Venture Debt Update: Will the Recent Rise in Venture Lending Turn to Bust?

Although venture debt financing is in the midst of a strong rebound, there are signs that the recovery might not last. Some of the conditions that caused a swift decline in venture lending earlier in the decade have resurfaced, threatening the growth of this form of financing.

Growth in Venture Capital Investing

Along with a revival in venture capital investing since 2003, venture debt financing has expanded sharply. Thanks to the ample funding provided by a cast of new venture lenders, startups are using this relatively efficient form of financing to extend the runway between equity rounds and to avoid ownership dilution. Along with the lenders' overflowing coffers have come looser lending terms and cutthroat competition. While startups and their investors are realizing the benefits of the abundant supply of financing, the fierce competition and compressed margins have put many venture lenders at risk of stumbling. Will the revival in the venture debt market end in an unceremonious fizzle, as it did during the meltdown earlier this decade?

According to PricewaterhouseCoopers' MoneyTree Survey, venture capitalists invested more than $26 billion during 2006. This level of investment represented a 34% increase over the decade low-point reached in 2003. During the 2001-2003 meltdown, many venture capital investors focused internally on supporting the promising portfolio companies and later selectively invested in later-stage startups with proven performance. As the general economy and the technology markets recovered, venture capitalists resumed investing in early and seed-stage companies. During 2007, growth in venture capital investing continued, as both the number of transactions and the level of funding grew.

With entrepreneurs launching more startups and the demand for additional financing rising, venture lending (which includes venture leasing) has also grown. This financing grew to around $2.5 billion in 2006 from its decade low-point of around $836 million reached in 2003. Both forms of financing are recovering from the high levels achieved during the 'New Economy' bubble years of the late 1990s when venture capital investing eventually topped $100 billion and venture debt financing reached almost $5 billion. In both cases, growth in these forms of financing seemed driven by unwarranted optimism in economic growth and unstoppable expansion in the technology markets.

The 1990s

During the late 1990s, venture lending thrived as a moderately high-risk form of debt financing targeting early stage companies. Participating in venture lending's great expansion were equipment vendors (e.g., Cisco, Sun Microsystems, and Lucent Technologies), banks (e.g., Silicon Valley Bank, Fleet Bank, and Imperial Bank), specialty finance companies (e.g., DVI, Comdisco, WTI, LINC, LTI, Lighthouse Capital, Phoenix Growth Capital, and Pentech Capital), and large diversified finance companies (e.g., Transamerica, GE Capital, and GATX). Staggering equity investments by venture capitalists and Wall Street investors stoked the growth in venture debt transactions. Venture capitalists and Wall Street investors alike envisioned a rapidly expanding 'New Economy' fueled by transforming information, telecommunications, and life sciences technologies. Belief in this new economic model led to ratcheting venture investing and triggered rising demand by startups for loans and leases to finance equipment and working capital.

The premise of venture lending during the 1990s seemed straightforward enough. Most venture lenders believed they would profit if enough venture customers repaid their loans from a combination of revenues, cash on hand, and future venture capital rounds. With gross transaction yields in the 17% to 24% range and only modest defaults, this model appeared sensible and irresistible. During most of the decade, venture lenders recorded delinquencies and charge-offs that were only marginally higher than moderate risk loan portfolios. Several of these lenders reported cumulative net charge-offs of less than 2.5%, while delinquencies remained well below 5%. Also attracting venture lenders were the numerous venture capital-backed startups in telecommunications, software, information technologies, and life sciences that received multiple follow-on investments from their sponsoring venture capitalists. These favorable conditions boded well for venture lenders until cracks surfaced in the New Economy's armor in the late 1990s.

At the dawn of the new millennium, a confluence of factors sent shock waves through the venture lending segment. Rising venture failures and delinquencies, a slowing economy, a contraction in venture capital investing, overaggressive lending practices, and questionable business models sparked widespread faltering in venture lending. Publicly held specialty finance companies such as LINC Capital and later Comdisco, which embraced venture lending's higher yields, rapid growth rate, and favorable perception on Wall Street, were slammed by investors. Ultimately, these companies foundered as their losses mounted, they violated their credit agreements, and they were cut off from essential equity and debt capital. Similarly, large diversified finance companies with venture lending portfolios reeled from mounting portfolio losses. Venture lending groups within TransAmerica, DVI, and GATX eventually folded or were jettisoned as a result of the turmoil. Private companies specializing in venture lending were largely closed off from new funding to support these transactions, forcing many of them to abandon venture lending or to liquidate their portfolios. The few remaining lenders and leasing companies gravitated to more stable segments of the market, such as the life sciences, or curbed volume dramatically by focusing on smaller, better-collateralized transactions.

