Mastering Investment Principles With Art Hogan, Chief Market Strategist, B. Riley Wealth

 

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In this episode, Art Hogan, Chief Market Strategist at B. Riley Wealth, shares over 30 years of experience, diving deep into investment principles, the importance of rebalancing, and how to stay ahead in a rapidly evolving market. Learn how to navigate paradigm shifts like AI, while mastering strategies to avoid down rounds and leverage tech opportunities.

In this episode, Zack and Art discuss:

1. Avoiding Down Rounds
2. Venture Debt Explained
3. Tech Opportunities

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Mastering Investment Principles With Art Hogan, Chief Market Strategist, B. Riley Wealth

I have with me one of the best strategists in the world, Art Hogan, who is the Chief Market Strategist at B. Riley Wealth. With that, Art, I’d love to hear about your background and how you got here.

Art Hogan’s Career Journey

Sure thing. Yeah, so I started in the business 30-some-odd years ago and started working at Dean Witter, which turned into Morgan Stanley. I shifted gears a bit and moved to a company called Jefferies and stayed there for about a decade and shifted my focus. I was running sales and trading at Morgan Stanley and moved into research.

I found a passion for that at a point in time in my career where it was probably the right thing to do. I worked there for a bit and I got hired away at Lazar Capital Markets and then since, Lazar Capital Markets, I’ve been at B. Riley Wealth or one of its affiliates for the last few years. The career has spanned from starting in the sales and trading distribution side of things, developing research products, and helping financial advisors understand what those products mean and how to use them.

What are some of the key investment principles that you live by and that you help educate a lot of these advisors on?

I think the biggest thing to focus on is threefold. I think that my most important thing is never to do anything because you are scared. That’s where the biggest mistakes come in. There’s been plenty of things to be scared about over the last couple of years, and certainly, there’s plenty of things to overreact to. What I try to do is help separate a lot of the noise that we all hear all day with a 24-hour news cycle, social media, and all sorts of other inputs. Let’s talk about what’s news and how that might affect the economy earnings and your investments.

When I think about it in that fashion, I spend a lot of my time helping people feel less concerned about some of the disaster de jours that are going to be happening, whether it’s going to be the China reopening story or the quantitative tightening or the treasury needing to refill its coffers post getting the debt ceiling raised.

Lo and behold, most of those things, if you’ve made a list of everything that people have been concerned about in 2023, most of them haven’t come to fruition. Sometimes, it’s important to think about things in the proper context. The second thing is never trying to time the market. I think that’s the biggest mistake investors make. Thinking about sensible rebalancing versus trying to time things. There’s only been one year in my career where a diversified portfolio hasn’t helped you, and that was in 2022. That was the first time since I’ve been doing this. Nothing worked. Fixed income and equities were down. That’s likely not going to repeat itself. Talking about diversification, compounding, and not trying to time things and getting spooked into or out of things for the wrong reasons.

Importance Of Rebalancing Investments

This brings up a question that I think about a lot, which is how do you think about entering and exiting investments? Obviously, the long-term is the right horizon to be thinking about, and investors shouldn’t make emotionally-based decisions because that usually leads to suboptimal outcomes. There does need to be some system or some process around entering and exiting, because you don’t want to always be fully invested in the market. There should be times where you say, “I don’t like the prospects here. I’m going to dial back or I’m going to reallocate.” How do you think about entering and exiting investments, but also how do you think about rebalancing and shifting between different investments?

Yeah, you answered the question right there. I think rebalancing is the most important piece. For example, let’s look at a 60-40 portfolio. In that mix, you’re always going to have some percentage of that in cash for opportunities. However, let’s take the typical portfolio and focus on that equity side for the first part and say, “I’m going to set up a barbell strategy,” and that does that. That takes the emotion out of it.

How does it do that? You say, “On one side of this barbell, for instance, what we’re looking at now is things that have underperformed.” We like healthcare, energy and staples right now. On the other side of that is going to be some of those well-defined technology companies that most run their business, but don’t have to access bank lending, capital markets, dependable cashflows, etc.

If you rebalance that barbell so you don’t get out of whack, you’re not oversaturated with the mega cap technology companies, and you do that, let’s say, on a quarterly basis, you’re actually forced to sell some of your winners. I think that’s a very healthy process. It also gives you the ability to dollar cash average into some of your losers, keeping that barbell approach.

Rebalancing your portfolio quarterly helps take emotion out of the equation and forces healthy decisions. Share on X

If you were to look at that approach, of course, that barbell approach would outperform the SP500 because it takes the emotion out and forces you to take profits on things that are doing well, but you’re still exposed to it. I think that’s important. The other piece of the puzzle is not always having the same things on both sides of your barbell. Think about why did I think healthcare and energy and staples were the right idea?

They’re defensive. They’re steady. They likely do well as the economy starts to do better. If that changes in your opinion, you might want to shift what’s on one side of that. It’s basically having value on one side, growth on the other, and keeping it balanced. However, times change. If we had started the barbell approach twenty years ago, our growth stocks would be things like AT&T, Xerox, General Motors and Exxon.

