As VC markets cool, more cash-starved companies are turning to venture lending to tide them over until a new equity round is possible. Lenders are taking note—but it may not be the lenders one would expect.  

In this Q&A with Jennifer Post, managing partner of Thompson Coburn LLP’s Los Angeles office, she discusses if recession fears are slowing down equity markets, if start-ups are depending more on risky “uncommon players” for venture capital and other critical challenges startups face. 

“Nonbank lenders are increasingly entering the market, often in the form of family offices that are working side-by-side with venture debt funds,” says Post. “Family offices seem to have a renewed interest in expanding their lending portfolios since the equity markets remain soft, and they’re looking to be part of the deal flow with direct access to lending opportunities, not just passive investors in funds.”  

TSL: How can diversified financial services firms can provide expansion capital together with VC lenders, and which types of public and private companies might be appropriate targets. 

Post: Non-bank platforms that offer ABL products can find opportunities in later stage venture companies and newly public companies to partner with venture debt funds. The ABL products – typically AR lines of credit –will need to be structured with greater flexibility in exchange for better returns overall. The benefit is that the venture debt funds may be willing to fund on a partially subordinated basis which supports the senior credit products, and provides acquisition or growth capital, which ultimately supports overall scaling of the company. These would not be typical AR lines given the need to show flexibility on the scope of eligible accounts and advance rates, but these companies provide significant potential scale, allowing for future opportunities for expanded AR credits, inventory and other products. These companies have significant revenue and growing EBITDA, but would benefit from the blended rates of an AR line and a venture debt facility to support further growth and in the case of public companies, support market capitalization.

Why can’t private equity firms always compete with traditional sources of venture debt?

PE firms and venture debt funds are not focused on the same stage of company growth and overall don’t share the same ecosystem of capital providers. PE firms generally look to develop undervalued operating companies with established market share, or that represent entry to new industries or platform aggregation opportunities with different objectives, capital needs and expertise associated with their portfolio development. They also exist in their own ecosystem of capital providers including acquisition or mezzanine debt providers. Of course, in later stage companies where PE funds would have an interest, larger venture debt funds can remain in the deals, if they can provide additional capital including new acquisition financing. Of course, the risks change for venture debt funds once a PE firm comes in, as company management changes and the core decision making tends to move away from the board and founders that the venture debt funds worked with in developing the company. Venture debt funds unlike PE funds tend to focus on earlier stage companies in support of boards and founder managements; the risks are high, but the returns can be substantial.  PE firms simply have a different business focus and tend not to take the early-stage risks. It is also not consistent with the investment thesis for most PE firms.

Did you see nonbank lenders increasingly entering the venture debt market before the recent SVB collapse?

The venture debt market has always been populated with venture funds and other alternative asset lenders, like BDCs. In fact, SVB was a part of the overall venture debt markets as a provider of a variety of depository and financial products in the startup ecosystem, including for companies, funds and founders. Think of it this way – SVB was able to offer a turnkey banking solution to start ups and it maintained relationships with many players in the ecosystem, so the early-stage lending – especially to young companies – was not really a driver as much as another product offering. SVB was an early player in venture debt historically, but, given the expanse of their later stage credit and other financial products, the early-stage lending was not the dominant portion of the bank’s revenue activities. Having said that, venture debt funds that focus on smaller credits to younger companies will no longer have to compete with SVB in terms of market share in that segment of the venture debt market. So, there is actually an opportunity for venture funds that focus on Series A or earlier stage, including pre-revenue companies, now that SVB is no longer a go-to for those companies and their investor base.

Do you foresee the demand from venture-backed companies seeking loans to linger on for a while?

There will always be a market for venture-backed companies to take debt financing to expand runway without creating dilution pressure on investors and founders. The question in this market is – what companies should be funded with venture debt and what company boards will take that risk? Companies with recent or likely equity rounds, expanding revenue and increased profitability (or EBITDA) would be good candidates for venture debt, and same as to companies that can work with formula-based ABL and accounts financing – venture lenders may be more willing to come in even if the full first lien position is not provided. As to why it is a risk, venture loans are fully secured, often in the first lien position and often with a lien on IP. The venture lenders have meaningful rights to exert pressure, or call the loans if the trajectory of the company is not tracking to plan. If the company cannot manage growth in an environment of limited equity and high interest rates, or the company is not poised for an ABL line in the coming quarters, taking the debt can present operating risks. This obviously creates a lot of dynamics for the company’s board to manage.  For both venture lenders and boards, the lens of venture debt is now being viewed in light of the tightening venture markets generally, which means companies will continue to seek debt but fewer will be funded given the risks.

Some advisers also anticipate that lenders will be more conservative in lending practices until the fog of uncertainty clears. Are you seeing this?

Absolutely, that is true. With valuations down and equity in short supply, the managers are doing two things: first, carefully assessing changes in their portfolio including restructures, decisions on follow on funding, and working with portfolio management teams to refine operating plans and exit paths; and second, seeking and executing on higher quality transactions that demonstrate stronger fundamentals and less foreseeable risk. At a minimum, managers are looking for greater diversity in the portfolio – taking stock of what they have and looking to add position that add differentiated positions, and they are exercising patience in assessing companies and completing diligence. If the lenders are family offices, they may also be looking to align with new funds (and new managers) that can bring a different domain expertise or track record to the market.

How do non-bank lenders work with family offices?

Private funds can have mutually beneficial relationships with family offices by providing offices a means to diversify to private credit transactions, and in return bring a flexible and enlarged capital base to the funds.  In addition to bringing in family offices as limited partners, funds can create co-investment and first-look relationships. These direct transactions can have smaller fee commitments for the offices allowing better economics, or at least blended economics in their relationship with the fund managers. In addition, direct deal access also provides the offices with a right to obtain equity positions (usually warrants) directly in the portfolio companies. These arrangements provide deal flow and management experience and efficiencies to the family offices, and conversely help to expand the capital base for the funds, allowing the funds the opportunity to transact on larger deals, or provide follow on capital for successful positions. This type of relationship is important for emerging managers that generally have smaller funds as they look to scale opportunities with individual borrowers.

What is driving the renewed interest from family offices expanding their lending portfolios? Do you think they will continue for a while?

Certainly, there is a lot of uncertainty in the private debt and equity markets now, especially the venture investment market. With banks monitoring their balances sheets and interest rates being very high, banks are less competitive across asset classes, generally, creating opportunities for private credit. This is especially true as the market resolves the gaps left by the SVB failure in terms of credit sources for venture-backed companies and sponsor transactions. Family offices looking to rebalance allocations of equity and debt, may find debt more attractive given higher rates, secured lien positions, and the opportunity to partner with experienced private credit managers. The venture debt transactions almost always include warrant or other equity investment rights, so the potential upside is not limited to the expected underwriting on the credit alone. Also, as the markets continue to be uncertain, the quality of the deals taken to completion should actually improve, with better fundamentals, longer term exit strategies, and enhanced management teams, as c-suite executives are also looking to join more stable environments. As long as the equity markets – including the IPO markets – are sluggish and cautious, private credit will remain an attractive asset class for family offices.