Tiger Global, a hedge fund and growth investor, recently announced the launch of a seed investment fund. Alongside its ability to fund late-stage growth rounds the firm will now offer investments of up to $5 million for seed rounds. Is small now better than big?
The key motivation appears to be returns in the technology-enabled sector, where valuations rise rapidly, competition among investors is high and backing the right companies earlier can generate substantial gains.
Software and tech-led businesses were deemed high risk a mere 10 years ago. At the time, big technology companies still dominated and the perceived threat of disruption (from ‘known unknowns’) was much higher and the level of sector experience among the investor ecosystem understandably lower, with some echoes from the dotcom era still prevalent. IT services and telecom players were consolidating rapidly, backed by high levels of debt and often without proper integration and operating systems, which resulted in some high-profile defaults.
Plenty to like
Now the outlook could not be more different. European private debt has enabled lower and mid-market investors to acquire fast-growing profitable businesses within the digital transformation and tech-enabled sector at high valuations and pursue rapid growth through debt-funded acquisitions. In many instances lenders have substantial funding exposure in their portfolios – sometimes higher than the investor and multiple times the revenue generated by the underlying business – and therefore theoretically higher levels of risk than more established sectors.
In many ways, private debt achieved this by overcoming the traditional thought processes held by banks around lending to technology businesses. There was a hesitancy to back younger tech-led companies with high growth and to offer high levels of debt to these smaller and asset-light businesses. Any sanctioned deals typically required high levels of contractual loan amortisation to reduce duration risk, extensive covenant packages for credit monitoring and lower hold levels. The banks were probably right to adopt this approach at a time when the sector was not widely understood, the definition of a tech business was narrow, and there was not enough credit portfolio exposure or experience to fall back on.
There is plenty to like about lending to tech-enabled businesses. The acceleration of digital transformation within businesses driven by increased adoption of cloud, 5G and connectivity provides a huge opportunity. Rapid transformation, intensified by covid-19, in the areas of payments, supply chains, e-commerce, learning, communications and software applications to replace and automate traditional business processes only serves to enforce lender appetite for tech-enabled businesses.
However, embedded in this are two assumptions: that these businesses will remain more valuable, due to higher growth rates, than other sectors; and that the near-term risk of disruption to prevailing technologies is lower, or their ability to adapt is higher. These assumptions ultimately backstop the refinance or credit default risk scenarios.
As vintages of technology-enabled companies grow and mature quickly there remains a buoyant ecosystem of younger fast-growing businesses with predictable business models often led by entrepreneurs, venture capital investors and the growth arms of large private equity funds.
These investors are typically armed with significant experience and are looking to improve on an existing technology, product or service, or replicate the success of others in a market big enough for multiple businesses to exist and grow simultaneously (not always a winner-takes-all model). These businesses largely choose to pursue growth at the expense of profits, as the former metric is a key value driver for equity funding and exit valuations. Few businesses are bootstrapped to profitability because such an approach would take much longer to achieve growth.
“Private debt can potentially target a higher return and carve up a lucrative niche in a growth sector with long-term positive fundamentals”
Fundable companies tend to have a few rounds of equity investment under their belt and a proven business model with measurable key performance indicators. Such KPIs include revenue growth, net customer churn and profitability based on unit economics (after re-investment for growth), which can often be readily compared against industry metrics. Listed and private peer group valuation metrics are also available to benchmark many subsectors such as software as a service, payments and e-commerce.
There is also a growing segment of high-value, ‘unicorn’ businesses that are approaching profitability and actively pursuing acquisition-led growth. Most of these have a strong alignment of interest from investors and founders – and some are very substantial by track record, fund size and reputation.
Venture debt offered by both European banks and funds has traditionally been set up to serve this market. However, commercial terms and debt structures can vary widely, and there are strong preferences for any debt raised to be accompanied by a much larger equity round. There is also a bias towards institutional ownership versus founders being majority shareholders. Multiple debt offers are harder to source and compare. Debt available to invest per deal is also limited, while the cost of debt is high (in the mid-teens). This results in many attractive growth companies opting to raise more equity or convertible debt from investors instead.
Venture debt return expectations are not typically adjusted to differentiate between a predictable software-as-a-service proposition (with annual recurring revenues), an embedded payments technology offering, e-commerce or a riskier intellectual property-based tech proposition. This is perhaps driven by hurdle rates determined by the ultimate shareholders and investors of the banks and funds and a lending model styled on the earlier days of venture debt where technology was more nascent and unpredictable. Lack of mainstream competition and a general liquidity gap for smaller businesses appears to sustain these returns expectations.
This raises the question: could a private debt strategy be developed to fill a void between venture debt and mainstream lending for the right type of emerging tech-enabled borrowers? In doing so, private debt can potentially target a higher return and carve up a lucrative niche in a growth sector with long-term positive fundamentals – given that the mainstream technology sector seems to be on a much stabler footing than was the case during the dotcom era.
Private debt funds can apply their sector knowledge and learnings from other tech-enabled transactions within their portfolios. This could provide them with an edge as well as the opportunity to work with many reputable entrepreneurs and small to large-cap private equity funds with dedicated growth investing strategies. A handful of PE funds that were pioneers of technology sector buyouts have already set up dedicated credit vehicles. Whether this develops further remains to be seen. In the meantime, there seems a potential window of opportunity for private debt funds to evaluate further.
Viral Patel is founder and managing director of Prime Lead Partners, a pan-European debt advisory platform that helps private equity, growth venture funds, family offices and entrepreneurs raise structured debt