Obviously, you need to change with the times to make sure you’re updating that, but that doesn’t mean you want to change it every day or every week or every month. It’s taking that assessment every time you rebalance and say, “Do I have the right things on either side of this barbell?” It keeps you current with those growth opportunities and those value opportunities should be. I think that’s the best way to take the emotion out of it. If this side has gotten too large and it’s larger than 50%, you’re going to trim some of that at the end of the quarter and you’re going to put that money on the other side.

Do you typically think quarterly is the best timing for rebalancing or should it be more frequent?

I would say it depends on your risk tolerance how long you have before you do use this money. If you’re a very long-term investor, I certainly think you can actually have that rebalanced more frequently. I think quarterly takes a lot of noise at it. You’re not saying, “We had a terrible March because the regional banks imploded. I’m going to jump and make a decision in March.” However, if it’s at the end of the quarter, you’re making adjustments on a regular basis. If you get much more than quarterly, I think it adds a lot of volatility and noise to that, and it likely pulls back on what transaction costs would be as well.

When you do that rebalancing, how do you think about what you should sell and what you should buy each quarter? Especially when there are new investments that haven’t been around for as long as some of the others, whether it’s something that’s tied to innovation, for instance, how would you think about adding that? I guess what I’m getting at here is how do you think about strategic asset allocation, which is longer term, versus tactical, and then how do you also account for paradigm shifts or new investment opportunities that didn’t exist when you originally crafted that investment policy statement?

I’ll give you a perfect example of that. Artificial intelligence, while it sounds like it’s brand new, there’s something that company’s been working on for multiples of years. However, as it started to throw itself into the before, at the beginning of 2023, let’s say, you want to step back and say, “In any new paradigm, who’s likely to be the early beneficiaries of that?” To me, I always think about the gold rush and then who did best in the gold rush? That was the folks that sold the picks, shovels and pans. You didn’t have to take too far of a leap to say, “What’s the one thing that everyone wants to have an AI strategy for? What do they need?”

They need that computing power. Where does that come from? NVIDIA? You look at an NVIDIA and say, “That wasn’t on the side of the barbell for a period of time, but now, it is. Why is it?” Regardless of who the winners are going to be at the end of the day, at least in the here and now, they’re going to need an NVIDIA for computing power. I think that has proven to be true. You have to take that other step and say, “Shouldn’t I start looking for some of these hot AI IPOs?”

Everyone’s going to come out and say, “I’ve got an AI strategy.” That’s why you have to be very careful. I think in the early stages of this, you want to look at the incumbent companies that can actually afford this strategy. It’s very expensive to actually do have an AI strategy for yourself. Looking at some of the incumbent companies that also make sense that an alphabet and a Microsoft are going to be the early winners of this.

The importance of this is, even if you were to look at that at the beginning and say, “Here are my winners,” by the end of the first quarter, and certainly by the end of the second quarter, you trim some of those profits because obviously, the exuberance has lifted some of these names. At some point in time, those multiples won’t be sustainable. I think that’s where the rebalancing comes in, but that’s how you get into the what’s new. You have to be careful because what’s new isn’t always what’s great. We’ve seen so many new things, whether it was biotechs in the ‘80s or the dot-com in the ‘90s. We all remember 3D printing was going to take over the world. There was a host of names that had magnificent climbs and significant falls along the way.

The fact that you’re rebalancing and taking some profits while this is going on but still having exposure to this new paradigm, I think, makes a great deal of sense. There’s a difference between jumping all in on this and having it be part of your portfolio. There are plenty of things that can go wrong here. We’ve seen that in all sorts of new things over the course of the last few years. Look at crypto. There’s going to be opportunities here at the end of the day. We certainly think in the early stages, it is best to play the incumbents and then play with the provider of the picks and shovels.

This is a good segue into my next question, which deals with risks because you’ve identified that there’s these opportunities, but the reality is that when there’s these paradigm shifts and there’s these attractive new opportunities, a lot of these investments will wind up being losers, in many cases, zeros. You look at what happened with the dot-com boom in the late ‘90s and how that ended.

Obviously, the internet was here to stay, and it transformed the world. As an investor, most investors lost money during that period because a lot of those investments that had dot-com after their name, zero. That’s what we’re going to see with AI unequivocally. I’ll put my reputation on that right now. AI is here to stay. It’s going to completely transform the world, but the majority of investments that are being made now are going to wind up being zeros because people are investing in things they don’t understand.

Artificial Intelligence is here to stay, but be careful what you invest in. Not all AI companies will survive. Share on X

They’re not necessarily investing in the incumbents. They’re investing in the hot new thing. I see it every day in my position as a venture debt provider. Everybody now is pitching us on a company that has some AI component, and most of it is BS, to be quite frank. Most of them have no idea what AI is or what the difference between different forms of AI are or how it differs from machine learning. They don’t have any expertise in it.

Risks And Common Mistakes Investors Make

The first thing I do is basically dig into their AI chops, and 9 times out of 10, they have none. I kick them to the curb. Most people don’t have that ability to dig in deep and see what’s true and what’s not. This brings me to the question of risks and mistakes that investors make. Over your career spanning over 30 years, you’ve seen a lot of people make mistakes and you’ve learned a lot from those mistakes. What are the biggest mistakes that you’ve seen people make? How do you learn from those, and how do you mitigate risks as an investor?

