Is Pipe putting lipstick on a pig?
Alt opinion piece that compares & contrasts one of the hottest FinTech startups with the structured products that underpinned the 2008 Financial Crisis...
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I did a double take today after seeing a featured TechCrunch article that covered Pipe’s $150M raise at a $2B valuation. I could’ve sworn that they were just trending in the tech world after completing a $50M raise three weeks ago. After a quick search through the TechCrunch archives, I realized that I wasn’t wrong. How interesting. Based on their fundraising cadence, Pipe must be seeing a significant uptick in traction. Naturally, I decided to dig in to learn more. I will note that my subsequent thoughts and opinions are solely based on publicly available information as I was not able to track down any sources close to the company.
Pipe gives SaaS companies a way to get their revenue upfront by connecting them with investors on a marketplace that pays a discounted rate for the annual value of those contracts. In other words, they’ve created an alternative financing option that allows companies to receive instant cash advances based on their MRR receivables. For example, if Company A has a select portfolio of 12mo SaaS contracts totaling $1M, it can utilize Pipe’s platform to syndicate the future cash flows of those contracts out to investors in return for the annualized value of that portfolio upfront. It’s important to note that the upfront advance is provided at a marginal discount, representing a pseudo interest rate. If the investors bid $0.94 per contract, Company A would receive $940K upfront. Similar to traditional finance, the rate varies with the underlying assets. The higher the perceived risk of the company, which is determined by stage and an automated algorithm that plugs into company financials, the steeper the discount rate (or the higher the rate of return for the investor).
This is a novel new alternative for startups to fund growth without debt or dilution. Additionally, Pipe revealed that its product has found traction with mature SaaS vendors whose large enterprise customers, who are now just as cash flow-conscious as SMBs, need more flexible payment options as the invoices for their annual renewal contracts come due1.
From the investor side, it presents an interesting new option for asset allocation. Pipe describes its buy-side participants as “a vetted group of financial institutions and banks”2. With over $1B of tradable ARR currently on the platform, Pipe has essentially created an exchange that functions as a dynamic asset-backed security pool where investors can create custom tranches. Product screen shots on their site display indicative bids of $0.96 to $0.85 - or rates of return of 4% to 15%, depending on risk appetite. For reference, here’s how traditional asset classes have performed over the past 15 years.
Investors can define and adjust their target risk profile and the platform automates filling the orders. Additionally, by bundling, or securitizing, a large amount of contracts together, investors can lower their associated risk through the division of ownership of these debt-like obligations. However, let’s not forget that securitization doesn't help much if the underlying assets default and little can be realized through the sale of those assets.
Given my foundational roots in Investment Banking, I couldn’t help but think about MBSs, CDOs and the Great Recession as I dug more into Pipe’s product offering. Could this potentially be a “lipstick on a pig” situation reincarnated in Silicon Valley? If we recall what happened in 2008, America’s financial empire imploded because of a fraudulent mortgage market. Mortgage lenders were writing an increasing amount of subprime loans, which would get scooped up by Investment Banks, bundled into CDOs that falsely received high-grade ratings from ratings agencies and then sold off to investors. The money that mortgage lenders received from the Investment Banks allowed them to turn around and write more unqualified subprime loans and the flywheel continued as the folks on Wall St. pushed more product and collected their fees. It was a masterclass in greed. The unraveling ultimately occurred when the ultra-low quality assets that underpinned the CDOs collapsed. At the height of the crisis, the 12mo default rate on subprime mortgages exceeded 25%3.
Am I saying that I think the same dynamic will happen to Pipe? Absolutely not. I’m just raising awareness, perhaps for entertainment purposes, to a possible bear case in the most extreme fashion. Here are a few things that I am personally curious about:
Is Pipe purchasing the contracts first and then selling them to investors?
