Two noteworthy transactions in the payments fraud and chargeback space highlighted this past week’s M&A activity. On Monday, May 24th, Forter announced a $300M Series F funding from Tiger Global Management, and on Tuesday, May 25th, Sift announced it entered into a definitive agreement to acquire Chargeback for an undisclosed amount. Though both transactions speak to the heightened investor interest and activity of the Fraud Economy – the interconnected network of fraud and fraud abuse types that fuel one another, which was arguably catalyzed by the pandemic-induced consumer shift to online commerce – they also beg more specific questions surrounding the valuation of different types of Fraud Economy assets as a function of where these assets stand in the Fraud Economy value chain.
Fundamentally, an all-encompassing, end-to-end fraud solution for a merchant must be comprised of two core components: a system to detect and prevent “true” fraud, where a consumer’s payment information has been stolen or compromised and used to make purchases, and a system to address consumer originated claims against merchants for a faulty product and/or service delivery, otherwise known as “friendly fraud”. In both cases, the outcome typically involves a chargeback which can be a costly assessment to the merchant in terms of refunds, fees to payments providers, and, especially in the case of online merchants, loss of inventory or collection and restocking of reclaimed inventory.
As there are two core components, there are also two types of core assets in the Fraud Economy value chain: those that provide detection and prevention of fraudulent activity, and those that handle disputes, claim representment, and resolution of chargebacks. Sift and Forter represent the former, and Chargeback represents the latter. As a function of providing fundamentally different products and services, the make-up of these two different types of assets – financially, technologically, and in terms of scalability – is also very different.
The businesses of fraud detectors and preventers like Sift and Forter are based on sophisticated, machine learning AI technology that uses massive amounts of data to detect unusual patterns of activity which get flagged in their respective systems and escalated for review. This is all done in real-time and if raised to the level of a potential threat, will prevent the payments transaction from getting pushed through. The chargeback management companies, on the other hand, are not built on top of machine learning AI, but rather have succeeded in automating data aggregation from merchants, banks, payments processors, and fraud detectors, analyzing that data and streamlining the representment process, largely through automation, to resolve chargeback claims. The technology used by the detectors and preventers is cutting edge compared to that used by the chargeback managers. And even though the chargeback management firms have come a long way in developing automated processes, the nature of their product and service offering still requires people to drive data analytics and decision making.
The disparity in technology, by extension, leads to a disparity in financial well-being by way of the costs of goods sold. The necessity of the human component in the chargeback management companies necessarily eats away at gross margin. Whereas R&D blowback from the detectors and preventers may even out at the operating income level, R&D ought not to be considered recurring expense as such, and this brings into question the advantages that the detectors and preventers have when it comes to scalability: the Forters and Sifts of the world can leverage the same technology to grow while the Chargebacks of the world must increase personnel proportionally.
The dichotomy between the business models of fraud detection and prevention companies and chargeback management companies is stark when seen through this perspective. The preventers and detectors look like highly scalable technology assets while the chargeback management firms like tech-light, human-heavy services companies. As such, it’s my opinion that the scalability and greater potential operating margins that advantage the detectors and preventers must command a higher valuation than their Fraud Economy, chargeback management peers.
To be clear, nothing suggested here speaks to the value of the service/product offering that either type of asset, fraud prevention or management, brings to the table. They both offer critical infrastructure to merchant businesses, and countless cost savings and time. As stated earlier, they are both integral to any end-to-end fraud solution and this is exactly what the Sift acquisition of Chargeback represents: a highly strategic merger of products and competencies that offers comprehensive, one-stop fraud prevention and management offering.
But the Series F round taken in by Forter is consistent with a more dominant investment theme in the marketplace that suggests that the big money, and I believe, higher valuations, will ultimately continue to flow to the fraud detection and prevention platforms. There’s compelling evidence to support this conclusion by virtue of 2021 investment and M&A activity alone:
It’s hard not to conclude from the above that the fraud detectors and preventers aren’t the market winners when compared to their chargeback management peers. Surely, there’s market demand for both types of assets, but it’s very clear, right now, where investor monies are flowing.
Fraud detection, prevention, and management is an active space for M&A and investment, and I expect to see the fundings and acquisitions continue. Fortunately for investors, and perhaps less so for merchants, the consumer preference for online commerce appears to have achieved a semblance of permanency, and as a result, the market demand to manage losses from fraudulent payments has never been greater.