Claret Capital Partners on why market conditions are ideal for growth debt

With demand for debt rising, returns increasing and a big market growth opportunity in Europe, the growth debt strategy appears to have a bright future. David Bateman and Johan Kampe, co-managing partners at Claret Capital Partners, explore the key trends.

This article is sponsored by Claret Capital Partners.

How would you describe the growth debt strategy, and its current market conditions?

David Bateman

The genesis of growth debt is a recurring need in fast growing companies for capital in the stages prior to them becoming profitable. This particularly affects technology and life sciences businesses, which are almost always commercialising some form of innovation. They start out with no revenues and high R&D costs, then move through a launch phase and finally a market adoption phase that continues until the company eventually becomes profitable and able to source debt from banks.

Throughout that journey, the company is consuming capital – usually equity –  that is highly dilutive for the founders. Growth debt as a private credit investment strategy typically becomes relevant one or two years before the company becomes profitable. Growth debt players provide term loans, with equity kickers attached, that are relatively expensive in terms of debt but save the founders and early investors one to two cycles of dilution. It can be seen as an anti-dilution tool for the early-stage technology and life sciences ecosystem.

Growth debt also allows companies to pursue more ambitious strategies because they have more capital available to shoot for the stars. When you look back, Cisco, Google and Facebook all took growth debt, often several times, in Silicon Valley in the 1990s and early 2000s. Claret’s principals were part of introducing this strategy to Europe in the early 2000s.

In terms of the current market, growth debt thrives in periods when capital is tight. Between 2018 and 2021, there was quite liberal equity capital available to these businesses. Demand for debt right now is high because valuations have fallen quite substantially and so have funding volumes, making accessing capital both more difficult and more dilutive.

What impact have rising interest rates had on the growth debt opportunity set?

Johan Kampe

Rising interest rates affect the growth debt market in several ways. The primary effect is on valuations, where we have seen a strong link between rising US interest rates and falling valuations for technology businesses in the US and Europe. This is because risk aversion and risk-free returns have gone up, which makes things difficult for businesses that look to the future.

If you look at the Goldman Sachs Non-Profitable Tech Index over the last few years, you can see valuation parameters for loss-making companies remain well below recent levels (see Goldman Sachs Non-Profitable Tech Index chart overleaf).

Looking at it more narrowly, the interest rates that growth lenders charge to European businesses have risen with Euribor rates, providing a boost to returns.

In which sectors do you see the most attractive lending conditions?

Frankly, we see attractive lending conditions across almost all growth lending sectors including software-as-a-service, e-commerce, online marketplaces, medical devices and diagnostics. Many growth companies have had to adapt their business plans to be less capital intensive. They have all reduced their burn rates and are taking less risk than in 2021. However, these intellectual property-rich companies with high gross margins continue to expand, even in the current market conditions – albeit more slowly than before. So, straightforward deals to fund their growth are plentiful.

Growth lenders also look as much at situations as we do at sectors, and today a lot of lending is supporting acquisition finance. As these growth companies start to merge to create market champions, the Claret funds are providing the capital to put them together.

How should LPs approach growth debt as part of their private credit portfolios?

The fundamental attraction for LPs is the underlying asset returns allied to the capital preservation. Claret funds have a long-term record of generating 17-22 percent asset returns over a sustained period. The 2015 Harbert European Growth Capital Fund I is already back in carry and the 2018 Harbert European Growth Capital Fund II is 70 percent distributed to paid-in capital.

Relative to other asset classes, LPs can secure a high cash yield, which is also distributed to LPs quarterly. The fund’s lending is all cash pay interest, which is different to some other debt strategies where there is a heavy reliance on PIK. Claret funds are also unleveraged – these returns are not flattered by leverage.

Capital preservation is another key feature for LPs. The capital is primarily invested in the form of senior secured debt obligations, giving high recovery even in downside scenarios.

Finally, LPs benefit from the equity kicker, where the funds receive equity kickers in the capital of the target companies. This entitles LPs to a slice of the long-term upside in a wide, diversified pool of between 50 and 80 growth companies.

These companies don’t all turn into superstars; however, some of them will be big returners and the diversified nature of the funds’ kickers generally provide 6-10 percentage points to the IRR of the underlying assets in the fund, providing a significant boost at the tail-end of the fund’s life.

 Click to enlarge.

What should LPs look for in a manager when targeting growth debt?

Investors should focus on track record and alignment. Claret’s senior team have been involved with growth lending for more than 20 years in Europe and carry is distributed throughout the firm to incentivise the entire team to provide returns to LPs.

Claret Capital Partners is also independently owned by its team, which we believe delivers better outcomes for investors.

How do you expect the asset class to evolve over the next five years?

This asset class will continue to grow and become more institutional, particularly in Europe, given how relatively underdeveloped it is compared with the US. In terms of collateral to lend against, there remains a huge number of equity-funded growth companies in Europe that will sustain the demand for growth debt for some time to come.

It takes four to five years for a company to get to the stage where it is ready for growth debt, which means the prospective borrowers in the years ahead were probably formed in 2018 and 2019 and raised large rounds of equity in 2020 and 2021. This has resulted in a lot of unleveraged companies to keep Claret and its peers busy.

One would also expect the market to continue to get more competitive as more players emerge. However, one thing that will preserve returns in Europe is the persistence of multiple jurisdictions. It is not easy to build a pan-European lending platform, given the wide range of credit regimes and bankruptcy codes that exist in Europe. Getting secured lending right in multiple jurisdictions, as the Claret funds have done, is a key part of the capital preservation element of this strategy, without which the risks can dominate.

How can managers effectively incorporate ESG considerations into growth debt strategies?

We believe growth debt is naturally aligned as a strategy to support environmental, social and governance objectives. There is alignment from an environmental perspective because almost all technology and life sciences companies are trying to do more with less. They are trying to build efficiencies and find new ways of operating that use fewer scarce resources. A lot of the cost reduction they enable is related to energy efficiency, so they are generally environmentally enhancing.

On the social side, growth companies tend to be younger organisations competing with mature incumbents, and are more likely to promote progressive policies and internal behaviours. There may be instances where that is not the case, but it is typically what one finds.

On governance, the vast majority of growth debt deals are donewith sponsored companies where validating the internal alignment and governance is a key aspect of due diligence. Investing in these companies at a loss-making stage is risky enough, without tolerating the additional risks that poor governance or organisational issues will bring. Growth lenders are well incentivised to seek out companies where the equity sponsors are aligned with each other, the management and its strategy. Again, the growth debt strategy aligns well with a common-sense view of ESG.

Claret Capital Partners (“Claret”) is the Investment Adviser to Harbert European Growth Capital Fund I, Harbert European Growth Capital Fund II, Claret European Growth Capital Fund III, Claret European Growth Opportunities Annex Fund I and Claret Kermode Fund I, together the “Claret Funds” or the “Funds”