Hi friends, welcome to another issue of Net Interest, my newsletter on financial sector themes. If you’re new here, thanks for signing up. Every Friday I go deep on a topic of interest in the sector and highlight a few other trending themes below. If you have any feedback, reply to the email; I’d love to hear from you. And if you like what you’re reading, please spread the word.

Tinkoff, Russia’s Capital One

Today, Russia’s Tinkoff is lauded as one of the best digital banks in the world. But it wasn’t always that way. In October 2013, the company had just gone public and at my fund we had become shareholders. Tinkoff was a leader in the fledgling Russian credit card market; founded several years earlier by Oleg Tinkov, a serial entrepreneur. Its growth prospects were fantastic and its valuation reasonable. Yet within a month its stock price was down by a third and over the next two years it would go on to lose 90% of its value. 

We didn’t stick around for the full duration of that slide. Fortunately for today’s shareholders, the management team did. They weathered the downturn and brought the company out stronger. No longer just a credit card play, Tinkoff is active across a range of financial services and beyond. It has delivered revenue growth of 40% a year and generates returns on capital in excess of 30%. Unlike many other digital banks around the world, it is profitable. And unlike them, it started life as a bank, complete with license and balance sheet.

In fact, it started life as a Russian replica of America’s Capital One.

Oleg Tinkov

“I spent the summer of 2005 happy as a puppy, in Tuscany, cycling and relaxing. I felt pretty pleasant—removed from it all—as I had just sold my Tinkoff beer business to the Belgian company InBev for 260 million dollars. At 37, I had become a true multimillionaire.”

Oleg Tinkov always fancied running a bank. As a customer, he would often wonder what it would be like if the tables were turned. He questioned whether the people running banks were any smarter than him. “For some reason it was they who were giving me money and not the other way around. On top of that, it wasn’t even their money; they were attracting it from someplace.”

Tinkov had spent a lot of time in the US, having studied at Berkeley in the late 1990s, and saw how big the credit card market was there. In Russia, credit cards circulated widely, but their distribution was closely controlled by incumbent banks. Consumers would get them either directly from their bank if they had a good track record of paying off personal loans, or – in the case of debit cards – if they enrolled in a scheme offered by their employer’s bank. 

With a second home in the US, Tinkov experienced first-hand an alternative distribution mechanism—direct mail. His mailbox in Marin County, California was regularly bombarded with credit card offers. One brand in particular stood out: Capital One. “I got a couple and started to think that this would be a good idea for Russia, a massive country just like the US. Russia’s roads and airports may be sub-par, but you can send mail anywhere.” [1]

Through the second half of 2005, Tinkov worked on the idea. He got Boston Consulting Group to spin up a feasibility study and spoke with business contacts including senior bankers. Most scoffed: “What are you thinking? You’re too late. The market’s completely saturated with experienced professionals. You’re being ridiculous.” Nevertheless, in November he assembled a team on his hero Richard Branson’s Necker Island and decided to proceed. 

Direct mail has proven to be an enduring customer acquisition tool for credit cards. In 2020, US card issuers mailed out 2.3 billion pieces of mail (according to Mintel Comperemedia). And that’s in a pandemic; the year before, volume was 50% higher. Capital One, the company that inspired Tinkov, sent out over 300 million credit card offers alone. 

Tinkov’s first maildrop was in May 2007. He did a test mailing of 75,000 invitations to potential customers, mostly in Volgograd. The first response consisted of 1,500 card applications, which then got whittled down further on approval. A 2% response rate wasn’t bad – response rates in the more mature US market run at around 0.5% – but it could be improved. That summer, he and his team ramped up to around 200,000 letters per month, all the while tweaking the content. 

“We used a test and learn approach, based on the experience of Capital One, testing all kinds of different approaches to getting through to the client. Our method is somewhat like Japanese kaizen: we are constantly looking for the smallest improvements that we can make, which taken together yield big results. Here is a banal example: originally my signature was at the bottom of the letters that we sent. Later we started testing other signatures… Some people might say that it makes no difference whose signature is at the bottom of the form, but we had to do this test to see which one of them worked better in practice.”

