Introduction
Investors have long enjoyed good yields by lending capital to companies. But because monetary policy has driven rates lower in recent years, those loans, along with many other types of traditional income-providing securities, no longer offer appealing returns.
Looking for a solution, institutional investors have increasingly been deploying capital toward alternative forms of credit, such as private credit. Private credit encompasses an array of strategies, with widely differing characteristics and limited comparability. Importantly, evaluating those strategies can be challenging, leaving some investors exposed to unexpected and inappropriate levels of risk.
Venture debt is a key part of the private credit universe. It’s a form of direct lending to growth-stage technology companies that differs from traditional lending in a number of important ways. In this white paper, we outline how venture debt can offer a solution to the problems yield-oriented investors face. We also explain the differences between venture debt and traditional lending, and show how those differences can have a positive impact on portfolio returns. Finally, we’ll look at the characteristics of technology companies that make them particularly attractive borrowers, and the unique ways in which venture debt can benefit them.
Advantages of investing in venture debt
Venture debt can generate high yields for investors, which is particularly important given today’s low interest rate environment. But its income potential is only part of the reason why investors should consider adding a venture debt component to their portfolios. As an asset class, it has five other attractive attributes that are worth noting:
Lower portfolio risk
One of venture debt’s greatest features is the diversification it brings to portfolios. Because returns from venture debt are relatively uncorrelated with those from other asset classes, investing in it can create value at the portfolio level.
Although there’s a substantial body of academic literature around diversification, the intuition behind it is very straightforward. Simply put, the world is an uncertain place. If every investment in your portfolio responds to environmental changes in the same way, then anytime something bad happens, those investments will all go down in value together.
What this means is that in an ideal world, your portfolio should be made up of an array of investments that don’t all move together. That simple fact helps make the case for investing in venture debt because there’s a body of evidence that suggests that the returns from private credit and venture debt aren’t particularly correlated with returns from other asset classes. In other words, the returns from venture debt don’t change in lockstep with many other investments.
If venture debt returns aren’t correlated to other holdings in your portfolio, then adding that exposure can lower your portfolio’s overall risk. In that way, investing in venture debt has the potential to increase the value of your portfolio by increasing its diversification.
Risk and returns aren’t precisely correlated
Of course, venture debt isn’t just about diversification. It’s an attractive investment in its own right given that it generates higher yields than many other income-producing assets. While for the most part, yields and risk move together — investors demand higher returns to compensate them for holding riskier assets — there are structural reasons why that isn’t completely true of venture debt.
Although there aren’t many specialist venture debt providers, there are a lot of companies in need of their capital. This imbalance between supply and demand means that the yield on loans isn’t just a linear function of the borrowers’ risk, thus creating an opportunity for lenders. In most cases, the antidote to that sort of imbalance between supply and demand is having more lenders enter the market. However, venture debt lending requires specialist knowledge and processes that aren’t easily acquired.
Among mature, stable companies, for example, the price of both equity and debt is relatively transparent, especially if the company is public. CFOs can optimize their debt and equity weightings to achieve the lowest possible weighted average cost of capital (WACC). Those companies can easily be compared to one another, meaning that their risks — and therefore the cost of their capital — are also very comparable. That similarity lends itself to a very transparent pricing model.
That isn’t true with venture debt. A tech borrower’s financial statements don’t look much like the financial statements for a mature enterprise. In fact, they might not look like the financial statements for other tech companies, for that matter, and the company’s products might not look like anything else on the market at all. These sorts of issues make it hard to casually compare one company to another and decide which is less risky.
While it’s hard to compare businesses, it’s not impossible. Specialist venture debt lenders can do so because they use different tools and processes than traditional lenders. The models that drive venture debt underwriting processes are also quite different than the ones that traditional lenders rely on in terms of their construction and uses. So too are the skills and experience needed to interpret those models.
