IAIC 2021: Rise of Private Credit: Venture Debt by Ankur Bansal, CFA

Indian debt market is roughly $2.1TN and Corporate Debt accounts for ~22% ($467BN). Approximately $98BN of Corporate Debt is in the form of debentures and bonds. Private credit is of various types depending upon stage of a company:

• Infra debt: For development and investment in existing infra-assets for long tenure (10+ years).
• Mezzanine debt: Subordinated debt with features like preferred equity, plus warrants.
• Distressed debt: Taking over debt of companies that are bankrupt or likely to enter bankruptcy.
• Direct lending: Senior debt to mid-market companies including revolving credit lines or second lien loans.
• Real estate debt: Direct lending for real estate acquisitions or new project funding.
• Special situations: In the form of structured lending / business turnaround / investor take-out.
• Venture debt: It is an alternative form of capital wherein Venture Capital-backed early and growth stage startups can access custom debt financing for their growth and working capital needs.

Per SEBI regulations, Alternative Investment Funds (AIFs) are classified under category I, II and III. Venture debt funds are classified under category-II AIF, funds that do not take leverage or borrowing other than to meet day-to-day operational requirements. Category-II AIFs invest in debt or debt securities of listed and unlisted companies with good corporate practice and growth potential. Venture debt investments are in startups with lower credit rating and yield is generally high in the range of 16%-20%, compared to an A rated bond (9%-11%) or a BBB- rate bond (11%-13%).

Venture debt is currently a fraction of India’s Corporate Debt market at 0.43% or ~$430MN. Global venture debt market is ~$20BN. Venture debt funding in India grew at a CAGR of 26% between 2015-2020. The number of deals increased from 11 to 50 during the period. Majority of deals took place in e-commerce, consumer services and fintech sectors.

Banks are not prevalent in the venture debt market as they need to comply with regulatory requirements which restrict them from certain areas since they require tangible collateral and profitable business. Although Non-Banking Financial Companies (NBFCs) have historically been a flexible and cost-effective source of funding but aggressive lending practices caused an increase in their NPAs and asset-liability mismatches recently. Venture debt as an asset class has emerged to fill the capital gap for startups which need a debt partner for their growth and working capital requirements. It has created an opportunity for players with domain expertise to provide flexible and customized debt products to rapidly growing companies backed by high quality institutional investors. Collateral for a venture debt can be intellectual property or trademarks as opposed to hard-assets which a traditional lender requires. Disbursement for venture debt is between 1-2 months compared to 3-6 months for a traditional lender.

Venture debt can be extended to companies in various forms like term loan/non-convertible debenture, revolving credit facility, revenue linked loans, receivable discounting, equipment financing and contract financing. Venture debt provides the following benefits to the borrowers:

• Less equity dilution (no major ownership in the company)
• Extend cash runway (increases the length of time to operate by providing liquidity)
• Increase valuation (scaling up using venture debt and next round of funding at higher multiple)
• Flexible structure (compared to a bank loan)

Venture debt investments are subject to various risks but these can be minimized.

• Exposure Risk: Venture debt is generally less than 20% of equity funds raised and forms a small part of overall capital structure.
• Financial Risk: Continuous performance tracking of the borrower, covenants, escrow account and debt service reserve account to make repayments when cash flow is low.
• Time Risk: Loan tenure of 2-3 years with a small moratorium period of 3-6 months. Duration is short compared to equity investment horizon and near-term cash flow visibility through regular EMI payments.
• Downside Risk: Creating a charge on borrower’s current/fixed assets and intangibles
• Equity Stake: Warrants up to 10%-15% of the debt amount which provide potential upside gains on exit.

Venture debt is different from Venture Capital (VC). In 2020, VC market was ~$10BN whereas venture debt market was $430MN (or 4.3% as a % of VC market). VCs tend to take a sizeable equity stake in the company and do a comprehensive valuation and strict due diligence. Venture debt investors, on the other hand, do not take much equity in the company and due diligence process tends to be less comprehensive compared to VC. While VC is the primary source of funding for startups, venture debt provides the additional liquidity support to start-ups which can be utilized for specific purposes where high cost of equity is not a preferred option. VC’s return is typically 3x-5x while VD return is 1.3x-1.5x.

Venture debt investors’ returns are a combination of interest income with an equity kicker. There is consistent distribution of income monthly/quarterly for investors seeking liquidity. High yield is received regularly by investors unlike structured products which can be back-ended in nature. Warrants vary between 10%-20% of loan value, typically translating to not more than 1%-2% of equity in the company and augment overall IRR.

Investors consider venture debt in their portfolio for the following reasons:

• Asset allocation: Sophisticated investors can leverage venture debt as an additional asset class to achieve desired returns with downside protection.
• High-yield strategy: Venture debt is a great option for conservative investors who want to explore the early-stage startup ecosystem through a value-oriented fixed income strategy.
• Low correlation to traditional fixed income products: Investors can consider venture debt as complementary to investing in traditional fixed income instruments for diversification benefits.
• Proxy to VC funds: Opportunity to invest in cherry-picked deals by VC fund managers without taking riskier equity route.
• Investment horizon: Venture debt funds are focused on a company’s ability to repay loan over few years.