2001 Redux?

Despite the sharp rebound in venture lending over the past four years, storm clouds are gathering over the horizon as the market continues to recover. Along with rising loan demand has come an over-abundance of financing. Several well-heeled lenders have now entered the market. New entrants include several bank-affiliated lenders, a few newly formed funds, some small-ticket leasing companies, and a host of other firms with experience lending to high-risk companies. Several participants have organized as funds, raising capital from investors seeking above-average returns. Others have adopted more traditional corporate structures. Two new funds that have raised several hundred million dollars, TripplePoint Capital and Hercules Technology Growth Capital, are led by former Comdisco managers. One new participant, Ritchie Capital Finance, is part of an established hedge fund.

As market conditions have stabilized, producing relatively low default rates and delinquencies, venture lenders have taken on more risk and accepted lower pricing. Typical loan pricing during less competitive periods produced cash returns of 12%-14% and warrant participation in the 5%-10% range (expressed as a percentage of the transaction amount). Pricing in today's venture loan market is significantly lower. Cash returns have fallen to 9%-11%, while warrant participation is in the 2%-5% range. This reduction in cash returns and warrant participation has squeezed lender margins, reducing overall yields in some cases by as much as 500 basis points.

In a similar fashion, underwriting standards have weakened. Startups with less cash on hand, limited operating performance, and weaker venture capital sponsorship are now receiving loans. These companies, savoring the lenders' insatiable appetite for new loans, routinely play one against another to snare better terms. Sometimes these terms include requiring less collateral and/or financing more soft costs. Additionally, many startups are now receiving loans at earlier stages of development.

Another potential threat to the venture lending market is the recent turmoil in other parts of the credit market. In the late 1990s and early 2000s, many banks and investors reeled from the impact of the faltering telecommunications market and the debacle at Long-Term Capital Management, a major hedge fund. The ripple effect from these and other problems areas led many lenders and investors to shun riskier loans and investments. Today, havoc in sub-prime lending and in leveraged buy-out financing has the potential to derail venture lending. Although venture loans usually are not securitized, this segment is vulnerable to a significant pull-back by investors and lenders pinched by the malaise in CDOs and other asset-backed securities. Several of these lenders and investors, smarting from portfolio write-downs, also participate directly or indirectly in financing venture lenders.

Turmoil in the sub-prime and leveraged buyout markets that results in an economic slowdown or recession could spell even more trouble for venture lenders. As was the case earlier in the decade, many startups are particularly vulnerable to a slowing economy. During the last slowdown, companies that usually buy new technologies or try new services significantly reduced their expenditures in these areas in favor of proven products and services. Slowing growth for many of these startups led to an early demise as their venture capital sponsors subjected them to a Dr. Kevorkian-style triage process that all but eliminated future support. A slowdown in the economy today could lead to a similar reaction by venture capitalists looking to cut their losses.

Lastly, many participants in the venture lending market rely heavily on their borrowers' receiving future venture capital rounds to achieve loan repayment. With weaker loan structures, marked by insufficient collateral and the absence of other credit enhancements, venture lenders often must hope that their borrowers receive multiple venture capital rounds to survive. If one thing was proven during the collapse of the technology bubble during the early 2000s, it was that venture capitalists will cut bait and run when their portfolio investments seem unsalvageable.

Venture Lending's Next Stop

Given the recent developments in venture lending, it is clear that this market segment faces some formidable challenges. What is unclear is which venture lending models will succeed over the long term. Although collateral values, borrowers' cash on hand, loan terms, and security deposits are among the key determinants of successful venture loans, ongoing venture capital sponsorship clearly trumps them all in importance. Recent history suggests that many venture lenders miscalculated the risk inherent in venture lending and the returns necessary to profit in this segment. Additionally, many of them ignored traditional risk management concerns, such as portfolio concentrations, financial leverage, and interest rate volatility. These factors are magnified when funding a venture lending portfolio.

Even if lenders create workable risk'reward models, many still rely on funding models fraught with pitfalls. Those lenders relying too heavily on traditional bank funding earlier in the decade discovered, to their dismay, the fickle nature of this funding vehicle. Similarly, the equity markets eventually punished venture lenders who concealed the high-risk nature of the business and those permitting their participation in venture lending to tarnish their core businesses. The ability to navigate these challenges, to avoid the pitfalls created by an overheated market, and to dodge the growing instability elsewhere in the credit markets might determine which venture lenders survive and whether venture lending will avoid another big spill.

George A. Parker is a Director and Executive Vice President of Leasing Technologies International, Inc. ('LTI'), responsible for LTI's marketing and financing functions. Headquartered in Wilton, CT, LTI is a leasing firm specializing nationally in direct equipment financing and vendor leasing programs for emerging growth and venture capital backed startups. More information is available at: www.ltileasing.com.