I think you hit it on the head there. One of the things, luckily, in the stage we’re at and the excitement over AI is that that differentiates from what we went through in dot-com is that we haven’t had that flood of IPOs yet. That’s where it gets very dangerous. Where everything goes up, you put AI in your name, come public, you have a massive 50% upside in your opening. Everyone craves that. You get FOMO amd you start payment.

Having worked at Morgan Stanley during that timeframe, we were as guilty as anyone bringing companies public because they had a website or they were measuring themselves in clicks and eyeballs, etc., but understanding that there were close to 900 companies that came public between 1996 and 2000, there literally are only about 5, less than a handful, that still remain and made it through to where the internet changed our lives.

Close to 900 companies went public from ‘96 to 2000, all of them hugely successful, all of them exciting, and multiples a day of companies coming out and you couldn’t get enough of them. They were all exploding in their opening prints and they were all going to change the world. Guess what? There’s a handful that still exist now. They completely went out of business. CMGI is a good example, an internet incubator. The Patriot Stadium was going to be named after CMGI. It was one of the hottest stocks around. They had a lot of internet properties that they were incubating and about a stock that went from $20 on its IP to $500, then back down to zero. They’re not alone. We’re not at that stage yet because capital markets have been virtually closed.

We haven’t seen deals for pure AI plays. That’s where it gets standards for investors. How do you mitigate that risk? The good news is if you’re a retail investor, you’re not going to get into any of these IPOs. That’s a self-governing thing. If they’re going to be that hot, the institutional pots are going to get them all. The second thing is not chasing anything until we find out who the winners and losers are going to be. It’s going to be a while. Unless you can describe what a company’s doing, you can describe to me like I’m a fifth grader what a company’s doing and what part of the artificial intelligence revolution it’s going to play, I would warn you against investing it.

We can certainly say right now what Google’s doing with it, what Microsoft is doing with it, and how NVIDIA’s helping. Away from that, it’s very hard for the average person on the street that you’ll meet at a barbecue, a cocktail party or a Home Depot to explain to you what part of that puzzle this new company is. If that’s the case, I would warn people not to invest. If you understand, your brother-in-law told you about this, and if you think it’s going to be great, explain it to me like I’m the fifth grader. If you can’t, then you shouldn’t be investing in it.

That was the same methodology I used when it came to crypto. Whether or not crypto has value going forward remains to be seen, but I think we can all agree that the majority of investments aren’t going to be worth much. Even if there are a couple of winners, most people that invested in crypto are going to wind up losing. It’s for the same reason that most people that invested in IPOs of dot-com companies in the late ‘90s. I also lost money.

I think when you think about crypto, it’s a good analog to dot-com. It’s a new technology, blockchain, versus the new technology, the internet. Literally hundreds of coins being minted. There’s going to be two incumbents likely at the end of the day, and then we likely know who they’re right now it’s likely Bitcoin and Ethereum, and the rest will fall, by the way, just like dot-com did.

This is something I think a lot of people don’t realize, and it comes back to bite them in time. How should investors be thinking about playing AI then? Should they invest in the larger incumbents that have an AI edge like Microsoft or Google?

I certainly think that the rational approach in the early stages is the picks and shovels and the incumbents, and then other opportunities will start to show themselves. I’m sure Apple, Amazon, and some of the other megacap technology companies are going to present to us at some point in time a credible business opportunity that incorporates artificial intelligence. I don’t think you need to be in a hurry to be chasing anything new necessarily here, because it’s going to take a while to about it like this.

The internet had publicly traded companies in ‘95 and ‘96. It wasn’t well into 2005 that there was massive adoption of using the internet. We all got dial-up service and we started using email and then online commerce took off and that was the next leg of that journey. I think it’s the same thing. Likely the timeframe will be compressed more, but the actual commercial opportunity for artificial intelligence is over the next couple of years, and that’ll start to present itself. I think that’s important. Not to say, “I need to get in now because this is going to explode before Christmas.”

Don’t rush into AI investments. The big winners are yet to emerge. Play the long game. Share on X

Another example, not quite as big as those that we’ve talked about, but mobile phones. Blackberry is nothing. Apple has been successful, but if you look at all the manufacturers of cell phones, there’s been one winner. Maybe a couple that have done okay, but the reality is, it’s basically been Apple and everybody else has fallen by the wayside. If you were investing in Blackberry years ago, you’d have a big donut, and you wouldn’t have known any better.

That’s been true through every innovation. When you think about this, there was a point in time when we had close to 100 car companies in the United States. The invention of the automobile started. We had all these startup car companies. Lo and behold, we have three now. I would say the same thing is true for cell phones. The same thing is true for airlines. I think when you look at any new innovation that is so new and exciting, that’s going to change our lives, you get this massive influx of new players, and at the end of the day, the best ones are going to win. We saw that in the dot-com. We are certainly going to see it in artificial intelligence, and I think whatever the next new thing is going to be, that’ll be true too. It’s better not to jump in with both feet. Have a logical, explainable rationale for why you want to invest in this new technology and be able to defend it to me like I’m in fifth grade. I think that’s the best way to describe it. It’s like, “Tell me what their revenue opportunity is. If you could describe that to me, I think that’s terrific. If you can’t, it’s probably not the time to make that investment.”

