BackPerforming credit amid the funding winter
Venture debt can be offered to companies that may not be cash flow positive yet
PremiumThe funding winter is here and many venture capital (VC) firms have reportedly asked their portfolio companies to cut costs and revise budgets and projections. VC funding has seen a decline from $17bn in the third quarter of calendar year 2021 to $7bn in the second quarter of calendar year 2022, due to adverse macroeconomic scenarios led by geopolitical tensions, low anticipated growth and multi-year high inflation.
With VC funding drying up, emerging enterprises and start-ups are increasingly shifting towards non-equity-based funding, or, debt. Debt is generally available from traditional sources of lending such as banks but that option demands collateral or shares to be pledged. In such a situation, venture debt (VD) becomes an alternative. VD is a type of loan offered to early-stage, high-growth companies, which are already backed by VC firms. The VD deals are structured to include an equity component in the form of warrants, preference shares, rights, or options.
VD can be done by dedicated VD funds. VD can be offered to companies that may not be cash flow positive yet. It can be provided to companies without existing collateral. It does not require a valuation to be set for the business and gives way to less dilution for existing shareholders compared to VC funding.
As we move away from AAA & AA rated bonds down to BBB rated companies, a lucrative opportunity for investors in a white space—known as the Performing Credit (PC)—exists between mutual funds (MFs) and distressed debt at two extremes.
The yield range of up to 8% is mostly covered by MFs, where the portfolios are disproportionately skewed towards safety due to risk parameters set by Sebi and low liquidity risk on account of being open-ended vehicles. At the other extreme, there are venture, real estate funds, and distressed debt operating in the above 16% yield range. The PC space consists of papers issued by rated and stable companies which are undiscovered and yield high risk-adjusted returns. As per our estimates, more than 90% of these companies in any rating bracket are Ebitda (Earnings before interest, taxes, depreciation, and amortization) positive. However, when we analysed 80 VD investee portfolio companies, we found that they are largely Ebitda negative with limited ability to generate cash flows. The VD portfolio comprises companies that are typically unrated unlike companies in the PC space. This could make asset quality in the VD universe inferior, although VD investors have lately been considering the underlying business model, path to profitability, positive unit metrics and longer runways for evaluating their investment decisions.
Considering that the PC space comprises mainly A to BBB rated investee companies, we see a disproportionate increase in the premium of return over risk when we compare their respective yield spreads over 3-year G-sec with respective default rates. However, if the VD investee companies are ever rated, they would lie in the BB and below bracket which is marked by much higher default risk. This is because these firms have unproven business models, lower vintage, and mostly negative Ebitda, posing a higher risk on even principal repayments.
Apart from asset quality, investors in VD funds need to look at the pricing of future rounds of VC investment, which determines the upside potential to overall returns. However, the returns from funds in the PC space are predictable as they are entirely dependent on returns from debt instruments making the risk-return spectrum not as distorted as VD funds.
Vineet Sukumar is founder & CEO, Vivriti Asset Management. The views expressed here are personal.
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