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Western EuropeMarch 14 2011

Is European venture debt gone for good?

As the financial crisis all but decimated venture debt in Europe, the possibility of its return is a thorny issue. While some countries are seeking alternative methods to fund start-up companies, others are preparing for business as usual. 
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Is European venture debt gone for good?Andrea Travesone, Amadeus Capital Partners

Small and medium-sized enterprises (SMEs) always find it difficult to acquire the financing they need during an economic downturn – representing as they do a different value proposition to banks than large companies. During the whole of 2010, there was anecdotal evidence of just how hard it has been for SMEs to stay afloat, with reports of some businesses relying on their owners' personal credit cards to remain solvent.

But if SMEs have had it tough, for start-up companies the situation has been almost impossible.

Innovative new businesses rely on specialist venture capital to mainly provide equity to develop their products, but very little has been available since the financial crisis hit. Last year, only $2.8bn was raised by venture capital companies in Europe, against $9.8bn in 2007 and $10.2bn in 2008, according to research company Dow Jones VentureSource. In the US, the decline is similar, with $11.6bn raised in 2010 against the recent peak of $40.1bn in 2007. On top of this, in Europe the relatively new specialist lenders market, which provides the so-called venture debt – as opposed to equity – to these companies, suffered a near collapse.

Enjoy the boom...

During the buoyant decade prior to the financial crisis and economic downturn, European companies at an early-inception stage found it relatively easy to access such specialist loans. Venture debt providers have detailed knowledge of a specific market or technology and therefore have a higher risk appetite than that of commercial banks. Venture debt is extended to companies backed by well-known venture capital firms and the loan provider also receives warrants worth between 10% and 20% the value of the loan.

These loans are much more expensive than commercial loans, of course, given the higher risk that start-ups present, but during booming economic cycles when equity valuations are rising, venture debt allows early stage businesses to reach a certain level of cash flow, push the valuation of the company higher, and therefore obtain the next round of equity injection more easily. In good times, repaying principal and interest on the venture loan of 1200 or 1400 basis points over Libor is entirely feasible.

But beware the bust

In a downturn, however, the situation is very different.

When equity valuations are flat or decreasing, equity providers are reluctant to invest money into a company whose value might not grow, and might even go down – especially if the business also has expensive debt obligations that could end up being repaid using equity. As a result, to be able to attract the needed additional equity for their natural growth, start-ups have often had to undergo an expensive restructuring; these had to work around the strict terms of the venture loan agreement, ultimately leaving the borrower worse off. Recent data in this sector is rare, but anecdotal evidence is available.

“There have been many restructurings [in Europe] and they were very expensive and painful,” says Andrea Traversone, partner at Amadeus Capital Partners, a venture capital firm. “The venture loan provider holds all the cards when it comes to restructuring, and people have been burned by it. Venture debt is an instrument that only really works in an rising equity market. If the market is flat, or going down, it is very, very detrimental. It is a one sided bet. If you take on a venture loan, you basically take the bet that you will have raised more equity before you repay the loan.

“The companies in our portfolio are avoiding taking on venture debt [now]. While two or three years ago, a lot of our companies would have raised venture debt, over the past 12 months, I can’t think of any of our companies that has done it. Some chief executives who have seen it before are avoiding venture debt at all costs.”

Funding difficulties

It was not only businesses that got hurt. Difficulties in funding operations affected venture debt firms as well.

London-based ETV Capital, previously one of Europe's most prominent and long-standing capital providers, had to withdraw from the market because one of the three banks that were funding its operations cut off its credit. The bank in question, which was closing down a significant part of its London operations, was unable to support the refinancing needs of ETV and no replacement could be found.

With lower levels of venture equity being invested in early-stage companies, it would be foolish to expect that venture debt – which follows such equity investments – to come back anytime soon, or at least not before the economic climate improves. But the fact that so many companies have been burned by an over-enthusiastic approach to the venture loan market of the past few years, begs the question about whether this product will ever come back in a significant way in Europe at all. And should anyone care if it does not?

A difference of opinion

The UK banking sector does not seem to. When the UK Business Finance Taskforce – which is made up of the chief executives and senior representatives from Barclays, HSBC, Lloyds Banking Group, Royal Bank of Scotland, Santander, Standard Chartered and the British Bankers’ Association – released its Supporting UK Businesses report in October 2010, it recommended the establishment of a new business growth fund which would target the financing needs of growing companies. It did not even acknowledge the existence of venture debt as a product aimed at this target group.

