Zack Ellison of Applied Real Intelligence: 5 Things I Need To See Before Making A VC Investment

An Interview With Jason Hartman

Management Team: We seek management teams with a strategic business plan, credible track record, and very strong execution capabilities. Integrity is incredibly important. We need to trust the management team. The litmus test is: Do I believe that the CEO and their team will be able to do what they’re saying they’re going to do?

As part of our series about “5 Things I Need To See Before Making A VC Investment” I had the pleasure of interviewing Zack Ellison, CFA, CAIA, Managing General Partner, Applied Real Intelligence (A.R.I.), Chief Investment Officer, A.R.I. Venture Debt Opportunities Fund.

As Managing General Partner and Chief Investment Officer of Applied Real Intelligence (“A.R.I.”), Zack Ellison is responsible for leading the firm’s management and investment activities, including sourcing, due diligence, structuring and execution, and portfolio management. Currently, Mr. Ellison is a Board Member of the CFA Society of Los Angeles, a Board Member of the Southern California Chapter of the CAIA Association, and the West Coast Regional Director of the Hedge Fund Association. Additionally, he is the Chair of the CIO Advisory Council and Chair of the University Relations Committee with CFA Society Los Angeles. He is also a member of the Milken Institute’s Young Leaders Circle (YLC) and sits on various leadership sub-committees of Tech Coast Angels (TCA), the largest angel investing group in the United States.

Thank you so much for joining us in this interview series! Before we dig in, our readers would like to get to know you a bit. Can you please share with us the “backstory” behind what brought you to this specific career path?

I spent the past 15 years of my career in the investment world as a banker underwriting media and technology loans, as a bond trader on Wall Street, and as a portfolio manager at exceptionally large global institutions including Scotia Bank, Deutsche Bank, and Sun Life Financial. Along the way, I earned the Chartered Financial Analyst and Chartered Alternative Investment Analyst designations, completed my full-time MBA at the University of Chicago Booth School of Business, and obtained a Master’s degree in Risk Management at NYU Stern.

In 2018, I saw that the long-term outlook for corporate bonds and publicly traded debt was bleak. These products were commoditized, yields were at all-time lows (below zero in some cases), there was a move towards low-fee passive management in ETFs, and “electronification” of bond trading was taking hold — all of which meant that there was little upside and significant downside. The decimation of public bond market returns that we’ve experienced this year was inevitable. In fact, I warned of this multiple times over the past few years, including in a white paper at the beginning of 2021.

Because of these risk factors, I started studying strategies in the private debt markets that offered much higher return profiles, more inefficiencies on which to capitalize, and significantly less competition. Through my research I discovered what I thought was an amazing opportunity in venture debt, which several mentors in the VC space confirmed as an underserved part of the market with huge growth potential. They told me, “Zack, a lot of successful startups that we invested in are very keen to utilize debt to fund their growth because it minimizes the founder’s dilution and it’s cheaper for them than equity financing.” It’s also beneficial for the VCs because they need to put less money into each funding round of these startups and therefore have more capital preserved for later rounds of funding or for different investments.

Initially, I was attracted to the high returns of venture debt, which historically produced about twenty percent annualized return. But I was floored once my research revealed extremely low historical loss rates of less than half a percent and impressive performance during the Global Financial Crisis of 2008 to 2010. My analysis led me to the conclusion that venture lending was — on a risk-adjusted basis — one of the top performing investment strategies in the world over the past two decades. But because it was such a small segment of the market, almost no one knew this! I felt like a gold miner or wildcatter who struck a giant deposit on land that everyone else thought was useless.

I began studying venture debt, reading everything I could get my hands on, talking to VCs, founders, and lenders. I was expecting a bunch of skeletons to fall out of the closet at some point and ruin this golden opportunity, but the more I learned, the stronger my conviction became. I realized that this was going to be the biggest opportunity in the entire investment market within the next five years. And there were very few people who were doing this and even fewer doing it well — not more than a dozen firms in the entire country by my count.

I recognized a huge opportunity in the market because there was a need from founders for cheaper, less dilutive financing that wasn’t being filled. I thought, “I can fill this gap because I’ve got the acumen, experience, contacts, and grit to make this happen.” In hindsight, it really was perfect timing — it was as if all of my training and work until that point was setting me up to be the person to fill this gaping need of the market that only a few people saw.

As a little kid, I would always check discarded lottery tickets at the local convenience store, just hoping that I would find the big winner that someone else had missed. I never found any winners, but I’ve kept that mindset. Venture debt is that jackpot opportunity. It was a winning ticket there on the street this whole time, and no one picked it up but me.

