Venture debt unperturbed by GoMechanic issues; 2023 a vital growth year

For investors, making a loss is part of business strategy, but for venture debt players, default is a risky proposition, yet, players in venture debt segment are unperturbed so far

The recent GoMechanic issue has raised many questions for the Indian startup ecosystem but it also brought into focus one of the asset classes, which has seen a significant rise in the last two to three years: venture debt.

Venture debt as an alternative mode of raising funds among startups started to gain momentum over the last 6-7 years and made a meaningful impact over the last two to three years, especially as the funding winter set in and founders were forced to seek alternative modes of raising funds.

For equity investors, making a loss on an investment is part of the business strategy, but for venture debt players, default or fraud is a risky proposition. But players in the venture debt segment are unperturbed so far.

“India has over 100 unicorns and over 200 soonicorns and GoMechanic is just one case. The percentage of such cases in the startup ecosystem is very low. There are many good companies that we would want to be part of,” said Ankit Agarwal, director of venture debt at LightHouse Canton.

"From an investor's point of view (LPs/GPs). Yes, they raised questions but when they see that all the fiduciary responsibilities had been adhered to then they are fine. One-off incidents will happen," said a senior debt venture player on condition of anonymity.

Rather a majority of players that Business Standard spoke to concurred that GoMechanic should not be taken as a case to paint all other players in the same colour. However, many concur that investments will be careful and the focus will be on derisking.

“We have been choosy. We do not necessarily just go by what is happening in the market. We knew that with the kind of valuations that were happening and the rounds growing, it was not sustainable. We did not know when it would stop nor know the party would end so soon. As a lender, we do not have the same yardstick as equity guys (investors), who can make 3x or 5x.  The lender will never get that kind of return. In the best-case scenario, it would be 1.2X. We (as venture debt) can’t compensate for write-offs the way venture capital guys can afford to do so and have to be much more choosy. In these conditions you know it is going to be difficult to raise equity,” said Ankur Bansal, co-founder and director, BlackSoil Captital.

Bansal added that the first five deals the company did in 2021 are EDITDA break-even businesses.

Venture debt industry

Unlike in the US and Europe venture debt as a category is still small. Apoorva Sharma, partner, Stride Ventures venture debt now contributes to roughly 3 to 5 per cent of the venture capital inflows. “If you have to talk about the size then 2021 would have seen investments of about $500-$600 million. The year 2022 would have seen deployments of closer to around $800 million. Compared to VC investments, which fell drastically, venture debt has actually grown for the same period,” added Sharma.

Stride Ventures has been one of the active players in the creation of venture debt understanding within the industry. “As a player in this segment, we have had to do a lot of education both for our investors as well as founders. People now understand that if you take debt for the right reasons it helps in growth and dilution prevention,” she explains.

What is perhaps working in the slow and steady growth of the venture debt industry has been the returns it has managed to give investors as well as showcase that as an asset class this is an attractive bet. Sharma shared, “The venture debt players in India have managed to demonstrate annual net returns of 17-18  per cent with robust asset quality.”

Of course, venture debt in India is still a play for domestic investors. International institutional investors are yet to make a splash here.

De-risking

But players are not going on a spree to invest in startups. Every player that Business Standard spoke to said while the demand has gone up, it may not translate into deal volumes.

“In 2022 the conversion rate was 12 percent, that is, 100 companies came up with proposals and 12 got money. Now that number is like 8 per cent. So it is a drop even though the business that we are looking at may have grown by 30-40 per cent last year. You basically have to do more work in these conditions. But you do not stop business,” says Bansal of BlackSoil.

Also, investors would now be more diligent and focus on derisking. Stride Ventures, which has exposure to GoMechanic for instance has been a very careful investor. Some of the parameters that they consider are that the startup should have raised funds from institutional VCs. They do not fund angel or bootstrapped companies. Stride ideally looks at companies who have already raised a series A, and have figured out the product-market fit and monetisation.

 “We do not fund negative gross margins businesses. The company may have negative EBITDA because you have not achieved the scale to take care of your fixed costs but the business should have strong unit economics.  We focus on market leaders. Also, we will not be in a segment which has any regulatory overhang so no crypto, real money gaming,” Sharma added.

In the case of LightHouse Canton which recently launched its first fund, they make sure that their exposure per company is not more than 4-5 per cent of the fund size. “Our average ticket size is around Rs 10-20 crore and we would look at mature companies, more in the series B and upwards. The way we go about constructing our portfolio is that we make sure we have a healthy mix of companies across stages, the amount of investment as a percentage of our fund is capped for the company,” added Agarwal.

2023 outlook

Bansal says it is actually a great time because they are now getting higher-quality businesses that may have not thought about raising debt.  More and more growth-stage and late-stage businesses have started approaching them.

Sharma is cautiously optimistic about investing. "We are very selective, the deal volume has increased but that does not mean the deal momentum will be higher," she added.

This is all the more important as investor (LP/GP) sentiment around startups is yet to come back to earlier levels. Especially with the performance of some of the listed entities as well. “We have not been on the roads to raise funds for the last four or five months. And will not do for another couple of months because most High Net-worth Individuals, and family offices have seen huge erosion of the value of their start-up portfolios. Many of them would have invested in a start-up in pre IPO and then scenarios like GoMechanic happen. There is negativity around the space (start-up),” said Bansal.