Human ingenuity has always driven technological shifts. Yet the speed of adoption of technology in daily life has accelerated markedly over the past decade, a trend reinforced during the current pandemic. Whole industries have been transformed by digitalisation, automation and the increased use of data in decision making.
In financial services, the fintech revolution is gradually transforming entire verticals. However, large-scale lending to technology companies has seen relatively little change. In Europe the reason is partially historic: geographic fragmentation, different development of capital markets and lower familiarity with a variety of debt instruments. Limited and fragmented adoption of technology, however, is another key factor.
Traditional bank lending is still focused on the strength of the borrower’s balance sheet: ie, ensuring that the value of the assets sufficiently covers the loan amount. Banks have difficulties valuing intellectual property and intangible assets, which are often the main assets of growth businesses. Thus, while loans might be comparably cheap, the volume offered is usually insufficient while tying borrowers to ancillary services, such as deposits, foreign exchange services, etc.
The explosive development of the private debt market following the 2007-08 global financial crisis has been driven by the inflexibility of that approach as well as the various regulatory hurdles. Private debt lenders recognised that lending against stable cashflows can be very profitable. The technology sector benefited: it accounted for 32 percent of total German lending deals through Q3 2021 versus only 12 percent in 2018.
Many European scale-ups do not have the stable positive cashflows required by banks and private debt lenders, due to high investment in intellectual property, frequent product launches and geographic expansion. Venture debt, a 30-year-old invention, is perceived as the only option.
Venture debt is based on the insight that VC-backed companies drive future growth but require a different approach. It is targeted at early-stage start-ups, with financing usually raised concurrent to/immediately after an equity round and with due diligence relying on reports conducted by third parties. The lenders devise an instrument that allows them to reduce risk by requiring almost immediate amortisations while being compensated with a combination of interest, fees and warrants that brings the cost of capital to 15 percent or more.
Per Dealroom data, venture debt funding to European companies was expected to reach $3 billion in 2021. While this represents 2.5x growth over the past five years, it accounts for less than 3 percent of total venture financing in Europe versus 5 percent historically, and closer to 15 percent in the US.
Far fewer companies in Europe pursue venture debt, partly because there needs to be a differentiated, data-driven approach which reflects real-time risks and tailors the solutions to the business. Simply said, a well-funded Series C enterprise software company should not be receiving the same term sheet as a Series A payments start-up.
At GP Bullhound, we see a gap in the debt market for mid-market tech companies, defined as companies between €20 million to €200 million in revenues. This is an attractive sector as growth loans have significantly lower risks as the companies normally exhibit (i) recurring revenues, stable customer base and low churn; (ii) scale; (iii) profitable unit economics even if the overall cashflow might be negative; and (iv) significant equity capital raised, with loan proceeds invested into further growth.
In addition, direct lenders are often the only creditors, giving more control over terms, therefore mitigating default risks. However, to be truly successful in this sector lenders need to actively embrace operational and financial performance data and incorporate it in all aspects of the investment process.
Rise of European tech
The need for a new approach to lending is largely the result of two seismic, mutually reinforcing developments: (i) technology went from a narrow sector to transforming, and being embedded in, whole industries; and (ii) sustained, sizeable investments have created scalable market leaders.
As such, technology is a misnomer: no longer a defined sector but rather encompassing several “traditional” industries. Is e-commerce really a separate industry or a crucial distribution channel in retail? Is proptech not the incorporation of tech innovation and the resulting business models into the real estate sector?
Further, investments in tech in Europe have gone through a profound change over the past five years. Per Dealroom, $113.7 billion of VC funding has been invested in European tech in 2021, more than double the amount invested in 2020 or 2019. There have been more than 100 $100 million-plus rounds last year in Fintech and SaaS, with transportation not far behind. Over 320 European tech companies reached $1 billion-plus valuations in 2021 and a further 26 reached the decacorn status ($10 billion-plus).
Importantly, Europe is no longer dominated by one or two hubs: unicorns emerged in 28 countries and 98 cities. Further reinforcing the entrepreneurial activity and investment flows across Europe is the recycling of exits proceeds, with capital and talent increasingly staying in the local ecosystems. A total of $275 billion in exits via M&A, IPOs, direct listings and SPACs in Europe in 2021 created multiple growth engines across Europe. The “work from anywhere revolution” is only enhancing this trend.
European tech companies are finally attracting top global equity investors, corporate partners and customers. The future is bright: market observers believe Europe has the strongest ever start-up pipeline, on par with the US.
Key real-time data
Data is the fuel of the financial services industry. We believe the following factors will become key differentiating factors for lenders in the future: (i) superior ability to analyse data throughout the investment process; (ii) using such insights to structure transactions and the correct risk mitigating terms; and (iii) delivering a highly customised term sheet to borrowers.
While there has been significant progress in using data in sourcing, due diligence is still done using months-old balance sheets and income statements. We believe detailed data analysis incorporating real time financial and operational KPIs combined with customer data and relevant macro trends allows you to better predict the future outcomes, therefore reducing risks.
According to Accenture, of customers who abandoned a business relationship, 33 percent did so because personalisation was missing. It is the deep understanding of the businesses obtained from data analysis and the resulting intelligently built financings which will help to avoid the current race to the bottom in lending terms in undifferentiated term sheets.
Such flexibility requires covenants. Although venture debt often has no covenants, growth loans normally have several tied to cashflows or receivables. However, rather than rely on standardised covenants such as debt/EBITDA, the latter being increasingly distorted through adjustments, it is time to introduce covenants tailored to the actual financial and operational KPIs which address the main business model risks.
Monitoring can be vastly improved by real-time analysis of business specific KPIs, avoiding the “negative surprises” often associated with monthly financials delivered 30 days after the fact.
At GP Bullhound we serve the needs of the world’s best entrepreneurs with transactional advice, research insights and capital, prioritising the development of data-driven lending products and outstanding customer experience to gain competitive advantage.
We believe traditional lending products no longer have the right product or market fit: standardised term sheets with warrants and poorly designed covenants are a significant hurdle for later stage tech companies.
By making investments into IT and fully adopting the right data infrastructure and analytic tools across the investment process, lenders can gain higher profitability and stronger security. A real-time, data-driven view improves decision-making and allows for designing better, simpler and more flexible growth lending products while improving profitability, risk management and performance for the lenders.
Olya Klueppel is partner and head of credit at GP Bullhound, a London-based technology advisory and investment firm