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Where banks fear to tread

With traditional venture capital financing on the scarce side right now, there are opportunities opening up for Europe's handful of venture debt providers. But what is this form of financing? And should investors be interested? We offer an introduction to this niche sub-set of the venture capital industry.

Venture debt? What's that?
Venture debt is generally split into two types of product: venture loans and venture leasing, forms of finance available to companies at the early stages of their development, usually when they are still cashflow-negative. These are companies that would normally be considered too risky for banks or traditional leasing companies to take on their books.

Venture loans are provided to venture-backed companies in return for interest payments over a fixed period of time plus warrants for ordinary or preferred shares in the company and, of course, the initial capital loaned. Venture debt providers are the senior lender and secure rights over a company's intellectual property and other assets.

Venture leasing provides equipment to venture-backed companies - typically those in industries requiring a large initial capital expenditure on technology, such as those in the biotechnology sector - in return for a typical lease-type agreement. Companies pay venture lessors a monthly sum as interest for a fixed period, again plus warrants for ordinary or preferred shares and an agreed sum for the equipment at the end of the term.

Venture capitalists often see this type of funding as a useful addition to their equity financing. ‘Venture leasing can be an important part in pulling together a funding package, especially for capital equipment intensive businesses, such as biotech or hardware companies,' says Gary LeSueur of Scottish Equity Partners. VCs and entrepreneurs also see it as a way of injecting finance into a business without diluting their equity too heavily.

That's great for venture-backed companies, but of what interest is this to private equity investors?
It is of interest because the providers of this type of finance often raise funds in the form of venture capital-type partnerships. In the US, where - predictably - this sub-section of the industry developed, there are firms such as Western Technology Investments and Lighthouse Capital that raise funds through the traditional partnership-type vehicle. In Europe, the industry has been rather slower to take off and there are only two firms that raise funds. The most established player is European Venture Partners, which is currently raising a E150m venture leasing fund and has been in existence since 1998. The other is European Technology Ventures, formerly known as GATX European Technology Ventures, a venture loans firm that is about to hit the fundraising trail with a target of around E100m and that has been investing since 2000. GE Technology Finance, a part of GE Structured Finance, has also just announced plans to open a London office to provide venture debt in the UK and Ireland, although it says it does not intend to raise a fund. Some US firms, such as Silicon Valley Bank, have also done occasional deals in Europe.

What are the returns like?
It depends on where you invest. The US venture debt business has its roots in the 1960s, but it wasn't until the venture capital boom in the mid to late 1990s that it saw rapid growth. With many new entrants to the market, returns started heading south as players began to compete for deals. As a result, lease rates in the US now average eight to nine per cent, according to European Venture Partners figures, and warrant coverages are in the region of six to eight per cent. By contrast, says EVP, its lease rates in Europe are in the teens with double the US warrant coverage. The European players argue that, in the absence of strong competition, they are able to generate higher returns than their US counterparts. In fact, European Technology Ventures' Humphrey Nokes says: ‘We should be generating returns in the top quartile of venture capital returns over the long term.'

But the other interesting thing about these types of fund is that they are not as highly correlated to the public markets as straight venture capital has proved to be. Returns in venture debt are not so heavily reliant on buoyant exit markets - something that could be welcome in today's difficult environment. The monthly interest and lease payments inherent in these types of investments guarantee LPs an annual rate of return (if the company remains in business) even without an exit. The warrants at the back end of the investment period then provide an additional boost to returns. Overall, the effect of the interest/lease payments is to smooth out the volatility of returns usually seen in a traditional venture capital fund investment.

That sounds like mezzanine to me…
At first glance, there are some similarities - such as the debt and equity make-up of the investment and the smoothed return profile to limited partners. But actually, the risk profiles are quite different. A venture loan, for example, is the only debt in a young company and so lenders will take priority over a company's assets in the event of failure; mezzanine finance, however, sits between senior debt and equity and so has to wait in line for any share of the assets. Venture leasing is also different in that the equipment remains the property of the lessor, says European Venture Partners' Ross Ahlgren. If a company therefore defaults on payments, the lessor is able to seize the equipment from the lessee. This is obviously not an option available to mezzanine players.

The flip side to this, of course, is that mezzanine firms invest in less risky, established companies; venture debt players are investing in unproven, cashflow-negative companies.

