For the first time in SLS’s history, we spent real time this year looking at a handful of venture lending deals. Strong, resilient companies caught in the SaaSpocalypse crosshairs where, we reasoned, good deals could be made.
(Yes, SLS is a credit business built for the venture and growth markets, and yes, since inception we’ve avoided the single most common product in our space: the venture loan.)
Here was the feedback:
TL;DR - we got smoked. Not close on price, not close on structure.
We came away more convinced of something I've believed for years: venture lending, at least in Israel, is one of the most challenging risk-adjusted businesses in private credit.
To start with the biggest issue: this market is abnormally crowded.
In the US, the tech sector was historically not something the US banking system needed exposure to. It was one among many, with real underwriting challenges, and both regional and even national banks could stay out of it without missing much. Israel is the inverse.
High tech is the most important part of Israel’s economy, which means every local bank here has to find a way to be relevant to it. Not for the loan, but for the deposits, the FX, the treasury, the relationships with executives who could become private banking clients…the list goes on.
Beyond local banks there is a long list of non-bank lenders and foreign banks active in the market. All of them are hunting in a pool of borrowers that's a small fraction of the American one.
As an aside, my friends on the equity side complain of a similar dynamic: major foreign funds have crowded the market such that Israel now typically prices at a premium to Silicon Valley not a discount. At least in equity there are power law dynamics that can create huge outcomes even for expensive entry prices - no such laws exist for credit, where returns are capped.
And that's only the market. Let’s look at the loans themselves.
Much of the lending happens at Series A, B, and C, which means you're writing a three-year loan against a business that likely won’t see profit during your hold period. Repayment typically relies on a refinance or a fresh equity round, which is to say it comes from somebody else's conviction about a company nobody can forecast today.
When I ask how these lenders get comfortable about how they’re getting repaid, they respond, with remarkable consistency, that they have a relationship with one or more of the VCs on the cap table, and have received assurances that this is a company they believe in and will continue to support.
Huh?
That is the underwriting… a conversation that took place when everybody was feeling good.
And then one day…
You know you're not that fund's biggest priority. They're fiduciaries with their own investors and their own problems, and if they've gone cold on the business by year three, they are not writing the supportive check because somebody once reassured a lender.
In fairness, this was defensible for a chunk of the prior cycle. What I'd call the lazy period of venture had a remarkable signal-to-noise ratio, and a company with the right team and the right early investors moved from their seed through A and B rounds almost mechanically. It ran like a conveyor belt, and while I never loved the banks' version of it, I understood how a lender standing beside that belt formed a view about who'd still be there at maturity.
We're now back to real venture, which means back to real technology risk. Enormous rounds are being raised on AI products that may never work, against timelines nobody can defend, and a company everyone is certain about this quarter can be a company nobody will touch by the time your loan matures.
There are structural ways to mitigate some of the credit risks that venture poses. Most commonly, lenders can provide a fully amortizing loan, where a material portion of principal comes back every period, such that the loan is fully repaid by maturity. While it solves the “balloon” risk, it creates two other problems.
Firstly, it’s a challenging product for the founder. Borrow three million for a business burning a million per year, and it reads as three years of runway. Fully amortize it, and it's only eighteen months. You just get a lot less bang for your buck.
Our problem is less obvious and more corrosive. A fully amortizing book means a constant stream of cash coming back to you. This sounds great in theory, but cash sitting in our account earns (almost) nothing, dragging the fund's returns until it gets redeployed. And as an investor, feeling forced to redeploy can really erode discipline.
I have friends running books like this, and the way they describe it is that they can never quite catch their breath. Banks have myriad ways to redeploy cash that comes back, funds do not, and some of the biggest problems in private credit have been spurred by firms who felt cash was burning a hole in their pocket.
That said, there are flavors of this world that we are more excited about. Our objection is to venture risk priced as credit. Its cousin interests us a lot more, call it late-stage lending. The post-2021 push for profitability and discipline has given rise to a cohort of later-stage companies that have been “slow” growing (~15-30% per year), nicely profitable, but with no clear near term path to liquidity. Not the sexiest story in a frothy AI market, but businesses that seem like sensible credit risk with believable equity stories too.
The vanilla version belongs to a bank, and rightly so. AppsFlyer's recent $400 million line from Bank Leumi in August was that type of deal. What interests us sits one step further out: late-stage plus complex. A subsidiary being spun out, a management buyout, a dividend recap. The combination of large size and complexity tends to reduce competition. Even the non-bank venture lenders typically prefer simpler transactions that fit their target check size, because as noted above, their business is predicated on rinse and repeat. At SLS, we can’t help ourselves but be drawn to large, complex situations and we expect we’ll see a lot more of them as the number of potential targets organically grows.
None of which stops us from going back to look at venture loans from time to time, almost a compulsion. When the market gets shaken - Silicon Valley Bank's overnight crash or right now with all the SaaSpocalypse fearmongering - we like to look around and see whether the risk/return may have, at least temporarily, dislocated in our favor. As I said up top, we unfortunately keep coming up short by a wide margin.
Given the number of players in the space, I assume I must be missing something, so I keep asking. So far, every answer has ended with somebody telling me what a VC once told them.