Rising interest rates imposed by the Fed have bedeviled venture debt this year as credit spreads go above and beyond rate hikes. In such an environment, the bond market suddenly looks like an attractive alternative to skittish venture lenders who can get acceptable returns with virtually none of the risk associated with a loan. This is especially evident in sectors undergoing rapid transformation, such as technology, media, telecomm, as well as struggling sectors, such as healthcare.

“So you have a bunch of these lenders saying, ‘Well, why would I want to lend a venture debt where it’s illiquid and it’s a startup – and who knows what’s gonna happen? – and get maybe a 13-14% return when Netflix bonds are trading at 10%. That’s a hard trade off,” says John Markell, managing partner at Armentum Partners, which specializes in debt solutions.

He says it will be interesting to see where the market sentiment is by the end of the first quarter. A lot of larger lenders, such as BlackRock, Apollo, and Aries have the resources to do massive venture debt deals. Their willingness will be another question as the year unfolds.

“They have the ability to, say, lend $90 million to a startup and they also have the ability to invest in publicly traded bonds,” Markell says. “What’s happening now is there’s just been a glut of capital that’s now being pointed to the public market because the impact of interest rates rising and the knock-on effect of just credit generally in the market has caused a little bit of a disconnect.”

Markell is one of the featured expert speakers at DealFlow’s upcoming Venture Debt Conference in New York City on March 31.

When the Fed raises rates, as it did seven times last year, the cost of capital goes up for everyone, making the deployment of capital subject to much more careful decision-making.

In sum, firms that provide venture debt are getting picky.

Although lenders have become far more selective as to where they’re going to lend, they are very much still lending, says Markell. “Yields are great. It is definitely a lender’s market now versus the borrower’s market two years ago.”

Two years ago, when a borrower might want to raise $30 million of venture debt and they come to market, “we would do a deal, maybe at 9 ½% of all-in cash pricing as we call it. There’s cash pricing and then there’s warrants or some upside. Cash pricing is everything you have to contractually pay. So the upfront fee, the coupon, maybe a note, maybe a backend fee – everything — and you can’t really measure that on day one. Right? So let’s remove that for a moment. But cash pricing, because of interest rates rising, has gone up. It’s gone up as much as interest rates have gone up, but also because money’s gotten tighter generally and the economy, of course, gets impacted by that.”

Markell believes once rates stabilize and people have clarity in what the Fed is doing, high yield markets will settle down, the economy will become more predictable, spreads will come down and there will be a broader resurgence in venture debt.

Most of the Armentum team members come from investment banking backgrounds, although the firm’s exclusive focus is on debt raising. Armentum works with 250 lenders to craft a debt package unique to the needs of the corporate client.

The venture debt market between the United States and Western Europe turns over $40 billion to $50 billion annually. Armentum, for its part, closed just under $4 billion worth of deals last year.

Virtually all of their business is referral based.

“We will get a phone call from a venture capital firm, ‘Hey, we have this portfolio company, they could use your help raising debt.’ They’re looking for $50 million or whatever,” Markell says. “So we get introduced to that company, we talk to them and figure out, okay, what are you looking to do? The first step is to determine if they need our services, because we don’t insert ourselves in situations where we’re not needed. Then, if we engage with a company we are the borrower’s advisor to help them optimize debt terms.”

Markell also spends his work days talking to the larger asset managers, the Blackstones, the KKRs, Aries and Bain – massive firms looking to gain exposure to the venture debt asset class.

“Venture debt is something that’s much smaller than what they typically do,” he says. “But as an asset class, what’s puzzling to most non-venture lenders is the risk-return profile is very counterintuitive. So I spend a lot of time working with that side of the market as well. We don’t get paid for that side of the market, but it benefits us because we hear just about everything that that’s going on. Who’s going where? Who’s starting up a new fund? Who wants to get into what? What portfolios are doing well, what portfolios aren’t?”

Virtually all of Armentum’s clients have some sort of minority institutional sponsor, typically a venture capital firm. Most are already carrying some amount of debt. Often, they want to refinance and take on more debt.

The consumer sector easily faces the biggest challenge right now in securing venture debt. Loans are being issued to high-quality eCommerce companies, but that’s about it for the consumer sector, Markell says. “Whereas enterprise software companies, lenders will do that all day long.”

Mostly, though, lenders are “really peeling the onion” to figure out what’s stable and what’s not in terms of which businesses have a line of sight on 1-3 years of revenue visibility and gross margin visibility – and which ones don’t.

While that may seem obvious, there’s a key difference from two years ago.

“The pricing is way out of whack,” Markell says. “There’s still lots of high quality consumer companies. The credit spreads on these really high quality, high visibility and enterprise software companies, they haven’t really moved a whole lot compared to a couple of years ago before the Fed’s rate hike. So pricing’s gone up, but credit spreads haven’t gone up significantly in for these sectors. They’ve gone up like maybe 100 to 150 basis points, but on the broad consumer stuff, spreads have gone up 300 to 400 basis points. Big difference.”

Now, there are still some lenders, such as Sixth Street and others “who are saying, ‘bring us everything. We’ll dive in. We’re not afraid to do loans where we’ll get 20% returns,’” Markell says.

The problem isn’t so much finding lenders that will do a deal. It’s the clearing price where the borrower realizes “Gee, that’s really expensive.”

At Armentum, Markell says 90% of their negotiating is not with a lender. “It’s with the borrower, trying to convince them that, look, we’re not going to tell you to take this money. We’re also not going to sit here and tell you it’s a great deal. What we are telling you is that it’s a lot cheaper than equity.”

Some companies don’t want to look in the mirror and determine their realistic valuation, so they opt to raise debt. “Then they go get a debt term sheet that’s 15%. Then they decide to just raise equity, instead. Okay, go raise equity where your cost of capital is more like 300%.”

Plus a diminished level of control over the company.

One of the key themes of the upcoming Venture Debt Conference is to discuss what may happen at the end of the year when structured equity companies or structured equity investee companies “start realizing, oh, that’s not really equity, that’s actually debt that’s gonna come due in a year and a half. Oh no, why didn’t somebody tell me that? I think early 2024 is going to be far more interesting than right now.”

Get your ticket to The Venture Debt Conference while space is still available.

Armentum Managing Partner John Markell has over 15 years of technology industry experience having worked as an engineer, project manager and investment banker. He has been involved in numerous debt, equity and merger & acquisition transactions in the technology industry. John previously worked at investment bank Seven Hills Partners in San Francisco, at CIBC World Markets in Toronto and New York in the Technology, Media & Telecom and Debt Capital Markets Groups, and at JP Morgan in New York in the Fixed Income Group. John is also a Licensed Professional Engineer. John received his Master of Business Administration in Finance from the Schulich School of Business at York University and his Bachelor of Science in Engineering and Mathematics from Queen’s University. Armentum Partners has combined experience of over 50 years in investment banking, private equity, lending and operations. This allows them to develop financing strategies that complement equity raises (public or private), mergers, acquisitions, and other corporate transactions. They target emerging growth companies, raising between $20 million and $500 million.