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Why tech bubble could spell trouble

The $1bn Spotify deal highlighted the hunger for tech companies among some debt capital providers. But will they regret following the latest fashions?

When Spotify’s plan to raise $1 billion in convertible debt first hit the news, it turned a few heads. It was an unusually large tech deal. Journalists and industry observers were curious that the music streaming service would be raising debt instead of equity.

“Tech startups are increasingly turning to convertible debt — bonds that can be exchanged for stock — as investors push back on rich valuations amid a volatile stock market and economic uncertainty,” The Wall Street Journal wrote.

Spotify received the package from TPG, Goldman Sachs and Dragoneer Investment Management in a deal that closed last Friday. While the former two are household lending names, some people had questions about who exactly was Dragoneer. In fact, it’s a private equity shop set up by Marc Stad and Pat Robertson in 2012. Stad previously worked at TPG, while Robertson had stints at Goldman Sachs and Kirkland & Ellis. Dragoneer has raised two funds so far and invested in several tech companies, including AirBnB and Etsy.

The firm is based in San Francisco, where a lot of tech lending deals get done. Having visited the Bay area last week and caught up with debt managers, PDI can report that the city is abuzz with start-ups and new ideas. It’s also home to many of the household names in online lending, including Lending Club and Prosper, as well as established tech companies like AirBnB and Mozilla Firefox.

Many private debt fund managers are especially fond of making loans to marketplace lenders. Victory Park, for example, has done many deals in the space. Fortress Investment Group, which has its credit group in San Francisco, and KKR, have worked on a handful of such loans. And with LendIt USA, the online lending conference, about to take place next week with a whopping 4,000 expected attendees, the tech capital will be even more of a deal-making frenzy.

But not everyone is convinced. Golub Capital’s late stage lending team in San Francisco doesn’t do much with marketplace lenders. “It's hard for us to underwrite to another lender's underwriting,” said Peter Fair, Golub’s San Francisco-based managing director.

Back in New York, Ivan Zinn, chief investment officer of Atalaya Capital, said he sees online lending as having an agency and principal problem. Most online lenders don’t hold the loans on balance sheet. Instead they funnel the money from their investors to their borrowers. “The investors get to interesting returns only by levering it at 10:1. It’s going to end in tears at some point,” said Zinn.

He also pointed out that these companies tend to advertise as “fin-tech,” when they are really just lending businesses. Other start-up founders and lenders agree that tech isn’t exactly tech anymore. “Tech is just the way that business is done these days,” said one start-up founder, explaining that Spotify is in the music business, AirBnB is in hospitality, and online lenders are just that: lenders.

However debt managers approach the sector, it would be wise to dig deep into how these businesses work and make money. Streaming services like Spotify and Pandora have become the way people consume music, so the Spotify deal seems legitimate. And some of the online lending businesses will be successful, though there are concerns that the industry is heating up too fast.

Ultimately, when it comes to new technology, it’s easy to fall in love with the entrepreneurial spirit, but harder to decipher which new ideas are here to stay and which are just a fad.