Tinkoff’s Model

Oleg Tinkov was neither a banker nor a tech guy. So when he launched the business, he borrowed from elements of each field. On the banking side, his very first step was to acquire a banking license, which he did by buying an empty bank, Khimmashbank. These days, many fintech companies press ahead without a license, only to acquiesce further down the line; he started with a license. 

On the tech side, Tinkov made significant investments, spending $20 million on the newest technology available. “A lot of people still do not understand how we are able to grow so quickly… no other reason than that we managed to acquire and integrate the credit card market’s latest international technological advances.” He recognised that the card business is a data business and to process that data he needed the best tech, which he didn’t even need to invent because it was available abroad. 

He also knew how to hire. Oliver Hughes has been operationally in charge of the business since the beginning. Previously an executive at Visa, he knew how the credit card model operated. His first meeting with Tinkov was testy but, says Tinkov: “if you see a good manager, he is usually an Englishman.” Amen to that!

The final piece of the jigsaw was funding. Tinkov calculated he could put $50 to $60 million into his new venture, but would need partners. He approached Goldman Sachs, who agreed to back him alongside some private equity firms. We have commented before in Net Interest on the value that Goldman Sachs has created in financial services outside of its organisational perimeter; this is yet another example. Goldman acquired a 13.6% stake over 2007 and 2008 for no more than $15 million; it sold two thirds of its shareholding in the IPO, with its stake worth $368 million.

Tinkoff became profitable in November 2008. Its model was simple. It had around RUB4.7 billion ($160 million) credit card loans outstanding (the number now is RUB262 billion, or $3.4 billion), on which it earned a pretty high yield of around 60%. Although interest rates were high, credit limits were low enough that customers were not especially sensitive to the absolute interest charges they were being asked to pay. In addition, customers who paid in full during the 55-day grace period didn’t have to pay any interest at all, although most chose not to do that. 

Today, the company still earns high yields of around 50% on its credit card loans. On paper these are higher than regulatory caps because they include all sorts of fees, such as cash withdrawal fees. Despite its high rates, Tinkoff has grown to become the #2 credit card issuer in Russia, with a market share of 13.5%.

Out of its yield, Tinkoff absorbs funding costs, provisions for credit losses and operating costs, leaving what’s left over as profit. As Tinkov puts it, “the bank’s business consists of buying money, cheaply, and then selling it for more.” 

The model is typically vulnerable in two areas: credit and funding. Of the two, funding is the more pernicious since it tends not to be as diversified as credit, where the risk is spread over hundreds of borrowers. Tinkoff’s muse, Capital One, experienced a funding crisis of its own in 2002, when the company was shut out of the wholesale funding markets for around nine months following a regulatory review. Management was able to avert a liquidity crisis by cutting back on asset growth and aggressively marketing web-based deposits as an alternative funding source.

Although it launched its operations in the teeth of the financial crisis, Tinkoff was lucky to have been able to secure wholesale funding during a brief market opening in June 2008. That’s not to say Tinkoff didn’t have a trying time before that. In October 2007 the company struggled to get a bond issue away. Tinkov was left in shock: “I sat in the office at my round table, just crushed, and I cried. Of course, I am Siberian, a strong man, but I had tears running down my face.” The funding he raised in June allowed him to get through the crisis, but like Capital One, Tinkoff committed to diversify into deposits.

Capital One ultimately diversified by buying a bank; actually two banks. Web-based deposits were costing it 0.50% over market rates and so in November 2005 it acquired New Orleans-based Hibernia Bank followed by New York-based North Fork in December 2006. The deposits these banks brought with them funded half the group’s combined balance sheet and, what’s more, its wholesale funding costs declined as a reward for the diversification. 

Tinkoff didn’t need to buy a bank; it already had the license it inherited from Khimmashbank. But it had no branches, a problem when Russian law requires that to accept deposits, a representative of the bank must be present to validate a customer’s ID. It hit on a novel solution: a bank representative would go out and visit customers at their home or place of work; smart couriers they were called. The scheme was piloted in 2009 and rolled out fully in February 2010. Initially the bank offered rates significantly higher than the market but after achieving a planned level of deposits, it gradually lowered rates in order to slow down the speed of new customer acquisition and as a response to positive customer perception of the bank’s services. Today, around 84% of the bank’s liabilities are customer deposits, exactly the same as at Capital One. 

