall mortgage market and I don’t yet have enough data to make predictions or solid assumptions, but of the 886 loans we have in our records to date: 115 loans / 13% of all originations have been HELOCs.
We’ll be tracking this moving forward and hope to expand by both property type & geography..
Just found your blog, Frank. Great! In the cards business, before the cannons was Chris Columbus. I joined Citi in ’75. Walt Wriston and John Reed had recently taken the card business out of the branch system and gone nationwide with a 10 m + mailing based on emerging credit reports and scoring. Huge losses to mature the portfolio, but the ship was launched. Love Fintech too.