Of course, spreadsheet-based financial analysis is only part of the story. In addition to the quantitative analysis needed for venture debt, specialist lenders incorporate a lot of qualitative work into their assessments. They might rely on their knowledge of what’s happening in a particular vertical to gauge the likelihood of a company’s success, for example. Alternatively, they might look at the personal qualities of a management team or the degree to which a company’s equity sponsors are committed to its future success. In each case, their specialist knowledge and focus enable them to better understand the value of these enterprises and affords them greater visibility into loan to value. The fact that those insights aren’t generally visible decouples the risk-reward relationship to some extent.
Ultimately, risk and return may not be as precisely correlated in venture debt as they are in other asset classes. The fact that dedicated capital and specialist underwriting knowledge are in relatively short supply, while lots of companies need funding, creates an imbalance. The way to resolve that imbalance — generally in the lenders’ favor — is through terms and pricing.
Low loan-to-value
How do those advantages in terms and pricing benefit venture debt investors? As noted above, venture debt lenders’ specialized focus allows them to better understand prospective borrowers’ enterprise values. Knowing that enables them to assess loans at appropriate ratios to value, thereby protecting their investors in downside scenarios.
Interest rates on tech loans look closer to distressed debt financings than most other credit instruments. But while debt might comprise a high percentage of the enterprise value of a distressed entity, venture debt can be structured to represent just 10 to 15 percent of the value of a rapidly growing business.
That low loan-to-value (LTV) represents a margin of safety for venture debt investors that you won’t find in many other structures paying out comparable yields. Moreover, it can be augmented with support from other stakeholders, such as equity sponsors.
The combination of low LTVs and motivated investor bases leads to lower default and loss rates than you’ll find in similar asset classes and cumulative credit events and provisions that don’t correspond to the headline interest rates charged. Specifically, while an estimated 17.4 percent of small business administration loans awarded between 2006 and 2015 went into default, the venture debt industry realizes just 2.0 percent in lost capital each year.
Specialist venture debt lenders are able to more accurately discern the value of their borrowers’ business than other lenders might be able to. That means that if the business deteriorates unexpectedly, a good venture debt lender can take whatever steps are necessary to monetize the asset. Even if the deterioration has been steep or dramatic, the relatively low initial LTV ratio that many venture debt loans are underwritten at provides investors with a margin of safety that you won’t find in more leveraged strategies.
Partnering with sponsors
Low LTV ratios are one way in which venture debt lenders protect their investors, but there are other ways in which specialists can increase the margin of safety on investments. We’ve already talked about familiarity with the people involved in tech companies, which might be very different to those seen in mature businesses. But it’s also important to know and understand a young company’s backers.
In fact, understanding the scale, quality, and depth of an equity sponsor’s commitment to a company is an explicit consideration when underwriting a venture loan. And it’s one that leads to better outcomes for lenders.
Venture debt lenders get comfortable with the amount and kind of equity support that a prospective borrower can tap through having their own relationships within the venture capital universe. The more times that people deal with one another, the more valuable those relationships become. Again, this isn’t an analytical tool that’s available to non-specialists, even though it is incredibly important.
Beyond the value that sponsor relationships can afford a lender in terms of underwriting, they’re also important sources of deal flow. Sponsors want to partner with firms that have the capacity to help their portfolio companies. They also want to partner with people they like and trust. That trust is earned over multiple iterations of a process and can’t be replicated.
Relatively short term
Venture debt lenders aren’t generally trying to guess what the world will look like in a decade’s time, and they’re certainly not investing on the basis of those views. Instead, they’re trying to gauge what’s most likely to happen in the next two or three years, and lend on terms that will see them paid back in that timeframe.
There’s a chronological tipping point after which debt is a less appealing choice than equity. Where that point lies hinges on many factors, but it’s a valid consideration for managers and equity holders, and often serves to motivate them to refinance a company’s debt.
The impact on a lender is that the duration of any asset is likely lower than the stated terms would make it appear. Unlike corporate loans, venture debt isn’t priced as a spread off a yield curve to begin with. The short duration of a typical loan further differentiates the return profile of a venture debt portfolio from that of a traditional fixed-income asset.
