S1E5: Venture Debt with Alkarim Jivraj from Espresso Capital

Foreign.

This podcast is brought to you by Gensler Wealth. The information discussed today is meant to be general in nature and not tailored to your specific investing circumstances. This means that you should talk to your regular Gensler wealth advisor or your own advisor before acting on any information we discuss today. Nothing in this podcast is intended to be a solicitation, and past performance does not guarantee future returns. And a hint. We always ask our guests the same question at the end. Stick around and find out our guest's answer today. Today on the Gensler Wealth Unlimited podcast, we have Alkarem Givraj, CEO of Espresso Capital, a very focused venture debt lender based out of Toronto. Let's hear what venture debt is all about, why it may not be as risky as it sounds, and how Espresso has been successful in the space. Welcome everybody. We're here for the Gensler Wealth Unlimited podcast. Really pleased to have Al Karim Givraj, who's the CEO of Espresso Capital, a venture debt lender. It's a unique asset class that I don't think everyone's aware of. Everyone's heard, I think of venture capital, but venture debt is a little bit of a deviation. So really excited to have Al Karim here. Thank you very much for joining Alkarim.

Thank you very much for having me on your podcast.

Great. So maybe before we dive in on Espresso, which I do want to find out a little bit where that name comes from, but before we dive in, maybe a little bit about yourself and how you came to be the CEO of Espresso. A little background for our listeners.

Absolutely. So my career background began in investment banking, technology investment banking, and then I went on to start a small venture capital fund. Concluded that first fund and when I was about to launch a second one, I came across Espresso. The company had been. So this is 2013. The company was launched in 2009 and so I was really intrigued by its unique brand of private credit in the Canadian context. I thought there was a huge opportunity and so I joined and it's been a great ride since.

And so the company existed before you obviously became CEO there. So what was the happenstance for meeting and what attracted you to Espresso?

Yeah, so as a technology investment banker, I raised capital mostly from VCs and other private market investors or technology companies and then took them public. And so lots of exposure to the category, but was aware of venture debt, which is lending to the same companies except on the credit side versus the equity investing. And when I saw the performance of the asset class in the unique way the loans were constructed, you know, the light bulb went off for me and I said, this is probably a category that, because it's more complicated, because it requires specialized skills, is going to be less well served. But from a risk perspective, it should perform very well. And so the combination of low loss rates and getting higher yields as a result of being in less well served market, and so that's. That was really the inspiration for me. And then, you know, Espresso was a small fund at that time. I think it was 10 million when I joined. Three years later, we bought the business and it was, you know, it was 20 million in size, and today we're 330 million. So just validating the fact that I saw a huge opportunity and we've been able to capitalize on it since.

Amazing, Amazing. That's great. And I definitely want to dive in a little more to venture debt itself. But before we do, you got to tell me the story of Espresso. I'm a huge coffee fan. I have Espresso, you know, twice a day. It's like my favorite thing. So where's Espresso come from? And why that name?

So this may sound like an urban myth, but it's the absolute truth. Two of the original founders of Espresso were talking about the concept of the business, were sitting in a coffee shop. At the end of their session, they decided that this was a good idea, they wanted to move forward with it. And so came up the question of what should we call this business? They happened to be having cappuccinos. And so one of the. One of the original partners said, well, how about cappuccino? And the second said, ooh, I like that. I had a coffee reference, but I think our cappuccino is going to be hard to spell. How about Espresso it?

Right.

And it's stuck ever since. And it was. The whole idea was, you know, a little jolt of capital to help you grow.

Right? Yeah. Makes sense. That's my morning and my afternoon. A little jolt of Espresso to keep me going. So maybe now let's just do a little bit of a deeper dive into this. This asset class called venture debt. As I said at the beginning, I think everyone knows what venture capital is. It's all over the news. It's in all the papers. I can't recall, aside from through meeting you and your team and, you know, studying your company for many years and now in full disclosure, allocating client assets to your fund, which, which we like venture Debt is just not a phrase that I'm seeing or reading about in the sort of daily news or the financial papers or whatever it is. So back to basics 101. What is venture debt? How does it work? And maybe just explain your process there.

