Private debt markets unlikely to fill the void on a permanent basis

Debt issuance has seen strong demand from venture & growth companies through 2022 and into 1Q23. In a recent report by GP Bullhound’s credit team, debt’s overall share of private capital doubled in 2022 to 30% from consistent levels of 15% over the past five years. Given the strength of the VC market in 1Q22, we estimate 2H22 may have reached up to 50%.

A combination of venture debt, ARR-linked financing, term loans and other credit instruments have partially filled the residual funding gap left by softness in the equity funding environment. The below chart taken from a recent SVB presentation simplifies cash flows at the asset class level. The fall in profits and fundraising is only partially offset by lower losses. For example, the US venture capital market has run at US$100bn of cash outflows over the last 12 months, suggesting two things. First, companies have adjusted their financial profile. Second, investors are more reluctant to deploy capital.

The growing contribution of debt to the overall growth funding mix may be unsustainable, given debt financing is unlikely to provide the permanent capital base required to scale a growth business. Moreover, venture debt is often a floating-rate instrument which adds additional leverage in a rising rate environment, while the secondary effects of a rate hiking cycle and market shocks such as the SVB bankruptcy may tighten credit standards and reduce credit availability.

Ray Dalio suggested in a recent post (linked here) that the growth in debt issuance across venture capital may be at risk. He argued that we are entering the ‘contractionary period in the short-term debt cycle’ which may lead to a combination of weaker demand (deteriorating fundamentals), equity dilution (down rounds), and acquisitions of distressed companies. This dynamic may playout in the second half of 2023 and into 2024.

Selectivity over business models as funding shifts back to equity in 2H23

We may have similarly entered a ‘sea change’ in the investment landscape, following the 40-year bond bull market (see Howard Marks recent memo here). Business models which benefit from the arbitrage between raising cheap debt and investing in top-line growth, now derive more limited terminal value with i) marginal economics, ii) cash flow cycles and iii) the achievability of long-run margins more focal for investors.

This leads us to consider which companies are likely to raise equity in the remainder of 2023. In simple terms, we categorize our expectations in the figure below. Firms which fall into the top-right quadrant are most likely to raise equity rounds – these firms can grow revenue through the cycle, with high levels of operating leverage, and a clear route to profitability.

Companies which fall into the top-left or bottom-right section may find raising equity more challenging (with more deal structure) and could be acquired by strategics or merge with competitors. Others in the bottom-left will struggle to attract equity investment and continue to rely on short-term debt.

The growth profile and capital requirements of high capital intensity, asset-heavy early-stage companies in InfraTech and DeepTech is also very different to a typical SaaS model. There are two trends we have seen. First, the participation of different capital pools, with increased activity from strategic investors and government-back investment vehicles. Second, the changes in funding mix between equity and debt capital, with IP-linked or secured lending increasingly common in early-stage companies.

According to McKinsey, asset managers, private equity, and venture capital funds need to add around US$950 billion to US$1.5 trillion of annual financing for the transition to net-zero. 1Q23 activity in European markets appears to suggest that venture capitalists are adjusting to this demand, but there is still a lot more to come.