Mastering Opportunities In Growth Credit & Venture Debt With Dan Zwirn, Part 2

 

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Welcome to another episode of The 7 in 7 Show with Zack Ellison, which features full length interviews with the world’s leading investors in innovation.

The show this week features the second half of a great interview with Dan Zwirn, a legendary hedge fund manager and one of the best credit investors in the world.

Part one (Season 2, Episode 7A) can be found here: (LINK)

Dan co-founded Arena Investors in 2015 to bring creative solutions to those seeking capital in special situations. With a mandate unconstrained by industry, product or geography, Arena currently manages approximately $3.5 billion as a global investment firm focusing on special situations asset and credit investments in corporates, real estate, structured finance, and corporate securities. And Dan and his team have become well known for their ability to develop pragmatic, very precisely-structured investment opportunities in complex situations where others can’t or won’t.

Before founding Arena, between 2009 and 2015, Dan founded and/or led several specialty finance enterprises including Applied Data Finance (a consumer finance company), North Mill Capital (an asset-based lender), North Mill Equipment (an equipment lessor), and Lantern Endowment Partners (an investment fund).

In 2001, while a managing director and founder of the Special Opportunities Group at Highbridge Capital Management, Dan, along with Highbridge, co-founded D.B. Zwirn & Co., a global special situations firm. Dan served as managing partner of D.B. Zwirn & Co., which grew into a $6 billion enterprise. He had previously founded the Special Opportunities Group of MSD Capital, the private investment firm of Michael Dell.

Dan is a senior trustee of the Brookings Institution, a member of the Executive Board of the University of Pennsylvania Jerome Fisher Program in Management & Technology, and a member of the Board of Overseers for the School of Social Policy & Practice at the University of Pennsylvania. He previously served on the Leadership Council of the Robin Hood Foundation, the Board of Trustees of Barnard College of Columbia University, and the Board of Trustees of the New York Public Theater.

Dan holds a BS in economics from the University of Pennsylvania Wharton School of Business, a bachelor of applied science (BAS) in computer science from the University of Pennsylvania Moore School of Electrical Engineering, and an MBA from Harvard Business School.

In this episode, Zack Ellison and Dan Zwirn discuss:

1. The evolving venture debt market and its potential for investors.
2. The importance of being selective and disciplined in venture lending.
3. How market cycles affect venture debt opportunities.
4. Growth credit as a blend of venture lending, distressed debt, and direct lending.
5. The changing dynamics of venture capital and its impact on venture lending.
6. Strategies for de-risking venture debt transactions with a focus on cash flow.
7. Recommendations for investors to consider over the next phase of the economic cycle.

Mastering Opportunities In Growth Credit & Venture Debt With Dan Zwirn, Part 2

Dan, with all the risks that you’ve identified, which are the ones that keep you up the most? Which are the hardest for folks to hedge, in other words?

Identifying Risks

On an individual basis, it’s fraud. It’s one of a whole series of idiosyncratic risks that we look at and think about. Just as we want to minimize what we will call beta risk, correlation to the overall markets in a manner that we don’t have control over, we want to minimize alpha risks and idiosyncratic risks. Those include fraud and other industry or geographic-specific factors that may be out of our control.

With regards to the latter, the only real way to mitigate that is through a combination of position diversity and relative orthogonality, a lack of correlation amongst the constituent parts. Anyone looking at that would go, “That sounds obvious. Why don’t we go do that?” The answer is, “Why don’t people do that?” With regard to position diversity, as an example, in credit, it’s a lot harder to accumulate 50 investments than it is 20 investments. There may be diseconomies of scale and scope that preclude certain people from participating in that and leave them overexposed.

People on the equity side traditionally used 30, which is a Mendoza Line around what is proper diversity but that’s in a series of investments that have a normal distribution of outcomes, as opposed to one skewed toward capped upside and unlimited downside that you have in credit. Second, with regard to the lack of correlation amongst the constituent parts that might otherwise mitigate alpha, you have the issue of these very narrow-scoped investment mandates that have arisen post the GFC, which effectively create this tremendous incentive toward moral hazard.

