In a highly competitive market, there may be a better way for asset owners to tap into popular startups – without vying for access to the best venture capitalists.
Venture debt is a booming segment of the market that has long been dominated by a few players. That’s changing, according to Zack Ellison, chief investment officer of credit-risk firm Applied Real Intelligence.
“Once institutional investors wake up and smell the coffee, there will be a ton of demand for it,” Ellison said. He spoke about the subject Thursday at the Alts LA conference in Los Angeles.
Venture capital has been a major driver of massive returns for asset owners in 2021, adding fuel to an already hot market. While grantees feared missing out on the next big investment, venture capitalists were able to raise capital at a rapid pace.
But many investors struggle to access branded mega-funds like Andreessen Horowitz or Sequoia, which are snapping up portfolio companies left and right. Subprime debt can provide a reprieve, according to Ellison.
Venture debt investments typically consist of senior secured term loans combined with stock warrants or success fees. In addition to the return of principal and interest, investors may receive either the right to purchase shares at a certain price (via stock warrants, for example) or a success fee. It’s not actually a fee, but rather a small portion of the stake in the holding company that can only increase in value when the company is sold.
Venture capital lenders are first in the capital structure, which means if a company fails, they have the cash first, the intellectual property and “everything else,” Ellison said.
Today, Silicon Valley Bank is the biggest player in venture debt, holding about 60% of the market, Ellison said. Publicly traded business development firms Hercules Capital, Horizon Technology and TriplePoint Venture Growth make up another big chunk of the market, he added.
But new entrants like Applied Real Intelligence are appearing more and more. Just this month, fintech firm Mercury Capital announced that it had been quietly building its venture debt practice since June 2021.
“Venture capital debt is an incredible tool for startups to preserve ownership, extend runway, and accelerate timeline to achieve their goals – but the current landscape of venture capital debt providers is stuck in the past,” Jason Garcia, head of capital and relationship management at Mercury, wrote in a blog post on the news.
According to Ellison, there is a strong value proposition for founders: they need capital to keep operating, but don’t want to dilute their stakes in their own companies — which could happen if they accept outside investment.
Venture capital debt investments are also relatively short term, held for around two years or even less. They have floating interest rates, which Ellison says makes the asset class attractive in an inflationary environment.
Unlike venture capital investments, debt also avoids much of the J-curve and gains are not reported via an internal rate of return.
“You can’t eat the value of the business,” Ellison said. “An IRR that is not realized means nothing to me.”