Is there a particular book that made a significant impact on you? Can you share a story or explain why it resonated with you so much?

My collection of John Wiley and McGraw-Hill finance books probably helps keep both companies in business. I read voraciously and think laterally…applying what I learn in different fields to help improve A.R.I. each day. Remember the saying “Reading is Fundamental”? Well, for me, reading truly has been fundamental to my continued success.

Imagine being able to pick the brain of the world’s most brilliant thinkers, learning ideas that they have distilled over decades in just a few hours…that’s what every good book provides. There are very few situations in which I’m intimidated because I feel like I have been “trained” by the world’s best minds through their best works.

Given there are so many impactful books that I’ve read, I want to mention real-life role models instead. The two people that I look up to that have been true game changers and pioneers in the investment world and whom I have modeled a lot of what I’m building after are Michael Milken and Howard Marks. They were the originators of the high-yield market in the early 1980s, back when it was called the “junk bond” market.

When they started, they saw a gap in the market and a need that wasn’t being met. They provided access to debt for companies that weren’t rated as “investment grade” but could nonetheless be great investment opportunities. They had to convince the market that “junk bonds” were going to solve problems for a large segment of underserved corporate borrowers, while also delivering great risk-adjusted returns for investors.

There were a lot of doubters back then. I remember reading a piece by Moody’s, one of the large rating agencies, that said, “Don’t buy junk bonds at any price.” And Howard Marks said, “That’s ridiculous.” It’s nonsensical because you cannot know whether to buy something without attaching a price to it. You can only measure value if there is a price.

If I asked you, “Do you want to buy a Ford Mustang?” You’d say, “Well, for how much?” If I told you $150K, you’d say, “Pass.” If I told you $10K, you’d say, “Done, I’ll pay cash today.”

Ultimately, they were innovators who changed the entire industry. The amount of education that they had to provide to investors to get them comfortable with high-yield bonds is akin to what I’m doing now in venture debt.

There was a lot of apathy and skepticism back then, but they saw a need that wasn’t being met and plowed through. They had a vision. They took risks. They persisted through doubt. They added immense value. They were successful.

Now they’re giving back. Milken has made a significant impact on innovation and creating access, while making the world more inclusive and equitable. And there are very few people in finance that you can say that about. And that’s exactly what I’m striving to do in venture debt. I’m seeking to emulate their paths in many respects…only 40 years later.

Do you have a favorite “Life Lesson Quote”? Do you have a story about how that was relevant in your life or your work?

Oh, this is tough. There are so many good ones to choose from. One that comes to mind frequently is the Warren Buffet quote, “risk comes from not knowing what you are doing.” People might consider my former career in bond trading as “risky”. But I achieved success in that role because I knew what I was doing — I was educated and trained by some of the absolute best in the business. I’m constantly learning and surround myself with others that have diverse perspectives that I can learn from.

When I was younger, I boxed for many years and a saying that stuck with me is: “There’s no such thing as tough. There’s trained and untrained.” If you think about it, this mirrors Buffet’s thinking. Investing and boxing are inherently very risky if you don’t know what you’re doing — you can lose your financial and physical well-being very quickly. If you don’t believe that, look at the recent carnage in the crypto market. But if you’re well trained and know what you’re doing, risks can be effectively mitigated.

How do you define “Leadership”? Can you explain what you mean or give an example?

Leadership is about making a difference. In general, venture debt helps to fill a large gap in the startup funding market. However, there are “gaps within the gap”. What I mean by that is that access to venture capital is highly concentrated in a few key pockets — think software in Silicon Valley or biotech in Boston. But there are entire sectors, regions, and large groups of founders that are being completely underserved and sometimes completely ignored by investors.

The marginal amount of money that goes to underrepresented founders is staggering and this is what we consider the biggest “gap within the gap.” Less than 3% of venture funding goes to women, people of color, military veterans, and other underrepresented founders despite the fact that they are more than 70% of the US population. Not only is this inequitable, but it’s also a huge economic inefficiency that isn’t being solved by any existing venture debt funds.

When starting A.R.I, I thought, “Wow! Not only can we fund innovation in a more effective manner, but within the innovation economy, we can democratize access to capital, create a more equitable environment, and create a more efficient funding solution for founders.”