It goes back to the advice that Warren Buffett, Peter Lynch, and many of the great investors have given over the years, which is to invest in companies that you know and understand and whose business model you like but that you actually deeply understand. If you don’t understand the company and how it makes money, you probably should not be investing.

Yeah, I think that’s extremely correct, and that’s always going to be true. It’s been true for the last 30 years. It’ll be true for the next 30 years. The problem with any new, exciting, innovative revolution is that there’s always going to be some bad actors. We want to chase that and hope that they can transform that chasing that and raising of capital into a business. It’s usually not the way to go about it. You don’t raise money and then hope to have a business model. It’s a much better idea to have a business model and then hope to raise capital and show that you’re going to be part of this revenue stream.

Transitioning a little bit from this topic, but related to it is how do you think about alternative investments as part of a successful portfolio for those that are listing alternative investments or essentially anything that are not stocks or bonds? That could be real estate, private equity, private credit, venture capital, venture debt, and a whole slew of other niche strategies. What’s your thinking around alts and how are alts making their way into the high net worth space? Historically it’s been more of an institutional product, and now it’s starting to become much more accessible. A) How do you think this helps portfolios? B) How do you get access, and what is the right type of access for smaller clients?

The great news about alts is that they’ve been democratized over the course of the last few years. What do I mean by that? You’re right, it used to be just institutions that were afforded access to some of the alternative investments. I think you touched along a lot of those. Over the course of the last decade or so, there have been funds that have been raised that actually allow retail investors in.

The good news about most of that is you have to do a significant amount of due diligence to actually allow it to be on your platform. Whether it’s access to things like fine arch, which have gotten very popular, private equity, venture capital, venture debt, or all of those things that are important that the retail investor never had any access to before, they do now.

What does that do? That’s another further buffer to your portfolio. It helps you diversify, and it certainly helps you ride out some storms, but it also gives you access at some point in time to something, to your point, that’s not a stock or a bond. What other things should I be thinking about? It’s easy for everyone to say, “I’ve got access to real estate because I own my own.” That’s not true. It’s not an income producing asset for you. Access to real estate as an alternative makes a great deal of sense.

What I love about alts is they’ve been brought down to the level of the common man. We have access as retail investors. What I love about the fact that we’re a very regulated industry is we have to do our due diligence to make sure these things are appropriate for the clients that we’re talking to them about. The window barely opened over the course of the last few years to where the opportunities have gotten large. I think they’re a very important part of a diversified portfolio.

Are there any alts that you like in particular? I also have to ask about what your thoughts are around venture capital and venture debt. When we spoke in person at the B. Reily Investment Conference, you had some interesting views based on takeaways you had speaking with vcs and some portfolio companies. I’d like to hear about what those conversations led to, because essentially, it sounded like you had a bit of an epiphany after talking to some of the vcs.

The Rise Of Venture Debt

Yeah, I did. It goes something like this. Venture capital obviously is startup funding. Startups tend to need more funding as they go along, as they progress through their building out their businesses. That’s all well and good when the venture capital market is open, but you throw a monkey wrench into that like you did in 2022, and certainly took a bigger bump in the road when Silicon Valley Bank, one of the major players in the venture community, went under the waves. All of a sudden, there’s a dislocation. I think there was already a dislocation because valuations had come down and venture capitalists that raised capital, venture companies that raised capital don’t want to go back to their same investors and say, “We need to raise more capital, but our valuations could be lower.”

“I know we raised this much at a billion-dollar valuation, but now we need to raise this much more. By the way, now we’re at $600 million.” It’s not endearing. No one wants to do it. It’s called a down round. No one wants to do a down round of capital raising. That jams up both on the venture side, the private equity side, and certainly in capital markets. Nobody wants to do an IPO and the down round. How do you fill that gap because there’s capital needs?

I think venture debt is an amazing new opportunity. You’ve got these businessmen that need more capital, and all of their capital has been raised on the capital side, with virtually none on the debt side. You have the ability to raise venture debt. Who was the biggest player in that? Oddly enough, it was Silicon Valley Bank. Remove them from that picture, that opens this huge gap of need for these venture capital companies to find other sources of venture debt, which I think is extremely important.

If you can’t get your original investors to do a down round, let’s put some debt on the balance sheet to you can continue operations until valuations start going up. You have, you’re more successful in front of your company and you have access to other capital. I think that there’s a void from the major players there that needs to be filled by others. We’re already starting to see that being athletes or other people wanting to get into the venture debt proves the thesis that hold was blown wide open on March 10th by the failure of Silicon Valley Bank. It’s an exciting new opportunity and it avoids that down round that none of these guys are willing to do at this juncture.

