“The only true voyage would be not to visit strange lands but to possess other eyes.”
— Marcel Proust
It was June 2007 and I was a wide-eyed 19 year old summer intern working in Toronto at GE Commercial Finance*. In hindsight, the world was also naive at the time thinking that a slowdown in the mortgage market would only last 6 months. Fast forward to Spring 2010 when I just joined the Syndicated and Leveraged Finance team at J.P. Morgan New York — the department was on a hiring spree after having restructured and let go more than two-thirds of its talent over the previous three years.
Supply and demand for debt financing (also known as ‘lending’, ‘leverage’ or ‘credit investing’) is a leading and often very accurate indicator of an impending economic recession and market recovery.
If you think about our global economy — government, businesses, investors, consumers — it is all operating off levered capital. And the only way the world keeps running is if growth continues so that its participants can pay back the cost of other participants’ borrowed money with cash. When future growth becomes cheaper than near-term cash (or liquidity) than the markets have become distorted. The ‘food chain’ of the financial world is out of whack.
This started happening in 2018. I noticed that venture and growth debt were priced more expensive and being out-competed by venture and growth equity (see unpopular prediction). In October 2018, Ray Dalio, founder and co-CIO of successful hedge fund Bridgewater, published his Principles For Navigating Big Debt Crises (free PDF; highly recommend reading) predicting a downturn in the next 2–3 years.
Debt should always be cheaper than equity, when structured correctly. The reason being goes back to fundamental finance and economic theory — a concept known as Capital Asset Pricing Model (or ‘CAPM’) which measures the relative reward-to-risk ratio of an asset. Debt is lower risk relative to equity because it ‘sits senior’ — it is paid before — equity shareholders in an exit, and it receives pay back on borrowed money sooner and more frequently than equity (due to shorter holding period and overall structure). In other words, debt is effectively structured equity with liquidity, downside protection, and limited upside.
So why does this matter?
When the activity of lenders and debt markets start picking up again in a big way, we will know our global economy is on its way to a full recovery. Right now, we still live in an world of uncertainty (see VIX index below – above 20 the IPO market is closed) and major industries such as oil—which generates $86TN or 4% of global GDP—are firefighting and restructuring massive debt to avoid a complete collapse (read this, this, and this article).
How has European venture debt been impacted?
Over the past two weeks, I spoke to the active providers of European venture and growth debt — including (but not limited to) Bootstrap, Columbia Lake Partners, Harbert, Temasek, Vækstfonden, and a couple unnamed.
They have indicated the following:
1. Actively supporting portfolio companies
60–100% of the team’s time is spent on weekly calls with companies and investors. B2C businesses and those operating in the Travel, Retail and Hospitality, and Manufacturing sectors are most adversely affected. Companies have maximized debt available to them. One provider had $1BN of capital draw down in one week.
2. Pipeline improvement, reduced deployment of capital
Most lenders have seen volume of opportunities increase by 2–5x over the past month. While many startups and investors often think of debt as ‘reserve management’, in fact, debt providers can and will be more selective by ‘cherry picking’ the best businesses to work with in 2020. A few venture debt funds indicated they will only do 10–12 deals this year, instead of the 20–30 investments annually in recent years.
3. Moved upmarket where risk is lower, return equally attractive
When it comes to B2B software companies, majority of venture and growth debt providers are focused on those generating $5MM to $20MM ARR (or higher), given the ability to weather the downside (credit) is more important than limited upside (equity) for sub-scale businesses. Since valuations have declined 40% (and more) in venture, credit providers are no longer willing to take equity-like risk in overvalued startups.
4. Fewer use cases acceptable
Although there are many use cases of venture debt, it is highly unlikely that savvy lenders will be ‘bridging’ scale ups to the next financing round. Investors and businesses hoping to use venture debt as an insurance policy or to avoid setting a valuation will likely find themselves disappointed. The common use cases that debt providers will support focus more on a traditional credit (rather than equity) lens — for instance, (i) financing working capital, (ii) extending the cash runway contingent or right after an equity round, (iii) short-term bridge to exit, or (iv) M&A financing.
5. Pricing remains the same, less flexibility on structure
Venture funds are still targeting low double digit IRRs (excluding warrants or ‘equity sweetener’). This effectively translates to 10–12% annual interest and 10–15% warrant coverage or 1–2% fully diluted ownership. However, structuring is more classic (what I experienced 3–5 years ago), namely 36–40 months term, 6–12 months interest only period only (following a recent equity round), and no delayed draw feature.
6. Long recovery anticipated
While no one has a crystal ball to predict the future, many lenders anticipate a “U-shaped” recovery of 12–18 months (and longer).
*GE Commercial Finance was sold to Wells Fargo in 2015 (see here) as part of a broader initiative to restructure and wind down the GE Capital business post-2008 (read here). Big thanks to InRoads and Richard Zeni for opening my mind to the world of Finance.