Lucky enough as I am, I can experience PE deals and VC deals at my firm. So while you mostly see mezzanine and convertible debt at early stage VC where the argument for it is as counter intuitive as “we don’t have a valuation, yet” can get, the PE world uses debt to drive equity returns given stable cash flows. But, you might think, what in the name on earth prevents venture funds from using more leverage in their financial transactions?
Is there a case for classical debt financing in venture capital? Just a random thought experiment.
The case of TargetCo debt for a start-up
Well, truthfully enough, it is hard to raise actual debt for a company that just burns money, has an unclear outlook into the future and where there is a 90% chance of hitting bankruptcy. So I completely get that given these statistics, debt doesn’t make much sense for a seed start-up as part of the financing mix. Although venture debt itself isn’t something super unusual and is offered by EIB, SV Bank, and the likes.
It also makes complete sense to add a super seniority to a seed funding round in the form of convertible debt with the option to convert to preferred or common later on with a potential cap and a sufficient upside gain from the initial investment. Given that you are simply not sure how to value a pre-revenue seed and want the option to force your ticket into liquidation.
But nevertheless, let’s forget about financing start-ups with debt.
The case of fund debt in Hedge Funds
[tbc] Apart from revolvers, another thing seen occasionally, and more in hedge funds than in private equity funds, is the idea financing a transaction with debt to increase assets under management without any deeper consideration than optimizing the value of the equity value. Mmh, why is that a thing that works in hedge funds? Because you can package and bundle risks in investment strategies and the time and effort it takes to bundle this risk somehow warrants to use cheaper forms of cash than equity / investment commitment to finance a fairly structured and solid investment. The over-proportional cost to identify, research and structure an investment which is carried by OPEX of the manager – and hence the management fee – or investment commitment of the fund – deal related cost – is something that can make the idea of taking an overall investment position look sufficiently risk-controlled and hence worth a debt-financing. So the ability to employ debt instruments on the fund level makes sense from the structuring aspect that really allows to tailor risk profile but comes at cost not carried by the debt portion. In that sense, debt is a viable strategy to increase equity returns after sunk cost in OPEX and deal related expenses have already accrued. Debt financing in this enviroment is the result of the somewhat bizarre observation that you have to focus assets under management on your capability to execute on the size of assets, while having management fees found by fee structures, and having to maximize the return on investment to show a return profile that attracts more investors. So taking leverage here to increase return on investment to save fund returns after burning calories that go beyond what is healthy for the fund size, makes sense.
BidCo and TargetCo Debt in Leveraged Buy Outs
Fund level debt is even hardly seen on the PE side. So while PE firms hardly take debt to increase their AuMs, PE firms invest into special purpose vehicles or BidCos that eventually provide equity financing to HoldCos/MergerCos. The BidCos are the entities that eventually take the debt portion with the assets of the TargetCo as collateral. The idea is that the PE fund provides equity that it draws down from the fund, adds extra debt to increase cash available to afford larger investments on the BidCo level, and then provides this to the MergerCo that invests in the TargetCo, which then is merged with the MergerCo via shareholder resolution and infuses the total amount of equity at the MergerCo level left to the TargetCo.
Understood? Good. The BidCo basically got some leverage, let’s say at 6% fixed annual coupon, is accruing coupon and has a bullet structure and a typical option to repay in full any time. The PE fund provides equity. The mix is 30/70. So the fund spent 300 million and bought a 1 Billion company 100%. The TargetCo was bought for 1 billion. That is the equity value during the transaction. Good.
Nothing happening, this is a bad deal. You buy a 1bn company, sell it after a year for 1bn, repay the loan at 742m and reduced your equity to 268m. But at least you got to buy a 1bn company while only having 300m in your account. Makes more sense, if you have reason to believe that the company is underpriced and pricing will be corrected and you can sell at 1.06x of your original purchase price in one year. Correct, you earned 6% (same as your loan interest) on the company, deduct your 6% * 70% from your loan repayment and get a 18m return for your equity, which is a decent 6%, too.
Things get a bit more interesting, however. Your TargetCo has steady cash flow and can take a 700m extra portion of debt – given it has a 1bn equity value, why not!. You get a mix of loans averaging a 5% annual interest. You take the loan to pay back your BidCo, which now paid only $12 on coupon, you increase net income at the TargetCo via the coupon payments from the debt, and just keep on paying the coupons. After the end of your 1 year debt financing and investment horizon, you again take a 700m debt portion on your BidCo with redemption rights, pay back the 700m debt of the TargetCo, and you are all else equal with some cash from the tax savings. You sell the company for the same 1.06x multiple and just got the same return, but got some extra 0.5m in tax savings and saved 1% on coupon. You pay back debt on BidCo level again, paying $12 coupon and now get 25.5m total return on your equity, giving you a 8% decent return on equity.
Of course, you also expected a market shift and your EBITDA multiple increased to a 1.2X original value and you did some working capital and top line improvements, gaining you another 1.2X on EBITDA, so you got 1.44X on your valuation. So you gained another 44m. Adding this to your 25.5m, you have realized 79.5m and giving a return of 29.9% return on equity. Under your typical PE fund structure, you likely get an over proportional return to the partners who now each made 2 million, realizing a 200% IRR. Good enough.
So in this case, we expand our universe of company investments by taking up leverage in buying a company, we swap our interest by leveraging the company and repaying the original debt to purchase the company, get some tax credits, etc. All makes sense, right? So that works well in PE, but doesn’t really make any sense from the tax and credit perspective for a VC fund.
