Demystifying Misconceptions Around The Risk/Return Profile Of Venture Debt

Demystifying Misconceptions Around The Risk/Return Profile Of Venture Debt

When examining the asset class often referred to as venture debt, there is a more accurate and realistic moniker to consider. While many refer to it as venture debt, it is crucial to debunk some common misconceptions that prevail in the industry.

Understanding the Misconceptions

A common misconception among fund allocators and private credit managers is the belief that venture debt carries the same risk as venture equity but with capped upside from the debt. Despite this belief, supported by decades of publicly available performance and research, the reality is quite different. Venture debt actually holds far less risk than venture equity and offers built-in upside Features linked to equity returns.

This article aims to demystify these misconceptions to attract more capital into the asset class, providing more non-dilutive options for technology companies. The primary confusion stems from the word “venture,” which is often misinterpreted to imply a higher risk class, when in reality, it signifies that the majority of borrowers have been funded and supported by venture equity funds.

Risk Mitigation Strategies

Several avenues are simultaneously employed for risk mitigation in this asset class. Experienced fund managers effectively mitigate lending risk to technology companies through various strategies, including focusing on mid- to late-stage companies that have achieved a minimum threshold of viability.

They also pay keen attention to technology sectors that offer mission-critical Products and services with high switching costs while structuring loans as senior secured debt at the top of the capital structure. Additionally, various protections are embedded in the loan structure itself, such as covenants, tranched funding, and performance milestone metrics.

The Impact of Risk-Mitigation Measures

These risk-mitigation measures result in an asset class that has historically demonstrated a low loss rate, typically ranging in the 1%-2% range on a cumulative basis. This stability is supported by public filings and results from various BDCs in the space, providing a compelling case for the efficacy of the risk-mitigation measures implemented by fund managers.

Conclusion

In conclusion, referring to this asset class as venture debt may not accurately capture the essence of what it truly represents. A more precise and realistic descriptor would be “private credit, focused on technology companies, with downside protection and equity-linked upside.”

Contrary to the misconceptions that prevail, funds in this asset class have demonstrated consistent yields across cycles, offering investors access to venture-like upside optionality that comes with high-growth technology companies.

Disclaimer: In this article, focus is placed on private credit funds that center on mid- to late-stage technology companies. Therefore, the observations may not entirely apply to commercial banks or credit funds that lend to early-stage technology companies.

Source: forbes