Why Venture Debt has become a Popular Choice for both Founders and Investors

Venture debt. Isn’t that an oxymoron? While venture signifies high risk, debt signifies the opposite. But start-up founders seem to love venture debt. In fact, it is fast becoming a multi-purpose tool that founders deploy at the heart of their growth strategy. It also means that venture debt funds are able to deploy more capital, faster.

Investors, too, seem to be enamoured by venture debt, if fundraising is anything to go by. The pace at which India’s top venture debt firms are closing their fundraising tells the story of this asset class, and its blistering growth. Take for instance Alteria Capital, which has companies such as Dunzo, Country Delight and Rebel Foods in its portfolio. Launched in 2017, the Mumbai-based firm announced the close of its first fund in July 2019. When it hit the limited partner (LP) market for its second fund in December 2020, the plan was to initially raise funds from domestic investors before reaching out to international LPs in May 2021. But it didn’t have to; by April 2021, the fund hit its final close at Rs 1,820 crore, just from domestic investors, says Co-founder and Managing Partner Vinod Murali. At present, this is the largest venture debt fund in India. Alteria, which began investing in March 2018, currently has assets under management of Rs 2,800 crore.

Meanwhile, Gurugram-based Trifecta Capital managed to raise two funds last year—a rare feat. It achieved the first close of Rs 750 crore for its third debt fund in November 2021, within two months of the fund’s launch, wholly from domestic investors. Trifecta had secured a final close of Rs 1,025 crore for its second fund in March 2021. The Rs 1,500-crore third fund is nearing its final close. Trifecta has companies such as bigbasket, Cars24 and ShareChat in its portfolio.

Delhi-based Stride Ventures, the youngest among the leading debt funds, too raised the first close of its second fund in under two months. It received commitments for Rs 550 crore of its target corpus of Rs 1,000 crore. The fund has an additional greenshoe option of Rs 875 crore. Founder and Managing Partner Ishpreet Singh Gandhi says the company, which has start-ups like SUGAR Cosmetics and HomeLane in its portfolio, plans to secure the original size by the end of FY22 and complete the greenshoe in another couple of months.

Mumbai-based InnoVen Capital, the pioneer of venture debt in India, hit the first close of its new fund at Rs 740 crore in September and is 3-4 months away from hitting a final close at `2,000 crore (including greenshoe), says Ashish Sharma, MD & CEO, InnoVen Capital India. The company has firms such as Udaan and Dailyhunt in its portfolio.

“More start-ups are getting created, good quality capital is going into those companies, and markets are getting deeper. We are seeing greater acceptance for venture debt, and funds are also getting larger pools of capital. The timing between fundraises is getting compressed. Today, funds can write larger cheques, and that allows us to be relevant to a lot of companies,” says Alteria’s Murali.

But what exactly is venture debt? Put simply, venture debt is debt provided to venture-backed new-age companies. It took years of work on capital formations, educating founders on its possibilities and stimulating demand before this asset class could enter the mainstream funding environment. Now, with growing fund sizes, faster fundraising cycles, and larger cheques, it does feel like venture debt has finally arrived.

In the US, the size of the venture debt market is estimated to be 10-20 per cent of the annual flows of venture equity. This alternative asset class has been around for 50 years in the US, the most mature market. In India, unofficial estimates peg it to be 2-5 per cent of annual venture capital flows. For context, technology start-ups raised a total of $42 billion in 2021, according to a report from investment firm Orios Venture Partners.

According to the ‘India Venture Debt Report 2022’ by Stride Ventures, the amount of venture debt disbursed has increased over 10x in the past 5-6 years and has doubled in the last one year. 2021 saw 111 companies raising funds through debt.

“This is a derivative asset class, meaning the more amount of equity that comes into the market signals to the fact that more companies are getting funded, their capital structures have a lot more liquidity which means they can afford to take more debt and repay it. As venture capital and private equity money continue to come into the market, the size of the venture debt market also continues to go up,” says InnoVen’s Sharma.

In fact, InnoVen’s origin is also how venture debt funding started in India. It began in 2008 when global financial services firm SVB Financial Group set up a unit of Silicon Valley Bank in India to provide debt capital to domestic, venture-backed, early- and mid-stage, high growth companies in the country. But its efforts at securing a banking licence never materialised and in 2015, the Singapore government’s investment arm Temasek Holdings acquired the entity and rebranded it to InnoVen Capital India.

“From 2017, the venture ecosystem started expanding rapidly. The amount of funding that we would have done from 2009 to 2016, we do more than that today in a year,” says Sharma. InnoVen, which initially operated through an NBFC before floating an alternative investment fund (AIF) in 2017, has disbursed over $500 million to Indian start-ups.

Trifecta, the first firm to launch a formal venture debt fund in India in 2015, disbursed just shy of Rs 900 crore in 2021 and expects to disburse about Rs 1,200-1,500 crore in 2022. In total, it has invested about `2,700 crore across its three funds and 95 companies and has gone on to launch an equity fund for late-stage bets.

Alteria, launched by former SVB India senior executives Murali and Ajay Hattangdi, has committed to about $200 million worth of deals in 2021 alone, across 65 transactions, taking its average deal size to approximately $3 million. Today, the company manages more than $375 million of capital across two funds and anticipates $200-250 million worth of deals in 2022. Almost 60 per cent of its second fund has been drawn in just the first 12 months.

In a typical seven-year lifecycle of a venture debt fund, the draw and recycling period is till year five, while the fund returns capital on the principal in the last two years. To be sure, debt funds generate interest income all along its life which gets distributed on a quarterly basis. A fund’s recycle ratio is typically 1.8-2x during the investing period, which means a fund of $100 million could potentially do over $200 million of credit during its lifecycle by recycling capital.