I think you said that very well in the sense that there’s a fundamental need for this type of capital. In many respects, it reminds me of what happened in the early ‘80s when Michael Milken and Howard Marks popularized what’s called junk bonds. Now, it’s called high yield, but back then, there was this need from non-investment grade borrowers and larger corporates to access the debt market. It didn’t exist back then. You had to be an investment-grade borrower. Otherwise, you weren’t going to get capital. Ultimately, that product grew to be what it is now because it was driven by fundamental needs. The innovation was on the part of Marks and Milken and saying, “We can figure out a way to facilitate this and get capital to these companies that previously weren’t getting it.”

What I see in venture debt is very similar in the sense that there’s a fundamental need for debt capital from startups, from the most successful startups, in fact. There’s nobody that’s providing it in the size that is needed. There’s about a dozen lenders in the space in the US that I would call institutional quality that are out there making venture debt loans. The market’s wide open and the demand for capital is significantly greater than the supply. Whenever I talk to investors on my show, for instance, one of the things I always talk about is how they identify attractive investment opportunities. Probably the number one way to do that is look for products where there’s more demand for it than there is supply.

It’s super simple. It’s Economics 101 because if there’s more demand than there is supply, it’s going to drive the price up over time. In other words, your returns are going to be higher if you’re providing something that is scarce. In this case, capital to these startups. I think Silicon Valley Bank going down was a big catalyst, and it’s poured gasoline on the fire, but this opportunity was there before and now it’s becoming more visible, which is good in some ways. For us, at least.

It’s nice when BlackRock went out and bought one of Europe’s biggest venture lenders who will not be competing with us. It validates this product completely. When you’ve got BlackRock putting out a press release saying, “We bought Kreos because they’re offering this differentiated, unique, exclusive access that has a low correlation to other investments and high risk-adjusted returns.” That basically wins the argument. I don’t need to argue this point anymore with investors. When they’re like, “I don’t believe venture debt. It is as good as you say it is,” I’m like, “I don’t care what you think because BlackRock agrees with me, and by the way, so does Oaktree and Blackstone, so case closed.” That’s been very nice.

I think the point that you bring up, that’s true. It’s the proof of concept when you have players of that magnitude stepping in and seeing that gap. To your point, the gap has been here for a while. Not wanting to do a down round has been going on for quite some time. Silicon Valley Bank didn’t invent that. They just highlighted it even more. Clearly, some of those valuations in venture companies were one of the reasons that Silicon Valley Bank had so many withdrawals. It was a self-fulfilling prophecy.

I think you brought up a very important point, too. When you look at this, it’s not demand, but it’s demand for quality companies. You have to believe in the businesses that they’re building to actually take that risk, that can get that high-risk adjusted return to make sure that there’s going to be something at the end of that for the folks that are taking on that risk.

One of the big misconceptions that I hear quite a bit is that there’s binary risk in venture debt. People are conflating venture debt with early-stage venture equity in terms of the risk and the return, which is silly. Would you compare a senior secured loan to early-stage, small-cap, publicly traded stock? Absolutely not. They have very different risk characteristics. Same with venture debt versus venture equity.

One of the ways that I like to describe venture debt relative to venture equity is the following. Imagine you go to a horse race and you have to bet on horses. Equity investors are essentially betting on horses they’ve never seen run. VCs are saying, “We’re really early. We’ve never seen this horse run. We don’t even know if the jockey’s any good, but we’re going to bet on a bunch of these horses. Hopefully, a couple of them will win and win big.”

Others will not even race. Others will break their legs in the race. Others won’t finish for other reasons. That’s very different from venture debt. The venture lender is going to that race saying, “I’m going to bet on the horses when the race is 80% run. Not only have I seen them run, but I also know who’s in the lead. I might not always know who’s going to win, but I have a very good shot of determining who’s going to win place or show.” I brought this up at a conference I was at, and I was speaking on a panel, and one of the other panelists said, “All you need is for the horse not to die to make money.” That’s the difference.

You won’t necessarily have the opportunity to have a 100X return on a venture debt investment, but you’re getting a 15% to 20% cash yield, plus you’ve got equity kickers through warrants on all these deals, which gives you that exposure over the longer term. If the company does happen to, to be a big winner, you’re going to participate in that meaningfully. You’ve got this upside skew, but you don’t have the downside skew.

The other thing I always like to explain to people is that these are short duration senior secured loans to the best VC-backed companies in the world. This is not some small business and they haven’t made a buck yet. These are companies that are backed by the Sequoias, Andreessen Horowitz’s and Kleiner Perkins’ of the world where they’re already doing $20 million, $30 million or $40 million a year in revenue, and they’re trying to figure out how they’re going to get to many multiples of that. That’s a very different risk proposition than other types of small business loans.

A quick question for you. In terms of the changing environment, what gets venture capital to start going again? When did companies start saying, “I’m biting the bullet and doing that down round.” Is it we get to a place where they have to throw up their hands and say, “We’ve taken on too much debt and/or we’re taking on new investors and we’re doing another round?” Have you seen some or both of that?