If I’m given money to do a very narrow thing, 99 out of 100 folks will go do that narrow thing, no matter whether it’s interesting or not. Furthermore, they have no other choice if they’re going to effectively feed themselves but to do that. Not only do they do things that don’t make sense and subject themselves and other people to moral hazard but they couldn’t if they wanted to create that level of orthogonality because their narrow mandate precludes it. Therefore, they’re set up to be in front of the bus when it comes to hit them.

 

 

Growth Credit And Venture Debt

I want to shift gears a little bit and talk about growth credit and venture debt. Those are related, not in the same thing but are similar in many respects. It’s funny when you mentioned this idea of the core portfolio being a great marketing term because it makes people think low risk. The people on the venture side screwed up because they call making loans to startups venture debt. People hear the word venture and they think it’s risky. That’s a huge misconception and probably the worst marketing decision of all time.

It also leads a lot of people astray in the sense that they think venture debt is risky when in fact, if done properly, it’s got incredible risk-adjusted return potential. You’ve been involved in the space pretty much from the beginning. You’ve done some incredible things. I’d love to hear about your early days in venture debt, how you got here, and then what you’re seeing going forward as opportunities in both venture debt and growth credit.

You’re right. That is a negative dog whistle. It’ll probably increase now that everything venture is scary from all the blowups and ugliness that’s happening in the aforementioned mass extinction event. The reality is like anything that we do, every permutation of industry, product, and geography in which we engage, there’s a time to do it and a time not to do it. In each direction, it gets overdone. There’s a frequency and wavelength to all of these different permutations in which we engage. Venture lending is no different.

When I started thinking about venture debt was at the time of the late ‘90s when there was a business called Comdisco. Comdisco was originally a venture lessor, which is another term you don’t hear too much lately. It got its way into venture debt and then went public. It raised a huge amount of debt itself and then consequently blew itself up for a whole variety of idiosyncratic and bad incentive reasons.

As I looked at that blow-up and thought about what went wrong there, and we bought some of their obligations at pretty interesting prices, what was particularly interesting was this notion of if you look at the life cycle of a growth enterprise, at what point is there any risk other than an equity risk? Let’s start with that. Early on, even into the ‘70s, in-growth companies needed to buy big hunks of equipment that allowed them to run their computer programs or test their life science projects or whatever it was. They didn’t want to dilute their equity value, so those things had value.

Suddenly, there was something in that enterprise, no matter how risky it was, that could provide somebody in the capital structure a risk other than an equity risk. As an example, I’m in an emerging pharmaceutical area. I’ve raised venture capital and tested my drugs. I have a whole range of lab equipment that is necessary to do that. All my tests went wrong. The drugs don’t work. It’s a complete nightmare. The company and enterprise are gone. Equipment can still be used by somebody else.

There’s a non-zero outcome for those who capitalize on that equipment. That was an interesting notion because, at the time, there were banks that said, “That’s a risky enterprise. I’m not financing that equipment.” They didn’t take into account the fact that the equipment itself would effectively have a value for the creditor that would provide a different type of return per unit of risk. That was created by the equity.

As that evolved, leasing became less of a thing because there was a lot less relatively speaking to lease. Computers got cheaper and more affordable. People started thinking about venture lending. The question is at what point is there a differentiated return period of risk among capital structured constituents in a venture company? The answer is very simple. If it “doesn’t work,” is the thing worth zero? There’s no debt risk to be thinking about. Therefore, it doesn’t deserve somebody willing to take anything other than an equity return for participating in that capital structure.

There's huge potential for new originations in this next part of the market cycle. Share on X

What you found is even after Series A or Series B, there was a recurring revenue stream from SaaS. There was a customer list and some tangible value, going back to the first principles of curating cash, that some other party, minimally, could derive cashflow from, such that if they were differing participants in the capital structure, they could have different outcomes. Therefore, there was some nonequity risk to be taken thoughtfully.