Absolutely. So venture debt is lending to companies that have venture capital as their equity source. These companies tend to be high potential, high growth companies. And to give you a context, venture debt is a small portion of the total capitalization of venture capital companies. This data is a little anecdotal, but last year in the United States, $330 billion of venture capital was deployed and I think about 30 odd billion of venture debt. So that's kind of the gearing ratio, 1 to 10. And the reason why venture capital stage companies borrow venture debt is principally reducing dilution. So that's one motivation. The other one is the journey of venture stage companies. Never a straight line, you know, it's kind of a step stage. And so sometimes you need to extend the Runway before your next round. So that's where venture debt can come in. Sometimes the company has, you know, working capital needs. It may be collecting its revenues and arrears or you know, it may be, it may have a hardware component, so it needs physical inventory to assemble its products. So all of those things also are a use of Internet. So that's, that's kind of what venture debt is relative to venture capital. And then in terms of how venture debt works, mostly it's applied to a particular subset of venture capital stage companies. It's mostly applicable to companies that have subscription or recurring type revenues whose growth rates are pretty predictable. And you know, the math often is you need to spend a dollar upfront to get, you know, 70, 80, 90 cents of recurring subscription revenues that will last you for 10 or 15 years. And so that's kind of the nature of the company. These companies, you know, apart from growing rapidly because they're young, getting bigger, they're also benefiting from a secular growth trend as computing shifts from, you know, on premise, your office to the cloud. So servers to the cloud. So that's a big driver around these companies. And then on the flip side, you know, these tend to be different from mid market loans in the sense that, you know, buy out loan, for example, maybe 60, 70, 80% of the capitalization of the borrower, whereas the venture Debt typically is 10 to 20% of the capitalization of a borrower. So low leverage loans, they're all secured loans, as you know we spoken about earlier, they are equity sponsor backed the equity sponsors in this case are the venture capitalists. And then, you know, the last component is it requires to do this kind of lending. You know, you really need to understand early stage companies. You need to be able to assess them in terms of, you know, are they creating economic growth? You know, they, they will typically have high growth rates, but they will also be negative EBITDA because they're consuming cash. And so it requires a more specialized skillset in analyzing those things. And then the last is unlike a portfolio of mid market loans, a venture debt portfolio needs to be actively managed because the companies are continuously, you know, raising capital and so on. So that's, that's venture debt.

Okay, so just a few questions following up on that. Number one, I do want to dive a little bit into the sponsor backed portion of what you mentioned because I think there's a bigger piece there that's pretty important and adds some sort of risk control. Perhaps that'll be maybe question two. But the first question, which I think is pretty obvious, but just for clarity, as you say, many of these companies are EBITDA negative, but debt obviously has an interest rate associated with it. So how are these companies servicing their debt obligations or their interest payments? And actually what other, if any sort of compensation does the venture debt fund get for lending to these, to these entities?

Great questions. I'll frame it in the broader context of the journey of a company. You start it up, you raise some pre seed capital, you build a product, you raise some seed capital, you go to market, get some customers, show enough traction, then you raise a series A round and so on. So you know, every 12 to 24 months these companies are raising more money and most of the money is coming from the venture capitalists. And each round that you raise based on the success you've had, the valuation of the business continually goes up. Right. So the first point is that, you know, the companies are using the money that they have to fund growth, to hire employees, to spend on marketing, to continue to develop the product. And a small portion of that money also goes to service the debt because they've purposefully opted to raise less equity and use a little bit of debt in that mix and therefore benefit from reduced dilution. But it increases marginally the service cost. Right. So that's typically how, how these companies are financed. And that's why, you know, notwithstanding it's an EBITDA negative company. They're continuously raising money to fund their growth needs, including servicing their debt. Which brings us to the second point. These sponsors typically are invested in any given company for seven years on average. And so they take a long term view. These are private companies, so they don't go up and down in value every day based on the, you know, where, where the stock market is trading. They're valued really by their fundamentals. And so that is an important part of the story around why venture debt is an attractive asset class. Because you've got this long term investor that's backstopping the company who represents 80% or 90% of the capitalization of the company. And therefore they're patient investors, they take a long term view and effectively they're a backstop to the loan.

That makes sense. And just the follow on to one of my other questions. Aside from an interest rate, is there any other terms that as a venture debt lender you're able to extract? I say extract, but in a nice way, of course.

Absolutely. So the typical terms of a venture debt loan would be an interest rate. And you know, that interest could be, you know, 90% cash pay every month and maybe there's a 10 or 15% paid in coming, so just adds to the loan balance. There may, there's typically also a minimum term to the loan. So let's say a minimum interest period of a year and a half, two years. And so if the loan repays early, you know, that's, that, that's a prepayment penalty that the borrower must pay. So that's another form of income. And these loans tend to be pretty short duration. So you know, certainly in our case we regularly supplement interest income with these prepayment fees. And then, you know, there may be an exit fee at the end which is just another form of compensation to the lender. And then finally occasionally there are going to be warrants. And so that's kind of the total package. You know, we, we always seek to optimize what we can get. So you might trade a little bit here for that. But that's generally how borrowers compensate the lender and what forms the basis of investor returns.

