The expanding role of private credit in tech
This is cross-posted from the original article published on Forbes.
It's been a volatile time in markets. The combination of inflation, supply chain woes and geopolitical events have made it difficult to predict where capital markets or even the broader economy are headed. Despite these challenges, private markets and private credit in particular have held up well. In fact, according to Pitchbook, the industry’s AUM could grow to $16.1 trillion by 2027.
While private credit is having its moment, it’s been a traditionally opaque asset class, one not as well known and perhaps even at times misunderstood. Private credit, by definition, is an asset class of privately negotiated loans and debt financing from non-bank lenders. It includes small business and consumer loans, venture debt and other forms of private debt. It has been and continues to be sought out by small businesses, startups and individuals who did not have access to public markets.
Much of the recent growth has been driven by Fed policy. While the Federal Reserve's rapid fiscal tightening all but halted bank-led leveraged lending, businesses still needed financing. Borrowers turned to private markets in droves. As a result, private credit saw steady sequential gains throughout 2022, surpassing $200 billion in full-year fundraising for the third consecutive year, according to PitchBook's Private Debt Report. Industry analysts anticipate demand will remain elevated as borrowers contend with higher input costs and even tighter liquidity in public markets, exacerbating the need for cash on hand.
Typically, lenders raise funds from groups of investors who get a premium over the life of the loan. Investors who are already familiar with traditional high-yield investment or leveraged loan markets often also invest in private credit funds. These funds have grown in size and scope following the financial crisis when new regulations caused traditional banks to limit lending. Now, the universe of potential private credit investments includes a wide range of financing types, lending terms and risk levels that both investors and borrowers can customize to fit their needs. All have their pros and cons and must be weighed carefully.
Private credit offers investors additional diversification, with investments that are largely uncorrelated to public markets and higher yields. Investors can generally expect a 3-6% return premium over investments in other asset classes and the broader syndicated loan market, according to Goldman Sachs.
The State Of Private Credit In Tech
Out of all of private credit’s sub-asset classes, I believe venture debt is the most applicable for technology companies. But for many years, there was a stigma around using venture debt. There was a feeling among founders and boards, particularly in technology, that using venture debt could be an indicator that a company was running out of options or wasn't going to do well in a traditional fundraising round.
This dynamic has changed significantly. Following recent bank failures, extremely tight liquidity and a tough fundraising environment, venture debt is often one of the only options left. Founders and boards alike recognize this challenge, and the stigma around venture debt has largely fallen away.
Common Challenges Of Private Credit And How Tech Leaders Can Overcome Them
Because private credit is often still thought of as a last resort within tech, technology startups and companies may enter into a process with unclear or unrealistic expectations.
Venture debt offers relatively quick access to funds that can help bridge the gap between traditional fundraising rounds, but that doesn't mean it is always easy to acquire. In this environment, technology startups and companies need to approach private credit as they would any other type of traditional financing. Companies have to show that they have a strong balance sheet and a clear pathway toward profitability as well as an ability to repay.
Managing timelines is also important. Startups and companies may realize they need to look at financing and try to start with a bridge financing agreement among existing investors, only to realize that's not going to work and then have to start a second process. If all of that goes beyond the number of weeks or months that a company has cash on hand, a company could end up in a difficult position. Assembling the necessary information and running these processes in parallel can safeguard against running into any timing issues.
Founders and boards will also need to be mindful of terms. This is a lender's market. There are many companies in need of financing, and with traditional channels closed off, the risk of lending is higher. Costs have also gone up as interest rates have risen. As a result, founders will need to be prepared to pay more for financing and may face tighter lending covenants. Startups and companies will have to engage with their boards to make sure that the tradeoffs make sense for them.
Final Thoughts
We are in a new era of financing high-growth companies. Private credit is increasingly becoming a mainstream tool supported by founders and boards. However, management teams will have to have hard conversations internally to understand how much financing they can realistically afford and what repayment looks like. If everything lines up, private credit can be a valuable option in an otherwise challenging market environment.
This information is for educational and informational purposes only and should not be considered financial advice or promotion of any financial product or service. Always consult with a qualified financial professional for advice concerning your specific situation.