Furthermore, when you looked at that advance and the resulting cash balance and the cash burn of the enterprise, something that was never priced in was the fact that as companies got closer and closer to not having cash, they started conserving cash. If you were an interest payment versus all the other uses of cash they had, you would be the last to go, so to speak. Inevitably, burn was not just, “Here’s the cash on my balance sheet. Here’s the current cash. Here’s the time at which I’ll have cashed out.”

You would have a gently sloping logarithmic decline in overall cash burn as companies dealt with their issue. The venture lender, as an arithmetic fact of the matter, could say, “On its face, if things go terrible here, I’ve got $0.46 of interest in principle before this thing goes cash out and some additional value that may be derived from its hard asset value or other monetizable valuable by a strategic. On a systematic basis across a diverse pool of these things, given that logarithmic trend that was not modeled into the outcomes, it might have been $0.68.”

Suddenly, if you advance a little less, you’re going to systematically have that much more chance of being covered. As a result, across that whole portfolio, you’re going to have that much greater chance of a new round getting raised at which point all your risk is out. You may then be appropriately compensated by a series of options or warrants that you might receive, such that when you put it all together, there was a very thoughtful, actuarially, determinable, and favorable return per unit of risk to be had without ever taking a venture capital risk. That’s a mouthful but it is mathematically provable. It’s math that can work at times and then cannot work at times when it becomes overdone. We’ve seen three cycles of this since the ‘90s.

Everything you said sounds complex but the reality is that a venture alone is typically a short-maturity loan, 3 or 4 years. It’s a floating rate so it doesn’t have interest rate risk. It’s usually well-collateralized in the sense that the loan-to-value is very low. What we see in the market is the LTV on these loans from the better lenders is in the 10% to 15% range typically. You’ve got this cushion. It doesn’t necessarily mean it’s collateralized by all hard assets but to your point, there’s a lot of residual value in these companies. They’re generating revenue. They’ve got contracts, customer lists, and intellectual property that has value.

As the investor, you’re taking a low-risk bet on the credit side because you’re at the top of the capital structure and the LTV is very low. You’re also compensated with equity warrants. What a lot of people miss is that you get that upside when the company does well. You’ve got that optionality that other credit products don’t have. To me, that’s what makes venture debt and growth credit such a spectacular potential investment. You’ve got this steady income that you’re earning from the loan but you’ve also got this optionality to have massive upside if the company succeeds. How do you think about that structure being unique and the outcomes that it can provide?

Structure

As you point out, with sufficient diversity not only in terms of position number but even the types of businesses that are financed and even potentially where they’re financed, you can diversify away a lot of the risk, given the extreme asymmetry which at times, infrequently, venture capital bets do pay off big. You can end up when it’s working a risk-adjusted 15% to 20% plus in a low-rate environment with a very difficult time losing money.

As you got to ‘05, ‘06, and ‘07, too much money came in and the math started not to work. Even in the ‘20, there was still too much competition. There was pressure to deploy on the part of some of these enterprises that had become BDCs. As you had to blow up in the venture world, it’s a much better time. The bar is much higher to get capital on seed Series A and Series B. What does that mean? In a world of screaming heights and growth, seed Series A and Series B generically look like 18-pre, 58-pre, and 150-pre. Now, that might be 7-pre, 22-pre, and 37-pre.

 

Ultimately, the asymmetry of the options you’re receiving is going to be potentially better. The amount that you can or might need to advance is going to be lower. The rate you can charge is going to be higher. Risk-free is higher as well. It seems to be that we’re very much in an environment where the left side of the barbell, new issue opportunity, and venture lending are very compelling.

I would point out as well that we have this notion of growth credit, which generically in our mind means a combination of venture lending, distressed debt investing, and direct lending. There are very large-scale enterprises that are looking to borrow $200 million to $300 million whose latest round was $5 billion. They were hoping for $8 and then it’s going to be $2. They delay A so that in their minds, they can hope for the markets to normalize so they can get back to being billionaires to borrow at 15% loan-to-value and pay in the 20s is delightful. Particularly, when they’re faced with a vicious down round from their venture capitalists, that might be very compelling.