The answer is, when they start to run low on cash, then it’s not in their control anymore. They either have to raise money at any price or they’re going to go out of business. For early-stage companies in particular, cash is king, and the number one reason early-stage companies fail is that they run out of cash. Most funding cycles for early-stage companies are 2 to 3 years. In other words, they’re coming back every 2 to 3 years to the market to raise external capital to fund their growth. If you look at the funding cycle over the last few years, 2021 was a record year. It was a blowout year. To, to put it in concrete terms, if you look at the amount of venture equity that was invested in 2020, it was about $160 billion, which was an all-time record.

You have an all-time record of $160 billion in 2020. The next year it went to $345 billion. It’s mind-boggling. Imagine there’s a baseball player who hits 70 home runs, and the next year, somebody hits 150. They’re definitely on steroids just like the economy was. In 2022, that number was about $240 billion. You’ve had a massive amount of money going to these VC-backed companies over the last few years, roughly $750 billion in aggregate.

On the debt side, about $100 billion was deployed during that three-year period. You had $750 billion in equity, $100 billion in debt, and $850 billion in total over three years. Guess what? Now, all those companies are going to need to start coming back into the market. All the companies that funded in 2021 came back to market in 2024.

Those that funded in 2022 came back to market in 2024, 2025 and somewhat in 2026. There’s a massive amount of demand for capital that hit in 2024 and 2025. That’s what’s going to drive companies to have to do rounds at any price. The other thing I’ll mention too is that because this is a private markets product, there is a lag in marking down investments. It’s not like the stock market where you see it in real time. There’s been a lot of folks who have, I would say, undermarked their book. They haven’t marked it down as much as they should have. They’re basically causing the smoothing effect and that hasn’t fully filtered through.

I think that’ll take a couple more quarters, but at some point, you can’t cook the books anymore as a VC. You’ve got to write down the company to what it’s worth. I think most of the companies that were funded in 2020 through ‘22 are going to wind up being down anywhere from 50% to 90%. The majority. The reality is if you look at secondary markets and where trades are taking place, most of the trades are taking place at valuations that are 40% to 60% lower than 2022 and 2021. I would say that there’s not even a strong bid at those prices. In other words, there are opportunities to buy in at 50% of the valuation of 18 months ago, and nobody wants to do it, which means that the prices are going to fall further.

To answer your question in succinct terms, I think when we see the valuations fully reflect reality, which will happen over the next 6 to 12 months, and when we see this demand for capital surge in 2024 and 25, that’s when you’re going to see the VC market pick up again. The reality is then those with capital are going to be seeing eye to eye with those that need capital. Right now, the founders want their valuations to be much higher, and the funders, the VCs are saying, “We’re not going to fund it the price that you wanted. That’s silly.”

That’s why transactions aren’t taking place. Eventually, that’s going to come together and I think that’ll probably be sometime in 2024, which I also think will be a banner year for venture debt because as these equity deals start to print again, these companies will be looking for additional capital that’s cheaper and less dilutive than equity capital. They’ll tell lenders to basically tack on capital to their equity raises because it works.

When you think about that ratio, we’re talking about the last three years and $750 billion in venture equity and $100 billion in venture debt. Is that about right? You think in terms of, “I’m a venture company. What should the ratio of debt to equity be that I do when I’m doing a raise?

Historically, the amount of venture debt relative to venture equity over the last 10 to 15 years has been about 10%, plus or minus. That’s not a lot of venture debt. If you think about it, $100 billion in equity would be $10 billion in debt. That’s in aggregate across the US. On a company specific basis, most lenders want to keep the loan to enterprise value below 20%. Most of the better lenders are keeping that ratio around 10%.

Quite frankly, the deals that we are looking at AI right now that we’re intending to execute on over the next 3 to 12 months have LTVs in the single digits. You take a company that’s worth $100 million, conservative valuation, not a VC valuation, but our valuation based on relatively conservative metrics and multiples. To take a company that’s worth $100 million, that loan size would probably be $10 million or less.

The way it works mechanically is that the debt comes after the equity raise. Another common misconception with venture debt is that people think that companies that need capital and are struggling can get a loan. That’s absolutely unequivocally not how it works. The way it works is the top 10% or 20% of companies that have raised equity capital effectively are then able to tap into the debt capital. It’s the equity raise that de-risks us as the lender. What you’ll often see is the company wants to raise, let’s say, $50 million total. They’ll go do a $40 million equity round, and then they’ll do $10 million in debt. They get their $50 million, but they’ve saved themselves that $10 million in dilution. They greatly reduced it because the lender, of course, does have equity warrants, but it’s a relatively small percentage.

The company is happy because debt capital is cheaper. Their weighted average cost of capital is reduced. Most importantly, I would say the founders are excited because now they’re keeping more of the companies they’ve built. They’re saying, “Now when this thing does IPO or we get acquired, we’re going to have a larger ownership stay,” which ultimately is what they’re incentivized to do. They’re not there to make the VXs money. They’re there to make themselves money.

That’s where I think people go wrong. They think, “Venture debt’s risky.” No, it’s not. It’s actually got the best risk-adjusted returns of any private market asset over the last twenty years because you’re lending to the winners that are already very successful. They’ve gone through deep due diligence with the best vcs on the planet. They’ve got some game-changing technology in many cases. They’ve got incredible traction. They have real revenue. Oftentimes, they’re close to profitability or going to be very profitable in the short-term and the longer term, of course. It’s not this binary risk that people think it is. It’s a compliment to the equity financing and it’s only provided to the best companies out there.

