What’s driving institutional interest in venture debt?
Venture debt originations totaled over $30 billion last year. The strategy’s sixtyfold growth since 2006 has been fueled by more VC-backed companies incorporating debt into their funding mix. Venture debt is now attracting the interest of sophisticated institutional investors who are drawn to its high risk-adjusted returns.
Keep reading to see how Espresso’s performance compares to that of our peers on an apples-to-apples basis. In this inaugural issue of our investor newsletter, you’ll also learn about:
- Why venture debt outperforms in comparable credit categories
- Why venture lenders use leverage in their capital stack
- Venture capital update – first half of 2023
Have questions? Don’t hesitate to reach out – we’d love to chat.
Why venture debt outperforms comparable credit strategies
Alkarim Jivraj, CEO
To understand why venture debt has outperformed comparable credit strategies, you must appreciate six of its key structural features that make the strategy’s high returns and low loss ratios possible. These include:
1. Favorable competitive dynamics
Regulatory obstacles limit bank participation in venture debt. That allows non-bank lenders to earn higher gross yields relative to the risk taken, resulting in higher net returns than comparable credit strategies. Based on data from Cliffwater, a significant allocator to both direct lending and venture debt, the venture debt gross yield was 14.5% compared to 11.6% in direct lending for the quarter ended June 30, 2023.
2. Recession-resilient borrowers with highly predictable revenues
Venture debt borrowers (i.e., SaaS companies in Espresso’s case) are among the most recession-resilient businesses because they sell mission-critical or core operational solutions on a subscription basis. As providers of next-generation software solutions, they benefit from secular growth as their customers adopt new innovations and replace legacy solutions.
As the table below shows, our portfolio companies continue to demonstrate meaningful growth across cycles, with average portfolio company revenue growth peaking at approximately 50% in mid-2021 and slowing to below 20% during the current downturn.
Equally important is high forecast attainment, which is presently tracking above 90%. This speaks to the predictability of borrower revenues during our investment horizon, which is typically between 12 and 24 months.
3. Low LTVs are a core feature of venture debt
While mid-stage venture debt is typically capped at 20% loan to enterprise value (LTV), Espresso’s median portfolio LTV is approximately 12.8%. Low LTVs provide venture lenders with both the runway and loan coverage to exit problem loans before they pose a risk of capital loss.
4. Sponsor backing provides an effective backstop to venture debt
Venture capital sponsors typically have majority ownership of borrowers at loan inception, meaning they are highly incentivized to backstop borrowers through challenging funding environments. If we segregate our lending to borrowers backed by traditional venture capital sponsors, representing 75% of the $1.1 billion deployed since inception, the loss ratio drops to nil.
By no means are we suggesting that our losses on traditional sponsor-backed borrowers will always be nil, but rather that lending to this segment is far less risky than lending to unsponsored borrowers or those backed by non-traditional sponsors such as family offices and corporate funds. The reason for this significant differential in loss rates is that traditional sponsors are rational actors and predictable in their behavior.
5. Cash income
While all venture debt lenders earn the bulk of their income in the form of cash interest income, most rely on warrant gains to achieve their return targets. Given our positioning as a fixed-income alternative for investors in the wealth channel, we prioritize cash income over pay-in-kind income when compared to our peers, and, therefore, earn a higher proportion of our returns in the form of cash income. Prioritizing cash income also reduces volatility and the need for mark-to-market any pay-in-kind positions such as warrants. The following data is based on Espresso results; net income is allocated proportionately to cash and non-cash gross income.
6. Near real-time account management
Venture lending also benefits from a more active portfolio management style. Espresso is at the forefront of using software and AI to improve loan outcomes, as evidenced by our best-in-class loan loss ratio. Our proprietary software platform, Espresso Insights, has enabled our team to track portfolio performance in near real-time, allowing us to identify and mitigate potential risks before they become critical.
How does Espresso stack up?
Wondering how Espresso compares to its peers? See the pro forma returns below, which show normalized Espresso performance at the average leverage utilized by our peers. We present pro forma results as Espresso only secured material leverage in late 2021, prior to which it was underleveraged compared to our peers. The results show that Espresso has generated similar returns as our peers but with a lower average loss ratio.
