A company can finance itself through a combination of debt and equity. The optimal capital mix depends on the cost of debt and the cost of equity.
If a company can borrow an unlimited amount at 0% forever, then going the 100% debt route may be a wise move. If a company’s equity valuation is at absurdly high levels, then raising money by selling equity to undisciplined investors may be a better move.
Zynga insiders cashed out at $13/share and within a year the shares dropped to $3/share. Similarly, GoPro’s insiders cashed out when the company had a $7B+ market cap. Today, GoPro’s market cap is under $2B. It’s all about finding suckers to sell to when your equity valuation is high as an owner, and not invest in funds who don’t realize they are the suckers as a limited partner.
For greater risk adjusted returns, you want to deploy capital in the OPPOSITE WAY a company wants to raise capital. Yin to the Yang, remember? Venture capitalists who chased private company equity deals at the end of 2015 got crushed. Meanwhile, steady eddy debt investors are collecting their coupon payments provided their companies are still in business.
In this post, I will expand on an earlier Venture Debt investing post. I’m considering investing $150,000 in a second venture debt fund this Spring, and want to make sure I’m not missing anything. If I can convince you that venture debt investing is a good investment at this stage of the cycle, then I should be able to convince myself to part with my money.
Why Venture Debt Investing?
1) Decent risk-adjusted returns. I believe making any sort of positive return in the public stock market will be difficult in 2016 and 2017. venture debt is an interesting asset class that generally pays an 8% – 15% annual return for the life of the fund. Loans with 2 – 4 year durations are made to companies with strong Venture Capital (equity) backing. A founder would rather pay 8% – 15% than give up more equity. A lender just cares about getting paid back what was agreed upon, and is not looking for a home run. Think about venture debt as P2P lending for companies.
2) Someone managing a portion of my money full-time. The older and hopefully wealthier I get, the more I’m willing to pay someone a fee to manage my capital. My friend and his partner have been investing in venture debt for over a decade each and will be completely focused on providing the best possible returns to limited partners if they want to build a good reputation, make more money for themselves, and raise another fund in the future. While they focus on making a return for their investors, I’ll focus my time making money through real estate, public equity, and mainly my online business. I trust my friend because we were business school classmates at Haas 10 years ago. He’s an MBA, CFA, and CPA, and I like the way he thinks about money.
3) Highest priority of repayment. If things get really ugly, debtors get paid before equity holders. The people who get screwed the most are common (ordinary) shareholders who almost always get nothing if a company folds. Unfortunately, employee shares are usually at the bottom of the totem pole.
4) Exits are much easier in debt than equity. Companies no longer want to go public because they’ve seen what has happened to LendingClub, GoPro, Etsy, Box, Fitbit, Square, Twitter, etc. Many companies that went IPO in 2014 and 2015 are now below their IPO price. For venture equity investors, if there is no IPO or buyout, there is no exit.
For debt investors, you don’t really care about a big exit because you’re lending a company money based on a 1 – 4 year time frame. Each year that passes, you earn an interest payment. Let’s say the interest payment is 15% a year for five years, but the company goes to zero in year five. After four years, you’ve collected 60% in interest, which counteracts a 100% decline in principal. Therefore, your real loss is “only” 40% instead of 100% for the equity investor.
5) Piggy back off well funded companies. There’s a bubble in venture equity funds, which is great for the survival of private companies. Given a record amount of capital has been raised by venture equity funds, a record amount of capital needs to be deployed. Limited Partners don’t pay 2/20 (2% management fee and 20% of profits) in fees for funds to sit on cash. A lot of that money will be reinvested in existing private equity investments to help support their survival and growth. Foursquare is a great example.
In 2013 Foursquare raised $35M at a $650M valuation. The same investors: DFJ Growth, Microsoft, Silver Lake Partners, Spark Capital, Union Square Ventures and Andreessen Horowitz, recently invested another $20-40M in the company at a $250M valuation. Clearly, in 2013 the investors made a mistake and are now hoping to salvage their investment at a more reasonable price. Foursquare probably should be dead. But thanks to venture capitalists flush with cash, it lives on!
6) Better cost structure, pricing, and deal pipeline. This new fund has already identified over 15 potential investments over the next 1 – 2 years. As a result, the time and money spent sourcing deals is much less. Less time and money spent means better returns for LPs. Always be wary of investing in a brand new fund. Given equity fund raising is expected to be more difficult in 2016, companies are looking to do more debt fund raising. When demand for debt funding increases, so do the terms of the debt investor. This is simple supply and demand economics.
7) Diversification of investments. Only about 9% of my investable assets is in alternative investments. The rest is invested in the public market. I’d like to increase my alternative investment percentage to 20%. I enjoy locking my money up in long-term funds so I don’t have the temptation to spend the money. Investing over the long term also helps remove emotion out of investing and enables investors to better weather the cycles.
Notice how 17.8% of Yale’s endowment allocation is with absolute return and 32% is with private equity. They believe that by taking advantage of relationships and dislocations in the private markets, greater returns can be made. The public market has “more perfect information.” As a result, it’s harder to gain an edge. But in the private market, you can use your relationships and private information to make better decisions.
It’s one thing to invest in a specific private company’s equity. I’ve only got a couple of such investments. It’s another thing to invest in a venture debt portfolio of private companies, where the chance of making a return is much greater.
INCREASING DEBT INVESTING EXPOSURE
I believe the three main reasons people don’t invest in alternative investments are: 1) the investor is not accredited, 2) the investor has little understanding of the investment asset class, and 3) the investor does not want to tie up capital for 7 – 10 years. The more capital you have, the more you welcome locking in the capital with a potentially high IRR (internal rate of return). It feels nice to have someone invest your money for you and not worry too much.
My favorite alternative investment for the next 10 years is investing in real estate crowdfunding with Fundrise, founded in 2012. There is a multi-decade trend towards moving away from expensive coastal cities and into the heartland due to lower costs, technology, and rise in remote work.
I think it makes a lot of sense to invest in heartland real estate where net rental yields are much higher and valuations are much lower. I’ve personally invested $810,000 in real estate crowdfunding so far, and the returns have been stable and around 10% a year for several years now.
Updated for 2020 and beyond.