Returns For Venture Debt Are A Combination Of Regular, Predictable Interest Income With An Equity Kicker
As we touched upon in the last topic, the risk-reward profile of Venture Debt is very different from that of venture equity. Venture Capital follows a high risk- high reward risk-return profile. In contrast, Venture Debt has moderate risk yet provides superior returns, making it an important asset class for the investors.
Typically, in India, Venture Capital funds target 25%-30% net returns (net of fees, expenses, and profit sharing). On the other hand, target net returns for Venture Debt funds is usually around 15-20%. However, the investment thesis and inherent risk profile of Venture Debt is quite different from venture equity.
VC funds generate most of their returns from only 5-10% of their investments (investments that return 10x the Capital or ‘Home-runs’). However, returns for Venture Debt are a combination of regular, predictable interest income with an equity kicker usually in the form of warrants or options. This mezzanine structure enables Venture Debt providers to earn superior returns.
While the regular interest income (coupon payment) on Venture debt moderates risk, the add-on equity kicker enhances returns.
From investors (LPs) point-of-view, the distinct risk-return profile of Venture Debt compared to Venture Capital enables them to consider these as unique asset classes. The downward trend in interest rates has pushed investors to seek alternate investment opportunities for maintaining their fixed income yields.
Increasingly, investors are considering Venture Debt as a substitute to investing in traditional fixed income instruments from their debt portfolio. Thus, Venture Debt enables investors to participate in the venture ecosystem through a high-yield strategy. Sophisticated investors can leverage Venture Debt as an additional asset class in their asset allocation framework to achieve desired returns.
Venture Debt is also a great option for conservative investors who may want to explore early-stage ecosystem. At times the high risk – high reward nature of Venture Capital makes certain investors uncomfortable. This is also true for several international investors who are keen to understand and explore the early stage ecosystem in India but are wary of the risks involved.
These investors don’t want to miss out on the fast-growing startup sector in India. For such investors, Venture Debt is a good option to explore early-stage ecosystem with moderate risk and get comfortable with the sector. Over time they can then take on more risks through traditional Indian VC funds.
Factors That Make Venture Debt An Important Asset Class For Investors In Indian Context
Interest Income
The safely of regular, predictable interest income sets a floor rate of return, enhances liquidity and moderates risk. This debt is usually secured via IP, cash receivables or assets. When traditional assets are not available, startups have hypothecated intangibles like their brand, trademarks, copyrights or future asset purchases.
This debt is senior to any other instrument in the capital structure and has the highest priority in the event of liquidation. Distribution of interest incomes begins from the very first quarter of funds existence which is very attractive for investors seeking liquidity.
Warrants And Participation Rights
The second component of Venture Debt returns is equity kicker in the form of cashless warrants, options or partly paid-up shares at last valuation. They usually vary from 10-25% of loan value which typically translates to around 1% equity in the company. These warrants/options are priced today but exercised at the funds’ discretion at a future point in time.
Since the entry premium is small and the fund has discretion on which deals and at what time to exercise these options, they give a good boost to the overall IRR (Internal Rate of Return). In addition, the fund has right (but not obligation) to participate in any subsequent rounds of equity financing at the then prevailing valuation. This opportunity to capture additional upside further adds to the IRR.
This equity exposure is where funds like Unicorn India Ventures stand out compared to traditional Venture Debt funds. Since we bring a track record of venture equity investing, we look at every investment through an equity lens. Thus, instead of just focusing on interest payments, we pay close attention to identifying winners. By leveraging our understanding of equity returns we are able to possibly spot home-runs and maximise returns on our warrants and participation rights
Re-investment
Venture Debt funds usually have a medium duration (approx. 7 years) and capital is called (from LPs) only when new investments are made. This minimizes any holding time when funds are not invested. In addition, recovered capital is reinvested and recycled a second time to maximise returns over the fund’s life. This reinvestment further boosts IRR.
Risk Management Framework
At Unicorn India, we follow a rigorous proprietary Risk management framework for each investment. We analyse every deal from a Financial, Operational and Management risk perspective assessing more than 50 different criteria. We also pay attention to portfolio diversification and usually associate with the category leader or key competitor in any sector.
Once identified, each deal goes through a rigorous due diligence process. Post-deal, we monitor companies on a regular basis and work with any companies that may be falling behind. This rigorous risk management framework enables us to keep slippages in low single digits. In addition, our profit sharing is completely aligned with the interests of our investors (LPs).
We have modelled our governance structure based on best practices from US and European Venture Debt markets.
Opportunity To Invest In Top-Tier Startups
Over the last decade, most capital in Indian Venture ecosystem was deployed by dollar VC funds. Several high profile startups like Rivigo, UrbanClap raised almost no domestic rupee capital. This selection bias has limited domestic investor’s access to top-tier dollar VC fund portfolios. Since Venture Debt funds collaborate with VCs, Venture Debt provides domestic investors with an opportunity to invest in these top-tier VC fund portfolios that they otherwise wouldn’t have access to.
In sum, Venture Debt provides an attractive alternate asset class for investors who want to explore venture ecosystem through a high-yield strategy. It’s also a great option for cautious investors who want to experience the Indian early-stage ecosystem without getting their feet wet.
[This article is part of 4 article series on Venture debt funding. You can read more articles here.]
