India’s nascent venture debt market is at a crossroads. Today, startups in the market for debt are spoilt for choice with multiple funds vying for their attention. The year gone by has seen a virtual doubling of deals from the previous year. The big question to ask, however, is whether providing just venture debt is enough. Do the country’s venture debt firms need to play a wider role in the startup ecosystem than just lending?
Venture debt started in India in 2005 with the introduction of the first credit programme by Citibank India. Subsequently, in 2008, Silicon Valley Bank (SVB) set up the country’s first dedicated venture debt business through an NBFC. This form of debt currently accounts for less than 5% of the country’s annual venture capital (VC) flows but is growing rapidly with the entry of new players. A look into the history of how the venture debt industry evolved in the US could provide some indication of the path that the industry might take in India and some lessons that could be learnt.
How venture debt works
Venture debt is a blanket term that covers situations in which a startup that does not have operating cash flows or asset collateral can avail a loan in exchange for paying interest and granting warrants. This form of lending, which appears counter-intuitive in nature, rests on the lender’s ability to assess whether the startup can attract further rounds of equity capital in the future and use that to continue to repay the loan.
The inversion of conventional banking principles is made possible by the presence of VC investors who can infuse equity capital when needed. Targeting only those startups that are funded by VC investors is, therefore, a crucial condition to making venture debt work. Ironically, the condition of restricting lending to only those companies that are backed by VC investors places some unavoidable constraints on the growth of the industry.
As the number of specialty lenders increases relative to the finite number of startups funded by VC investors, there is pressure on debt firms to compete by either lowering pricing or dropping credit standards. These actions lead players to compete in what becomes a quick race to the bottom. Interest rates fall, credit losses mount, and lenders are ultimately unable to deliver the returns needed to stay in the business.
But that’s not everyone. Firms like SVB, Hercules Capital, TriplePoint and WTI have bucked the trend to emerge dominant in the US venture debt industry. To understand how they got there, we need to examine the history of the industry from its inception in the 1970s.
The emergence of venture debt as business model
Venture debt first appeared in the US in the 1970s but began to take off only in the 1990s. The Bank of New England (BoNE), which dominated the industry in the 1980s, made way for SVB by the end of the 1990s. The industry then went through a phase of intense competition which reached its height during the dotcom era. The dotcom bubble attracted the attention of many lenders who went after the market aggressively and in an over-exuberant industry bubble, made poor credit decisions in the hope of making outsized equity returns from their warrant positions.
The dotcom bubble burst led to a significant reshuffling of the venture debt world. Large players like Comdisco, Transamerica Corp and GATX Financial Corp went out of business due to failing portfolios and the resulting substandard returns to their investors.
SVB, a commercial bank often described as the 800-pound gorilla of the venture banking world, survived the meltdown thanks to its strict discipline on credit underwriting. While other lending firms competed on pricing and looser credit structures, SVB competed by offering a suite of banking services to startups to balance their tight hold on credit quality, loan sizes and lending practices. SVB may have won fewer deals and made smaller loans than the other firms in that period but when the downturn hit, the impact on its portfolio was much more muted.
The next phase for the industry started from the early-2000s after principals from the lenders that failed in the dotcom bubble bust joined or started other firms like Triple Point and Hercules Capital. Competition began to grow rapidly again as venture debt penetration rose to where it stands today, at broadly 15% of overall venture capital investment flows.
Unsurprisingly, the following ten years saw a steady decline in interest rates and warrant amounts on loans. The lower deal commercials coupled with a more challenging equity exit environment made it increasingly difficult for lenders to deliver returns on their businesses. Consequently, several firms like Lighthouse Capital, Gold Hill and ETV Capital all failed to raise subsequent funds after the challenging phase in the mid-to-late 2000s and went out of business.
How some players have differentiated their models
The venture debt industry continues to be highly competitive. In an unforgiving environment, it is the ability of players to differentiate themselves in some way that is critical to staying competitive without compromising on business returns.
Full-service banks like SVB differentiate themselves by providing a range of banking products and services for startups. The recent acquisition of Leerlink Partners, an investment banking firm, for $280 million is intended to complement SVB’s commercial banking and lending products with a full range of investment banking services focused on healthcare and life sciences companies. It is not by accident that while many venture debt firms have gone out of business, SVB’s market capitalization has grown more than seven times since 2012.
Non-banks, which are not bound by the regulatory restrictions on banking companies, compete by providing significantly larger loan sizes while others offer seed investments, equity co-investments and equipment leases in addition to venture debt. Either way, the environment has selected in favour of players that can deliver something unique to startups beyond just being a cheque book for the loan.
The smaller traditional firms that provide only venture debt have neither the ability to compete on loan sizes nor on product range. The consequent pressure on delivering returns to their investors means that there are very few of these traditional venture debt funds left in the US other than boutique funds that operate in certain niches.
Coming to India, while the number of firms competing in the space is growing, there is still room for venture debt penetration levels to grow. Government policies and regulatory liberalization, which is actively supporting the formation of new debt funds and models for extending loans to startups, could however accelerate competitive pressures within the industry.
Indian firms may have less time to react than their counterparts had in the US. Indian venture debt firms will quickly need to find a value proposition that extends beyond just being providers of loans or risk being weeded out of the market.
The bottom line for Indian firms is simply this: think big, get different, or go home!
Ajay Hattangdi is managing partner at venture debt firm Alteria Capital.