The European Investment Bank and its European Investment Fund (EIF), however, have a different view. The EIF has been a supporter of the asset class over the past 10 years, which included providing financial guarantee to some venture debt providers.

A US perspective

Venture debt has existed in the US for decades and was introduced to Europe at the end of the 1990s. By allowing high-growth companies to keep operating until they are ready to look for additional equity providers, some argue it plays an important role in the development of technologies that will contribute to a country’s economic development but that will not become commercially viable until years after the initial idea.

However, its growing availability and seemingly favourable terms – compared to the cost of capital and the disadvantage of diluting ownership with any new equity provider – coupled with the lack of experience on this product in Europe, pushed venture debt into businesses often beyond reasonable limits.

“I think that in Europe, companies that were too early to raise venture debt did it because it was available,” says Mr Traversone at Amadeus Capital Partners. “In the US, it does not happen that way. Companies raise venture debt because they can repay it from the operations. In Europe, there has been a lot of venture debt that has been repaid with equity. They had taken the money because it looked cheap. If the industry today went back over the past five years and did a calculation of how much that debt actually cost [because of the equity they had to raise to repay it], they’ll find out that it was on average probably a lot more expensive than raising equity in the first place.”

An alternative perspective

Funding is crucial not only to start-ups but also to the lenders that finance them. At the other side of the funding spectrum from ETV and its bank syndication model is Silicon Valley Bank (SVB), which entered the European market in 2005 and has now applied for a full banking licence in the UK. SVB funds its operations from deposits of venture capital, private equity firms and growth companies around the world, benefiting from its long-standing experience in the US market. “We now bank almost 600 venture capital and private equity firms around the world,” says Oscar Jazdowski, head of UK origination for SVB. ”Their [investment] portfolio companies, by-and-large, also bank with us. It is almost old-fashioned. You will not be able to find one [financial] institution today that funds the whole loan book from its deposits.”

As upbeat as SVB on the venture debt market is Kreos Capital, which effectively created the European market with its first loans in 1998. Kreos is still active. “In the past four years alone we have invested something like €500m in about 130 transactions, which [involves] about 95 companies,” says Ross Ahlgren, general partner at Kreos. “We make about 35 investments and €150m worth of investments a year.” Data available for 2007, 2008 and 2009 indicates that total value of deals closed by Kreos, ETV Capital and Noble Venture Finance – another formerly very active player – on a yearly basis was £196m (€226m), according to figures collected by the British Venture Capital Association.

However, Mr Ahlgren is also aware of the importance of using venture debt at the right moment of the business life-cycle. This might move the product away from its original definition. “Venture debt has some kind of negative connotation,” he says. “Venture debt implies working with really, really early-stage companies. We tend to do, now, about one-third of deals with very early-stage ventures – it’s a foothold in those fast-growing companies – and in the past four years we have been working more with growth companies, companies with £100m or more in revenues.” 

Wider context

Despite the ongoing tough market conditions and the bad name that venture debt has earned in Europe, ETV chief executive Neil Pitcher is adamant about the role that those loans have for economic growth. “Venture debt has a big part to play in helping to provide funding to the high-growth sector. This has been identified as a key sector for the UK, especially if it is to trade its way out of its current economic difficulties.”

With the right adjustments, the provision of an additional financing option to innovative entrepreneurs can only be a good thing; especially in a region where the appetite for high-tech venture capital investment does not seem as enthusiastic as it does in the US. And, as for any business, in the right amount and at the right time, debt is simply an essential part of a company's life.

“In the US, many believe that there is always an over-supply,” says Scott Sage, associate at venture capital firm DFJ Espirit. “In Europe, there aren’t people fighting to get into some of the deals. But in the US, and increasingly in Europe, the debt element is very much part of the same eco-system as the equity element. They are pretty symbiotic and they work together.”

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Silvia Pavoni is editor in chief of The Banker. Silvia also serves as an advisory board member for the Women of the Future Programme and for the European Risk Management Council, and is part of the London council of non-profit WILL, Women in Leadership in Latin America. In 2019, she was awarded an honorary fellowship by City University of London.
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