Note: throughout this series, we use the terms ‘venture-stage companies’ and ‘venture capital-financed companies’ interchangeably. We understand these to be any private company (from seed to growth stage) that has raised equity from a venture capital firm or institutional source. We understand venture debt to be non-dilutive or low-dilution debt products provided to venture-stage companies, characterised by unique risk assessment and pricing models.
The search for yield continues. The prevailing low-interest rate environment has driven down banks’ profit margins on traditional assets, compounded by increased competition from disruptive lending entrants. As the effects of COVID-19 put pressure on traditional corporate and consumer lending, financial institutions are being forced back to the drawing board to identify new sources of return.
At the same time, banks are investing in external innovation engagement models – from seeding startups through incubators and accelerators, to investing in high-growth companies. In 2019, corporate venture capital investment reached an all-time high, with ~$57.1 billion invested across 3,234 deals. Banks are increasingly active, participating in 43% of all financial services corporate venture capital deals.
However, there is a substantial and obvious gap. Despite globally maturing startup ecosystems and increased participation of commercial banks within these ecosystems, there has been a scarcity of direct lending from incumbents to venture-stage companies. This is not to say that there is no demand for debt from venture-backed companies – or that they are not receiving it. Over the past 10 years, a growing market of non-bank specialist lenders has emerged, providing an estimated $8-12 billion in bespoke debt products per year since 2014.
Given that lending is the cornerstone of commercial banking, why have banks shied away from debt financing for high-growth ventures?
In this two-part series, we’ll be exploring the untapped venture debt opportunity. This article unpacks the growing venture debt market, and why commercial banks have historically not participated in the opportunity . In the second article, we’ll explore how pioneers are capitalising on the potential of venture debt, and outlining how commercial banks can effectively compete (and even outcompete) non-bank specialist lenders in the market.
Venture debt is a growing market opportunity
Venture debt is a debt funding mechanism tailored to pre- or post-profit venture capital-backed companies, available earlier and in larger amounts than traditional bank loans. Debt is typically provided in a three- to four-year term loan; often interest-only for the first 6-12 months, followed by an amortisation period with few operational restrictions or covenants. This provides founders with relatively low-cost growth capital, without equity dilution, often used to bridge the business to the next round of funding at a higher valuation than could be achieved at the time of the loan.
According to a recent survey, the US venture debt market has almost doubled since 2016, growing from ~$5.5 billion to ~$10 billion in 2019. Other estimates are more aggressive – suggesting that venture debt makes up ~15% of all venture financing in the US market – which would put venture lending at $8-12 billion per year since 2014. Silicon Valley Bank, one of the major specialist lenders to startups, currently has around $10 billion in commercial loans outstanding, compared to less than $4 billion in total commercial loans outstanding in 2009.
Before deteriorating market conditions brought about by COVID-19, venture debt deal volumes, value and size were expected to rise in 2020, with lenders aggressively competing for the best startups. Some of the most successful major ventures – including Airbnb and Uber – have leveraged venture debt to propel their accelerated growth trajectories, instead of diluting equity through raising additional rounds of funding.
But what about the yield? Venture debt lenders typically expect returns of 12-25%, achieved through a combination of loan interest and capital upside. Industry analysis suggests that returns have been stable compared to mid-market lending, with a gross IRR of ~18% in the last 10 years. For the perceptively high risk taken by lenders, it is estimated that the venture lending industry realises just a ~2% loss of capital, compared to a ~17% loss rate of Small Business Administration loans granted between 2006 and 2015.
However, banks are missing in action. To date, venture debt has typically been provided by specialist non-bank lenders and venture financing firms, who have close ties to the venture capital ecosystem. Commercial banks are notably absent. Why, as natural candidates to fill the debt financing gap, have commercial banks shied away from supplying loans to venture-stage companies?
A growing market – but where are the banks?
The lack of commercial bank participation seems to be driven by five main reasons – the size of transactions; perception of risk and credit assessment processes; perception of returns; sourcing quality deals; and regulatory constraints.
- The size of transactions
Deal sizes typically associated with venture-stage companies are relatively small – especially if viewed through an investment banking lens. Given the time and effort required to assess each loan application, banks (particularly if unfamiliar with earlier-stage company business plans and financials) may not see the immediate ticket sizes as worth the upfront cost of screening deals.
- Perception of risk and associated risk assessment processes
Banks perceive venture debt as requiring a higher risk tolerance than they are accustomed to, given the high failure rate of venture-stage companies (despite the market’s low capital loss rate). Traditional credit decision-making processes tend to overweight the individual likelihood that a principal loan amount will be repaid – rather than optimising for risk-adjusted returns across a portfolio of loans. These processes make use of predefined criteria, which typically discourage lending against untested future performance. Traditional due diligence processes, loan assessments and underwriting models are therefore not fit for purpose for venture-stage companies, and decision-makers within commercial banks often lack the paradigm, skills and experience necessary to assess the types of risks involved in venture debt decision-making.
- Perceptions of returns and the distraction of equity
Given the nature of startup ventures and the ‘promised land’ of 10x equity returns, commercial banks have tended to engage with emerging companies through the lens of equity investment – viewing these assets as firmly within the realm of investees or vendors – and not potentially lucrative clients. This perception has blinded banks to profitable lending opportunities to venture-stage companies, who are willing to pay relatively large margins to avoid dilution of their equity interest.
- Sourcing high-quality deals
Given their historical lack of integration with the venture capital community, banks may have struggled to source high quality venture deals. Unlike larger private and public companies, relevant information on prospective venture borrowers is difficult to find, and even where it exists, traditional credit assessors may not be able to effectively interpret it. Given the (mis)perceptions of relative risk and returns, banks have not been sufficiently incentivised to develop the specialised capabilities required to identify venture debt opportunities.
- Regulatory constraints
Traditional banks face strict regulations governing lending to high-risk sectors. Although regulations vary by jurisdiction, banks are subject to scrutiny of their loan book, and must ensure compliance with defined risk tolerance levels. Supervisory bodies can inhibit a bank’s ability to write new loans if a particular loan class is perceived as risky or impaired. This means that if a bank accumulates a portfolio of loans in a specialist area, it must be confident that regulatory bodies will be able to effectively evaluate the loan book based on its inherent characteristics, rather than by comparison to conventional portfolios. The risk of mis-evaluation and a resultant write-down disincentives banks from building venture debt portfolios, particularly where the perception of risk is overstated.
In the next article, we’ll explore how pioneers are overcoming these challenges and outline how commercial banks can leverage their existing assets and capabilities to effectively compete – and even outcompete – non-bank specialist lenders. Stay tuned by following us on LinkedIn!
Elixirr have helped commercial banks and specialist lenders develop the strategies, business models and operating structures required to effectively capitalise on white-space market opportunities. We can support you in effectively capitalising on this growing opportunity, if you’d like to know how speak to us.