Subscription-Feeder Debt in Venture Capital
Now things get even more interesting. In a typical fund, at least a set of LPs – for simplicity investing as one using a investLP fund – invest, and another fund called the investGP fund are the investors of a fund. The GPs that own the investGP fund get the typical fund return in terms of carried interest. Let’s assume a typical “skin-in-the-game” scenario where the investGP fund stems 5% of assets under management, the investLP stems 95%. In both their status as investors, both get a claim on repayment of all the money the provided including expenses, a 10% annually compounded preferred interest on their investment and everything after that is split pro rata 80% (to LP) and 20% (to GP).
So how could debt possibly creep into this structure?
There are several options:
– Option 1 – Personal GP Debt: GPs get private debt and use it to lower the 5% they have to pay. Viable option if they don’t have the money to advance the money drawn down by the fund. But not a good practice. They could calculate the risk and reward of getting a decent return on the investment, so even if they don’t make enough money on the investment to earn the carried interest (80/20), they might choose to do so if they manage to capture enough of the 10% compounded annually preferred interest that it outsets their interest payment for the debt. In that case, they would even fully finance their share of investment. But only if they would know any better investment for their own money and it would also yield higher returns than the 10% compounded annually. This is likely never the case, and hence their equity contribution is a better investment alternative than taking debt and investing their equity elsewhere. And in general, incentives go perverse if voting rights aren’t in the hands of them and they use debt to finance something they otherwise can’t afford. So let’s forget about this option.
– Option 2 – Subscription Feeder Debt: Adding a third fund called the GP-LP fund. The GP-LP fund could be a subscription rather than a pro-rata fund [subcription: decide if you participate on an investment or not; pro-rata, all have to reach an agreement and all have to invest or the deal doesn’t pass] would have two advantages: The GPs could use their subscription rights to increase the pro-rate portion of the total investment ticket in the investment (instead of 5%, let’s say 10%) and get the 10% annually compounded for themselves, Downside ? Well, not upping on the subscription could be bad signalling. But let’s ignore it. If they know they will have a sufficient return on the investment, they basically shift the investLP return from the investors or LPs to themselves as GP-LPs. That is a clear benefit in itself and what is found in any fund where subscription feeders are used rather than pro-rata feeders.
More interesting in the context of this article is the option to now construct debt financing options.
1.Increasing fund size:
Even if the fund only managed to get 1bn assets under management, they could add, let’s say 30% (300m) extra equity assets by leveraging up the GP-LP by 70% (210m) and providing 90m in extra equity from their checkbooks. The benefit here is that fund size can be increased to do follow-on investments where otherwise the capital allocation strategy would be violated or a new follow-on investment would require a new generation fund.
This is a more viable option and is the one we explore here. The question is, when taking debt makes any sense.
A. Leveragble investments: Let’s assume we are only looking at investments that are transitioning towards cash flow positive. In that case, we could think of GP-LP as a hidden PE vehicle in the fund that could be used to pass debt to the TargetCo and use it to optimize the founderLP fund. From the perspective of the fund, this appears ok. The LPs who are not inclined to take a debt portion for a VC investment are not affected, all they have to do is to grant the mechanism of moving funds generated via debt positions directly and only to the GP-LP structure. But the option dies given that VC investments are not buyout or 100% ownership cases and the even if the LPs would be fine with debt in the VC TargetCo, the other investors of the TargtCo won’t be too amused from the extra risk. It is simply not a good case to think this way and there is no collateral from the TargetCo that could be used to get a good interest.
B. Leveraging based on GP position: But let’s assume the VC fund found one of its star investments / TargetCos. It invested in Series A, did a follow on in Series B and C, and capital allocation is slowly hitting its limits. So from the fund level perspective without Option 2, it would not make sense to deploy more capital and it would need another, new fund to do a next follow on the star investment. But, at the same time, given reasonable protective structures in the preferred asses classes the fund invested, there are a few forms of collateral existing. (1) Claims on preferred return and carried interest realized by the latest financing round with a managable and quantifiable portion of risk to these positions could lead to the ability to get a decent debt financing for continuing the investment in new investment rounds alone, since there is enough cushion that protects the claims from the investment on a stand-alone basis. (2) If the fund performance overall is sufficiently stable and even a diversified view on the total portoflio provides a diversified cushion for losses in the GP claims from the investGP vehicle, this even provides a diversified collateral. So (1) and (2) combined could provide collateral if the debt in GP-LP is collateralized with the claims from investGP. The benefit for GPs would be that they could participate in highly attractive rounds by doing follow-on investments with a reduced equity contribution compared to a simple subscription fund, without necessary diluting the investLP and investGP fund, if they only take portions that otherwise foreign investors would have taken. In the overall deal mechanics, they could hence increase their upside by exposing their own unrealized gains to additional risk. The up- and downside case being that they can increase their total share in returns compared to the fund and taking higher claims on the preferred interest while taking an increased position in investment (no longer 5% of their investGP share, but 100% as GP-LP) lowered only by the portion of debt (70% here) and increasing their risk (collateral on the debt portion).
On top, not as cool as in an LBO, but also tax effective, could be the effect of interest on the net (post capital gains tax) returns to the individuals taking the debt portion. While structuring capital gains tax reductions on the individual level would be hard, the tax benefits would effectively increase the 30% equity vs. 70% debt share in the cost of equity participation in the GP-LP investment.
So overall, while traditional LPs would not have it in their guts, DNA and covenants to use debt for a alternative asset class investment into venture capital, the founder partners could have it.
Would be interesting to get some feedback from a tax expert here. And to understand if this the debt taking is realistic and what rates would hit the GP-LP.