Releasing pressure at Exit
How could Venture debt increase returns of Venture Capital funds and shorten the time to Exit.
Latest annual review of European Venture Capital Activity by PitchBook show up some important insights. There have been c.470 exits with a total value of €14.7bn. Therefore, average is set at a disappointing €25m.
Some might argue that Venture Capital distribution of returns follow a power law distribution. It is true, OneRagtime has breakdown the figure (see above).
Let’s take a birds eye view on the asset class, if the €25m Average Exit will grow up to (10% YoY) it end up in 2025 at €40m (25 x (1+ 10%)⁵).As you see I am being very bullish on the European VC Ecosystem.
If take a closer look to Venture Capital investments in Europe and according to Dealroom median and mean Series A in Europe is somewhere c.€7–8m.
Average dilution for an investment round is set at 25%. Given all the above, Equity Value of Series A companies is at (7÷25%=28m). Therefore expected IRR of the asset class (Series A) is not very competitive.
(40m Exit ÷ 28m Eq.Value Post Money)⁵-1 = 8% Returns.
The 8% IRR is not competitive against the historical return of other more liquid assets such as Large Cap Equities or High Yield bonds (both on double-digits). It is worth mention that given the distribution of returns many funds will keep on delivering outstanding returns to their investors.
However, unless you believe that you are smarter than the rest of investors and will be able to cherry pick the right companies you should keep reading this post.
- How can Venture debt boost the returns of Venture Capital funds?
Through leverage.
In our previous example we assumed a 25% dilution to come up with a €28m valuation. We have therefore set the maximum dilution level that the current shareholders would be able to bear for a given amount, €7m.
Taking as an example this €7m ticket and €28m Eq. Value with a 25% dilution. We have worked out a similar ticket composed by €4m of Equity Capital and €3m of Venture debt:
Venture debt to boost performance
In the example below, we have shared the equity-dilution savings as we have changed the Initial Valuation of the company for the Venture Capital (€21m vs. €28m). Current Shareholders should tolerate this change as the final dilution for the company has also being reduced from its base case.
Assuming the leveraged entry price of €21m (vs. the European Average presented above at €28m) the returns for the Venture Capital as an asset class would change from 8% to 14% being now risk-reward competitive.
(€37m Exit ÷ 21m Eq.Value Post Money)⁵-1 = 14% Returns.
In addition to the economic performance presented above, Venture debt has no political rights and therefore it will not jeopardize any future exit.
The lack of political rights jointly with a lower initial price could substantially reduce the time to exit, being one of the most important problems of Venture Capital funds as Jaime Novoa pointed out.
In the third year, and assuming a 10% increase in the Exit Value a leveraged exit would have a 17% IRR (vs. a 6% in the European Average).
Leverage: (€31m Exit ÷ €21m Eq.Value Post Money)^(1/3)-1 = 12%
Non-leverage: (€34m Exit ÷ €28m Eq.Value Post Money)^(1/3)-1 = 6%
Venture debt could help to set valuation below the industry average (point of maximum liquidity of exits) and therefore generate attractive deals in the short-mid term.
Portfolio Approach to Leverage
Some may argue that the returns in Venture Capital are mostly performed by the outliers (which is true). In that case, Venture debt could restrict capital deployment in a good company. As it can be seen below, this is partially offset by a higher equity multiple (see below example hitting a unicorn).
25% *1bn= 250m / Multiple: 35x vs. 16%*1bn=160m / Multiple: 40x
In addition, if we take a portfolio approach to the same exercise. You would have saved the 42% of your fund by leveraging all transactions. Taking as an example a €100m fund this would correspond to €42m.
Let’s assume we would use this capital savings to the corresponding outlier at a valuation c.€300m (Series C). Leverage portfolio savings would imply an additional 12% (42 Ticket / €350m Post-Money of the round).
Non-Leveraged - 25% * €1bn = €250m
Leveraged: 16%*1bn=160m + Follow-On 12%*1bn=€120m= €280m
Leveraging your portfolio implies a higher multiple on Equity transactions in a one-shot basis. The leverage may also arise important capital savings which could be used in a more certain future to invest into the fund outliers.
Venture debt was born instigated by a very competitive Venture Capital landscape in the US. historically US funds have had the ability to leverage transactions and obtain superior results thanks to Venture debt.
According to Silicon Valley Bank, European Venture debt is still at an early-stage as it represents only 5% of the Venture Capital market in Europe (vs. 15% in the US ). I truly believe we should be able to close the gap in the upcoming years.
Notes:
This is a simplified approach using the Average Exit Price presented as a reference. This is helpful as I understand that liquidity in the exit market should be somewhere around the average (normal distribution).
We are assuming that the company investments perform a J-Curve in a reasonable time (c.12 months) in line with the standard grace period of the Venture Debt facilities.
We assume a 25% Equity-kicker entering the company at the Venture Capital Post-money valuation.
Follow-on on the Portfolio example has been simplified. For the ease of comprehension, we did not apply the dilutive effect of the follow on to any the cases presented Leveraged or unleveraged.