Tinkov credits the idea of the bank going out to the customer to something he learned in earlier life. As a student in what was then the USSR, he would buy goods that his fellow foreign students brought into Russia from abroad – jeans and lipstick and the like – and sell them to locals. He noticed that the margin was higher in Siberia where such goods were more scarce, but that they were higher still when he visited customers in their shoe and yarn factories.

Cross-Selling on a Digital Platform

In 2011, Tinkoff diverted its distribution strategy away from direct mail towards digital. The transition lowered customer acquisition costs and reduced the time lag between marketing spend and new card issuance. By 2013, most new credit card customers were coming through the online customer acquisition platform. Because of the consistently high profitability of credit cards, customer economics remained very positive. The company models future cash flows from each new customer using a high 30% discount rate and only approves customers whose cash flows meet that threshold.

As well as enhancing efficiency, the move to digital opened up opportunities to cross-sell which direct mail didn’t allow. It’s something Rich Fairbanks, the founder and CEO of Capital One understands: “Way back with old-fashioned direct mail, we set out to build a business. And we…didn't have much of a cross-sell opportunity. So much of the heritage of the company for a long period of time was focused on the origination of business.” The trouble is that a mass-market credit card isn’t the best hook for a cross-sell.

So in 2012 Tinkoff launched a transactional account, Tinkoff Black, aimed at a more affluent customer. Tinkoff Black is a debit card attached to an interest-earning current account with benefits like free cash withdrawals and merchant discounts. The company now has 10.7 million Tinkoff Black customers. On a stand-alone basis, they lose the bank money, but the product is a gateway into other products, such as cash loans, retail brokerage, insurance. Around a third of Tinkoff’s customer base now has more than one product. 

The pace of cross-selling is changing Tinkoff’s business mix. As more secured loans are put on the balance sheet, overall loan yields are coming down (with a corresponding decline in credit costs). In addition, revenues that don’t stem from credit are growing.

One driver here is retail brokerage. The company launched brokerage via a partnership in 2016 and then by itself in 2018. It has gone on to accumulate 2.4 million customers to become #1 retail brokerage on the Russian exchange by number of active customers. The Robinhood culture is as evident as it is in the US. Customers skew male (75%) and their average age is 32, younger than customers of the bank’s other products. The business now makes up about an eighth of pre-tax profit and CEO Oliver Hughes reckons that “we're still at the beginning of what is a secular shift towards brokerage and wealth management in Russia.”

More recently, the bank has begun to offer non-financial products too. With this it is replicating the super app strategy prevalent in Asia. Tinkoff launched its super app in December 2019 and offers travel services and entertainment via partners. The company has said that it will develop partnerships with businesses of any size, from Instagram bloggers to Russia’s largest B2C companies.

The shift is reflected in the company’s self-description. At IPO, Tinkoff was “an innovative provider of online retail financial services.” More recently it has become “an innovative provider of online retail and SME financial and lifestyle services.”

It’s perhaps no surprise that as it matures, Tinkoff has dropped Capital One as its exemplar in favour of Asia. Even Dostoevsky saw it coming:

When we turn to Asia, with our new view of her, something of the same sort may happen to us as happened to Europe when America was discovered. For, in truth, Asia for us is that same America which we still have not discovered. With our push towards Asia we will have a renewed upsurge of spirit and strength.

Fyodor Dostoevsky, 'Questions and Answers', A Writer's Diary Vol. II, 1881, trans. Kenneth Lantz (Evanston, IL: Northwestern University Press, 1994) p.1373.

The difference with the Asian super apps is that Tinkoff is coming to the market as a bank, with a balance sheet. Bank brand values have held up stronger in Russia than in other markets, giving Russian banks an edge in consumer engagement that banks elsewhere can only envy. But they’re still banks and, from a valuation perspective, a capital intensive balance sheet holds them back. 