Great, thank you, that's clear. So maybe going back to a sort of a question from before venture capital, well known to folks and I think everyone would agree and would say if you had to, you know, place some characteristics on venture capital, it's more risky investing. You're in early stage companies, you don't know if they're going to be successful, there's always a chance you could lose your money, etc. And then you've got venture debt. So it still has the venture in front of It. But as I've learned over the many years that I've been speaking with you and your team, it may not be as risky as it sounds. You know, the venture word can scare people sometimes. So maybe just a quick high level. How do you view the risk of venture debt as you think about it from an investor's perspective? And why might it not be as risky as maybe the headline sort of phrase might have folks believe?

Absolutely. So you know, venture debt typically comes in when the company's gotten far enough down the road. So you know, the first challenge for a company is to validate that there is product market fit. There's a product that the market wants and needs. And then the second stage is, you know, showing that there's customer traction. Meaning I've figured out how to sell this to customers and deliver it and provide the service so that customer is getting the value that they seek from the solution. There's obviously challenges of hiring and staffing and being able to build a good culture. And so all of those things are, are, you know, what drive success. And so typically as a lender, you know, we are entering into these deals when they've got revenues, when they've got customers, when they've proven those things out. So you know, therefore they're inherently less risky than a brand new startup that has a concept or an idea but hasn't built the product, hasn't proven our product market, that hasn't proven out the ability to scale. And so, you know, a lot of the losses in venture happens a lot earlier than when venture debt lenders show up. And then secondly, you know, within the venture world, you know, we're focused on a not only later stage, but also companies of a particular type of right, they have subscription revenues and so their revenues are going to be predictable and very, very sticky. You have seen their growth rate in the past. So you can project that into the future. And then, you know, in the event that there's dislocations in the market, these companies, even though they're burning cash to grow, have the capacity to say, you know what, we're going to pull back our sales and marketing investments. We're going to operate at break even for a while until, you know, the market circumstances change and we can lean in again. So you know, that's an important element of safety. And so that is a big part of why it's not risky as it might sound. And then the last part is the lenders are only represent 10% of a business. And so there's a lot of Room for the equity to be compromised before it's actually impacting the loan. And you know, the motivation of venture capitalists is to try and maximize return on their equity so they will sell that business well before it kind of gets down into impacting the lender. And so that's one of the reasons why, you know, venture debt as a private credit asset class has performed better than almost all other private credit asset classes from a loss perspective.

Oh, wow. That's a great sort of qualitative summary of the risk side. Maybe then to flip it, give us a little bit of a sense like Espresso has been doing this for 11 years, give or take. What's the experience for you, your team, your investors, I guess in this asset class just maybe from a loss perspective or whatever metrics you think make sense to highlight sort of the risk side.

Yeah, so we look at really three things. Number one is what's the, what's the return we've delivered to investors? And so in our case, it's been an average of 8% or better over 12 years. Second is what is the loss rate? You know, what are the, of the dollars you've deployed, how much of that has, have you lost? And so we have deployed 930, 40 loans to 330 odd companies. So a large volume of activity and our cumulative losses over that 750 million or more that we've lent out over our lifetime has been 60 basis points. Or if you said what is that an annual? It's about five basis points on average. Five losses don't happen every year. Five basis, they kind of happen occasionally and then averages out.

Right.

So those are the two metrics that you know, are most important. What's your return profile? North of 8, what's your loss profile? Call it 5 basis points per year. And then the third is how much volatility is there in the year to year performance. And that's the other arena where venture that really sings. It tends to be really, really consistent because the losses are so low.

Wow, that makes it clear. And then maybe just sourcing. You know this as you gave the relative size of this market relative to venture capital and venture DEB 30 billion or so last year, I think you mentioned how competitive is it to find these deals? I think if I'm not mistaken, you're, you personally are located in, you know, various geographies at different points in time to be close to, you know, the right potential investment opportunities. Maybe a little bit of color about, you know, how do you source deals? How do you Find them. And then actually maybe even a little bit of how do you due diligence before you get to the final pulling the trigger. Because that's, that's maybe the most important part.