Although venture debt financing is in the midst of a strong rebound, there are signs that the recovery might not last. Some of the conditions that caused a swift decline in venture lending earlier in the decade have resurfaced, threatening the growth of this form of financing.

Growth in Venture Capital Investing

Along with a revival in venture capital investing since 2003, venture debt financing has expanded sharply. Thanks to the ample funding provided by a cast of new venture lenders, startups are using this relatively efficient form of financing to extend the runway between equity rounds and to avoid ownership dilution. Along with the lenders' overflowing coffers have come looser lending terms and cutthroat competition. While startups and their investors are realizing the benefits of the abundant supply of financing, the fierce competition and compressed margins have put many venture lenders at risk of stumbling. Will the revival in the venture debt market end in an unceremonious fizzle, as it did during the meltdown earlier this decade?

According to PricewaterhouseCoopers' MoneyTree Survey, venture capitalists invested more than $26 billion during 2006. This level of investment represented a 34% increase over the decade low-point reached in 2003. During the 2001-2003 meltdown, many venture capital investors focused internally on supporting the promising portfolio companies and later selectively invested in later-stage startups with proven performance. As the general economy and the technology markets recovered, venture capitalists resumed investing in early and seed-stage companies. During 2007, growth in venture capital investing continued, as both the number of transactions and the level of funding grew.

With entrepreneurs launching more startups and the demand for additional financing rising, venture lending (which includes venture leasing) has also grown. This financing grew to around $2.5 billion in 2006 from its decade low-point of around $836 million reached in 2003. Both forms of financing are recovering from the high levels achieved during the 'New Economy' bubble years of the late 1990s when venture capital investing eventually topped $100 billion and venture debt financing reached almost $5 billion. In both cases, growth in these forms of financing seemed driven by unwarranted optimism in economic growth and unstoppable expansion in the technology markets.

The 1990s

During the late 1990s, venture lending thrived as a moderately high-risk form of debt financing targeting early stage companies. Participating in venture lending's great expansion were equipment vendors (e.g., Cisco, Sun Microsystems, and Lucent Technologies), banks (e.g., Silicon Valley Bank, Fleet Bank, and Imperial Bank), specialty finance companies (e.g., DVI, Comdisco, WTI, LINC, LTI, Lighthouse Capital, Phoenix Growth Capital, and Pentech Capital), and large diversified finance companies (e.g., Transamerica, GE Capital, and GATX). Staggering equity investments by venture capitalists and Wall Street investors stoked the growth in venture debt transactions. Venture capitalists and Wall Street investors alike envisioned a rapidly expanding 'New Economy' fueled by transforming information, telecommunications, and life sciences technologies. Belief in this new economic model led to ratcheting venture investing and triggered rising demand by startups for loans and leases to finance equipment and working capital.

The premise of venture lending during the 1990s seemed straightforward enough. Most venture lenders believed they would profit if enough venture customers repaid their loans from a combination of revenues, cash on hand, and future venture capital rounds. With gross transaction yields in the 17% to 24% range and only modest defaults, this model appeared sensible and irresistible. During most of the decade, venture lenders recorded delinquencies and charge-offs that were only marginally higher than moderate risk loan portfolios. Several of these lenders reported cumulative net charge-offs of less than 2.5%, while delinquencies remained well below 5%. Also attracting venture lenders were the numerous venture capital-backed startups in telecommunications, software, information technologies, and life sciences that received multiple follow-on investments from their sponsoring venture capitalists. These favorable conditions boded well for venture lenders until cracks surfaced in the New Economy's armor in the late 1990s.

At the dawn of the new millennium, a confluence of factors sent shock waves through the venture lending segment. Rising venture failures and delinquencies, a slowing economy, a contraction in venture capital investing, overaggressive lending practices, and questionable business models sparked widespread faltering in venture lending. Publicly held specialty finance companies such as LINC Capital and later Comdisco, which embraced venture lending's higher yields, rapid growth rate, and favorable perception on Wall Street, were slammed by investors. Ultimately, these companies foundered as their losses mounted, they violated their credit agreements, and they were cut off from essential equity and debt capital. Similarly, large diversified finance companies with venture lending portfolios reeled from mounting portfolio losses. Venture lending groups within TransAmerica, DVI, and GATX eventually folded or were jettisoned as a result of the turmoil. Private companies specializing in venture lending were largely closed off from new funding to support these transactions, forcing many of them to abandon venture lending or to liquidate their portfolios. The few remaining lenders and leasing companies gravitated to more stable segments of the market, such as the life sciences, or curbed volume dramatically by focusing on smaller, better-collateralized transactions.

