Venture credit rolls ahead

Summary: Already across mezzanine finance and venture capital, now sophisticated Australian investors are turning their attention to venture credit.

Key take-out: Some local venture credit funds are tipping returns north of 20 per cent, which would outstrip even their US counterparts. Here's how.

New alternatives are hitting the market, uncorrelated with property, and currently accessible to sophisticated investors through venture capital firms.

Often regarded as venture credit, it's a new phenomenon in Australia, but in the US, 10-15 per cent of venture capital deals have credit components, and around a quarter of all later stage deals have it.

Venture credit is a type of debt financing designed for high-growth companies. It’s often complementary to venture capital, with the upside being it minimises equity dilution for founders and early stage investors, but a potential downside in that the returns are less clear-cut.

In Australia, there is $2 billion worth of venture capital floating around, and until now, no matching venture credit market.

At present, there are three players operating at scale in the Australian venture credit market – OneVentures, Partners for Growth and Adventure Capital – and they’re opening their doors wider for sophisticated investors.

OneVentures has partnered with The Olive Group, a leading Israeli venture credit fund; Partners for Growth is the longest running and headquartered in Silicon Valley; and Adventure Capital, spun out of a Melbourne tech hub, is also working closely with the likes of Silicon Valley Bank.

They are backing all sorts of businesses, but most candidates hail from high-growth areas like cloud computing and IoT (internet of things), automation and robotics, biotech, and fintech.

Outstripping returns out of the US

OneVentures managing partner Michelle Deaker (pictured) says that, in the US, similar funds are tracking internal rates of return in the 14-16 per cent range, adding that “over many years, the Australian market, being less competitive, could aim for higher”.

Adventure Capital and OneVentures are currently raising money for dedicated venture credit funds, while Partners for Growth is right now raising for its fifth fund, comprised of $200 million in equity and $60 million in debt.

Partners for Growth raises a discrete pool of capital every few years and is currently closing a private equity-style fund. The fund is open to sophisticated investors who can put in a minimum amount of $250,000, but most of the money raised locally to date has come from institutions and family offices.

“It’s not quite apples for apples, but I think, generally, it’s true where there is less competition you can get better risk-adjusted returns,” says Partners for Growth managing director Jason Georgatos, based in Sydney.

“The type of venture debt must look different to the US, as a lot of the companies we finance here are bootstrapped and don’t have any venture capital.

“We do some non-tech and micro-cap listed companies here too, which we don’t typically do in the US, so we probably cast a wider net in terms of what we look at here – although we still look for tech-enabled businesses.”

The best Partners for Growth fund to date delivered an internal rate of return greater than 20 per cent, and the worst, during the GFC, still managed to do around 12 per cent.

However, Partners for Growth hasn’t dabbled with leverage in its funds until recently. In fact, its first three funds weren’t leveraged at all, and it wasn’t until its fourth fund that it included $40 million in debt.

“It’s tricky, when you think about what venture debt is, lending to companies that are uncreditworthy by definition – most of the companies we finance don’t have much in terms of assets or cash flow either,” says Georgatos.

“It’s a risky loan where you are getting equity options, so there’s some equity attached, but not a lot of equity like VCs so you can’t afford big losses. There may be one or two companies that get home runs, then five or six that lose all their money, and two or three who deliver a small return – or something like that.

“I think investors should expect risk with 50 per cent of venture credit.”

Scale-ups, not startups

Partners for Growth doesn’t pay a yield. Investors make commitments to potentially outlay money over a multi-year period, giving the fund managers the option to call the money down over three years. After five years, Partners for Growth stops making any investment in the fund and starts returning cash flows to investors.

He describes Silicon Valley Bank as the “800-pound gorilla” both servicing tech companies and lending to tech companies, and Partners for Growth teams up with them on 50-60 per cent of its US deals.

Adventure Capital also has strong ties to Silicon Valley Bank, and an adviser is former ANZ CEO, Mike Smith. Founder Stuart Richardson (pictured) started his venture journey with York Butter Factory before breaking out to back Australian startups.

He considers how people think “it’s super high risk to add debt to the venture equation” and counters that Adventure Capital is only looking at scale-up businesses, already proven in the market, close to breaking even. OneVentures says it's taking a similar approach.

“We’re talking about equity initiating growth and debt accelerating growth,” says Richardson.

“Because we had an undersupply of venture capital, the pricing of the early rounds has probably been very aggressive. The founders and early investors are quite allergic to excessive dilution and it can only take three rounds of capital for the founder to be left with only 10 per cent of their business, so the incentive for them to do something truly extraordinary is significantly diluted.”

Adventure Capital is offering a venture debt product for sophisticated investors, offering a potential return north of 20 per cent. The loans are fully amortising, ranging between $1 million and $7 million per business, and run for 2-3 years on average. To date, the product has taken funds from over a dozen Australian investors.

“We also take equity-based warrants in the companies which we gain at no cost because of the risk we are taking, but they are a fraction of what they would be in terms of additional capital dilution,” says Richardson.

Adventure Capital will charge management fees on funds under management, not assets under management.

How so high?

He estimates the potential return could cross 20 per cent based on the loans being written between 10-20 per cent, then adding the risk in terms of annual return (yield), and the warrant to the yield.

Richardson sets the scene of a company increasing in value two times across the life of the fund, for an investor to then expect alpha-based upside – returns could blow out to between 20-30 per cent because 15-25 per cent of the value of the loan was in warrants.  

As OneVentures' Deaker reiterates, the more kickers and warrants in the fund, the better the outcomes for investors. She says this, among other things, is a major drawcard for the top end of town. 

“Family offices like our product because they already do a lot of alternative mortgage lending and feel completely overexposed to that market," says Deaker.

"They are looking for an alternative product that gives them yield, and with the changes in government that could come in, they are getting very nervous about the impact that could have on the property market and trying to move that exposure."