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Venture Debt

Venture lending flourishes amid VC funding pullback

Fast-growing companies are tapping the venture debt market to stretch their liquidity runways.

Venture lending, long a backwater in the startup funding market, has attracted growing interest in recent quarters as cash-hungry, fast-growing companies tap the debt market for capital, hoping to buy themselves more time before embarking on a new equity round.

Startups in need of cash see debt financing as a way to avoid more dilutive equity investment at a time when falling public market valuations, a frozen IPO market and investor pullback from later-stage and pre-IPO startups have created a widening funding gap.

Blackstone‘s recent push into the venture debt market, reported last week by The Information, is the latest example of large asset managers making moves to capture this pent-up demand.

Other nonbank lenders have also shown increased interest in the market. Private equity and venture capital investor Insight Partners is reportedly raising its second fund focused on structured equity, while credit hedge fund King Street is stepping up its hunt for opportunities by extending high-yielding loans to growth-stage tech companies.

Blackstone has earmarked at least $2 billion for technology debt deals—including venture debt and hybrid financing for pre- and post-IPO startups—representing its first major foray into the venture lending market, according to the report.

Blackstone couldn’t be reached for comment.

“There is a lot of pressure building up at the late stage, where a lot of companies need to raise some form of financing so that they can continue operating until they are able to get to the public market, and that capital is not available in equity markets,” said Kyle Stanford, a senior analyst at PitchBook. “It could be the best option for these companies to raise a large amount of debt and continue to grow at a more sustainable pace without a significant amount of dilution.”

So far this year, just 27 companies have gone public in the US, raising a total of $4.2 billion as of Aug. 16, according to PitchBook data. That is a huge decline from last year, when 185 companies went public, amassing a total $538.5 billion.

Meanwhile, there are 50 unicorns in the US that haven’t raised an equity round in the last two years. These companies will likely need to raise new money soon in order to extend their financial runways and see themselves through the current, more challenging fundraising environment. Venture debt is an increasingly attractive solution to their growing capital needs.

As valuations in private markets fell in the first two quarters of 2022, some high-flying startups, including Stripe and Instacart, experienced a drop in their valuations. Other founders and sponsors resorted to debt financing and hybrid alternatives including structured equity and convertible notes to avoid down rounds.

“There are a lot of cash-burning businesses that were built for growth, not near-term profitability,” said Paul Goldschmid, a partner and co-portfolio manager at King Street. “These businesses have seen this sudden spike in their cost of equity capital, and they don’t know what to do about it. Many of them will turn to the credit markets. There’s a very large capital opportunity there.”

Some of these debt financings could seek yields in the mid-teens, Goldschmid said.

Welcome, new entrants

A few established players said they expect venture debt and other financing offerings by large asset managers such as Blackstone to complement the current venture lending world.

That’s because Blackstone’s initiative could improve repayment and exit opportunities for existing venture debt lenders, who typically exit through public listings, M&A transactions and refinancings by large bank lenders, said Daniel Devorsetz, CIO at Horizon Technology Finance, a venture debt firm focused on technology and life sciences companies.

“Blackstone recognizes this market opportunity and they are taking the very upper end of the venture world, which is in need of more capital providers,” he said. “There’s not enough capital providers at that spot in the market.”

Devorsetz added that investors active in both growth-stage startups and mature middle-market companies have retrenched.

“There has been a pullback among crossover investors who bridge that gap, and Blackstone can help fill that market need.”

While on the rise, the US venture debt market is still small. In 2021, US VC-backed companies received debt financings valued at $33.1 billion, less than one-tenth of VC dealmaking, which hit an all-time high of $341.5 billion last year, according to PitchBook data.

Other private equity firms have dabbled in funding pre-profitable growth companies before. Ares Management got into the venture debt business back in 2012, but the firm didn’t pursue it as a major business line and eventually sold its portfolio to Hercules Capital in 2017.

Venture lending typically requires investors to underwrite a loan based on the borrower’s enterprise value, a different approach from underwriting debt in buyout-financing deals that are structured against a company’s cash flow, said David Spreng, CEO and CIO at Runway Growth Capital.

Featured image by Watchara Ritjan/Shutterstock

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