I am curious how the exchange is facilitated given the fact that companies are able to receive their advances instantly. I highly doubt that the investors, who are financial institutions and banks, would commit pools of money that just sit there, not earning a rate of return, until their risk-preferences and bids are met. Or maybe I’m underestimating the platform’s liquidity at this stage or the advancement of payment transfer middleware. The alternative would be that Pipe initially buys the contracts, provides a company with their instant advance and then makes the contracts available for purchase to the buy-side investors. Either way, I assume the facilitation of investor access to these contracts is accompanied by a fee structure. Which brings me to my second question:
Since banks are listed as investors, is there any chance that they are securitizing the contract cash flows into ABS or CDO products?
Not that it’s necessarily a bad thing. Asset-backed securities still exist in all forms, e.g., credit card receivables and auto loans. I am just generally curious if the rapid growth of the software market has spawned a new asset class to invest in at the institutional level.
Earlier on, I commended Pipe’s ability to integrate with company accounting, payment processing and banking systems, in an automated manner, to analyze credit risk. However, here’s my next question:
As the business grows, will the platform’s buy-side investors demand that a third-party auditor provide an objective analysis of the risks associated with the structured, debt-like assets?
At the height of the 2008 Financial Crisis, ratings agencies were accused of misrepresenting the risks associated with mortgage-related securities. The accusations alleged that the agencies inflated ratings to win a bigger share of the lucrative sector. By 2006, Moody’s had earned more revenue from structured finance—$881 million—than all its 2001 business revenues combined4. If an occurrence like this, which ended with a $1.5B settlement, can happen when utilizing third-party auditors, do investors have confidence in the ratings analysis being done in-house?
Lastly, when we think about SaaS business models, we always have to consider churn. Which brings me to my final question:
How does Pipe handle churn?
According to Baremetics’ Academy, a typical “good” churn rate for SaaS companies that target small businesses is 3-5% monthly5. For an enterprise-level product, churn should be < 1% monthly. Annualizing the optimistic end of those indications results in the following rates:
SMB: 3% (monthly churn) * 12 = 36% (annual churn)
Enterprise: 0.7% (monthly churn) * 12 = 8.4% (annual churn)
For reference, here were the mortgage default rates in the US leading up to 2008:
Before we hit the panic button, let’s take a look at how Pipe handles churn risk. On their site, Pipe gives companies two options in the event that a contract churns:
Rebate the capital you received upfront on a prorated basis for the churned period with no penalty or fees, or
Pipe can auto-swap another contract to cover the rebate of the churned customer
After examining these options, it seems that Pipe does have a good plan in place to mitigate this risk. The company disclosed that there have been $10M in trades so far this year. With $1B of tradable ARR currently on their platform, companies, on average, seem to be utilizing 1% of their contract portfolio for cash advances to drive growth. In other words, there is ample supply to replace a churned contract, decreasing the risk to investors who hold the bunded contracts.
There is no doubt that the team at Pipe is acutely aware of the causes and repercussions of the 2008 Financial Crisis. It seems like they’ve implemented the correct steps to mitigate a repeat scenario at this point in their lifecycle, such as contract replacement in the event of churn, trading limits and automated analysis of a company’s credit risk. In the event that they are the initial purchasers of contracts, I’m sure they’ve imposed some sort of collateral requirement threshold as well. As the company scales its customer base to different product sectors, such as D2C subscription companies and streaming services, it’s imperative to prioritize transparency and integrity to prevent a deterioration of underlying assets.
https://www.pipe.com/blog/rethinking-the-upfront-annual-saas-contract-in-a-cash-flow-conscious-world
https://techcrunch.com/2021/03/31/pipe-which-aims-to-be-the-nasdaq-for-revenue-raises-more-money-at-a-2b-valuation/
https://www.chicagofed.org/~/media/publications/profitwise-news-and-views/2010/pnv-aug2010-reed-final-web-pdf.pdf
https://www.cfr.org/backgrounder/credit-rating-controversy#:~:text=In%202008%2C%20at%20the%20height,associated%20with%20mortgage%2Drelated%20securities.&text=By%202006%2C%20Moody's%20had%20earned,its%202001%20business%20revenues%20combined.
https://www.cobloom.com/blog/churn-rate-how-high-is-too-high#