So in terms of sourcing deals or one step back in terms of winning deals, to win a ventured debt deal, you need to sell to two different audiences. You need to sell to the management team of the business, the founders, and then you also need to sell to the sponsors because they have an important say in who's going to be in that capital stack. And so, not surprisingly, once a sponsor gets to know you, they'll want to come back and do repeat business with you because they know how you behave when things are not going so well. And so they're one of those most significant sources of deal flow for us. And we're continually meeting new sponsors and telling them about us. And, and if they're intrigued enough, they'll say, you know what, we'll give you, we'll give you a try on the next opportunity. And then two weeks later we get a call and say, hey, I've got an opportunity. Are you interested? You know, give us a build that, give us a brief description of what it is. And so that's, that's one source. The second source is, you know, there are lots of intermediary agents, accountants, people who serve the companies who say, you know, I was on a deal last month with Espresso seems, seem like really nice guys. They were a pleasure to do business with. You know, you should chat with them. So intermediaries are another source of deals. And then we have our own, you know, our, we're always in the market. And so we've got our own outbound marketing function. And so we are outreaching people with white papers and webinars and that type of thing. And so that's the third source of deal flow for us. And then your second question is, what's our process? So let's say a VC introduces us to the company. Then we have an introductory call, which we call a qualification call. We ask them a whole bunch of questions. And that stage is just to figure out if this company fits our box. And if it does, then we say, hey, sounds like you got a great business. We'd love to learn more. Can you provide us with the following documents? And typically it's, you know, we want their historical financials, we want their forecast model that's in great detail. We'll often want to look at their customer billing data or customer data just so that we can get into the details around, you know, what's the churn rate, what's the retention of customers, what's the upsell rate to all of the unit economics of the business? And then, you know, if, if, if upon that deeper dive it makes sense, we'll speak to our investment committee and say, hey, here's a loan we're thinking of doing. This is the industry it's in, these are its numbers. The committee will say, okay, that looks good, go ahead. Or you know, they may have some questions or they may say no. And then the next step is for us to issue them a term sheet, negotiate that term sheet. Once the company signs it, then we go deeper on diligence again. And so this time, you know, we're looking at their technology, we're looking at their investors, we're looking at and really every aspect of the business. The underwriter then prepares an investment memo and presents to our investment committee who approves or rejects that investment. Then the file is then handed off to our back office to set up the loan, to document the loan, to close the deal, to fund the loan. And then finally, the work doesn't end when the loan is funded because on a monthly basis the company is sending us reporting. And we look at that reporting to see how the business is doing relative to its plan. If you know the company is behind plan, then it triggers a conversation to figure out is this just a timing issue or is this a, you know, a fundamental problem that needs attention and resolution. And that's really how we manage these loans very actively. We're very close to it, we've got a lot of data coming in from the company and so in some ways we have the same level of access as their sponsors or equity investors.

And I understand you've actually built your own proprietary software system to monitor your portfolio companies very, very closely. Pretty unique, I must say.

Thank you. It's really helped us to focus on, focus our team efforts on assessing how the company's doing as opposed to taking all the data, downloading it, putting it in a spreadsheet, you know, looking up the loan documents, figuring out what the covenants are, calculating covenants, all of that work is automated. So the high priced help really focuses on what, focus on what they do best, which is figuring out is there a problem and if there's a problem, engaging with the customer to have a conversation.

Got it. Great. Well look, that's a good sort of start to finish on venture debt. One question before I let you go and I appreciate your time again, maybe, maybe a little bit on the fun side here. You know, obviously this is a unique asset class. We strive at Gensler wealth to have sort of unlimited options out there for our clients and not limited by the traditional stock and bonds or some of the other stuff that, that, that folks do. So question for you. Just as a little bit of a get to know you. If you had unlimited things in the world that you could be doing as opposed to being CEO of Espresso, maybe you might say you want to do that, but unlimited options, you could be doing anything you want right now as opposed to talking to me. Because there's probably lots of things you'd rather do than talking to me. What would you be doing?

I have a real passion for travel and adventure travel and so in my next life I'm certain I will want to do something around that industry. There are great companies like Abercrombie and Kent and Backroad who meld culture and activity based curated travel. And I think that that, and maybe, maybe it's reflecting my age as I begin thinking about the next phase of my life. But yes, I think that that's what I would do.

Okay, well, amazing. I'll join you on a trip. I'm sure it'll be amazing. Al Karim, thank you so much. A unique asset class. Really pleased that you could walk us and our listeners through it. Wish you continued success with Espresso. Your track record is as you described, it is quite spectacular, continues and no doubt it will with you and your team's skill and expertise. So thank you very much. Wish you the best and thanks again for being with us today.

Thank you very much for hosting us.

Take care.

Bye bye.

That was Brian's conversation with Al Karim Jeffraj, the CEO of Toronto's Espresso Capital. Hopefully you now have a bit better of an understanding of the differences between venture capital capital and venture debt and also just enjoyed their discussion. Please note that Ginsler wealth has invested with Espresso in the past and may continue to do so in the future. But this recording does not constitute investment advice nor an endorsement. This has been a Gensler wealth audio production. The unlimited podcast is hosted and produced by Brian Gensler and edited and mixed by me, Katherine Donville. If you're interested in hearing more from us, please like subscribe and give us a five star rating and follow us on all social media. We can be found at Gensler Wealth. See you next time.