Direct lending trends for venture debt

The difficult fundraising environment for venture-backed companies has made venture debt comparatively more attractive to many founders. At the same time, recent bank failures have prompted many emerging growth companies to consider private credit funds and other direct lenders as potential alternatives to their traditional bank lending partners.

This alert provides context for the convergent growth of the venture debt and private credit markets and offers some key distinctions typically considered by borrowers when evaluating proposals from banks and direct lenders.

Historical context

Lending to venture-backed companies has transformed over the past few decades from the “little brother” of the venture capital equity markets to an integral component of the broader innovation ecosystem. With deal flows totaling more than $30 billion in each of the past four years, companies across industries, geographies and stages of the growth cycle have obtained nondilutive capital on terms providing the flexibility to meet each business’s needs. Likewise, historical returns from these facilities have attracted new lenders into the space, including the so-called “too big to fail” national banks, smaller regional banks and direct lenders such as publicly traded business development companies and other private investment vehicles.

Mirroring traditional venture capital equity markets, the growth of the venture debt market over the past decade has been dramatic, with Pitchbook tallying 2,484 venture debt deals in 2022 (compared to 996 deals in 2012, and down from a high of 3,195 deals in 2021). Equally important, access to venture debt has been a part of the growth story of many prominent companies, including a number of companies that are now publicly listed. The growth of the venture debt market is similar in many ways to the growth of the private credit market, which has seen a tenfold growth in assets under management between 2010 and 2020. Benefitting from over a decade of significant tailwinds – in the form of low interest rates, rising valuations and enhanced regulatory requirements for banks in response the great financial crisis of 2008 – the private credit market is now a trillion-dollar market.

The intersection of these mega-growth trends has proved compelling. Investors have flocked to the comparatively high yields; borrowers have found value in the flexibility and efficiencies offered by these sophisticated counterparties; and asset managers have rushed to meet the demand. Consequently, a number of high-profile private credit investors have in the past year launched new funds focused on making loans to venture-backed companies.

Key distinctions between traditional banks and direct lenders in venture lending

As the venture debt market has matured, participants have developed relatively standardized practices and common deal terms. The following provides a high-level overview of some key points that may differ depending on whether a lender is a traditional bank or direct lender:

1. Substantive deal terms. Traditional banks have historically struggled to underwrite the risks inherent in pre-profit and pre-revenue companies. The panoply of financial and other restrictive covenants typically included in middle market and broadly syndicated credit facilities are less common (and are less restrictive) in venture debt transactions. Banks have generally been less willing or unable to forego these protections due to stricter regulatory mandates, more rigid underwriting controls and other factors. As a result, banks have developed a reputation for requiring a greater degree of standardization across their loan portfolio. Although this reputation may be overstated—particularly for banks that have developed a substantial presence in the venture debt market—nevertheless it persists (justifiably or not). In contrast, direct lenders often stress their nimble underwriting criteria and their ability to craft finely tailored solutions to address a company’s specific and individualized needs.


2. Relational fit. Beyond the substantive deal terms, many direct lenders have found success highlighting the flexibility and efficiency of their documentation and closing procedures. Traditional banks may be constrained by their need to develop economies of scale, resulting in more regimented documentation requirements, and may be subject to more demanding regulatory requirements than private credit funds, threatening cumbersome diligence processes (including “know your client” checks).
   
   These softer aspects bear on the parties’ relationship throughout the life of a transaction. As many as 77 percent of venture debt deals undergo a covenant breach at some point. Borrowers (and their venture capital investors) take comfort in knowing that their lending partner – both as an institution and as individual bankers – will work to find constructive solutions in the event issues arise. Doing so requires close collaboration to develop a thorough understanding of the borrower’s business and strategy, reinforcing the strong relationship orientation of the venture debt market.


3. Pricing. Borrowers often find themselves weighing the perceived flexibility provided by direct lenders described above against what has historically been a lower cost of capital provided by regulated banks who have been able to leverage the (often broader) scope of their operations and use their borrowers’ deposits as a low-cost funding source for their lending operations. The issuance of warrants is a common component in venture debt transactions for both banks and non-bank lenders, but many private credit funds will entertain other compensation structures, such as accepting an equity co-investment in the borrower in lieu of or in addition to any issuance of warrants.

Looking forward

Established venture lenders remain committed to the space despite the market disruptions, though the market appears to be taking a more conservative approach amid the reductions in valuations (particularly for later stage companies) and venture capital activity generally. Venture debt deal sizes are trending smaller, with more lender-friendly deal terms, and are expected by some to skew toward higher quality credits. Conversely, borrowers are hoping that increased competition from new entrants will mitigate these effects, as banks and private debt funds have sought to gain a foothold or increase their market share by capitalizing on the recent turnover in the industry.

These trends are unlikely to impact all parties in the same way. For example, despite the US government stepping in to protect depositors, borrowers have begun pushing for the ability to diversify their deposit accounts in the wake of the recent bank failures, which may put pressure on spreads for traditional banks that rely on deposit accounts to fund their lending operations. Enhanced scrutiny from Congress and regulators in response to recent events may further shift the landscape.

Though it remains to be seen who will be best positioned in the new market conditions, we expect venture debt to attract greater interest from emerging growth companies looking to extend their runway or increase scale.

If you would like to discuss or have any questions regarding the topics discussed in this alert or related matters, please contact one of the authors or any member of DLA Piper’s Venture and Growth Lending team.