If venture debt is now highly competitive in the US, won't the same happen to Europe?
It is possible that competition could hot up in Europe. The recent arrival in the UK and Ireland of GE Technology Finance suggests that experienced and large US players are now looking to Europe as a source of new business. But the fact that it is limiting its business to the UK and Ireland - at least for now– is quite telling. The US market is pretty uniform in terms of legal and tax issues; the European market is not. As a result, the barriers to entry of setting up a Europe-wide venture debt operation are reasonably high. ‘The leasing regulations and fiscal positions in each European country differ quite widely,' says Ahlgren. ‘The protection of our assets is core to our business and so it is essential that we have relationships with service providers across the region to advise us.' He adds that the firm itself also has people on the ground in its main markets - the UK, Scandinavia and Israel.

The other point to make is that the venture loans model in Europe is, as yet, unproven. ‘It's too early to tell,' says Nokes. ‘It's very difficult to see who is good and who has been lucky. Our track record, for example, has been built over the years 2000 to 2003 and that has obviously been a tricky time.' To be good, it's essential to spot which businesses are suitable for venture loans and which aren't. ‘Some companies are pure equity plays,' he says. ‘Remember that VCs can serve an ace to make up their losses, but we can't do that - we don't get the pay-offs on the upside.'

There have been other types of competitor in this market. These are in the form of leases from equipment manufacturers (which have no warrants attached to them) and some of the banks willing to take on some of the larger, better financed start-ups. But they have retreated from the market in recent years as the economic climate has worsened.

In fact, far from believing the market is getting competitive in Europe, some VCs believe that there are countless opportunities for the handful of players in the market to take advantage of. Tim Brown of Alta-Berkeley Associates is one. 'There is a clear need for venture debt in Europe,' he says. 'The problem is that the risk appetites of these debt providers have lowered significantly - quite understandably. We have serveral fast-growing start-ups in our portfolio for which venture loans would be appropriate, but the lenders are just too cautious at the moment.'

How do these funds source their deals?
To be successful, venture leasing and debt firms need extremely good networks. They invest only in venture-backed companies and so the main source of deals is venture capital firms, although some deals may come from service providers and other sources. Both EVP and ETV stress the importance of working with ‘top tier' venture capital firms. Generally, they tend to do less due diligence on areas such as company management and more on the VCs themselves.

‘Our warrant pool looks rather like a fund of funds,' says Nokes. ‘The information set that we look at is very similar to funds of funds in that we do heavy due diligence on the VCs. We want to work with the best ones.' The reason? Venture lenders of both types have less involvement with the companies themselves than a traditional VC has, although they are can lend support when necessary. The risk profile of a venture debt provider is such that they need greater diversification than a VC and so they tend to have more investments in their portfolio. As a result, a seat on the board of each company is pretty much out of the question. ‘And besides,' adds Ahlgren, ‘it's not our job to be adversarial with the board. We are there as a complement to the VC. We trust their judgment in their dealings with their portfolio companies.'

So is there any opportunity for venture lenders to add value beyond financing?
Yes. Venture lenders don't simply put in the money and sit back waiting for interest payments to come flooding in - they have as much of an interest in seeing the company succeed as a VC and so will offer help or advice where needed. Their network of contacts can often serve portfolio companies well, for example. ‘In my experience, those providing venture leasing and venture debt can often bring more that just finance to the table,' says LeSueur. ‘While they tend not to be as hands-on with portfolio companies as a venture capitalist, they can still be useful in offering a slightly different network of contacts that others around the table may not have. This might include an introduction to other funders or to potential new customers.'

Brown agrees: 'When we have attracted venture leasing finance, we have found that the provider's behaviour has been much more aligned with that of an early-stage VC than with that of a bank. They bring with them bulging rolodexes and they take a flexible approach to a portfolio company's needs.'

What of the future?
As a relative newcomer to the venture capital industry in Europe, there is obviously some room for development in the venture debt space. We've already mentioned that there may be some new players, but it's unlikely that it will ever be much larger than a sub-sector of the wider venture capital market. This is in part because the number of deals that lend themselves to this type of financing is in some ways limited and in part because of the difficulties of servicing a pan-European market.

The other limiting factor - at least for the moment - is the fact that few investors understand venture debt. Those in the US are, of course, more familiar with the concept. In fact, some of the more sophisticated among them see investing in venture debt funds as a way of gaining exposure to the European market without the volatility of investing in a venture capital fund. But in Europe, both ETV and EVP say that they are spending a lot of time helping investors understand this mixture between equity and debt. Some, they say, have difficulty knowing where to place it in their overall portfolios. There are also additional structural problems: UK investors, for example, are taxed on interest payments and so funds need to find creative ways around this.

But the fact that VCs are more conservative in their investments than they were in the boom times and therefore willing to invest less in early-stage businesses suggests that there are more opportunities for venture debt. Most VCs now also understand venture debt and will likely approach the providers with deals on a more regular basis than previously. So despite the difficulties, this new area of the venture capital market could become of greater interest to institutional investors.

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