Why tech companies are attractive borrowers
Tech companies might not screen well on traditional credit metrics, but they do have a number of attributes that make them better borrowers than they first appear. Those attributes include the nature of tech companies’ business models and the secular trends that drive the sector. Both of those dynamics have the potential to create an excellent scenario for lending.
They've built a better model
Despite the fact that they don’t look like the sort of business banks like lending money to, many tech companies’ business models are more robust than they may first appear based on their financial metrics. They’re also better borrowers than they might look. Software as a service (SaaS) companies, for example, can grow with their existing clients without incurring any meaningful costs to do so. Increased sales to existing customers therefore carry very high contribution margins and create tremendous operating leverage.
While there will always be a range, in our experience, SaaS companies typically have to spend $1 on sales and marketing to acquire $1 of annual recurring revenue. The return on that investment is significant, however, since contribution margins on that incremental revenue can be between 70 and 80 percent, with customer lifetimes typically ranging from 8 to 10 years. In addition, many of the best SaaS businesses have a negative net dollar churn. That means that the revenue growth from upselling existing customers is greater than any lost revenue from customer cancellations.
In contrast, if sales aren’t increasing, the cost of servicing an installed base is often relatively modest. Each historic sale is effectively a form of annuity. SaaS companies also have the flexibility to cut sales-related expenses in ways that aren’t available to other businesses. That’s because the installed base will keep generating revenues regardless of how many new sales a SaaS business closes. A SaaS company’s sales engine is a growth vehicle, not a maintenance effort. If a software business can’t generate economic returns from new sales, it can cut out that investment and still earn a return from its existing customers.
That nuance provides additional security for lenders. If a company is genuinely trading off short-term profitability for rapid growth, it implies that it can toggle toward profitability by cutting back on its growth spending. A business model that can become more profitable even as its growth efforts become a lower priority has an obvious appeal to lenders.
They're benefiting from secular growth
The tech companies described above have very appealing business models. On top of that, many are operating with the benefit of powerful tailwinds with respect to changes in how businesses and consumers use their products. Those tailwinds also benefit venture debt lenders and investors.
For example, SaaS lending is one of the biggest segments of venture debt lending and one of the most attractive. Many SaaS companies sell mission-critical software and related services or devices to a wide range of customers. As a result, they’re very resilient to economic turbulence.
Not only that, the waterfall nature of SaaS models can lead to bigger, longer-term revenue streams than traditional software revenue models. In fact, SaaS revenues tend to grow by an average of 25 to 30 percent, while on-premises solutions are only growing at 8 to 9 percent. For investors, those growth rates suggest that each dollar of funding can create $3 to $5 of enterprise value. That value creation can result in swift deleveraging of a company’s balance sheet, which has a positive effect on a loan’s safety.
Simply put, today’s tech companies aren’t just younger versions of companies that have been around for decades. They operate under an entirely different model. Their marginal costs can be negligible, implying the potential for tremendous operating leverage, while a number of trends provide considerable tailwinds for them.
How venture debt benefits borrowers
Venture debt can afford investors tremendous advantages relative to other investment choices, but the benefits flow both in both directions. Tech companies can also benefit from utilizing debt in a number of different ways.
Comparing debt and equity
As we noted above, large companies often use debt to lower their WACC, in part through the tax treatment of interest versus dividends. But since young companies are typically unprofitable, and therefore don’t pay tax, they don’t see any benefits from that tax shield. As such, how can they benefit from borrowing instead of selling equity?
The answer is less about the cost of the debt than it is about the cost of the equity. A $20 million company that raises $5 million in equity can invest that money to grow. Let’s say that it doubles in size over the next two years and then gets acquired for $50 million. If so, the original investors own 75 percent of that, making their stake worth around $37.5 million.
