Spinta | Orrick | December.11.2018
Todd Schneider (TS): Dolph, it’s been 10 years since the financial crisis. Company valuations may again be inflated, the market is generally awash with debt and equity capital, and there is nervousness about where we are in the credit cycle. Perhaps you can remind our readers what the credit markets were like 10 years ago, particularly in the venture debt market.
Dolph Hellman (DH): While the venture debt industry certainly did not collapse during the financial crisis, it did become extremely risk-averse. Lenders were doing all they could to stay afloat and mitigate loss. We saw a significant slowdown of new loans, fewer accommodations on covenant breaches, challenges with releases of follow-on tranches of capital, renegotiations on LP capital commitments, issues with debt funds’ underlying credit facilities, and more conservative underwriting across the board. We did lose a few lenders as a result of the collapse, while those who remained active increased pricing and reduced availability.
TS: Prior to the financial crisis, the economy was humming along. Do you see any similarities between what took place in 2007 and early 2008 and what you are seeing today?
DH: Ten years ago, like today, banks were very aggressive, the equity spigot was turned on to full blast, valuations were inflated, and optimism was high. Today, generally, companies are raising more capital, growing faster, and perhaps failing faster than they did 10 years ago. Both the private equity and private debt capital markets within tech are substantially larger than 10 years ago.
DH: Todd, what would you say are the biggest changes in the venture debt market from 2008 to today?
TS: This market has undergone enormous growth. Look at SVB’s balance sheet: $10 billion of commercial loans outstanding to tech companies today versus $3 billion in 2008. Hercules’ loan portfolio has grown from $0.5 billion to $1.8 billion in the past 10 years.
In 2008, the SaaS model was nascent. No one had heard of an “MRR Line of Credit.” Salesforce had been public for only a few years and was $0.5 billion in revenue versus $12 billion today.
Today tech companies are scaling faster and staying private even longer versus 10 years ago. The SaaS business model has proliferated; with it has come an embedded asset for issuers and lenders to collateralize and finance.
With this, banks have been writing much larger checks.
And the nonbank lender community in particular is now very diverse in terms of number of lenders, underwriting philosophy, sector focus, size focus, and structures offered, with nonbank debt frequently serving as an alternative to equity for later-stage companies.
DH: There’s a well-known phrase: “Those who cannot remember the past are condemned to repeat it.” As you look at the venture debt market in 2018, are there any lessons learned from the financial crisis that are being ignored today?
TS: Using SVB and Hercules as a barometer, the damage to most venture lenders was contained and short-lived.
SVB’s tech company commercial loan charge-off rate (as % of loans outstanding) more than quadrupled in 2009 to 4.5% but returned to a normalized 0.5% - 1.0% range by mid-2010. Meanwhile, the bank’s stock price had mostly recovered by 3Q09.
Similarly, Hercules saw its principal loss rate increase to 5.0% in 2009 versus 1.0% - 2.0% previously and then returning to the 1.0% - 2.0% range in 2011, where it has remained. Its stock price was fully recovered by 3Q09 after bottoming out earlier that year.
From the borrower’s perspective, similar to pre-financial crisis, unbridled optimism from lenders and borrowers probably poses the biggest risk when raising new debt in today’s market. Are companies’ capital structures positioned to withstand an economic downturn? How much of the debt facility is “on the come” via delayed draw or second tranches? How is a debt partner funded? How well structured are covenants or repayment schedules? Many companies aren’t wired nor incentivized to think this way, especially in good times.
TS: Dolph, since no one can predict what the economy will be like in 12 or 24 months, what advice would you give to a company that is seeking additional capital and having to choose between an equity raise and venture debt?
DH: Venture debt will not typically cause company failure, but it can accelerate it. The decision process is highly situation-dependent.
Venture debt is most frequently used to either support working capital needs or provide true growth capital. The former is likely a valid-use case in all economies, with such loans typically supported by liquid assets or contractually recurring revenue streams. The latter tends to be a bit more nuanced, where debt is used as a strategic tool to delay an equity round or achieve profitability.
In a robust equity market, we generally see VC-backed companies testing the waters on equity before turning to debt.
So, generally, the decision may not be debt versus equity but may be driven rather by a function of not attracting the right valuation/terms on the equity front and turning to growth debt as a tool to buy time. With that in mind, I don’t know if the decision process is any different with economic uncertainty on the horizon. If anything, capital may become less available in the future, and a prudent strategy may involve raising capital sooner rather than waiting, ensuring the debt structure and terms are flexible and that the lender can scale with the company.
TS: If we are, in fact, overdue for another “correction” in the economy, what advice would you give to a company seeking venture debt? Is it important to plan for downside scenarios, and if so, how?
DH: Warren Buffett has said, “Only when the tide goes out do you discover who’s been swimming naked.”
Yes, running downside scenarios can be quite “revealing” as to appropriate choices when evaluating debt options.
Is this to fund working capital needs, expansion, refinance, or acquisition? How much true “runway” will it provide under various growth cases? Are there financial covenants? If so, under what circumstances will the covenants be tripped, and how might an economic downturn accelerate a miss? What is the reputation of the lender partner? Do they view the world primarily through a credit lens (i.e., perhaps more rigid when things get tough) or an equity lens (i.e., more flexible/patient)? How much capital is “on the come” via delayed draw or follow-on tranches, and what are the triggers? For a variety of reasons, such follow-on capital becomes less certain in a downturn.
How much “risk” is the lender taking? This can be revealed by running a “threshold” analysis where the forecast is reduced to just above the limit of financial covenants. At this point, what is the company’s cash position versus the loan size?
DH: Todd, continuing with our theme of optimism and pessimism, George Carlin once said, “Some people see the glass half full. Others see it half empty. I see a glass that’s twice as big as it needs to be.” In the venture debt market, is there the right balance between those seeking capital and those that need capital, or are things out of balance?
TS: As mentioned earlier, obviously this has been an issuer’s market (supply-tilted). That said, activity in the market has been driven by both supply and demand.
On the demand side, technology companies’ appetite for growth capital is nearly endless, spurred in part by companies staying private longer and today’s mantra of rapid scaling. Debt has also gained acceptance across the VC community as a useful but complementary financing tool.
On the supply side, the proliferation of the recurring revenue business model and search for yield have attracted more capital, new lenders, and generally larger loan sizes, giving higher-quality borrowers many options with which to finance working capital, leverage assets, and support growth.
DH: Any final words on how to approach venture debt in the current economy?
TS: Think broadly. Take advantage of the diversity in the lender market as well as the availability of capital. Have a plan. Stress test the model. Treat your lender like a true risk capital partner, even if a bank. Meet early and often with your debt partner.