Is venture debt a good news story for investors?

As start-ups struggle with a venture capital pullback given rising rates, inflation and increasingly volatile markets, venture debt is coming to the forefront. The only companies that will survive are the ones who raise capital – either as equity, debt or both.

According to a recent PitchBook article, venture debt dealflow stood at $22.4 billion through September 29 and has exceeded $30 billion annually in the past few years. Expectations for continued rapid and substantial growth can be seen in recent venture debt funds launches from Blackstone and KKR.

Venture debt fills a funding gap in today’s markets. It enables nascent companies to access critical funding for operations and growth, while providing potential upside for smart investors in challenging markets.

Upside in a down market

When there’s a market downturn, venture debt can offer high yields and incentives to investors.

These outsized yields are undeniably interesting to investors, but they must understand that those returns correlate to heightened risk. Venture debt structures often include features to make that risk more attractive:

• As a debt instrument, venture debt has a higher liquidation priority than equity, raising the chances that the lender will be repaid.
• Warrants give lenders an additional upside since they can be exercised to purchase common stock in the borrower entity.
• Covenants can be provided to align incentives and boost the odds of repayment.

Venture debt deals typically have 12-36 months tenor and pay monthly contractual income from interest and fees. The ability to refinance or structure a new transaction at prevailing interest rates, once an existing deal terms out, can make venture loans even more appealing in a rising rate environment.

The value for equity investors

Equity investors may wonder about the impact of venture debt on the companies they back. They need not fear though as venture debt can complement venture capital by extending the runway between fundraising rounds. It provides working capital to support the company on its journey to profitability.

Equity investors who are able to invest in debt may also consider making a supplemental investment. As active investors, they already have insight into company fundamentals and confidence in its prospects. Beyond minimizing dilution and garnering yield in the short term, they can support the company’s ongoing viability. Over the longer term, warrants or covenants can add equity upside.

A chance for more investors to get in on the action

Since venture debt deals are typically a fraction of the size of venture capital funding rounds, their smaller scale creates opportunity for a broader group of investors. These transactions, particularly for earlier stage companies, generally attract fewer big funds, who may not be as interested in multiple, smaller investments.

This opens the door for small- or mid-sized funds to gain access to the higher yields and benefits noted above. They can make a relatively small loan or take a larger stake, syndicating it out to other investors to offset liquidity risk.

Caveat emptor

Evaluating venture debt opportunities is no easy task. While venture lending loss rates have been reportedly low, investors must do their own due diligence to understand the company’s profile and financials.

In venture debt, underwriting the investment from a qualitative standpoint becomes critically important. Similar to underwriting equity investments into a company, investors will want to dig beyond balance sheets and income statements to metrics that are less analytical or well-defined. This can include the experience of the company’s management, product market fit, the competitive landscape and overall macro trends.

In a tight market, look at the company through the eyes of a customer. Where do you think customers will put their money? Is this a luxury or convenience brand that will be pressured by high costs, or does it offer deeper and lasting value?

Many investors who are accustomed to investing in equity may be uncomfortable investing in debt. That’s where underwriters come in. Underwriters who specialize in venture debt have the experience to uncover the qualitative details that will green light a transaction, providing a level of comfort to investors that the structure is done in a way that maximizes investor returns.

A marketplace to help demand meet supply

In a market where technology has historically been non-existent, some newer options are aggregating and standardizing information to make evaluation and comparison easier. This transparency opens the door for a simpler funding and investing experience. Given market interest and demand on both the buy and sell side, that can’t come soon enough.

That’s why Percent is expanding its technology-enabled, efficient channel to raise growth capital via venture debt and onboarding new underwriters to our platform who specialize in venture debt. This additional expertise in vetting venture debt transactions will make it easier for investors to source and get comfort around these unique opportunities.

Ultimately, enhanced discoverability and an automated marketplace that supports syndication creates a framework for private debt to grow, even as markets remain unpredictable. Companies can quickly go to market and gain the critical funds they need for growth while more investors have access to investment opportunities with consistently attractive yields.

Nelson Chu is the founder and CEO of Percent, an alternative investments platform.