Venture debt financing is generally structured to yield 13-15 per cent interest rates with a 3-4-year repayment periods. Almost all providers structure an equity upside in the form of warrants which is normally about 8-12 per cent of the debt.

Investors or LPs are today much more comfortable with venture debt. They have seen how it performs through cycles and how relatively low-risk this asset class is, and appreciate the consistent distributions and returns they receive.

Done along with or after an equity round, venture debt funds broadly provide high-teen returns to investors. About two-thirds of the returns come from fixed income.

“I think there is a lot more conviction in the venture debt asset class today. Volatility in returns is lower. The base returns are fairly consistent. From one vintage year to another, the equity kicker can outperform, and so the upside can be far greater. From a returns standpoint, the upside is uncapped and the downside is fairly protected,” says Rahul Khanna, Co-founder and Managing Partner, Trifecta Capital.

The ever-expanding use-cases for venture debt help funds deploy more capital, faster. The supply of capital and the demand for this asset class has seen exceptional growth in the last two years. Many factors contributed to the growth. First, investors saw a sudden reduction in fixed-income returns from early 2020 and felt a need for safe, predictable fixed-income products which would give good returns. Second, pandemic tailwinds allowed for better depth and access to most digital businesses. It allowed venture debt providers to demonstrate that this asset class can yield greater returns at lower risks.

“As long as we were able to establish good performance, there was a substantially larger amount of money available from the domestic pool of investors. We came through the two waves of the pandemic with zero losses. We showed that this is not so risky and it can give you predictable returns. It basically got more people excited about this asset class from the supply side,” says Alteria’s Murali.

On the demand side, the new normal saw the birth of a lot more start-ups and greater growth for existing ones and this ensured unlimited flow of equity into them. Traditionally, new-age companies looked at venture debt to primarily optimise dilution, finance growth, working capital or operating leverage, and to increase runway between rounds. Even with an equity upside built in, a debt round comes at a much lower cost than an equity one and founders often realise it only when a liquidity event takes place. The increasing frequency of liquidity events through IPOs, acquisitions and secondary deals has exposed and established the real value of equity. And this is driving many founders to debt to further protect their dilution.

Growth stage start-ups with multiple co-founders are increasingly looking at venture debt as their ownership gets diluted to single digits after a certain stage.

“Founders are becoming very sensitive about dilution. They are open to making the debt component a portion of the round to protect a few percentage points of their shareholding, so that they can raise the next round at a much higher valuation,” says InnoVen’s Sharma.

Acquisition financing, fuelled by the rise of ecommerce roll-ups, has been a major driver for venture debt in the last 12-18 months. With roll-ups—firms which acquire ecommerce brands with an aim to scale them up—ticket sizes go up substantially as they hinge on debt to complete quick purchases. That has resulted in a larger requirement and faster deployment of debt products.

“A typical equity firm can take, from start to finish even in a very good scenario, 4-6 months unless they are one of those hedge funds which can turn around at a blistering speed. An equity term sheet is much more complicated than a debt term sheet. At a high level, all debt documents look 70-80 per cent similar. The language might be different, but the concepts remain the same. Everyone knows how the transaction documents look. That’s why it is much faster than an equity transaction,” says Ankur Bansal, Co-founder and Director of BlackSoil, a company which does deals with and without an equity kicker. It lends through an NBFC as well as a venture debt fund.

Venture debt stands to gain if equity becomes more expensive on account of a potential correction in the funding market. When equity slows down, good companies that need to raise capital may rethink their strategy and raise debt instead.

“In the near term, if there is a correction and equity financing becomes more expensive, it naturally creates room for more debt. Obviously, debt providers will have to be that much discerning and disciplined about the exposure they may want to take. There is a lot of headroom in the debt business that still needs to be serviced,” says Khanna.

Debt deployments are set to grow leaps and bounds this year as companies that are not doing well would need more growth capital while well-performing firms would need to replenish their war chest to maintain the growth momentum. Also, more and more growth-stage founders are expected to make debt a part of their funding rounds to balance out dilution.

However, not everyone needs to have a term loan. Debt providers are also exploring differentiated products or strategies. Use-cases are fast expanding from the realm of working capital management, runway extension or dilution optimisation to acquisition financing, receivables financing as well as order book discounting, says Vivek Soni, Partner and National Leader of Private Equity Services at EY India. “Going forward, new focus areas could include onward lending and creative solutions to fund capex or project financing.”

“At Stride, we have done close to eight-nine different transaction structures depending on what business we are investing [in] and what type. You have to make it founder-friendly today. Beyond helping reduce dilution, every founder and investor wants to know how useful a debt round can be for the growth of a business. They [venture debt firms] have to become partners rather than a provider of loans who collects interest at the end of the month,” says Stride’s Gandhi.

According to the Stride survey mentioned earlier, 100 per cent founders of growth stage companies are certain of raising venture debt in 2022. “In our view, the outlook for venture debt as an asset class is very good, both in the short- and medium-term,” says EY’s Soni. “While we have seen significant growth in both demand and supply, the reality is that the market opportunity for venture debt is significantly larger than what is currently being serviced. This asset class will grow faster as awareness increases and start-up founders begin to discover a better understanding of this product. As of now, there are a handful of firms that are in the venture debt asset class and over the next 3-4 years, we expect that number to increase significantly.”

If the growing trust of investors and acceptance of entrepreneurs are anything to go by, venture debt has well and truly arrived.