Venture debt has moderate risk, yet offers better returns: Rahul Khanna

Venture debt provider Trifecta Capital will raise more capital than it had targeted for its maiden fund. Rahul Khanna, the firm's managing partner tells Ranju Sarkar how venture debt is becoming a viable option for both investors and start-ups in India. Edited excerpts.  

Are investors (LPs) seeing venture debt as a more viable option than venture capital, like structured debt in realty?

Each asset class has its own risk-reward profile and most institutional investors have created an asset allocation framework to achieve their target returns by investing across multiple asset classes. As interest rates have moved downwards, investors are seeking out alternative investment strategies to maintain their fixed income returns targets. Over the last few years, venture debt has emerged as an asset class that has moderate risk yet delivers superior returns as there is an equity kicker in most venture debt investments. Accordingly, venture debt is not an alternative for investing in venture capital funds (equity) but instead an opportunity to participate in the venture ecosystem through a high-yield strategy. All our investors have made allocations to the Trifecta Venture Debt Fund-I from their debt portfolios and we expect this asset class to grow significantly in the coming years.

Is this because venture capital in India is yet to see significant exits and returns?

There are multiple factors that make venture debt attractive to Indian investors. First, the return profile of venture debt fund is a combination of regular, predictable interest income combined with an equity kicker in the latter part of the fund life. The debt is secured and the equity is in the form of options so minimal capital is at risk. We have distributed income to our investors from the first quarter of the fund's existence and this helps set the floor rate of return. Second, the term of our fund is medium duration (seven years) and the capital is called as and when new investments are made. This is quite attractive relative to some of the other longer duration funds where returns are typically much later in the fund life and hard to predict. We have already drawn a substantial portion of the fund commitments and expect to be able to recycle the capital one more time during the life of the fund. Third, there is a well-defined risk management framework and a clear strategy to focus on high performing companies that are backed by top tier VC funds. This helps keep the typical loss ratios to low single digits. Lastly, the profit sharing of the fund manager is completely aligned with the interests of the investors and is modelled on best practices from the US venture debt market.

How does venture debt stack up vis-a-vis venture capital in terms of exits and returns for investors?

Generally, venture debt funds have a target return profile of 15-20 per cent (net of fees, expenses and profit sharing) while venture capital funds target 25-30 per cent returns. It's too early to comment on relative returns as we have only been operating for 6 quarters but we are confident of achieving the returns that had been promised to investors.

You expect to surpass your target for the first fund by Rs 200 crore. Did you expect this when you started?

We started fund-raising in early 2015 when there was very little awareness of the venture debt asset class amongst Indian institutional investors. Equally, venture capital investments were at an all-time high as new offshore investors were aggressively deploying capital in India. Given this context, we tried to model the demand for venture debt between 2016 and 2020 as a subset of the venture capital market as globally venture debt is approximately 10-15 per cent of total capital deployed into venture backed companies. Back then, we assumed we could deploy around Rs 150-200 crore a year and so gave ourselves the target of raising Rs 300 crore with a green shoe option of Rs 200 crore based on market demand and investor appetite. Since we used no third-party distribution to raise the fund, we had the opportunity to interact extensively with chief investment officers of some of the largest Institutional investors in the country who gave us lots of feedback during the fundraising process. Having seen the fund performance during the first year of investing, several of our investors increased their allocations to the fund and this gave us the confidence to exercise the green shoe option. Equally, the market for venture debt has grown significantly and we are confident of being able to deploy the additional capital raised into some very high quality companies.

We see more and more start-ups raising venture debt. Is this because they are unable to raise equity?

After the highs of 2015, the venture capital ecosystem went through a correction phase. Capital did become harder to raise and valuations corrected significantly. That said, the best companies were in strong demand as there was a flight to quality. As entrepreneurs became more aware of the cost of equity capital and equally had achieved some scale where they needed working capital, receivable financing, asset financing and to some extend runway extension, venture debt emerged as an ideal option. By using a judicious combination of equity and debt, companies can optimise their cost of capital, minimise dilution and enhance return on equity.

What's the opportunity, annual deal flow you see in venture debt? Can the market absorb a couple of more players?

The venture debt market is tied to the growth of venture capital in India and based on our estimates, the Indian market can absorb about Rs 10,000 crore of venture debt between 2017 and 2020. In general, venture debt is a specialised asset class and therefore requires a deep understanding of both venture capital and fixed income investing thereby making it difficult for traditional lenders like NBFCs to service this market.

Are start-ups being able to service their debts in time? Have their metrics improved since you started investing?

We have been quite pleased with with debt servicing by our portfolio companies. To date we have not had a single default in our 21 company portfolio and expect that they will continue to service the debt either through new rounds of funding or getting to profitability. About a third of our portfolio companies have already raised subsequent rounds of funding and this has led to a healthy appreciation of our equity options in these companies. We continue to be very focused on serving the needs of these companies by supporting them with business development, partnerships and capital raising.