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Friday Letter: New venture debt fund has perfect timing

A.R.I. Venture Debt Opportunities Fund is in the market just as founder Zack Ellison is seeing a surge of interest from both potential borrowers and investors desperate for returns in a market downturn.

Zack Ellison has been waiting for this moment for more than four years.

In 2018, he was a New York bond trader, but he yearned for something more. “I felt the public bond market – mainly corporate bonds – had very little potential for the rest of my career,” he tells me. “They were low-yield and there weren’t that many actively managed portfolios. I started to ask myself, where do I want to spend the second half of my career, where I can generate high risk-adjusted returns?”

The answer was venture debt.

Zack Ellison, Applied Real Intelligence, ARI, A.R.I
Zack Ellison, Applied Real Intelligence

So said several of Ellison’s mentors. After lots of research, he was convinced it was perfect timing to get into the burgeoning market, which is served by only about a dozen “institutional quality” lenders, including Comerica Bank, Hercules Capital, Silicon Valley Bank and TriplePoint Venture Growth.

Ellison was only a little bit worried about launching Applied Real Intelligence LLC in the middle of a bull market. He told himself at the time, “The bull market is going to end and interest rates are going to increase, but this market [venture debt] is going to continue to grow because founders have a strong demand for it.”

Sure enough, we are now in a bear market and the Fed is quickly raising rates to battle inflation. At the start of the year, venture debt funds were charging prime rate (3.25 percent) plus another 5 percent to 6 percent, but now they are lending at prime (4.75 percent) plus about 8 percent, he said.

Ellison’s timing was just about perfect. His first fund, A.R.I. Venture Debt Opportunities Fund, is now in the market with a $125 million target just as he is seeing a surge of interest from potential borrowers and investors desperate for returns in a market downturn.

About 300 investors tuned into a venture debt webinar Ellison participated in on Monday. “I’ve probably done about 100 webinars in the last three years, but I’ve never had 300 institutions on one webinar – ever,” he says.

Los Angeles-based ARI is fielding interest from family offices, foundations, endowments, pensions and, increasingly, registered investment advisors. “RIAs are all over us right now,” Ellison says. “They’ve been putting their clients into equities and bonds and are now down 25 percent year-to-date, so they need a solution.”

What’s the attraction of venture debt?

Right off the top, venture debt providers have produced an average gross annual IRR of more than 20 percent since 2005, according to Ellison’s research.

Another big plus is that the risk of these loans is surprisingly low. The average loss rate for venture debt has been less than 50 basis points per year since 2005, compared to about 6 percent per year for an SBA loan, Ellison said. That’s because venture debt providers are picky about who they lend to, generally focusing on profitable companies that are growing revenue at least 50 percent per year. ARI plans to lend only to companies that have recently raised equity financing and to avoid start-ups that cannot raise fresh equity. Its loans will be secured by a first lien on all of a company’s assets, including intellectual property, receivables, inventory and cash.

Another plus: ARI will make quarterly distributions. “If you’re in a PE or VC fund, you’re waiting seven to 12 years to see any income, but in venture debt there is no J curve,” Ellison says.

If you invest with the right fund, you may also have the chance to co-invest. That can be particularly attractive to family offices that like to make direct investments. ARI expects to make about a dozen investments next year with its first fund, targeting loans of $15 million to $25 million. It plans to finance $10 million to $15 million of those deals itself and offer the remainder to its LPs with no fee.

“They get to choose the sectors and companies they want exposure to, like cybersecurity,” Ellison said. “We’re creating access that few people have [to a particular deal].”

ARI’s debut fund will charge a standard 2 percent management fee and 20 percent carried interest. “We’re structured as a five-year, closed-end traditional drawdown fund, similar to a private credit fund,” Ellison says. “We will have a three-year investment period and two-year harvesting period.”

That is just a bit longer than it took Ellison to get to where he is today. “I knew that I had to build an institutional quality firm, that’s what took a long time,” he says, adding that he spent “millions of dollars and went without a paycheck for over three years.”

He also had to fight against self-doubt and questions from peers.

“Two years ago, everyone thought I was crazy,” he said. “They were saying, ‘Why did you leave a great career and choose to start your own company with a product I’ve never heard of?’ But I was betting on myself and my ability to execute. Right now is about as good as it can be.”

Correction: Zack Ellison was director of US fixed income for Sun Life Investment Management in 2017, but left in 2018 to be a bond trader.