We launched a first-of-its-kind DEI Investment Council, consisting of our team and outside experts to provide education on capital raising and connectivity to resources for underrepresented founders. While our pipeline is predefined, given we are typically investing in companies that have already raised four to six equity rounds, we want to provide earlier stage founders with support that will help them go the distance.

Venture debt is already a very niche and differentiated part of the market — you need a very specific skill set and network. At A.R.I., we have a diversity focus that’s part of our company’s DNA and we will outperform because we go to where other investors don’t.

How have you used your success to bring goodness to the world?

People are sometimes incredulous about my focus on diversity, given I look like the classic successful white guy archetype who grew up with privilege and resources. On the surface, this might seem to be the case given I earned degrees from three elite schools, worked at three firms that each have more than one trillion in assets, sit on multiple boards, and run a leading investment fund.

But in reality, what’s inside the book doesn’t match the cover. I’ve never met my dad and he’s never provided a single penny of financial support. I was raised by a single mom in poverty during the 80s and 90s in Boston. My mom faced a lot of gender discrimination as a radio announcer. Back then, it was very “Howard Stern-esque” in terms of how women were treated and compensated. So, although my mom is very smart and hardworking, it never translated to any close to a comfortable lifestyle.

I had no access. No one I knew worked on Wall Street. No handed me an internship. Everything I had was earned through hard work. Because of these struggles, I’m very empathetic towards industrious people who don’t have access handed to them. I was in their shoes.

The way that the world is set up right now, particularly in the venture ecosystem, is that if you don’t have access, it doesn’t matter how smart you are, how hard-working you are, the probability of success is extremely low.

But I have immense access now, right? What motivates me is creating opportunities for others that I never had. I want to find the best and the brightest that others have overlooked. I care about creating access for the really talented people that don’t have it and unlocking the value they can bring to society and A.R.I.’s investors.

Ok, thank you for that. Let’s now jump to the main part of our discussion. The United States is currently facing a very important self-reckoning about race, diversity, equality and inclusion. This is of course a huge topic. But briefly, can you share a few things that need to be done on a broader societal level to expand VC opportunities for women, minorities, and people of color?

What makes this time in our history so different is that growth is no longer linear. Now it’s exponential. We’re in the midst of the fourth industrial revolution and massive amounts of wealth are being created every day at breakneck speed…faster than at any time in history. If we don’t focus on creating access to capital now so that a diverse population can share in that wealth creation, it means that in the near future the majority of wealth is going to be concentrated in the hands of just a few. And right now, they tend to have similar backgrounds.

There’s a real-time urgency to this that I don’t think gets touched on enough. If this was a hundred years ago, we’d have a little bit more time because wealth was accumulated much more slowly. These days, billionaires are being created in less than a year. Very soon we’ll have a fresh bunch of billionaires. What groups are they going to be from? If they are all very similar, I don’t think that’s necessarily a net positive for society.

Can you share a story with us about a success in venture debt investment? What was its lesson?

Let’s start with the simple notion that there are two ways to fund a business with external capital: equity and debt. Within the innovation ecosystem, the venture equity funding model is well known and widely utilized. But the debt side of the equation is still in its infancy, and this is what A.R.I. specializes in. We provide companies with debt to finance their growth.

Venture loans are typically made to companies that have already closed a Series B, Series C, or later equity financing round. These companies are generating revenue — $10 million per year is our minimum — and are seeking additional growth capital to extend their runway, reach their next big milestone, or prepare to be bought or go public via IPO.

The company and their existing equity investors benefit because using debt doesn’t dilute their ownership positions and is cheaper and faster to obtain than equity financing. The key is that debt helps prevent founding teams and their early investors from being diluted out of their companies. At A.R.I. our mantra is “You built it. A.R.I. helps you keep it.”

Venture debt is catching fire with founders because they don’t want to sell equity in their business once they know it’s going to be successful. If they can utilize debt and therefore not sell as much of their ownership stake, it’s very much in their best interest to do so. Every founder we speak to wants to utilize debt if given the opportunity. It’s as simple as that.

Venture equity comes first and is inherently risky because start-ups face a lot of uncertainty and have high rates of failure. In contrast, venture debt is only provided later in a company’s life cycle once it has already established itself as a winner, which means risk is much lower.

There’s an analogy I use that I think helps clarify this for many people. Imagine you go to the racetrack to bet on horses. Equity VCs often place their bets before the horses are even on the track and they need to pick the one winner. At A.R.I., we place our bets when the race is already 80 percent run and we will succeed whether our horse wins, places, or shows. We won’t always pick the winner, but the probability is extremely high that we will consistently deliver strong returns.