CEO Oliver Hughes tried to remove the shackles of the balance sheet back in 2015. “So we had the idea of an online financial supermarket at some point, this was back in 2015, where we thought we would do less balance sheet stuff and do more off balance sheet stuff. So we’d use our origination platform to bring customers in and write them onto a partner’s balance sheet… So we'd make our balance sheet more light, less capital-intensive and more about a commissions-based income… but the thing that we thought would work didn't work… we couldn't make the unit economics stack up. So we discontinued it, unfortunately.”

In spite of its strategy, Tinkoff’s valuation is more closely aligned to a bank than a super app. It trades at 12x this year’s earnings (earnings; not sales, earnings). This puts it at a small premium to Capital One, whose growth rate it surpasses, but a huge discount to Asian tech companies. To extract the full economics from banking, you need a balance sheet, but a balance sheet is a drag on valuation. It’s a quandary all fintechs will sooner or later face. 

[1] Tinkov’s home in Marin County may have been the source of the insight which made him very rich, but it may also be the source of trouble. He has been charged by the Northern District of California for tax fraud on the basis that as a US citizen when Tinkoff went public, he should have paid taxes on his gains. He renounced his citizenship three days after the IPO. He was arrested in London last year and awaits an extradition hearing while battling leukemia. 

Unless otherwise specified, the quotes in this piece are taken from the English translation of Oleg Tinkov’s book, I’m Just Like Anyone Else, published in 2010. He has written two other books, How to Become a Businessman (2011) and Revolution: How to Build the Largest Online Bank in the World (2018). Unfortunately these have yet to be translated, but if they contain any of the colour of the first book, I look forward to reading them! Other sources of information are Tinkoff’s 2019 offering prospectus, its latest investor presentation and a recent interview with CEO Oliver Hughes.

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Indian Payments

Every time I write about payments, like I did in the pieces about Visa and Buy Now Pay Later, Indian readers ask when I’m going to write about UPI, the country’s Unified Payment Interface. I know, I know; it’s on my list!

Data for December shows that UPI crossed the 2 billion transaction mark for the third straight month, with 2.23 billion transactions handled, worth INR 4.16 trillion. The adoption of digital payments in India is very rapid, but it is being dominated by just a few payments companies. In December, PhonePe accounted for 40% of transaction volume, followed by Google Pay, with 38%. There’s then a big drop down to the #3 player, Paytm, which has 11% of the market.

Nervous about the potential of duopoly, the Reserve Bank of India placed a cap on the volume a single player can facilitate of 30%. Starting from January 2021, the top two have two years to reduce their share. This is good news for WhatsApp, which entered the market late last year; in December it did only 810,000 transactions. It will be very interesting to see what kind of market structure emerges when network effects combine with regulation early in a market’s development. 

Brazilian Private Equity

Last weeks’ Net Interest explored the business model of private equity. This month, not one but two private equity firms hailing from Brazil will debut on the stock market. They are Patria and Vinci Partners. The appetite for private equity and alternative assets in general may be lower in Brazil than elsewhere given the country’s historically higher interest rates. However, it is a large market for infrastructure, and that’s where these two firms allocate a lot of capital.

With more and more private equity firms being listed (I count 12) focused on different assets and geographies, it is emerging as a useful sector for investors to explore. The bigger the sector is, the less the advantage of Dyal/Blue Owl as a vehicle to access it. 

American Banks

One of the striking features of US bank earnings is the volume of deposits they amassed over the course of the year. The big four had $6.6 trillion of deposits between them, up $1.2 trillion from the end of 2019!

Deposit growth in the industry hit 50% annualised in the second quarter of the year when the pandemic hit, and has remained historically elevated since. Loan growth, by contrast, has lagged, so banks have a lot of excess liquidity on their hands. With no need for more, they have pulled back on the rates they offer depositors; rates are pretty much at all-time lows across most bank deposits.

In the early part of the year banks kept their excess liquidity in cash, but they are now itching to invest it. Most banks anticipate that loan growth will return alongside an economic recovery in the second half of 2021. The competition to meet that demand could be intense.