Once Shunned, Regulated Industries Now a Lure for Some Investors

Xconomy San Francisco — 

When Alex Niehenke started his business career at an investment bank in 2005 as an advisor to Internet companies, there was one strongly held consensus among investors.

“You just didn’t touch regulated industries,” says Niehenke, who was recently promoted to partner at Silicon Valley venture capital firm Scale Venture Partners. Investors didn’t want the risks and the burdens.

A dozen years later, his investment thesis is a complete turnaround. He says some of the best prospects are startups in heavily regulated industries such as insurance, real estate, and financial technology.

But that doesn’t necessarily mean those startups will always be toeing the line with existing regulatory schemes. Regulations, as well as sectors, can be ripe for disruption, Niehenke says. (More on that later.)

It goes without saying that Niehenke’s views went through stages of evolution in the years since 2005, when the fledgling Internet-based economy would mushroom into a behemoth that has transformed some industries and nearly obliterated others. At first, heavily regulated industries seemed immune to the tech invasion. But the opportunities changed at each stage of Niehenke’s career, which provides snapshots of three different mini-eras.

June 2005: Fresh from the University of California, Berkeley, Niehenke (pictured) joined investment bank Montgomery & Co. as an associate, when Internet companies were still recovering from the dot-com bust. The original growers of the Internet industry were mostly limited to online forms of entertainment and sources of information such as Yahoo! and AOL. Niehenke participated in the early development of social media as an advisor to Myspace, which was sold to Rupert Murdoch’s News Corp. in mid-2005.

E-commerce sites eBay and Amazon were gearing up, but Web-based computing and mobile phones were still emerging technologies. This is when regulated industries, such as finance, were a non-starter for investors, Niehenke says.

November 2009: Niehenke was hired as an associate at venture capital firm Crosslink Capital in San Francisco, when the U.S. economy was reeling from the financial crisis that followed the failures of financial institutions triggered in part by collapsing values of mortgage-backed securities. During the resulting consumer credit crisis, Niehenke theorized that consumers whose trust in traditional banks had eroded might become a willing customer base for financial technology startups. But it was a bumpy time for tech companies entering the highly regulated financial sector.

Among those startups was Prosper, a peer-to-peer lending startup that had been temporarily shut down in 2008 by the Securities and Exchange Commission. The SEC maintained that the company was, in effect, selling securities rather than merely functioning as a marketplace connecting lenders and borrowers, TechCrunch reported.

In 2010, Niehenke spent a substantial amount of his time studying the regulatory environment of the finance sector, and Crosslink became a Prosper investor in 2011.

But this was a period when venture partners were still wondering whether this highly regulated industry was the right place to put venture dollars, Niehenke says.

Needless to say, things changed fairly quickly. Fintech companies would haul in $19 billion in global financing in 2015, and accelerate beyond that in 2016, according to a BI Intelligence report.

January 2013: Niehenke joined Foster City, CA-based Scale Venture Partners; he was named a partner in October this year. He says that today, regulation is just another factor to consider, not a problem that prevents VCs from investing.

“It’s something you navigate, like hiring,” Niehenke says. Investors have realized that some of the largest markets are regulated, he says. In fact, a heavy regulatory environment can now make a sector more attractive.

“Industries that do have regulation are ripe for disruption,” Niehenke says. Regulation raises barriers to entry and decreases competition, leaving established firms vulnerable because they have no incentive to innovate, he says.

As an example, the taxi industry didn’t bite when companies offered them software to fulfill consumers’ desire to call up rides with their mobile phones, he says. Uber and Lyft pioneered that model instead, disrupting taxi monopolies.

Niehenke now sees the insurance industry as a similarly stodgy field that could be transformed by technology that meets consumer expectations. For example, drivers could use their mobile phones to take photos of the damage to their cars after an accident, then go home rather than stay on the scene talking to a claims representative for 45 minutes or doing paperwork, he says. “We might want to do that in our living rooms while watching ‘Game of Thrones,’” he says.

Consumers currently choose among the top insurance carriers based mainly on price—but technology startups could help these firms distinguish themselves with a better user experience, Niehenke says.

Regulation can also offer opportunities for startups that can help companies comply with the rules, he says. One of Scale’s portfolio companies is KeepTruckin, which provides truck fleets with electronic tracking of truck movements to make sure drivers aren’t clocking an unsafe number of hours on the road, Niehenke says. He’s on the company’s board.

Tech firms have broken into regulated fields in two different modes, he says. One of them is the disruptive steamroller model initially pursued by Uber and Airbnb, which took the stance that prevailing regulations governing taxi licenses and hotel taxes didn’t apply to them.

That “high-risk, high-reward” strategy can work when companies have mass appeal and can attract a large customer base fairly quickly, Niehenke says. Their leverage over regulators is to say, in effect, “We’re going to have so many happy users that as regulators, we dare you to shut us down,” he says.

But that plan doesn’t work in industries such as insurance, where startups can’t sign up a single customer without complying with regulations, he says. In any case, the current trend is for tech companies to dig in and work with regulators to influence the rules in their own favor, Niehenke says.

“Uber and Airbnb both have so many lawyers employed full-time that they could operate a small law firm,” Niehenke says. “Google has become one of the largest political contributors.”

That shaping of regulations to suit established tech companies could set up a new cycle of disruption for the next generation of startups, Niehenke says. For example, if Uber and Lyft achieve monopolies in city transportation, and use their complete control of pricing to hike up rates, they could trigger a backlash from consumers demanding government antitrust measures, he says.

“Uber could become the quickest company to de-regulate an industry, only to re-regulate it,” Niehenke says.

Photo courtesy of Scale Venture Partners