Have you considered private debt as a finance source for your business? Darren Hodson, Corporate Finance Partner at PKF Smith Cooper, explains the benefits and disadvantages of using private debt and venture debt to fund your mid-market growth plans in our latest ‘5 minutes with Corporate Finance’ article.
As of 2022, private debt fundraising was worth just under $248 billion globally. More than half that total was generated by direct lending.
Investment in private debt, as an alternative to the traditional bank loan, has increased significantly in the UK since the 2008 financial crisis and is set to continue growing.
Four main factors have been driving the growth of private debt:
- Private debt funds have used their capital well, which has led to further expansion.
- It has been harder for businesses to secure a bank loan since the financial crisis due to the increased regulations around corporate lending that banks now face.
- Banks cannot meet the needs of every company interested in a loan. If a business requires higher leverage (e.g. more than 3 x EBITDA) then a bank is unlikely to approve the loan. A bank is also unlikely to assist if your business operates in a risky sector or has a complex trading history.
- There is an ongoing strong demand for private debt among limited partners.
What is private debt?
Private debt refers to loans or other forms of debt that are provided by private entities rather than governments or public institutions. It provides both individuals and businesses with a flexible and customisable alternative funding source to bank lending.
Sponsored versus non-sponsored deals
There are two types of private debt: sponsored and non-sponsored. A sponsored deal is led by a private equity (PE) firm, while a non-sponsored deal does not have a private equity sponsor. In Q2 2022, 92% of private debt deals in the UK were sponsored.
The reason sponsored deals vastly outnumber non-sponsored is that PE firms are known for supplying private debt funds with a regular deal flow and undertaking due diligence on borrowers before they commit any equity.
Meanwhile, non-sponsored deals still largely sit with banks and often involve small businesses with smaller leverage requirements.
Things could be changing however, as Q4 2022 and Q1 2023 saw sponsored deal numbers decrease.
Benefits of private debt
- Private debt funds are more likely to grant you a larger loan and to overlook a complex trading history.
- Covenants (legally binding agreements surrounding your performance) are less common in private debt. Even when covenants are used, private debt firms are less prone to harsh enforcement for breaches if your business is struggling.
- More flexibility – private debt providers are more willing to be flexible when supporting good companies experiencing temporary challenges.
Disadvantages of private debt
- Private debt is more expensive than a bank loan, as the firms need to guarantee a decent return for their limited partner investors. Risk-averse attitudes in the current economic climate have led to more reluctance from business owners to take on expensive debt.
What is venture debt?
Venture debt refers to short-term loans offered by specialist lenders for early-stage companies in need of capital. It is well-suited to borrowers that are comfortable with higher risk levels in pursuit of potentially higher returns.
Venture debt is typically used alongside equity financing, rather than as a replacement for it, providing businesses that have already received equity with additional funding to help them reach their next raise.
The credentials of your VC equity provider play an important role in whether you will be accepted for venture debt. The success of your potential next raise will also be taken into account, as this reassures your venture debt provider that their loan will be repaid even if your cash flow is not sufficient.
Businesses in certain ‘hot’ sectors are more likely to be granted a venture debt loan – these include digital and technology, business services, pharmaceuticals and healthcare.
Venture debt is currently booming because equity funding is on the decline and banks are struggling to adjust to rising interest rates, changes in investment strategies and asset valuations, which has resulted in more interest in this alternative source of funding.
How venture debt works
Venture debt is accompanied by a headline interest rate, usually between 9 and 12%. You will also be required to pay fees, typically a percentage of the approved loan, which tend to be a combination of upfront transaction charges and end-of-loan. Additionally, venture debt providers will often ask for equity at a fixed price for the duration of the loan, e.g. 1 to 3%.
You should be confident that you will generate enough funds to repay the debt and the additional fees in their entirety before committing to a venture debt loan.
Most venture debt providers allow you to take out a loan worth £2m to £10m, however some may offer larger amounts. Providers are unlikely to lend you more than 15% of your business’ enterprise value or over 40% of the value of your previous equity raise.
It is important to note that venture debt providers will still evaluate a number of the metrics that venture capitals do before granting you a loan so they can assess your business’ growth prospects.
Benefits of venture debt
- Venture debt does not usually require business owners to put up personal guarantees or abide by covenants, as these are not considered appropriate when the majority of businesses seeking venture debt are still loss-making.
- Quicker funding as venture debt funds frequently use the due diligence carried out by the venture capital investor to decide on whether to grant a loan rather than carrying out their own.
- Venture debt can provide your business with capital without diluting your equity. The funding can be used to support the road to profitability. The cash tends to be used for strategic purposes, like expansion, recruitment or M&A, with the aim of increasing valuation when it is time to raise further equity.
Disadvantages of venture debt
- Venture debt comes at a high cost compared to equity and other types of loan.
- It is not wholly unsecured – you will still need to put up some form of collateral, usually debenture, against your assets.
Specialist guidance on financing your future
Our award-winning corporate finance experts have helped hundreds of mid-market businesses achieve commercial success. Named ‘SME Advisory Team of the Year’ at the Insider Media Midlands Dealmaker Awards in 2022, our corporate finance division can provide you with strategic advice on whether private debt is the right choice for your specific business needs.
Contact us today to speak to one of our team.