On both sides of the barbell, there’s a real opportunity. The other small caveat I’d raise with you relative to your comment regarding floating is it is great to have a floating loan but it doesn’t completely protect you as real estate lenders have learned from diminution in asset value caused by an increase in rates. You may have a much higher loan-to-value. You foisted even more of the overall beta risk onto your counterparty by having a floating rate instrument. Ultimately, if that asset is worth a lot less, you’re a lot deeper into the credit. That is the crux of what real estate credit is contending with. The assets are worth a lot less, even when they are floating.

De-Risking Venture Debt Transactions

There are some great points you made there. When you think about venture debt, what are the keys to de-risking a transaction?

In this environment where the standards of venture capitalists are far higher, there’s a lot more opportunity to look at intrinsically good businesses. In my mind, the ideal venture loan is one where, for instance, there’s cashflow to be had where the borrower is specifically spending that cashflow to grow. We’re one to shut off that spend and you have cashflow again. Therefore, there’s a differentiated return per unit risk to be had by a credit investor.

You can see that in enterprise software, SaaS, and other recurring revenue models. There are other analogs to that in. Some businesses are not even traditionally venture capital type of businesses. Years ago, you didn’t have to be an internet company, a software company, or a life sciences company to get venture capital and have venture capital risks. Early investors like Sevin Rosen, Patrick Cox, Morgan Thaler, or all those very well-known names of that time did restaurants and a whole lot of different things. Look at Patrick Cox’s memoir. It talks about some of these more differentiated businesses he’d financed as a venture capitalist over time.

The quality and the line of sight to real cashflow are going to be much more available to venture lenders because of the nature of what venture capitalists are going to be focused on. On the opposite side of that is the intolerance for what are effectively big binaries. We don’t like big binaries. We saw venture lending opportunities in what were called challenger banks and other financial institutions or neobanks. We would joke among our colleagues that neobank is a term for a bank that makes no money.

Startups are the innovators. They're creating value. They need to get funded. Share on X

If that fails, there’s no cashflow. There’s nothing to get out of it or harvest. Therefore, everybody in the capital structure, no matter how high, is taking a binary loss at all risk. Therefore there is no nonequity exposure to be had. Therefore, we should not be there. The killer is when you start providing equity for debt returns and venture lending your debt. It does require a lot of discernment if you’re going to be successful in it through cycles.

A key point that I hear a lot and that a lot of folks will say is venture debt to me sounds like debt returns and equity risk. If done right, it’s the exact opposite. It’s equity returns plus some but with senior debt risk. It’s funny because to your point, when the market was peaking in 2021, there were a lot of folks who were making venture loans, even SBB that weren’t, in my mind, being compensated adequately for those risks.

Making a venture loan at a prime rate when the prime rate is roughly 3.25% is not a good bet or investment. It’s silly. There was a business model that they had that made that viable that we won’t necessarily get into. In simple terms, they mispriced the risk. A lot of that’s coming home to roost and we’re starting to see in the earnings calls that the public venture lenders are having trouble.

They’re pulling back. They haven’t deployed much new capital. They’re going to be quite hamstrung by their existing portfolios going forward, which makes new lenders or folks that have balance sheets dry powder. It puts them in a pole position essentially to be looking at every deal while being able to be very selective and having better transparency into these companies.

The winners are going to be backed strongly by the VCs still. You’re going to get much lower equity valuations at this point in the cycle, too. You’re going to get more equity warrants and get them at a lower strike price and ultimately, a much lower valuation. There’s huge potential for new originations in this next part of the market cycle. One of the questions I had for you is why aren’t more people doing this?

I started looking at this a few years ago and had worked at three very large trillion-dollar mega asset managers and banks. I thought that there’s not a lot of money to be made in commoditized products where there’s no informational advantage. Everybody’s seeing the same information. Success is beating a benchmark by 25 basis points in fixed income. I thought that wasn’t what I wanted to spend my career doing.

I started looking into the private markets and venture debt for many of the reasons you outlined, which stood out to me as a tremendous opportunity. It’s gotten better, which is amazing. I thought this was a grand slam opportunity years ago. To me, I can’t miss it. It’s almost like a home run derby. It’s not even a live game. There’s a lot of new pitches and you can knock them out of the park. What do you think the opportunity set looks like going forward? Why aren’t more people trying to jump in? What are the barriers to entry, in other words?