Why venture lenders use leverage in their capital stack
Enio Lazzer, Chief Operating Officer & CFO
Let’s start with the cost of capital. The venture debt market is dominated by business development companies (commonly referred to as BDCs), a corporate structure created by the United States Congress to fuel investment in emerging businesses. These companies function much like publicly traded limited partnerships in that they are allowed to distribute their profits to investors on a tax-free basis. To attract capital, BDCs must provide a high enough return to investors while lending at competitive enough rates to win high-quality loans. This is where leverage comes in. It reduces the total cost of capital for the lender, allowing it to satisfy both investor demands and borrower needs.
Leverage is also essential for minimizing (or altogether eliminating) cash drag as the vast majority of venture debt is repaid prior to maturity, and repayment velocity can vary widely across economic cycles. For example, in 2021, Espresso loan repayments equaled approximately two-thirds of new loan advances, resulting in a portfolio duration of only eight months compared to the current 19 months. Also, leverage is useful for smoothing fund flows, particularly for open-ended fund vehicles like Espresso and our peers.
Leverage positively benefits low-risk credit strategies and magnifies downside exposure in higher-risk strategies
Leverage is neither implicitly good nor bad. Rather, its suitability depends on the risk inherent in a given lending strategy. Strategies that evidence low correlations to public markets, high resiliency in challenging macroeconomic conditions, high excess returns with low volatility, low loan losses, and sufficient portfolio diversification can use higher leverage relatively safely. Importantly, venture debt exhibits all of these characteristics (i.e., leverage doesn’t compromise the objective of capital preservation).
To illustrate, our gross yields have averaged in the mid-teens across cycles, providing plenty of cushion to absorb loan losses, which have averaged 64 basis points in recent years, with a peak of 3% in 2020. These gross yields and loan losses resulted in actual investor returns in the 2017 to 2022 period ranging from 7% to 10%, depending on the interest rate environment and net leverage utilized. If we restate this performance on a pro forma basis utilizing the same leverage as our peers, our returns would increase to between 9% and 13%.
Conversely, if a strategy fails to evidence one or more of the above-listed characteristics, it may not be suitable for higher leverage, or any leverage at all, if capital preservation is the paramount objective.
When it comes to understanding the risks associated with using leverage, the following generalization is helpful: while leverage can benefit low-risk strategies, it will also magnify the downside in higher-risk ones. Venture debt, given its historical track record of consistent performance and low loan losses, combined with its unique structural downside protection features, is in our view, well-suited for leverage.
Nuveen and Aflac invest US$100 million in first Espresso securitization
We are pleased to report that we recently completed the placement of US$100 million in senior secured notes to Nuveen, a $1.2 trillion asset manager, and Aflac, an insurer with $130 billion in assets. The issuance was A-rated by DBRS Morningstar.
This first securitization transaction represents an important milestone for Espresso. Securitization is a key funding mechanism many private credit firms use to source funds from institutional investors and reduce their overall cost of lending capital. In a typical securitization, loans are bundled into a special-purpose vehicle, which then issues rated and unrated securities to institutional investors. Proceeds from securitizations are then reinvested into new loans. Our new fund, Espresso High Yield US Trust, will co-invest with institutional investors in the junior tranches of Espresso securitizations.
Venture capital update: First half 2023
Will Hutchins, Managing Director
While 2022 saw a broad pullback in public technology sector valuations as the market reacted to successive Fed rate hikes, investor sentiment showed improvement in the first half of 2023. The Nasdaq, for example, climbed 30% as the economy and earnings proved more resilient than feared. The Fed signaled a slowdown in rate hikes, and investors’ concerns over the prospects for growth companies were at least partially sidelined by their excitement over the opportunities in generative AI, particularly among some of the Nasdaq’s biggest names.
The IPO market, on the other hand, remained stagnant in H1 2023 due to both a lack of investor demand and companies delaying public exits until valuations become more attractive. Not surprisingly, this has had a knock-on effect on venture capital fund flows and, importantly, earlier-stage valuations. September saw a thaw in the IPO market with the initial public offerings of Softbank-owned chip maker ARM, marketing automation company Klaviyo, and grocery delivery company Instacart. Investors will be watching the performance of these recent IPOs carefully to gauge whether the appetite for technology stories has truly shifted or whether high interest rates and broader macro concerns will continue to weigh on demand for growth stories.
