Trends Watch: March 30, 2017

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks to Paul Capon, Managing Partner, LunaCap Ventures.

What is your outlook for venture capital?

Over the past 7 years, interest rates have remained at historic lows, fueling the economy with a low cost of capital. These low fixed income yields have pushed investors to search for high returns in the riskier private equity and venture capital markets. LunaCap believes that this unbalanced risk-to-reward ratio has over-capitalized some segments of the market, inflating valuations and producing below market returns for the majority of venture capital funds.

Moderate risk-taking investments can provide the capital foundation for innovation, economic growth, and prosperity. However, mispriced risk can be catastrophic. Overcapitalization is driving the inflated valuations and oversized early stage investments that are prevalent in today’s venture capital market. To make matters worse, uncertainty in the changing monetary and fiscal policies, such as the Choice 2.0 Act and a carried interest being taxed as ordinary income, are introducing catalysts that will produce unfavorable private equity/venture capital market conditions in the next 2-3 years, resulting in losses for many funds. Top tier funds will still make money, but the majority will struggle to provide LPs risk-adjusted returns competitive with public markets.

What will this mean for traditional venture capital?

Inflated valuations will cause problems for both investors and company founders over the next few years.  Markdowns and down rounds will become more common, the best companies will survive, but many will fail. The illiquid nature of venture capital investments will incentivize Limited Partners to reduce their exposure to the traditional high-risk venture capital funds. They will seek options that still tap into the early stage markets, but have a lower degree of risk. This is where venture debt comes in. 

Today venture capital funds often invest in companies that focus on number of users and may have never generated profits (or even revenue in some cases). The capital invested is typically through investment instruments in the form of convertible notes, SAFE notes, or straight equity. Investors’ capital is generally locked up for a period of 5-10 years and is only returned when equity achieves liquidity through a major capital event (usually an acquisition or IPO). Until then, an investor’s only metric for investment performance is based on either priced rounds or comps.

Conventional venture capital pricing methodology is focused on an equity growth play and not the appropriate financing to meet a specific company's needs -- in addition, incentives are improperly aligned and supported by a process that provides no counter-weight to create valuation equilibriums. Most priced rounds typically consist of additional investments from similar (and/or existing) investors at each round. It is in the interests of both new and existing shareholders for the valuation to increase at each capital event. 

How does venture debt mitigate these issues?

The venture debt model mitigates this risk by combining the short-term yield and downside protection of a debt instrument with the long-term upside potential of equity investments. Venture debt firms provide early stage companies who have strong financial profiles (such as a history of revenue growth) with loans before they are able to get them from a bank.  Venture debt firms charge 10-20% interest rates along with 1% - 10% warrant coverage, enabling them to generate immediate yield and return capital to LPs, while maintaining exposure to the upside potential of early stage venture investments. The term loan’s regular payment requirement filters for companies that prioritize cash-flow and provides a solid economic foundation: downside protection via cap table seniority. It enables investors to receive cash yield on their capital allocations every year. With this model, venture debt firms provide a lower risk way for LPs to tap into the early-stage venture markets and still achieve venture upsides.