Will The Sub-Prime Debacle Derail Venture Lending?

The unraveling sub-prime mortgage market has spewed its wreckage across a vast cross section of the financial markets. Investors and lenders continue to smart from massive losses on investments and loans tied to this market. As some scramble to assess the implications of the sub-prime meltdown, many investors and lenders have either abandoned higher risk asset classes or are approaching them with great caution.

Residing in a far corner of the financing panoply is a financing vehicle known as venture lending. This form of financing is used by start-ups supported by venture capitalists as a means of funding working capital and equipment acquisitions. A less expensive form of financing than venture capital, start-ups use these loans to extend the runway between equity rounds and to avoid ownership dilution.

Venture lending is in the midst of a strong rebound that started in 2003. This segment is recovering from a sharp decline that followed the bursting of the ‘New Economy’ bubble earlier in the decade. During the late 1990s, prior to the bubble burst, equity investments in start-ups topped $100 billion. That staggering amount of investment stoked unprecedented growth in debt transactions to start-ups, which reached almost $ 5 billion during the same period. The technology meltdown and economic slowdown that followed caused start-up lending to contract to around $836 million by 2003. By 2006, as the market steadily improved, loans to start-ups recovered to around $ 2.5 billion.

Although venture lending is rebounding, it appears as vulnerable today as it did at the beginning of the decade. Earlier in the decade, a confluence of factors sent shock waves through the start-up lending segment. Rising failures and delinquencies by start-ups, a slowing economy, a contraction in venture capital investing, overaggressive lending practices and questionable lender business models sparked widespread faltering in this lending segment. Publicly-held venture lenders like LINC Capital and later Comdisco, that embraced this segments higher yields, rapid growth rate and favorable perception on Wall Street, were slammed by investors. Ultimately, these companies foundered as their losses mounted, they violated their credit agreements, and they were cut off from essential equity and debt capital sources.

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Similarly, large diversified finance companies with start-up loan portfolios reeled from mounting portfolio losses. Venture lending groups within Transamerica, DVI and GATX eventually folded or were jettisoned as a result of the turmoil. Smaller, private lenders were largely closed off from new funding to support their venture transactions, forcing many of them to abandon lending to start-ups or to liquidate their portfolios. The few lenders and leasing companies that remained gravitated to more stable segments of the market. Many curbed their volume dramatically by focusing on smaller, better collateralized transactions.

Banks and investors that supported venture lenders also reeled from the fallout. As several lenders either collapsed or faltered, the banks and investors that financed these companies realized huge losses. As a result, many lenders and investors began to shun start-up lenders and other risky transactions.

Today, havoc in the sub-prime lending market and a possible economic slowdown threaten to derail venture lending. Some of the same lenders and investors who participate in the high-risk end of the securitized mortgage arena also participate directly or indirectly in financing these lenders. These financing sources are now running scared.

Lastly, most lenders to start-ups rely heavily on their borrowers receiving multiple equity rounds to achieve loan repayment. During the technology meltdown of 1999-2002, many venture capitalists focused almost exclusively on supporting the most promising companies in their portfolios. The weaker portfolio companies were subjected to a Dr. Kevorkian-style triage process that saw many of them abandoned. As a result, many of these start-ups starved from the lack of capital and failed. If this process is repeated, assuming there is an economic slowdown, it could spell big trouble for venture lenders.

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Will venture lending become an unwilling victim of the sub-prime debacle — one of the minor rail cars dragged by the sub-prime locomotive over the proverbial cliff? Only time will tell. Much will depend on the performance of the economy during 2008 and on the responses of the banks, institutional investors, start-ups, venture capitalists and the lenders who participate in the start-up market.