You don’t have a concern necessarily. Let’s say, hypothetically, that that typical funding round is we’re going to kick in in ‘24. Founders and venture capital companies are going to start to get closer on that bid and offer spread. We’re going to see some down rounds. That doesn’t matter to you because there’s also going to be a debt component to that. If company XYZ does a down round, the founders are willing to take that and price gets diluted, they’re still going to have a desire to have that 10% debt on top of that to get the capital needs taken care of.

The Future Of Venture Capital And Debt

In fact, they’re going to be more incentivized to utilize that because they’re raising equity capital at a lower valuation, which means, inherently, it’s much more expensive. The lower valuation, the more expensive the cost of capital. There’s going to be a very strong desire from founders to utilize as much debt as they can within reason. You don’t want to over lever a company, of course, but most founders are going to be doing rounds that are at lower valuations. They’re going to be highly incentivized to utilize debt to decrease that cost of capital. Also, raising money at lower valuation means you’re inherently selling more equity, so you want to do as much debt as you can. I think 2024 should be a banner year for venture lenders in general because there’s going to be a lot of deals taking place, I think.

Not only are we going to have more demand for the product, but given the fact that we are going to have equity warrants in all these deals, we’re getting the equity warrants and better terms also because we’re getting the equity warrants at a lower company valuation, and we can also negotiate for much lower strike prices. For those who don’t know what an equity warrant is, it’s essentially a call option or the right to buy stock in the company. You need to pay to exercise that option.

In the past, the strike price or the cost of exercising that option would often be the price of the last round of equity capital. The last stock price. Now, because these companies need capital and don’t have as much negotiating power, they’re willing to do deals where the strike price is a penny, meaning the lender can buy stock in that company for a penny per share. Ultimately, I think this is going to set up venture lenders for big returns in the next couple of years because we’ll be earning an attractive income, 15% to 20% on the debt side, plus the equity warrants will produce higher returns than they have historically because we’re getting them at lower valuations with lower strike prices.

That’s why we’re seeing our Russian companies announcing that they’d like venture this market.

This is why you’re seeing BlackRock, Blackstone and Oaktree all in the space, either as LPs, limited partners and funds or doing direct investments with their own capital, or in BlackRock’s case, buying Kreos. For us, that’s great because it validates the product, but they’re not directly competing with us because they’re doing much bigger deals in different parts of the market. We’re not in Europe. I’m not concerned about that. Blackstone, for instance, announced that they’re putting $2 billion of their own capital into working in tech lending, which includes venture debt, and ultimately, those are going to be bigger deals. $50 million, $100 million, $150 million deals where we’re targeting $10 million to $25 million deals. Very different parts of the market.

How would you differentiate your fund from a typical what’s what we know as BDC that seems to do some of this as well?

For those that are reading, there are publicly traded companies that actually make venture loans. There are five publicly traded, NASDAQ-traded business development companies known as BDCs that specialize in venture debt. If you want to buy liquid public stock, you can go out and get this venture debt exposure through these five companies. That also brings with it risks because they’re publicly traded, they also have market beta. We saw in 2020 when COVID hit, the market sold off initially before we got that big liquidity injection. What happened was the BDCs that specialized in venture debt, along with everyone else, all went down quite a bit because they have relatively high beta.

For instance, there were BDCs that were down 70% when COVID first hit because they have a beta of approximately 1.8. None of the underlying loans actually ever got hit. They all produced excellent returns, but because they were a publicly traded vehicle, people were selling everything indiscriminately and higher beta stocks would be underperformers. They produced terrible short-term returns.

I’ll tell you, a lot of smart people I know in the space loaded up on those BDCs on the sell-off and killed it. Absolutely had banner returns in the last couple of years because they bought at a huge discount. That’s a big risk, though. If you’re an allocator or you’re an advisor and you put your client into venture debt through the public bdcs and then there’s a sell-off, the recession hits and the market’s down 30% or 40%, these BDCs are going to underperform and be down even more.

You’re not going to look too smart when you’ve put 100 units of capital into an investment and you’re going back to your client a month later saying, “That’s worth $0.30 on the dollar now. Don’t worry, it’ll be fine in the long run.’ that doesn’t cut it. That’s how you get fired. That’s why I think private structures are a much better vehicle for venture debt because these are companies, an individual loan basis, don’t have a lot of systemic or macro risk. It’s a lot of idiosyncratic risk.

In other words, what happens day to day in the stock market is not going to affect a loan that we made to a venture backed tech company short-term. There are longer-term tie-ins of course related to the funding cycle that we’ve talked about but the reality is these are great portfolio diversifiers because they’ve got very low correlation over the short and intermediate horizons. A lot of people like venture debt for that reason, but they like it in the private structure because we can actually mark our books appropriately and it’s not the voting machine of the public markets.

Help us dispel a myth about venture capital in general. Venture capital companies aren’t always technical companies. There’s a broad distribution of multiple sectors that are at that stage of their development that take on venture capital and debt. Correct?