Barriers To Entry

The barriers to entry are not high. The barriers to inclination might be high. It’s a world where people want to asset accumulate. This is not something that’s going to be a $10 billion fund without doing very poor risk-adjusted returns. One of the best ways to be a venture lender is to be incredibly incremental from a structural perspective.

 

It means, “Here’s a $15 million or $20 million line. I’m going to give you a three. You’re going to do these wonderful things, at which point I’ll have no problem giving you another four because you completely de-risk me. If these further wonderful things happen, then I’ll give you another seven.” It’s tiny bits at a time with high monitoring and a lot of surveillance. Frankly, in a workout, it’s very work-intensive.

The second piece is there’s been traditionally a unique relationship between venture lenders with their venture capital counterparties. In earlier stages of the venture lending life cycle or timing many years ago, I saw instances where venture capitalists supported enterprises and wrote checks. If I were them, I wouldn’t have. They did it not just because of their views on the business but it seemed like they were looking at their creditors and stakeholders to a nonzero extent and saying, “I’m going to support this thing.”

PE firms even did that a little bit. Now, it’s a free-for-all. They’ll soon write the check. That creates a dissonance because you’re like, “I want the venture capitalists to love me. I know they’re going to protect me when things are bad like the leverage lenders to the PE firms.” It’s ridiculous but it persists in that marketplace. There’s a bit of a Stockholm syndrome problem. The equity investors’ behavior has certainly materially changed on a secular basis and will only become more bloodless, not only with regard to their creditors but also their fellow equity holders.

It’s probably time for what we would call a tough but fair way of dealing with these folks. We have seen extreme reluctance on the part of certain venture lenders that we know that have grown-up conversations with venture capital backers of enterprises where things are not going that well. That’s scary. If I’m junior in this capital structure, I have an out-of-the-money call option, and I’m willing to diminish the value of your in-the-money position to benefit my out-of-the-money call option, that’s fundamentally wrong. That’s not okay.

Covenants and that relationship should be set up so that that is precluded. You start to hear, “You won’t be founder-friendly.” The reality is no one was borrowing from you because they were looking to be your buddy. They saw from their perspective the capital that might have been overpriced relative to the debt risk it was taking but was still accretive in their view of what the ultimate equity value was going to be. Otherwise, they would have raised equity, and they didn’t.

There’s a material evolution in that conversation. If I were a global mega asset manager, I’d go, “Wait a second. It’s hard to scale this thing. I can’t put out multiple billions. A lot of the guys who do it are overawed by the counterparties and cheerleading for the counterparties. I don’t need to do this.” That’s why people don’t do it but there is a business there. It can make sense but it requires a tremendous amount of discipline.

I 100% agree. People ask me this all the time as I’ve been raising capital for ARI, our venture debt opportunities fund. One of their questions is always, “This is such a good idea. Why hasn’t somebody done it before?” I said, “I don’t know. Did you ask Mike Milken the same thing when he was reinventing or popularizing the junk bond market?” Sometimes there has to be innovation.

I want to hear your thoughts on this. I think it’s because it’s too small for the big players and the smartest players to care. If you’re already at a large firm, you’re not going to put all this effort into launching a $300 million to $500 million fund when you’re working on launching a $15 billion credit fund. If you’re talented enough to run a smaller fund successfully in a product that’s pretty complex in many ways, you’re already probably making a lot of money somewhere else.

People should be thinking about what is true liquidity and whether it's there or not. Share on X

You have other things that you’re thinking about, too. Oftentimes, you have a family and you’re in a certain geography. You’re not going to give up your job, making a couple million bucks a year on Wall Street to go launch a fund that’s going to be a fraction of the size of your current fund and potentially disrupt your personal life. There are a lot of factors that go into this outside of pure numbers. There are a lot of variables that people don’t contemplate.