Fundamentally, there is a stark difference between the risk profiles of venture equity and venture debt. Venture equity investors seek companies that have a return potential of 10x to 100x given that many of their “bets” (I use this word deliberately and distinctly from “investments”) on early-stage, often pre-revenue, companies will be losers. As a VC you need to have a big winner to have a successful fund. Therefore, VCs have to take large risks with mostly binary outcomes.

As an equity investor, if you’re not in on the small handful of big winners in any given year, you’re going to have terrible performance results. In contrast, on the venture debt side, we don’t need to invest in the small handful of big winners like Uber or Airbnb. As long as our borrowers don’t default on their loans, we will generate excellent returns for our investors.

With venture equity, you have to be in the innermost circle, and you need to be very early. You must invest in the one hot deal that only a few people are aware of, and if you miss it, your performance is shot. This causes a swing for the fences mentality with a lot of strikeouts.

It’s very different for A.R.I. and venture lenders. Since we’re investing mainly in Series B through Series D companies with significant revenue, our pipeline is largely predefined with more mature companies that are producing revenue. All we need to do to “win” consistently is get on base. While most in venture equity are looking for the perfect pitch to hit a grand slam with two strikes against them, we can patiently look at pitches, not swing at any we don’t like, and still get on base.

Can you share a story of venture debt funding challenge of yours? What was its lesson?

I started A.R.I. while facing three major headwinds. A.R.I. was a new fund with a strategy almost no one understood…launching in the midst of a global pandemic when almost no investors were taking meetings. It’s incredibly challenging to launch a new fund, particularly if there’s innovation involved. Less than one in ten new funds are successful. Most that do make it run an existing strategy that is well known, and the principals are spun out of well-established funds. These funds are just a continuation of an existing strategy under a different banner.

Because the market was so hot in 2020 and 2021, investors weren’t excited about consistent 20 percent returns from debt. At the time, they were more than doubling their money in crypto and real estate and achieving high returns in large liquid stocks.

I invested two full years in educating the market. 90 percent of investors had never heard of venture debt and another 9 percent had massive misconceptions, so it was a very heavy lift.

This year we had a breakthrough because crypto bombed, stocks and bonds tanked, and investors became much more risk conscious as the 13-year bull market came to a crashing end. All of a sudden, our strategy moved to the top of the list for many investors who had previously been kicking the tires. They are very attracted to venture debt’s steady mid-teens income, equity upside, floating interest rates that hedge against inflation, and portfolio diversification benefits.

Looking back on this period, I was in the same position that the founders I now work with everyday are in. I saw a gap that created an opportunity, realized I could fill it, plunged into making it happen…and then had to grind through the exceptionally long and arduous process of bringing the product to market and educating all the nonbelievers.

In hindsight, these large hurdles were a blessing because I succeeded in building a business from scratch under the most difficult circumstances. That’s something that few, if any, venture lenders have going for them and helps to really differentiate and provide credibility with entrepreneurs and founders.

Can you share a story with us about a problem that you encountered and how you helped to correct the problem? We’d love to hear the details and what its lesson was.

In 2009, I started the Big Brothers Big Sister’s Workplace Mentoring Program at Scotia Bank. It was the only workplace mentoring program started by any corporation that year in New York City. And you know why it was the only one? Because people were worried about their jobs in the midst of a global financial crisis. Understandably, they weren’t thinking about giving back, they weren’t thinking about mentoring, they weren’t thinking about diversity. Not because they were bad people. They were merely doing what any rational person would do — ensuring their own survival. Like when flight attendants remind you on an airplane to “put your oxygen mask on first, before helping others” in the event of an emergency.

The biggest, and most pervasive, risk I see right now for diversity involves an economic collapse that would divert attention towards self-preservation. Already we’re seeing valuations down more than 50% this year in venture capital while crypto is completely collapsing. What does that mean? VCs aren’t focusing on diversity. They’re thinking, “How do I salvage investment value from our existing investments? How can I explain the demise of many of my investments? Will I be able to raise money for my next fund? What do I need to do to keep my job?”

So, the current opportunity set for diverse founders may become smaller as economic growth slows. Assuming the economy worsens, I predict that we’re going to see less money allocated by VCs to diverse founders in a year than we have today. We took a half step forward over the past few years and now we’re at risk of taking a step back. We need to pay attention to that now.

Super. Here is the main question of this interview. What are your “5 things I need to see before making a VC investment” and why. Please share a story or example for each.