Yeah, there’s typically a tech focus when it comes to venture-backed companies because venture-backed VCs are looking for companies that have a lot of scalability and big upside. You won’t have that unless it’s got a tech component in most cases. It need not be software. There are a lot of different applications of technology across all different types of sectors. You’ve got healthcare and supply chain and logistics and energy and agriculture and financial services. The list goes on and on. It’s not pure software plays. It’s not AI. It’s not web Web 3.0 or digital assets. I think a lot of people forget that. In my view, the best investments are those that actually add efficiencies to existing businesses that are already successful.

You take an agriculture company or an energy company or a supply chain company and you give them a technology that’s going to add to their business through margin improvements or some other types of efficiencies. You know there’s a giant market there for this new tool. That’s what we look for because we’re not necessarily trying to hit a grand slam. We need to finish the race, like I was saying before. We need the horse not to die and finish the race, and we’re going to be fine. I think that the lenders look at things similarly in many respects to the equity investors, but ultimately, we’re much more risk averse and we’re thinking about protecting against the downside rather than hitting that one big unicorn.

That’s why your lot of values are all that small. That’s where your capital your loans values are at the levels you get them in.

If you’re making loans with an LTV of 5% and you’ve got covenants and you’re the only debt in the capital structure, you’ve got a lean on all the company’s assets and the company’s already done 5 or 6 rounds of equity funding, it’s very low risk. The loss rates, which we didn’t talk about in this space, are very low. Silicon Valley Bank, for instance, had loan write-offs each year that were on average about 30 basis points. That’s pretty impressive. In their worst year ever, 2009, they wrote off 2.6% of their loan book, which means 97.4% of their loans were still performing, which means they didn’t lose money. Before we go, Art, any thoughts you want to leave investors with in terms of themes over the next couple of years and how to play those themes?

Key Investment Themes For The Future

Yeah, it’s such a great question, and obviously, thematic change is on a year-to-year basis, but I think in the long-term, you highlighted something that I think is very important. I think successful companies or successful new technologies are going to push productivity, whatever sector you’re in. If it’s going to make us more productive at removing hydrocarbons from the ground and getting them to the end user, and we’ve gotten much better at that, we likely have more to get over things that make us more productive in our workplace, and Artificial intelligence will play a piece of that.

I think there’s going to be a lot of other things that come along. When you think about investing, you don’t necessarily have to discover the new thing, but when you think about the themes that likely drive us, it’s going to be companies that likely make us efficient, more productive, and likely those companies, therefore, will be very profitable.

I think that other major things we should think about is actually, the lessons we learned from the pandemic are going to help us. The biggest lesson that we learned is we can’t be overly dependent on supply chains that could be disrupted easily. The good news is we’re changing that. It’s going to take some time, but I think one of the biggest themes is that we’re either nearshoring or onshoring our important supply chains, things like semiconductors. I think that’s going to play a big role over the next couple of years when you think about that.

How do you want to play that? It’s not going to be the companies that are doing the investing and the new bags for the production of semiconductors in the United States. It’s going to be for the machines that actually make those. When you think about the cyclicality of what we’re doing now, we’ve got a big infrastructure build-out. It’s going to take eight years to put that money to work. What companies should we think about that’s going to be important in that infrastructure? It’s not roads and bridges. It’s things like an electric grid. I think the thematics play out in how we are improving ourselves in that nation. We’re fixing our supply chains, we’re fixing our infrastructure, and what are the sectors that play into that over the course of the next 2 to 5 years? It could be a very exciting time to be around.

I actually like the theme of onshoring. I think we need to do that. There are so many reasons for it. Obviously, the global supply chain is a mess. We learned that quite clearly. It still is a mess, which means there’s a huge opportunity. Also, from an economic perspective, personally, I think we need to bring more of those jobs back to the US. I think that there’s a real problem with the shrinking middle class here.

AI is also going to displace jobs, a lot of white-collar jobs, as well as blue collar jobs. We’re going to need to create some jobs for people, and having more jobs here based in the US is going to be critically important to our long-term success as a country. I’m excited about bringing more jobs back to America but also focusing on making America the innovation leader in every single vertical.

We’re in a battle, if you will, or a war with China right now to see who’s going to be the leader in AI and that will have major implications. We’re fighting on all innovation fronts. We want to be the leader in all of those. To do that, we need to bring resources here. Art, thanks so much for joining. It’s been great having you. For anybody who wants to reach out to you, what’s the best way to contact you?

If you actually have a sales rep at B. Riley, please feel free to look out that way. I’m also on LinkedIn. I’m on Twitter, so you can find me in both of those locations. I’d love to talk to anybody if you want to follow up in this conversation.

Thanks for reading, everybody. Thanks again, Art, for joining and we’ll see you all next time. Take care.

 

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About Art Hogan

Art Hogan is a Managing Director and the Chief Market Strategist.

His insightful commentary and straightforward manner have made Art a respected and well-known figure in the financial media for many years. He frequently appears in live interviews on CNBC, FOX Business and Bloomberg TV, and is quoted regularly in The Wall Street Journal, The New York Times, Financial Times, Yahoo! Finance, and many other outlets across the globe.