Tech founders have always had the option of borrowing capital instead of surrendering equity, but never has that option looked as attractive as it does right now. With equity markets in the doldrums, US banks pulling back and valuations under pressure, technology and venture capital firms are weighing up alternative sources of finance: private debt providers are seen more and more as one solution.
“Demand has increased significantly,” says Amy Mathews, managing director and head of venture capital coverage at Vista Credit Partners. “The valuation environment remains uncertain, the IPO markets are still largely closed off and growth equity capital is scarce. These factors have created a dynamic that is attractive for both borrowers and investors.
“If you are a founder, you still want to finance growth while preserving momentum and enterprise value, and direct lending offers a less dilutive avenue to do so. If you are a lender, the supply-demand imbalance created by market conditions is bringing more high calibre investment opportunities into your pipeline.”
Extending the runway
Alan Wink, managing director of capital markets at Eisner Advisory Group, argues that venture capital firms are also looking for new options amid a more difficult exit environment.
“The VCs all thought that the IPO market of 2021 was going to continue as an exit route,” he says. “Now, these companies still need cash to get to certain metrics and the VCs are questioning whether they should continue to invest when they don’t see a path to exit.
“Every VC I’m talking to right now is looking to extend those runways in two ways: advising their portfolio companies to conserve cash as best they can, and then looking at other sources of capital outside equity that can go onto the balance sheet. Venture debt has to be right up there among those alternative options.”
Equity capital raising is no longer an option for many tech ventures, says Randy Garg, founder and managing partner at credit fund Vistara Growth: “Many tech founders need money – they have cut as much as they can, but you can’t cut your way to growth, and they are now looking for different forms of growth capital.”
He says many firms have raised money at very high valuations, so to raise equity now would mean readdressing those valuations. “We are not pricing the equity, we are not behaving like a bank, so we are able to extend the runway for these companies until they can become profitable or grow into better valuations again.”
Bank lending is also being pared back, which is creating a gap in the market, says Jeff Bede, head of the growth capital business at ORIX Corp USA. “On the bank lending side, the banks are still offering revolving facilities but in our view, they look to be less aggressive on the term loan side.
“With less equity invested, that has created a gap, and we will see how that plays out, but the combination of potentially more conservatism and increased regulatory scrutiny is likely to mean the banks could be less active and there will be a growing opportunity for private credit.”
There is a clear opening emerging for venture debt providers, according to Daniel Zwirn, CEO and CIO at Arena Investors. He says: “That opportunity really looks like two ends of a barbell – on one hand it is about being in a position to go after opportunities among those companies that had created some sort of viable franchise, potentially cashflow positive or very near it, now facing difficult down rounds from their large-scale VCs.
“On the other side is a new opportunity in plain vanilla venture lending, with far more compressed seed, Series A and Series B valuations creating a much broader, higher quality universe of companies out there to be reviewed, taking us back to the beginning of the next cycle of straight venture debt.”
Likewise, high-growth tech borrowers are also on the lookout for more growth credit. “Very few people have really gone into growth credit,” says Wink, “but it is a really interesting area playing at the confluence of direct lending, venture debt and distressed debt investing.
“There are some really sizeable franchises out there that may not be able to raise equity in the same way, who are driving their businesses to profitability faster than they had been, and where there are real opportunities.
We see that in e-commerce and in parts of enterprise software, where there are a lot of great companies that were sometimes grossly overcapitalised from a valuation perspective.”
Barriers to entry
Global fundraising for venture debt strategies was way down in the first half of 2023, standing at just $180 million according to PDI numbers, versus $6.5 billion raised in 2022. But the opportunity is piquing LP interest.
For LPs, this is a maturation story, says Bede. “The combination of recurring revenue models that are leverageable and companies staying private longer is increasing the demand for venture and growth lending. But historically it was perceived as risky,” he says.
“Now the data, especially in relation to enterprise software, shows that is not the case. Strong performance by incumbent lenders, combined with private credit being something institutional investors are looking to grow, means we are seeing growing demand.”
Still, there are some natural barriers to entry that make it a difficult space for new entrants. “First, it is a proprietary origination channel, and there are not a lot of intermediaries or brokers in our space,” says Bede. “The underwriting is also a bit more complex and specialised than traditional asset-backed or leveraged loans. There are managers trying to raise capital and enter, but we haven’t yet seen any material shift in the competitive landscape.”
While cyclical factors have undoubtedly fuelled recent demand, many argue broader secular forces at play will favour private debt for the long term.
Garg argues the bilateral relationships that underpin private debt will fuel further demand: “For the longest time, choosing a lender was just about price, because people assumed you could just refinance and refinance,” he says.
“Now, the partnerships might last longer, so you want a partner you are aligned with, that has flexibility, and that has experience working through a number of market cycles. We have that experience and we are not there to try and call foot faults but to help these companies through bumps in the road, whether that means relief on covenants or providing additional capital.”
Mathews believes that the evolution of the software credit market is dovetailing with a maturing enterprise software sector. Today, second- and third-time founders are raising capital through a different lens and evaluating more expansive and less dilutive strategic options to finance growth, she says. “I think this shift in mindset is subtle but very important, and that founders will continue to view private credit solutions as an increasingly compelling option to spur growth in any market.”
The SVB impact
What are the consequences of Silicon Valley Bank’s collapse for direct lending?
The collapse of Silicon Valley Bank and other venture banking heavyweights earlier this year has added to the sense that direct lending has a bigger role to play in the growth capital sector.
Vista Credit Partners’ Mathews says the shockwaves are still working their way through the system: “In my view, the software credit market has historically been inefficient and underserved, and in March, we lost one of the most influential members of our ecosystem. Everyone is still trying to wrap their arms around the full impact of the crisis, but the near-term uncertainty in the banking sector has pushed up the cost of capital from more traditional commercial and business lenders.”
There is little doubt that SVB’s demise will benefit private debt: “It has also created more of an emphasis on counterparty, which has advantaged specialist lenders, especially those backed by a long-term capital base,” says Mathews.