To me, the biggest reason is it’s too small and that the people who are smart enough to do it well already have something going that they choose to do over this. I was a little bit of an exception because I wanted to build something innovative. I felt like venture debt had the opportunity to be revolutionary. More so now than ever, it does because there’s a huge gap in the market. This is a product, if you will, that’s fundamentally needed. It’s not some BS Wall Street creation.

This capital is needed by startups. Startups are those that are creating most of the value in the economy. Innovation is what creates value. Startups are the innovators. They’re creating the value. They need to get funded. They’re starting to learn, “There are other ways to fund my business outside of just equity. As a founder, I’m incentivized to keep as much as possible of the company that I’ve built.”

You talked about alignment. Founders don’t want to give away their company to Sequoia or somebody on Sand Hill Road. They want to keep as much as possible. When they’re given the option to utilize debt, which is far less dilutive and also cheaper, therefore, they keep a bigger stake in the company they built, they’re going to choose that option if they understand it fully. In my opinion, it’s 10 times out of 10. As an entrepreneur, I would and so would you, I imagine.

That’s part of the reason why venture debt has a huge upside. The pie is growing as the innovation economy grows. Within that pie, the venture is going to become a larger share. There’s no reason in my mind that revenue-positive companies that have the ability to service that shouldn’t have some in their capital structure. To your point, leverage is incredibly important.

The idea of milestone-based financing, incremental financing, or delayed draw loans is very important because it enables the company to draw on this capital but in a measured way where they’re not getting over their skis in terms of leverage. It also protects the lender but ultimately, they should have some debt in their capital structure. The amount of debt depends on the company and its financials. You need to think of what’s optimal based on each bespoke instance. Generally speaking, companies that have the ability to service debt should always have some in their capital structure, in my view.

I wouldn’t disagree with that. You mentioned Mike Milken. Look at the W. Braddock Hickman study upon which he based his thoughts on the high-yield market. The reasoning around return preemptive risk that got him there is very similar to the way in which you would get to that same conclusion within venture debt. For anyone geeky enough to care and want to dig in, getting that study is interesting because it may provide you with a scaffolding or framework to analyze the reality of the risk-optimized nature of venture lending.

If you were to summarize it, give us a little sneak peek of how would you do so.

 

It says that the average returns of high-yield or noninvestment grade bonds more than offset the incremental severity-affected defaults.

Investment Opportunities

It’s very complex in many ways but also very simple intuitively. Dan, I wanted to give you the opportunity to leave us with some parting thoughts. That could be anything you’d like but perhaps where you think people should be focusing their investment opportunities or capital deployment over the next few years. That’d be an interesting place to start.

It depends on what people you’re talking about. If you’re a retail investor, I’d be looking at shortest duration investment grade or near investment grade fixed income for the first time in a long time because it can make a lot of sense. It should be the benchmark against which people should look at other alternatives that might have marginally more risk but consequently require a lot more return.

People should be thinking about what is true liquidity, whether it’s there or not, what their day-to-day needs are, and what they can afford to have locked away, no matter what the terms of the investment documents say. Further, it’s worth thinking through the left tail risk of something much graver happening. We saw comments from Jamie Dimon. We see Berkshire with $150 billion in cash. Those are not coincidences. Very bright and experienced people think that there is a left tail risk out there that hasn’t been encountered yet. Making sure there’s some amount of resources to make one comfortable when and if that occurs is an important thing to be thinking about.

Thanks again for coming on. This is PhD level, plus some. A lot of people will have to probably read this 3 or 4 times but when they do and understand what you’re talking about, they’ll come up with some tremendous insights.

Thanks very much for having me. I enjoyed it. I’ll be happy to connect soon.

It was my pleasure. Thanks for tuning in to the 7in7 Show with Zack Ellison, everybody. See you next time.

 

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About Dan Zwirn

Daniel Zwirn began his investing career in 1995. Dan founded and built D.B. Zwirn & Co., one of the largest independent firms in the alternative credit space.

He has participated in over 3,000 illiquid investments in 25 countries, accounting for over $10 billion. Dan most recently founded Arena Investors and is the firm’s Chief Executive Officer and Chief Investment Officer.