Venture debt entices yield hungry investors

Investors looking for an intriguing mix of steady income, short-duration debt and a low-risk investment strategy may have just found a new asset class in venture debt.

Overall, the space is tiny when compared to other credit markets, representing an estimated $18 billion in total assets in 2020. The prospect of 20%-plus returns is creating buzz as investors seek out alternatives to traditional debt and venture capital investing, according to Zack Ellison, founder of Los Angeles-based venture debt specialist firm Applied Real Intelligence (A.R.I.)

According to Ellison, the venture debt market will likely grow to between $20 billion and $25 billion by the end of this year.

And he’s ready, bringing his more than 15 years of experience in fixed income working at Sun Life Financial, Deutsche Bank and Scotiabank. Ellison has done his homework over the last two years and after building an inclusive and diverse advisory board he is now raising money for his first fund launched last October.

The A.R.I. Venture Debt Opportunities Fund aims to provide financing solutions to high-growth, innovative, venture capital-backed companies operating in “recession-resistant” sectors and underserved regions throughout the U.S.

These industries include financial technology, software, SaaS, Internet and business services, B2B marketplace, biotechnology, drug development, healthcare, sustainable/clean energy technology, agricultural technology, supply chain/logistics, e-commerce consumer products, media and entertainment and telecommunications.

One of the most intriguing stats he gathered is particularly promising in that more than 75% of the venture debt market currently is controlled by fewer than 10 commercial banks and business development companies. This means that institutional investors have essentially been locked out of this debt market. But that is changing.

“The majority of institutional investors classify venture debt as an absolute return strategy that lies within their income generating of credit portfolios,” wrote Ellison in a recent white paper on the asset class. “For investors seeking direct exposure to venture debt, co-investment opportunities and lower short-term volatility, private closed-end fund structures offer the only opportunity.”

For investors the benefits of venture debt include the relatively short duration as most loans are paid off in one or two years, no “J-Curve” effect, no interest rate risk and the opportunity to co-invest, according to Ellison. The instruments themselves are senior secured and there is often skin-in-the-game from other venture capital firms sharing a vested interest in helping a young company expand and grow into another round of financing in many cases.

For the company, the benefits are great too in that the founding teams and their early investors are not diluted out of their positions and at the same time it is a cheaper alternative to equity financing, according to A.R.I.

Ellison pointed out that today only 2% of the capital base of early-stage companies is debt, compared to nearly 30% among companies in the S&P 500 Index.

A.R.I. estimates that this 2% figure will grow to 3% to 4% in the next one to three years. For investors this implies a market expansion of 50-100%, which will fuel the firm’s venture debt strategy all the more.

Generally, Ellison said, companies eligible for venture loans have already raised three-to-six rounds of equity funding prior to financing rounds. The borrower has been significantly de-risked at this stage as they have been operation for five to eight years and have undergone multiple rounds of due diligence reviews.

“Founders need access to non-dilutive capital, commercial banks have an approach that is incongruent with financing early-stage companies, and most private venture leaders have limited capacity,” commented Ellison last autumn.

A.R.I. also added on to its advisory board in selecting various industry leaders with an eye to bring a diverse set of advice to the venture debt shop. Joining were: Randy Cohen, Dan Espinal, Edward Finn, Laura Hope, Johnita Walker Mizelle, Julianne Recine, Blair Smith, Jamil Soriano and Ben Wiles. 

The 15-strong advisory board comprised of a broad and diverse group of renowned leaders. Ellison said that his firm has prioritized leadership, integrity, diversity, risk-intelligence and specific business expertise that will help the firm reduce risk and rapidly grow its venture debt platform.

“As the former manager of New York Common Retirement Fund’s $5.2 billion Emerging Manager Program, and current head of a consulting firm focused on advising leading asset managers and investors,” said Blair Smith, founder and CEO of Promethean AB Strategies. “I look forward to helping A.R.I. successfully navigate the emerging manager landscape with its flagship Venture Debt Opportunities Fund.”

Smith contributed a first-person commentary on the need for diversity and inclusion in asset management in Alternatives Watch last year.

Advisory board members like Smith advise A.R.I. on a portfolio that is set to grow along with the opportunity set in venture debt.