2001 Redux?

Despite the sharp rebound in venture lending over the past four years, storm clouds are gathering over the horizon as the market continues to recover. Along with rising loan demand has come an over-abundance of financing. Several well-heeled lenders have now entered the market. New entrants include several bank-affiliated lenders, a few newly formed funds, some small-ticket leasing companies, and a host of other firms with experience lending to high-risk companies. Several participants have organized as funds, raising capital from investors seeking above-average returns. Others have adopted more traditional corporate structures. Two new funds that have raised several hundred million dollars, TripplePoint Capital and Hercules Technology Growth Capital, are led by former Comdisco managers. One new participant, Ritchie Capital Finance, is part of an established hedge fund.

As market conditions have stabilized, producing relatively low default rates and delinquencies, venture lenders have taken on more risk and accepted lower pricing. Typical loan pricing during less competitive periods produced cash returns of 12%-14% and warrant participation in the 5%-10% range (expressed as a percentage of the transaction amount). Pricing in today's venture loan market is significantly lower. Cash returns have fallen to 9%-11%, while warrant participation is in the 2%-5% range. This reduction in cash returns and warrant participation has squeezed lender margins, reducing overall yields in some cases by as much as 500 basis points.

In a similar fashion, underwriting standards have weakened. Startups with less cash on hand, limited operating performance, and weaker venture capital sponsorship are now receiving loans. These companies, savoring the lenders' insatiable appetite for new loans, routinely play one against another to snare better terms. Sometimes these terms include requiring less collateral and/or financing more soft costs. Additionally, many startups are now receiving loans at earlier stages of development.

Another potential threat to the venture lending market is the recent turmoil in other parts of the credit market. In the late 1990s and early 2000s, many banks and investors reeled from the impact of the faltering telecommunications market and the debacle at Long-Term Capital Management, a major hedge fund. The ripple effect from these and other problems areas led many lenders and investors to shun riskier loans and investments. Today, havoc in sub-prime lending and in leveraged buy-out financing has the potential to derail venture lending. Although venture loans usually are not securitized, this segment is vulnerable to a significant pull-back by investors and lenders pinched by the malaise in CDOs and other asset-backed securities. Several of these lenders and investors, smarting from portfolio write-downs, also participate directly or indirectly in financing venture lenders.

Turmoil in the sub-prime and leveraged buyout markets that results in an economic slowdown or recession could spell even more trouble for venture lenders. As was the case earlier in the decade, many startups are particularly vulnerable to a slowing economy. During the last slowdown, companies that usually buy new technologies or try new services significantly reduced their expenditures in these areas in favor of proven products and services. Slowing growth for many of these startups led to an early demise as their venture capital sponsors subjected them to a Dr. Kevorkian-style triage process that all but eliminated future support. A slowdown in the economy today could lead to a similar reaction by venture capitalists looking to cut their losses.

Lastly, many participants in the venture lending market rely heavily on their borrowers' receiving future venture capital rounds to achieve loan repayment. With weaker loan structures, marked by insufficient collateral and the absence of other credit enhancements, venture lenders often must hope that their borrowers receive multiple venture capital rounds to survive. If one thing was proven during the collapse of the technology bubble during the early 2000s, it was that venture capitalists will cut bait and run when their portfolio investments seem unsalvageable.

Venture Lending's Next Stop

Given the recent developments in venture lending, it is clear that this market segment faces some formidable challenges. What is unclear is which venture lending models will succeed over the long term. Although collateral values, borrowers' cash on hand, loan terms, and security deposits are among the key determinants of successful venture loans, ongoing venture capital sponsorship clearly trumps them all in importance. Recent history suggests that many venture lenders miscalculated the risk inherent in venture lending and the returns necessary to profit in this segment. Additionally, many of them ignored traditional risk management concerns, such as portfolio concentrations, financial leverage, and interest rate volatility. These factors are magnified when funding a venture lending portfolio.

Even if lenders create workable risk'reward models, many still rely on funding models fraught with pitfalls. Those lenders relying too heavily on traditional bank funding earlier in the decade discovered, to their dismay, the fickle nature of this funding vehicle. Similarly, the equity markets eventually punished venture lenders who concealed the high-risk nature of the business and those permitting their participation in venture lending to tarnish their core businesses. The ability to navigate these challenges, to avoid the pitfalls created by an overheated market, and to dodge the growing instability elsewhere in the credit markets might determine which venture lenders survive and whether venture lending will avoid another big spill.

George A. Parker is a Director and Executive Vice President of Leasing Technologies International, Inc. ('LTI'), responsible for LTI's marketing and financing functions. Headquartered in Wilton, CT, LTI is a leasing firm specializing nationally in direct equipment financing and vendor leasing programs for emerging growth and venture capital backed startups. More information is available at: www.ltileasing.com.