Venture debt endured a challenging 2023, but as lenders look for new product lines to increase deployment after a quiet period, they are turning their attention to the venture debt market.
US venture debt lending dropped to US$30.2 billion in 2023 from US$41 billion the prior year, a drop of 26%, according to the National Venture Capital Association and Pitchbook, and venture lending deal count slid to its lowest level since 2017.
Macroeconomic headwinds and high interest rates contributed to that deterioration. However, the venture debt market was also significantly impacted by the collapse of Silicon Valley Bank, which had been one of the largest providers of venture debt; its collapse was a major factor in the decline of the overall volume of venture debt lending activity.
Opportunities for new entrants
The slowdown in issuances and the exit of a key lender from the venture debt ecosystem have presented opportunities for new entrants to either expand their existing platforms or launch new venture debt focused investment vehicles and capture additional market share. To that end, dozens of new entrants have entered the market over the past year, including banks such as HSBC and Stifel, private credit funds and family offices, as noted by Forbes.
Historically, venture debt has been a niche product provided by specialist lenders who are comfortable with lending to venture capital-backed start-ups that are scaling quickly but are not profitable yet. Generally, many lenders have tended to stay away from this market, preferring to focus on financing less risky borrowers that have strong cashflows and assets.
However, over the past year, more lenders have explored opportunities to grow their platforms in the venture space, where there has been a strong demand for debt funding from start-ups and options for lenders to underwrite financing at attractive rates.
Before central banks began to dramatically raise interest rates to curb inflation, start-ups and founders could rely on an abundance of equity investment to fund growth. But, as venture equity funding activity also cooled in 2023 (global start-up investment fell by almost 40% year-on-year in 2023 to the lowest levels since 2018, according to Crunchbase), demand for venture debt ramped up to fill the gap left by declining equity investment.
With equity funding rounds taking longer to close and investors writing smaller checks, venture debt has offered a way for start-ups to extend their “cash runways” (in other words, prolong the time the business can operate before having to take on extra capital) or bridge the gap to their next equity funding round. Another feature of venture debt that appeals to start-up founders is that it does not dilute their equity holdings.
Start-up sponsors are also looking increasingly favorably on venture debt given that access to liquidity is still constrained. Sponsors value that venture debt provides an alternative either to having to put more of their own equity into the start-up or undertaking a “down round” (in other words, an equity funding round that values a start-up at a lower valuation relative to a preceding funding round).
Risk and reward
Incumbent lenders and new entrants into the venture debt space have found that, with the help of sound underwriting practices, the perceived risks that come with lending to start-ups can be significantly mitigated.
Although the start-ups that venture debt players finance may not be profitable yet, these nascent companies will, in ideal circumstances, have dependable revenue streams, a loyal customer base and backing from long-term venture capital investors who will support their companies through a down period in the economic cycle.
Venture debt lenders also benefit from lender-friendly documentation and covenant packages that afford them more security and control compared to loan arrangements when underwriting more profitable businesses. Lenders also have the option to further protect their positions by securing financing against a borrower’s future recurring revenue streams or intellectual property.
Moreover, borrowers may be able to borrow additional capital if they meet certain growth or fundraising targets, providing venture debt providers with more downside risk protection.
Another draw for lenders is the attractive returns that venture debt lending presents. In addition to interest payments, venture debt structures also typically include warrants and equity kickers (securities that give the holder the right to acquire equity in the borrower at a specified price within a specific period of time). These increase returns on successful deals and further compensate lenders for taking on start-up risk.
According to Applied Real Intelligence, a Los Angeles-based investment management company that added a venture debt offering to its platform in 2023, venture debt has delivered annual returns in the range of 15% to 20% for the past two decades. These returns have very little correlation to other asset classes, as it provides investors and lenders with lower volatility throughout the economic cycle. Meanwhile, loss rates have come in at just 0.25%, presenting attractive risk-reward dynamics for lenders.
Strategically, venture debt also dovetails neatly with other product lines that lenders may already have on their platforms. For example, lenders who already have the capacity to underwrite annual recurring revenue (ARR) loans (financing offered to software and subscription-based businesses based on the predictability of their revenue streams) could build client relationships earlier by providing venture debt that they can then potentially flip into an ARR facility as the borrower matures.
Venture debt, once a niche financing product offered only by a select group of specialist lenders, is moving steadily into the mainstream.