I’ll preface this with another classic saying by Warren Buffet that really sums up how I think about investing. “Rule number one is never lose money. Rule number two…never forget rule number one.”

A.R.I. has rigorous investment processes built by synthesizing best practices learned over the years from the world’s best credit investors. Our due diligence manual is over 75 pages of just questions! We don’t ask all of these questions for every investment because it would take months to go through them all. The “art” of our process is knowing which questions to ask so that we can most effectively understand the company and efficiently reduce the risks of each investment. With that said, the five most important factors are:

1. Financial Strength: First and foremost is ensuring the company has a great business model and financial strength. As fixed income investors, we are always thinking about minimizing our risk of loss. All of our investments need to have the cash flow to service debt and strong collateral. This means that if a business doesn’t grow as anticipated, there is asset value in the company that de-risks us on the downside. Typically, the companies in which we invest are producing a minimum of $10 million per year in revenue, oftentimes much more than that. We look for a compelling product that has demonstrated traction with customers, a sustainable competitive advantage, viable capital structure, path to profitability, and thick margins of safety. Unlike venture equity, we don’t need to project 10 years ahead and get lucky to make money. All we need to do is look two to three years ahead and ensure that we can manage potential risks during that period. That’s something we do quite well.

2. Management Team: We seek management teams with a strategic business plan, credible track record, and very strong execution capabilities. Integrity is incredibly important. We need to trust the management team. The litmus test is: Do I believe that the CEO and their team will be able to do what they’re saying they’re going to do?

3. Deal Structure: A company needs to have a tight deal structure in addition to strong fundamentals. At A.R.I., our loans are senior in the capital structure with multiple protective covenants. The loans are secured by liens on all company assets and leverage is kept very low. Typically the loan-to-company value is 10–15%, meaning that the company could destroy 85–90% of its value before the loan is at risk of loss. Even in tough times it’s hard to destroy that much value! We monitor loans monthly and have Board Observer rights so we are atune to even minor changes in a company’s trajectory. If the company starts to slip we can help to rectify the situation before it gets out of hand.

4. Equity Sponsor Support: We look to fund companies that are backed by supportive VC investors who are committed to the company’s long-term success. Understanding the ownership structure of the company and the incentives this creates is important. We consider each VC’s level of support and alignment, including the amount of capital they have invested and how much more they intend to invest in the company. We also consider how the VCs have behaved in adverse situations in the past and how they have worked with venture lenders in both good and bad times. In practice, strong VC support has led to extremely low losses even in the rare instances when borrowers have defaulted. This is a result of the subordinate position equity investors are in relative to the senior lender, which incentivizes the equity investors to work constructively towards remedies and solutions, oftentimes paying out the lender in full in times of stress.

5. Impact of the Investment: We consider ESG factors on every single deal. We’re actively trying to create access for diverse founders and the investments we make are environmentally friendly. We seek companies that are doing something that we believe in. Making money while also positively impacting society. Right now, because there are so many opportunities in the market, we can choose the deals that are better for society, meet our ESG goals, and outperform economically.

You are a person of enormous influence. If you could inspire a movement that would bring the most amount of good to the most amount of people, what would that be? You never know what your idea can trigger. :-)

Innovation creates value for society. Therefore, facilitating innovation by creating access is the most impactful movement I could inspire.

What we’re doing at A.R.I. is exactly that — we’re funding the most innovative companies that are going to add a great deal of value to society and we’re bringing capital to those that have never really had access.

We are very blessed that some of the biggest names in Business, VC funding, Sports, and Entertainment read this column. Is there a person in the world, or in the US whom you would love to have a private breakfast or lunch with, and why? He or she might see this. :-)

I’d like to have a meal with both Michael Milken and Howard Marks. I would love to know what was going through their minds when they were building the high-yield market 40 years ago.

As I mentioned earlier, I admire their courageousness in innovating when I’m sure there were many, many doubters. I look to them for inspiration because the qualities that I see in them are the same qualities that I need for A.R.I. to be successful. In the sense that we’re innovating and require the same amount of grit and persistence to take venture debt from a small segment of the market to an institutionally investable asset class that’s one of the major funding mechanisms for startups.

I would love to talk to them about how they dealt with the doubt from others and even self-doubt. They were innovating something that people just didn’t understand. And looking back on it, what would they do differently? What made them successful despite the obstacles? I’m really just trying to follow their path, but in a different area of the market. I can learn a lot from them.

This was really meaningful! Thank you so much for your time