"No MAC, No Cov" eventually means No Return

A few hours from now, our firm’s investment committee will meet to look at two new venture debt transactions. It isn’t very often that we’d tackle two at once, and this morning’s schedule got me thinking about some of the trends underway in our corner of the debt market.

During the lead up to the financial crisis, you increasingly heard about mainstream lenders and other institutional providers of capital doing transactions that defied logic. Not in hindsight, but defying logic at the time (see prior post “The debt casino is open again” Oct. 19-07). Post-financial crisis, there have been moments of exuberance, but lenders have largely kept their heads on straight. High yield pricing may seem rock bottom right now, for example, but one doesn’t hear very often about wonky structures getting placed.

It may surprise you to learn, but we don’t win every term sheet opportunity. And when we lose, there are times when the would-be borrowers’ CFO tells us that he/she was able to secure a venture debt loan that had “no” covenants whatsoever.

No “Material Adverse Change” clause, no business performance covenant, no minimum cash test, etc. It doesn’t happen every week, but we are always surprised when it does. Whether you invest in equity or debt, capital providers in the innovation sector know that hiccups are going to happen. Technology folks are certain about that. And these firms are burning cash as they grow, almost by definition. That’s usually the point.

When a venture capital fund supports an entrepreneur with a $5 million Series A or B round for example, they are hoping to make 5 or 10 times their initial investment. Perhaps more. All the while knowing that they might just as well lose it all.

When a lender puts $5 million into that same tech company, the upside is generally quite limited, and the downside is that you might lose all of your capital. The theory about putting a covenant into a loan agreement is simple: if the business plan goes wildly offside, a covenant triggers a “conversation” between the parties about what went wrong, and had is being done to correct it.

If a lender agrees to put up capital without a covenant, they are essentially in the same boat as the equity players, setting ranking aside, but without oversight controls such as board rights or the potential for massive upside gains if things work out as planned.

When it comes to lending to high growth firms in burn mode, taking equity risk for debt upside isn’t a long term business model.

And yet, of the 12 or so firms in the United States who do what we do, a couple appear to have used “No MAC, no Cov” structures to win a term sheet shoot-out in 2014. Which begs the question: do their investors know they are essentially deploying equity at debt pricing?

Let’s say, as a lender, that you did 10 deals like that in a row. If the VC world experience is that 2 deals in 10 go to zero, the prospects for recovery for a lender in that situation are bleak if they didn’t have any performance triggers on their loan as the ship sank below the water.

If a decent outcome in the venture debt space is around 1.3x capital on an individual 2-year $5 million deal, and you happily make that on 8 deals, but lose all of your money on the remaining two, your investors will be left with a tiny return of 4%, before taking into account the cost of managing the firm. On a $100 million fund, the investors in this “No MAC, No Cov” venture debt fund wouldn’t be earning a penny.

Which begs the question. Do the pension plans and other institutional investors putting up the capital have sufficient transparency into how that venture debt capital is being deployed by their venture debt fund manager?

Seems unlikely, doesn’t it.

MRM