The dominant theme in venture capital activity during the first half of 2023, according to Pitchbook, was a shift to supporting existing portfolio companies at the expense of making new investments. New investments were also subject to a much higher bar than in recent years, reflecting a general flight to quality in the sector. Pitchbook also notes that insider-led rounds came in at the highest level in a decade last quarter, further reinforcing the thesis that traditional venture capital sponsors will backstop existing portfolio companies to an exit rather than walk away from their investments and unrealized gains.
While venture capital activity continued to level off in H1 2023, it is worth noting that quarterly deal counts remain above pre-2021 figures. Annualizing the H1 2023 deal count would put deal volume on track to hit approximately 16,000 — well above pre-2021 levels and within reach of the all-time highs seen in 2021 and 2022.
Deal value is another story. Reduced valuations, smaller deal sizes across stages, a pullback in non-traditional investor participation, and overall bias to quality have driven declines in aggregate deal value. Annualizing H1 results, the 2023 deal value is tracking to hit $171 billion, compared to approximately $247 billion in 2022, $348 billion in 2021, and $171 billion in 2020.
Against the backdrop of slowing venture capital deployment and lower valuations, portfolio companies have been cutting costs to grow more capital efficiently and relying more on insider rounds (including insider rounds accompanied by debt) to extend runways. Of note, Series C and D companies, which is where the bulk of Espresso lending is focused, trimmed their spending by 27 and 23%, respectively.1 We see this as an important re-set exercise for many companies for whom easy access to capital in recent years encouraged a growth-at-all-costs approach at the expense of efficiency, which is a shift that, broadly speaking, is beneficial to lenders to the sector.
Importantly, despite reduced investment in growth and broader macro uncertainty, software revenue growth levels showed resilience in H1 2023. Public market SaaS companies recorded revenue growth of approximately 20% in Q2 2022, compared to 23% in Q1 2023 and 28% in Q2 2022.2 Not surprisingly, growth continues to attract premium valuations. In Q2 2023, companies recording annual revenue growth in excess of 40% attracted an average EV/TTM multiple that was more than 60% higher than their lower-growth peers.3
Resilient revenue bases and positive secular tailwinds supported M&A activity for software companies in H1 2023. Q2 2023 saw strong deal volume for SaaS companies, surpassing historical Q2 levels if you exclude 2022.4 Indeed, if H1 2023 activity levels are maintained, it will put 2023 SaaS M&A figures just short of 2022’s total but significantly higher than 2021 and prior years.
So, what can we expect in the second half of 2023? Much will depend on broader macroeconomic forces, including evidence that past rate hikes have proved effective at cooling inflation and whether the economy is able to bounce off a soft landing or sink into recession.
The good news is that there is light at the end of the tunnel. Q2 late-stage valuations showed signs of improvement, with median and top-quartile valuations growing 19% and 28%, respectively, over Q1, according to Pitchbook data. Further, recent advances in AI promise the potential for dramatic advances in productivity and the beginning of the next wave of secular growth for the software sector as end-users upgrade their software platforms to take advantage of these innovations. Of course, there is plenty of hype, but that is exactly what powers new technology adoption!
And while VC fundraising has fallen in 2023 year-to-date, very high levels of fundraising over the past several years, coupled with reduced deal activity, have kept VC dry powder at record levels. With an estimated $279.8 billion of dry powder,5 VCs stand poised to jump back into deal mode as the investment environment improves.
The number of US venture capital-backed companies now exceeds 50,000, double the number in 2016. While not all will be suitable for venture debt, this represents a significant expansion in the market for venture debt. Furthermore, the collapse in March 2023 of Silicon Valley Bank, by far the largest bank lender to the technology sector, and the reduced appetite for lending among the remaining technology-focused banks provides an opportunity for non-bank lenders to expand market share without the need to increase credit risk. These factors, coupled with pent-up investment demand from venture capital firms, should underpin strong market fundamentals for venture debt providers going forward.
1 Q2 2023 PitchBook-NVCA Venture Monitor.
2 Software Equity Group Report, 2Q 2023 SaaS Update.
5 James Thorne, “5 big trends shaping VC investing today,” Pitchbook, July 14, 2023.