Tipping Point: Oft-overlooked venture debt market balloons into a $10 bln industry

Sam Bhaumik, an executive vice president at the venture lending division at Avidbank, has been in the industry for more than 35 years. In that time Bhaumik has seen a few recessions, as well as the rise of mega-rounds for tech startups and the emergence of the word “unicorn” to describe a young tech company valued at $1 billion or more.

Lately, Bhaumik said that he has definitely noticed the demand grow for the asset class of venture debt. “Today, most venture-backed companies, when determining their overall need for capital, plan on getting some amount of venture debt,” Bhaumik said.

What Bhaumik and others are seeing is that venture debt happens to stand as one of the hottest trends in the venture ecosystem, and venture debt deal sizes are certain to increase in size.

A recent report from Kruze Consulting found that venture debt is exploding at a rate of between 20 and 30 percent year-over-year. The report stated that the market is predicted to swell to $10.1 billion this year, about 20 percent higher than 2018 and double from 2016.

Kruze Consulting also found, in a survey of players in the venture debt market, that more than 70 percent believe that venture debt deal sizes are getting bigger, in line with the robust VC dealmaking taking place in which more equity rounds are $100 million or more in size. And Kruze Consulting reported that none of the respondents said that they see activity shrinking in 2019.

For Bhaumik and many other lenders in the space, venture debt is nothing new. It offers companies a cheaper and more flexible capital source compared to equity, and it doesn’t dilute ownership. The strategy comes in many forms and can be as simple as a revolving credit facility, a term loan or something more flexible. Over time, lenders have found it’s a market that can provide almost consistent double-digit returns and touts an incredibly low historic default rate.

Now, borrowers as well as the lenders are catching on that the market is growing.

Ten years ago, only 12 percent of venture deals included a debt component, but that number rose steadily to 17 percent last year and 20 percent so far in 2019, according to data from PitchBook. More than 1,400 venture deals so far in 2019 have had a debt component, nearly triple the 548 deals from 2009.

While the market has a strong bank presence from such players as Avidbank, Silicon Valley Bank and Comerica, it has also seen the additions of multiple private lenders within venture debt, which opens up the market for investors.

“The current marketplace for venture debt is not a big universe but a really competitive universe,” Bhaumik said. “It’s really come down to a small group of players that really understand the venture ecosystem.”

Rob Pomeroy, the chief executive at Horizon Technology Finance, a venture debt-focused business development company, said that he’s also seen the appetite for the market change since he started.

Pomeroy and his business partner Jerry Michaud have worked in venture debt since the early 1990s. Back then, it was driven more by tech companies borrowing to lease equipment. “The transactions now are different,” Pomeroy said. “It’s much more of an accepted [financing] tool for the management in these companies and their investors.”

While some of the appetite still exists for working capital, Kruze Consulting’s recent study found that 91.3 percent of venture debt borrowers take on debt to increase their runway before an upcoming round.

“It has become a very useful cash runway extension tool. It provides for an additional type of capital that is non-dilutive,” Bhaumik said. “It’s become extremely prevalent for venture-backed companies that would like to give themselves additional time to achieve certain milestones using less dilutive capital than equity.”

David Spreng, founder of Runway Growth Capital, said that raising a debt round on its own can also work as a way to protect from a downgrade. “One way to avoid doing a down round is by using venture debt,” Spreng said. “You can buy yourself more time to grow into an elevated valuation. A lot of people are beefing up their balance sheets in anticipation of an economic downturn or end-of-cycle consolidation opportunities.”

This capital also allows companies more flexibility over their timeline to acquisition or a public offering.

Michael Hara is the managing director of investor relations and corporate communication at Hercules Capital, a venture debt BDC. He said that with the IPO market currently looking volatile, and 62 percent of IPOs this year underperforming, many companies are looking to take on additional rounds of funding before taking that step.

“The IPO timeline is lengthening again. Companies are looking to raise an additional round and considering it with venture debt when they are that far along in their life cycle. It gives the portfolio company the option of time to best determine when it’s right to go public,” Hara said. He added, “The timing is also good for venture lenders in that they can provide extended capital without further dilution. This is exactly the time in the company when giving up equity is the last thing on their mind given the exit is so close.”

Hercules, which has the ability to write tickets up to $200 million, said it is able to grow with companies as they enter later-stage rounds.

Runway, which recently closed a $250 million public offering, can increase its ticket size to $50 million, said Spreng, who is also chairman, CIO and CEO of Runway.

Pomeroy added that Horizon looks to partner with other lenders so it can continue to grow with its portfolio companies.

Even as some lower mid-market firms encroach, Pomeroy said the space is not too competitive. “To be a successful participant in the venture debt market, you have to have market knowledge, market access and be considered a good partner to management and the investors,” Pomeroy said. “You have to understand how the technologies work, and the ecosystem of venture capital companies and how they create value.”

The strategy is attractive from a risk-adjusted return stance, as well. Pomeroy said that Horizon typically targets a loan-to-value rate of 10 to 25 percent which helps reduce a lot of the risks associated with venture.

The asset class has also proven itself during a downturn, Bhaumik and Pomeroy said. The average default rate for venture loans hovers at about 2.5 percent, according to Spreng.

Despite low risk, venture debt boasts high yield percentages.

Horizon recorded 16.8 percent at the end of the second quarter and Hercules collected 14.3 percent. Investors are taking note and the appetite for the asset class is growing.

Hara, Spreng and Pomeroy said that they’re receiving more interest from institutional investors, which adds to the strategy’s more traditional base of retail and high net-worth individuals. Even with increased competition, Hara said the market is ripe with opportunities.

“Deal flow continues to be very robust,” Hara said. “The deal flow pipeline at the top is as wide as it has ever been. The quality of deals is also very high.”