My whole life, I have watched macroeconomics. It is the “dismal” science. But, as a futures trader, you could make some money by paying attention to macroeconomics and trying to piece together what you thought would happen. A lot of my friends in the pit would watch them closely too. One of them blogs here. None of us were trained PhD economists. But, because we walked the edge of razor blade every day, we were keen on economic factors and how it would influence the economy. We didn’t need fancy economic models. We had our trading accounts. Most PhD’s that came to the floor in those days blew out.
When I got my MBA at Chicago Booth, I learned a great deal more about economics. In my undergrad class, my professor taught us classic saltwater Keynesian economics. IS-LM curves. My professor was schooled at Harvard from Keynes himself. At Chicago, I learned about freshwater economics. Classical C+I+G economics. My professor there was with the Federal Reserve and writes a great economic blog called Macroblog.
If an economist is honest about macroeconomics, they’d tell you that most of the predictions don’t work out.
However, there are a few maxims no matter which of the two economic theories you follow. Choices are made using costs/opportunity costs. Those choices lead to more costs/opportunity costs. Individuals want to maximize “utility”. The reason I preface everything is I wanted to show you a little bit about where I am coming from in my analysis.
There is a trend these days for startups to take on debt.
Debt is a four letter word. It’s a double edged sword. In Corporate Finance, you can grow via cash flow, debt, or selling equity. The cheapest is cash flow. However, it can be the slowest as well. Debt doesn’t dilute the equity table, but it must be paid back with future cash flows. Selling equity is the most expensive option, but can juice growth without impinging cash flow.
The biggest downside to debt? If you can’t pay back the debt, you go out of business.
The US Federal Reserve bank has maintained a 0% interest rate policy for the whole of President Obama’s term. It was only in the last year they moved the Fed Funds rate to .50%, which has turned into a market rate of .66% and a future expected Fed Funds rate of .75%. That’s still free money in my book.
Going back to macroeconomics, this low rate has created costs/opportunity costs throughout the economy. Traditionally, the Fed Funds rate hovers in a range between 3% and 6% depending on all kinds of economic factors. But, what I want to focus on is risk taking appetite.
When the Fed Funds drops, it changes the risk taking appetite of the investment community. If we look at the data from the last 8 years, the first thing people did was plow money into stocks. Here is a chart I made at Ycharts that illustrates it graphically. The S&P is in blue. The amount of lending, or corporate debt outstanding to non-financial institutions is only up 28% with the largest percent gain happening in the back half of the curve as corporations slowed stock buy backs and started aggressively refinancing their debt or issuing it.
Put yourself in a bankers shoes. You can borrow at 0%. However, there is no real economic growth, GDP has been anemic for 9 years. No economic growth means no demand for money. You have been putting money in US Treasuries and earning a blah return. You have some pressure to get more profitable. The home loan market is meh. People have all refinanced by now.
Hence, the increase in banks looking at venture debt. We have finally reached a point where the costs/opportunity costs for the banker have descended to a place where they will start to lend to startups-which is probably one of the higher risk loans out there. Founders are trying to hang on to their equity, and are turning to venture debt as a vehicle to do it. Many founders mismanaged their fundraising process in the beginning. Perhaps they came out at too hot a valuation. Perhaps they gave up too much equity in a Series A,B or C round. Lizette Chapman of Bloomberg News writes,
No one publishes national data on venture debt, but a half dozen lenders provided numbers showing activity spiked in 2016. Silicon Valley Bank’s loan-volume to venture-backed startups surged 19 per cent during the past year to US$1.1 billion for the quarter ending Sept. 30. Wellington Financial made more than 10 new loans to venture-backed startups in 2016, double 2015’s total. At Hercules Capital, annual volume is up and the average deal size increased 16 per cent year-over-year to US$15.6 million. TriplePoint’s volume is up more than 25 per cent. Western Technology Investment CEO Maurice Werdegar called volume “robust” and described the lending environment as “hyper-competitive.”
The Kaufmann Foundation published a short piece on Venture Debt here. It’s academic. It is a good overview of venture debt, with all the terms, trimmings, and tax advantages. If the venture debt environment is getting hyper-competitive, I think it shows that bankers have weighed the cost/opportunity costs of it and are trying to lend to get return. I don’t think it ends well for banks.
I have had companies I invested in take on debt. The decision to take it on and the amount of debt the company assumes depends on lots of factors. I highly discourage companies to look at debt as an option just to stay in business or because they don’t like the terms VCs are giving them.
However, companies that are moving to an IPO can use debt advantageously. If the Federal Government gets smart and eases up the restrictions on public companies and the costs for companies to go public, I think we will see more venture debt be used. My friend Fred Wilson wrote,
I am a big fan of venture debt late in the life of the startup. It can be a bridge to a sale or a bridge to an IPO or can be used to fund an acquisition or some other value enhancing transaction. I encourage our portfolio companies to tap the Venture Debt markets all the time once they have become credit worthy on their own. It is smart to use debt vs equity when you can absolutely pay the debt back.
I concur wholeheartedly. The key is, can the debt be paid back without impinging cash flows and growth?
If the company can’t pay, they will wind up like GigaOm, Ouya, and MindCandy. As I hear about more and more venture debt being issued, my gut tells me there will be the sound of trees falling in the forest when payback time comes. Those macroeconomic costs/opportunity costs will come home to roost.