Managing partner and cofounder of Sanctum Capital Management, a debt and equity investment firm focused on high-growth tech companies.
In my previous articles, I’ve written to a founder audience on venture debt for fast-growing businesses and how venture debt differs from traditional commercial bank offerings. In this article, I speak to large credit funds and growth PE firms looking to learn more about adding a venture debt capability to their existing platforms.
While venture equity has been the standard source of capital for technology companies, venture debt financings have grown over the last decade, from $8.1 billion in 2013 to $35.5 billion in 2022, according to PitchBook.
Broadly, venture debt is a form of private debt financing targeted at mid- to late-stage technology companies that are typically not yet EBITDA positive. Note that by “venture debt” I mean credit funds, as opposed to commercial banks that lend to the sector—an important difference I highlighted in a previous article.
Benefits Of A Venture Debt Strategy For A Diversified Credit Platform
A venture debt strategy in a diversified credit platform can provide a holistic solution for borrowers and include opportunities that were passed upon before. Based on my experience, here are a few ways a credit strategy that focuses specifically on technology companies can offer potential advantages:
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• Enhance origination: A venture debt team may source deals that are too late-stage for them but perfect for the main fund, and vice versa.
• Diversify sources of yield: Based on my experience and drawing from public data, yields can range from 10%-14%; most VD funds are levered and can provide gross returns of 20%. In addition, loans provide access to equity kickers in high-growth companies for additional yield.
• Increase access: This strategy allows access to an underserved segment of credit with barriers to entry that have kept the supply of this type of financing low.
When executed properly, venture lending can be a stable, weather-resistant strategy for those looking to avoid market fluctuations.
Risk Factors To Consider
Venture lending is a unique subsegment within broader private credit, and as such requires different underwriting tools and mindset, risk tolerance and internal processes to manage a portfolio of such loans. As with any credit strategy, over-extending leverage or not properly underwriting borrowers could lead to issues with the loans. This strategy requires:
• Experience with both credit and technology business models: This is needed for successful underwriting because several key markers used for credit analysis simply aren’t available, such as positive EBITDA or cashflow, hard assets, established liquidation values, predictable growth curves and default rates.
• Specialized due diligence: For a credit firm that may be more focused on later-stage, cash-flowing businesses, making venture loans can seem like a leap of faith. However, there are best practices and loan histories available from publicly traded BDCs that can help guide firms.
A credit firm looking to extend into venture lending might consider bringing in-house or forming a joint venture with a team that has already been in this segment for several years. Some considerations when vetting a team would be the team’s experience during a downturn, managing distressed situations and the strength of their network in the technology ecosystem.
Benefits Of A Venture Debt Strategy For A Technology-Focused Growth PE Firm
Adding a credit strategy to an existing technology-focused private equity platform has been accomplished by large PE platforms. Examples include Vista Credit, Thoma Bravo Credit and Francisco Credit—all added to firms that bear the same names.
Since venture debt is simply private credit aimed at slightly less mature companies than typical middle-market, it follows that growth PE firms that similarly invest in younger companies could reap the same benefits, including the following:
• Diversify sources of fees and income: This strategy can increase the valuation multiple of the GP over time. In addition, early ownership in a platform that can be spun out in the future creates a source of additional returns to the GP.
• Deepen relationships with large LPs: This means gaining access to other silos of capital beyond venture equity, such as credit, direct lending, etc. The existing relationship should help facilitate fundraising for the new platform and reduce ramp-up time. It can also enhance origination from the knowledge and pipeline sharing of deals back and forth between the equity and debt teams.
• Support existing portfolio as well as future investments: The in-house credit team can advise on debt and cap structure issues/questions within the portfolio, as well as design competitive hybrid structures (such as structured equity, converts, etc.).
Offering such a complementary, differentiated product that provides less dilution for entrepreneurs and management teams and adds to the long-term partnership story could help make a difference in winning deals.
Risk Factors To Consider
Growth PE firms are more accustomed to solving for upside, rather than lenders who are focused on managing downside risk. This will require a shift in analysis and underwriting, namely focusing on:
• Risk-adjustment: Venture lending is best understood on a risk-adjusted basis. While credit has a lower ROI than PE, being senior-secured means the credit investment is also less risky.
• Expertise: A growth PE firm looking to extend into venture lending might consider bringing in-house, or forming a joint venture with, a team that has already been in this segment for several years, has an excellent track record across cycles and can articulate to their existing LPs the benefits of adding credit.
Such a team should bring a similar appreciation for technology business models; the typical venture debt investment memo is actually quite detailed and covers all the same elements as an equity IC memo. Cross-incentivizing the equity and debt teams can ensure teamwork and cooperation. Finally, developing clear marketing and origination, so as not to confuse borrowers/portfolio companies about which side of the firm is making the investment is important.
Summary
Both scaled credit platforms and growth PE firms can now consider the impacts of including venture lending expertise in their platforms. As with any new strategy, it’s important to understand both the benefits and challenges associated with its implementation.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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