While that’s a great outcome, if they’d borrowed the $5 million they needed to grow, they might have paid 15 percent ($750,000) per year, incurring $1.5 million in interest charges over two years. The loan would be included in the enterprise value calculation at the time of the sale, leaving an equity value of $45 million before the financing costs (or $43.5 million, net). The original equity investors would still own 100 percent of that, yielding a measurably better outcome for them compared to the equity scenario. Not only that, the delta is actually understated relative to real-world dynamics.
Beyond the dilution that the share sale might bring about, later investors often obtain a liquidity preference, heightening the risk to earlier investors. Moreover, later stage investors might have different time horizons and investment parameters than those who invested earlier. A shareholder who’s owned stock in a venture for seven years might well feel differently about the right time to go public or sell the business than one who invested six months ago. That tension is rarely constructive for the business or its managers.
There are other, softer costs to issuing equity. While an investor who takes a board seat can add tremendous value, the long-term vision of a founder can differ radically from the needs of an investor whose fund has a seven-year investment horizon. Those differences might not become apparent until after the actual investment has been made. A CEO might have to spend her valuable time aligning her shareholder base in the event that she has stockholders with competing priorities, or deal with inefficient governance structures created to give every equity investor a voice.
Venture debt allows companies to avoid some of the problems associated with equity raises, while giving investors significant benefits compared to other yield instruments and vehicles. The increasing availability and use of venture debt facilities reflects a clear recognition of its value among both borrowers and investors. In fact, according to some estimates, venture debt now makes up approximately 10 to 15 percent of the total venture capital invested in any given year. That’s the equivalent of between $8 billion and $12 billion in venture debt annually since 2014.
Other reasons why venture debt makes sense
While the hypothetical example given above features a company on a fantastic trajectory, venture debt can also work for businesses whose path to success is less straightforward. Not meeting financial targets in the context of an early stage financing can force a company to seek new capital on less favorable terms, i.e., a down round, in which the implied value for later investors is lower than for earlier ones. That scenario not only entails significant dilution, but can also force investors to cede liquidation preferences or control mechanisms.
In this example, venture debt can give companies more runway to bridge the gap between equity rounds, offering a chance to sell stock on better terms. Importantly, however, debt isn’t a panacea for genuinely troubled companies. If the reason a company is failing to meet its targets is because it has a flawed business model, it’s unlikely to be able to borrow its way out of those problems. Nevertheless, in cases where a company just needs a bit more time, or can execute a course correction to change its growth profile, venture debt can provide significant optionality at relatively low cost.
There are myriad other use cases for venture debt, many of which are a function of the flexibility that can be built into a debt agreement. Companies might borrow to fund working capital or an acquisition. They might want to buy out a partner whose priorities have changed. Or the time and effort involved in raising debt might be less than that required for an equity deal.
The reasons why young, unprofitable companies should borrow money might not be intuitive or obvious. However, debt can solve a range of problems that equity sales often creates, including dilution, shareholder dynamics, and the need for flexibility. Meanwhile its use can create tremendous value for stakeholders under the appropriate circ*mstances.
Investing in venture debt
One of the ways in which venture debt helps investors to diversify their portfolios is that tech companies’ customers are so diversified themselves. Investments in software companies represent investments in their customer bases, which in turn span the whole economy.
Those companies have embraced the possibilities that software and other advances in technology offer in terms of cost reduction, scalability, and growth potential, and that trend isn’t going to reverse. Even if one part of the economy falters, the tech sector will likely continue to succeed overall. Investing in venture debt offers exposure to that success.
Venture debt allows nontraditional borrowers to fund their growth initiatives efficiently, and solves for a number of issues that can arise by relying solely on equity financing. Although it entails risks, when used properly, venture debt can increase the returns to other stakeholders and afford management teams and founders more flexibility than they might otherwise retain.
Finally, investing in venture debt can generate higher returns than are available in other parts of the credit universe, without forcing investors to take on unacceptable levels of risk. Fast-growing tech companies might lack the cash flows and assets that lenders traditionally look for. However, that creates an opportunity for other investors, allowing them to optimize the risk-reward trade-off in their portfolios.
