Why Embedded Lending Is Poised to Drive FinTech’s Next Wave

Venture capitalists (VCs) usually gravitate toward technology-enabled businesses chasing large profit pools, but many won’t invest in lending businesses. At Citi Ventures, however, we see good reasons to lean into lending while others lean out. We have been actively investing in the space, with recent investments in Flex, a provider of renter liquidity embedded in property management software; Pylon, a mortgage originator embedded in wealth management applications; Defacto, based in France, which embeds SMB loans in e-commerce platforms; Clara, based in Mexico, which embeds business loans into its spend management and bill payment offering; and Setpoint, a software infrastructure provider to both originators and lenders.

Many VCs have backed away from fintech lenders...

There are plenty of examples of fintech lenders that raised large amounts of capital at high valuations and went on to suboptimal outcomes (we won’t name names). These are capital-intensive businesses, and their reliance on the debt capital markets adds a dimension of risk that is not present in more typical, asset-light technology companies. Many show promising top-line growth early in their trajectories, but growth can be deceptive. Lenders’ product is money, which is notoriously easy to give away — the hard part is underwriting risk and getting paid back. As a result, even VCs who regularly invest in fintech are increasingly backing away from lending, as the data below suggest:

Source: CB Insights, Citi analysis

...but lending remains a huge component of fintech profit pools...

Lending is the lifeblood of our economy, and represents a massive profit pool: approximately 60% of U.S. banks’ total revenue is interest income. While lenders make up only 17% of the aggregate market cap of public fintechs, lending represents 26% of their gross profit, as shown below:

Source: CB Insights, Citi analysis

...and valuations, cost of capital and embedding offer advantages.

Furthermore, the valuations of fintech lenders have moderated since their 2021 peak. Though interest income can look a lot like recurring revenue for software-as-a-service (SaaS) businesses, the market has learned the hard way that fintech lenders should not be valued like SaaS companies — though they do receive a modest premium over traditional lenders due to faster growth and/or technology advantages. This presents an opportunity for VCs willing to wade into this market.

Source: CB Insights, Citi analysis

Investors may benefit from other tailwinds as well. In our view, lending businesses must differentiate across one or more of the following dimensions: cost of capital, distribution and underwriting. Each of these is evolving in ways that should help fintech lenders thrive:

• Cost of capital:Over the past two years, fintech lenders have had to grapple with the highest federal funds rates since immediately prior to the Global Financial Crisis. Of those that survived, many have done so by refining their credit boxes and ensuring that their pricing and losses overcome their high costs of capital. Lenders with strong gross margins today should be able to increase their gross margins further as their cost of capital decreases. This can happen naturally as they scale, but if rates continue to moderate, it may accelerate. The increasing supply of capital in the private credit markets could also lead to increased competition to supply capital to fintech lenders, further reducing their cost of capital.
• Distribution: Another, potentially more powerful, tailwind is also beginning to accelerate: embedded distribution. According to QED/BCG’s Global Fintech 2024 report, embedded finance — integrating financial products or services into non-financial digital experiences — will be a $320 billion market by 2030, led by embedded payments, insurance and lending. While several embedded payments and insurance providers have already scaled meaningfully, lending has only begun to emerge. Affirm and Klarna, both “buy now, pay later” (BNPL) providers, are among the most scaled embedded lenders: Affirm enjoys an almost 7x multiple of run rate revenue, while Klarna is reportedly planning to IPO in 1H25. We believe that there are many analogous opportunities outside of BNPL in which fintech lenders can benefit from the sustainable distribution cost advantages that embedding can offer, particularly in a business-to-business-to-business (B2B2B) context.
• Underwriting: Embedding also provides underwriting advantages for fintech lenders by enabling them to integrate into platforms on which borrowers are already providing useful data on their financial behavior. The platforms themselves may not have the appetite, capabilities or capital to provide lending products to their customers, but the fintech lenders with whom they can partner can benefit from visibility into that data — leading to faster and more contextual offerings as well as improved risk analysis and pricing and lower fraud rates.

In conclusion...

We believe that embedded lending startups are poised to drive the next wave of innovation in fintech and are closely following the evolution of the ecosystem. Due to our position within one of the world’s largest banks, we are confident in our ability to evaluate and partner with these fintechs by leveraging Citi expertise to analyze the incremental risks inherent in lending. More importantly, we can provide truly differentiated value to this ecosystem post-investment, including by offering embedded lenders warehouse facilities, forward flow and securitization arrangements. We are excited to connect with founders building at the intersection of fintech and lending!