Allocators Want Access to Top Startups Without All the Competition. Venture Debt May Be the Answer.

Amid a hotly competitive market, there may be a better way for asset owners to tap into popular startups — without vying for access to the top venture capital managers.  

Venture debt is a burgeoning section of the market which has long been dominated by just a few players. That is now changing, according to Zack Ellison, chief investment officer at venture debt firm Applied Real Intelligence.  

“Once institutional investors wake up and smell the coffee, there’s going to be a ton of demand for this,” said Ellison. He spoke on the topic on Thursday at the Alts LA Conference in Los Angeles. 

Venture capital was a major driver of asset owners’ massive returns in 2021, adding fuel to an already hot market. With allocators worried about missing out on the next great investment, VC firms have been able to raise capital at a rapid clip.

But many investors have trouble accessing brand name mega-funds like Andreessen Horowitz or Sequoia, which are scooping up portfolio companies left and right. Venture debt can offer a reprieve, according to Ellison. 

Venture debt investments are usually made up of senior secured term loans combined with equity warrants or success fees. In addition to the return of capital and interest, investors can receive either the right to buy shares at a certain price (through equity warrants, for example), or success fees. These aren’t actually fees, but rather a small portion of equity ownership of the portfolio company that can only become valuable when the company is sold.  

Venture debt lenders are first in the capital structure, meaning that if a company goes belly up, they have first dibs on cash, intellectual property, and “everything else,” Ellison said.   

Today, Silicon Valley Bank is the primary player in venture debt, owning about 60 percent of the market, Ellison said. Publicly traded business development companies Hercules Capital, Horizon Technology, and TriplePoint Venture Growth make up another large portion of the market, he added.  

But newer entrants like Applied Real Intelligence are increasingly popping up. Just this month, financial technology firm Mercury Capital announced that it had quietly been building its venture debt practice since June 2021.  

“Venture debt is an incredible tool for startups to preserve ownership, extend runway, and accelerate the timeline to reach their goals — but the current landscape of venture 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’s a strong value proposition for founders: They need capital to continue operating, but don’t want to dilute their equity stakes in their own companies — something that could happen if they accept outside investments. 

Venture debt investments are also relatively short duration, held for around two years, if not less. They have floating interest rates, which, according to Ellison, 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 enterprise value,” Ellison said. “IRR that’s not realized doesn’t mean anything to me.”