Venture Debt Attractive Now, Riskier Later, Panelists Say

Considering the enormous amount of capital overhangs, future venture capital (VC) conditions are expected to take a turn for the worse.

At the Canadian Lenders Summit last week in Toronto, Ontario, panelists discussed how liquidity risk and tightening lending conditions could impact VC markets in the future.

With the S&P 500 (INDEXSP:.INX) reaching all-time highs of 3,039.42 on Monday (October 28) and achieving over 20 percent returns year-to-date, it is clear that VC sentiment is uncertain.

Urging caution, the five expert panelists gave an inside look at lending conditions, different forms of debt and how a downturn could affect both parties — enterprise and lender — during venture-funded deals.

“This is the first time in my career where all constituents of the folks that I speak with — lenders, venture capital firms, growth investors, hedge funds, lawyers and accountants … uniformly thinks we’re in for problems,” said John Markell, managing partner at Armentum Partners.

Markell spoke about his work, including a US$75 million venture debt round with music streaming platform SoundCloud, and how SoundCloud is one example of a company that has been heavily reliant on equity funding.

The prevalence of corporate debt, unsurprisingly, has been paired with sky-high valuations in the market.

“There’s some massive capital overhangs, especially in the US, so people are asking, ‘Oh, why is that enterprise software getting priced at L plus seven?” said Markell. “The answer is it’s not because it’s an amazing company, it’s because there’s so much capital that these larger lenders need to deploy, and that’s sort of pushing down in the market.”

Similarly, Garron Helman, CEO of Venbridge, a VC firm based in Toronto, Ontario, said that companies may not be properly prepared for the next correction.

“What we see is that the venture debt market is taking on a lot of equity-like risk, and it’s happening more and more … and that is going to spell problems.”

This will be especially troublesome for companies with major debt loads, he added.

“I think there’s going to be a lot of surprises for a lot of companies that currently have debt, and there’s going to be some challenges on the equity side, but especially on the debt side because this side has levers to pull based on all the covenants of the loan agreement,” said Helman.

Still, the current lending environment is attractive for enterprises because of the near-zero lending rate environment. Randy Garg, founder and managing partner of Vistara Capital Partners, said during the panel that the last 10 years have been very advantageous in lending.

“Every Canadian bank is chasing all the growth stories that are out there currently and offering unbelievable terms. So as an entrepreneur, they’re getting incredible deals,” explained Rob Rosen, managing director at CIBC (TSX:CM) Innovation Banking.

In light of this, the panelists stressed the importance of knowing as much as possible about the various kinds of lenders and conditions before entering into a deal.

“On the flip side of that is that businesses really don’t know who their financial partner is and they’re not sure how they’re going to act,” said Rosen.

In the event of a liquidity squeeze in the future, circumstances could take a sharp turn for businesses, creating a ripple effect. Rosen advised businesses to be cautious considering the current environment.

Amid the massive amount of debt that is circling in the market, a number of different types are present: debt, venture debt, growth capital and mezzanine financing, among others, said Jasmin Ganie-Hobbs, senior development banker at BDC.

“There’s a lot of alternative lenders that have a specific niche in the marketplace, and you really have to assess what your business needs are,” said Helman. “If you want a short-term bridge, do you want a longer-term relationship? What is it that you’re looking for? What’s your asset base that you can offer?”

Helman added that the scale of debt options presents an opportunity, rather than a burden, to entrepreneurs. Still, Rosen noted things are likely to change course.

“It’s a very good time for an entrepreneur to get very, very cheap debt. I would like to say to them to be very careful who you get into bed with today because it may be great today, but it may not be so great tomorrow,” Rosen told the audience.

Adding further insight into current lending conditions, Ganie-Hobbs spoke about some situations that she’s encountered in lending to businesses.

“What can you do when you’re expecting C$2 million to come into a company? You have a commitment in writing and then at the 11th hour, the night before and you’re expecting funds, suddenly your lender is not funding. And there are some clauses in the commitment documents that make it perfectly okay.”

As the panel continued, the VC lenders spoke about typical lending structures, most of which operate within three to five year terms. Interestingly, Garg added that businesses are looking for more certainty in longer-term contracts to facilitate acquisitions or additional staff.

Looking at future conditions from a lender’s perspective, Rosen spoke about how CIBC is investing in companies with strong fundamentals and “sticky” software.

“From CIBC’s point of view, we’ll find really good companies that have strong metrics (behind them) that we believe will withstand whatever potential downturn there is,” he said.

On the other hand, Markell said, for many entrepreneurs that are in their 30s right now, this will be their first economic downturn — they have not experienced a lending squeeze or tightening credit environment. As a result, lending terms are more than certain to get more expensive, with terms that could reach as much as 20 percent.

With files from Georgia Williams.

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Securities Disclosure: I, Dorothy Neufeld, hold no direct investment interest in any company mentioned in this article.