Large-scale investors flock to venture debt’s ‘phenomenal returns’

John Markell, a managing partner at venture debt advisory firm Armentum Partners, has spent years helping several alternative asset management heavyweights expand their businesses to venture lending.

When his firm was founded in 2012, few would have predicted that venture debt would attract the world’s largest private equity firms and hedge funds like Blackstone, KKR, AllianceBernstein and Centerbridge. Back then, venture debt was a poorly understood product offered by only a few banks and a narrow group of specialized lenders such as Hercules Capital, TriplePoint Capital and WTI.

“Historically, venture debt were such small checks, that it didn’t make sense for the big funds to play in the asset class,” said Markell, whose firm is compensated by portfolio companies for helping them secure the most favorable borrowing terms.

But as startups have grown, so have their borrowing needs.

A decade ago, debt deal sizes topped out at around $10 million, but today, they can reach into the hundreds of millions. In December, Markell helped SellerX, a VC-backed German ecommerce brand aggregator, secure a loan for $400 million from Victory Park Capital and BlackRock.

More importantly, many of the biggest players in the world of alternative finance noticed in recent years that lending to unprofitable startups could be surprisingly lucrative—with relatively lower risk than many in the industry had assumed. As a result, in recent years, the likes of Bain Capital, Vista Equity Partners and BlackRock began offering venture debt products.

The latest entrants into the booming venture debt market include Blackstone, which recently announced a $2 billion allocation to lending to unprofitable startups, and KKR Credit, which reportedly is considering buying an existing venture lender or building its own effort.

And a whole host of other significant investors, from large pension funds to sovereign debt funds, are also considering jumping on the venture-lending bandwagon, according to Markell.

This year’s sour stock market has only added momentum to the trend, as growing numbers of late-stage startups turned to venture debt and other alternative sources of financing to extend their cash runways.

Venture debt deal flow, which has exceeded $30 billion annually in the past few years, has already notched over 1,900 deals totaling $22.4 billion through Sept. 29, according to PitchBook data.

“Venture debt investors put up phenomenal returns, and no surprise, phenomenal returns attracted new entrants,” said an investor with a large growth equity firm.

In addition to charging startups an interest rate of 10% to 20% on the loan, venture debt providers receive warrants for shares. “These warrants for a tiny part of the company that one day will be worth $10 billion to $20 billion provide unbelievable value,” the investor added.

Some venture debt deals can yield very high returns for the lender—such as when Airbnb borrowed $1 billion in 2020 from Silver Lake and Sixth Street ahead of its IPO. But returns for the venture debt industry are typically in the low-teens, according Markell.

And in today’s environment of rising interest rates, investors hope to be able to gain even greater returns.

“A good venture lending fund has all floating interest rates, and so it benefits from the increase in interest rates,” said Jim Labe, co-CEO and co-founder of TriplePoint Capital. “And given the increase in demand, you can be a little bit more stringent and command higher pricing.”

That, of course, makes the asset class even more attractive to new players.

But it can be difficult for newcomers to jump into venture debt. Incumbent firms say that loans to unprofitable startups are very different from lending to companies with positive cash flow or businesses with assets that can be used as collateral.

“We’re making a loan as a relatively small percentage of the enterprise value of the company, and so it’s really important that you assess the enterprise value properly,” said David Spreng, founder and CEO of Runway Growth Capital.

Venture debt lending is also much more qualitative than quantitative, according to Labe. Creditors must understand and develop a relationship with venture capitalists backing the startup.

“You need to sift good [companies] from the bad,” Labe said. “Our capital is for growth. It’s not for survival.”

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