Tough financial conditions belie a ripe venture debt market

TOUGH market conditions are creating a spike in demand for venture debt among startups. A tighter funding environment along with unfavourable exit conditions in public markets have led to more venture debt requests, even more so than at the onset of the pandemic in 2020.

Venture debt provider Genesis Alternative Ventures has been tracking quarter-on-quarter growth in venture debt requests, and is seeing an average of between US$80 million and US$100 million of requests per quarter currently. Innoven Capital, a venture lending platform, is seeing more companies build venture debt into their capital raising rounds.

“It comes down to the question of price, that’s important because the prices and valuations would affect a founder’s dilution. Naturally venture debt has become an even more attractive option in the current market environment because we are less dilutive and we don’t have to set the valuation,” said Paul Ong, partner, Innoven Capital.

When they first launched in the region, venture debt providers in South-east Asia found themselves having to educate the market as they were generally viewed as distressed lenders or lenders of last resort.

Dr Jeremy Loh, co-founder and managing partner of Genesis Alternative Ventures, says such labels are misplaced. “Venture lenders don’t lend to bad companies. If the company is in trouble, there is no reason for a venture lender to go in there and build them up. We’re not in the business of bailing out bad companies,” he said.

Venture debt only really surfaced in the region around 2015, when DBS set up its venture debt unit. It later set up a US$500 million venture debt platform EvolutionX Debt Capital with Temasek in July 2021. Innoven Capital, a joint venture between UOB and Temasek, entered the market next in 2016, followed by Genesis Alternative Ventures which started out in 2019 with its first fund raising US$80 million. (*see amendment note)

The main difference between venture debt and venture capital is that venture debt is predicated on having venture capital invest in a startup. Venture debt is structured as part of a fundraising round, where capital raised is a mix of equity and debt, with venture debt providers getting warrants which allow for shares to be purchased at a set price rather than equity, aside from the debt the startup has to pay off.

Traction among investors for venture debt appears to be growing, as Genesis Alternative Ventures is now raising its second fund, with a target of US$150 million. Half of the funding target has been committed, with 80 per cent of the investors following on from the first fund.

“At the top of investors’ minds is that venture debt works, and that there are opportunities,” said Loh.

Venture capital investors have been preaching financial prudence to portfolio companies, resulting in a refocus on business fundamentals by founders. Even as purse strings get tighter, venture debt providers say that there are still opportunities out there, as funding is still happening, albeit at a slower pace with more rational valuations.

Notably, growth stage startups - those scaling and expanding the business - still need cash to fuel their growth. Their dash for cash, coupled with a refocused discipline on unit economics and profitability, makes these companies potential borrowers for venture debt providers.

“For the growth stage tech companies in Asia that EvolutionX Debt Capital targets, founders are focused not only on raising alternative capital, but are also mandated by their boards to focus on unit economics and pathways to profitability. This provides an attractive window of opportunity for venture debt players to seek superior risk-adjusted returns as well as further catalyse the fast-growing tech ecosystem in the region,” said an EvolutionX Debt Capital spokesperson.

Debt players also look at other factors, from the quality of the startup’s equity holders, whether they have support from a good group of venture capital investors, to their business models. The penchant for risk at venture debt providers is lower than VC funds, according to Innoven’s Ong.

A key factor for Genesis Alternative Ventures is how startups generate their revenue. What’s important is that the startup should be generating real business growth rather than just using capital to subsidise revenue growth.

“These companies are not easy to find, (but) there are such companies out there. That’s the reason why out of 100 deals we look at, we’ll probably fund 3 to 4 of them because we need to find the ones that match the criteria,” said Genesis’ Loh.

Venture debt providers also function differently from lenders; they don’t just sit back and wait for the startups to repay the debts. Instead, providers are looking to add value to their borrowers, be it opening doors or supporting them in ways that founders and other investors on board are comfortable with.

“If that includes the company wanting us to be more of a financial provider, we are happy to play that role as a lender and not get too involved in a company. Our level of involvement in a company comes down to a case by case basis,” said Innoven’s Ong.

The next 12 to 24 months is likely to be business as usual for Innoven according to Ong, even with macroeconomic headwinds and a tighter funding environment. Innovation does not go away regardless of the financial climate, and Genesis’ Loh believes that entrepreneurs will continue to emerge to solve pain points, even more so in a time of crisis.

“We are seeing an early maturing of the South-east Asian startup ecosystem. These companies will need more capital to grow their business. We are very optimistic that the venture debt market will grow in the next couple of years,” said Loh.

*Amendment note: A previous version of this story incorrectly stated that EvolutionX Debt Capital was set up in 2015.