Note: 1) Total debt capital 2022 per Dealroom

Media reporting on public and private technology companies in the past 12 months has been dominated by negative headlines: dramatic declines in valuations, down rounds, and tech lay-offs. The Nasdaq composite index was down by 33% in 2022, and the IPO market was effectively shut in 2022 and in early 2023. Private markets were not spared: the declines in valuations held true across the globe – in the US, Europe, and Asia – even if the underlying reasons were different and the magnitude of declines varied across geographies. Much of the slowdown was concentrated in H2 2022, with growth-stage private companies taking the biggest hit, reflecting the late-stage proximity to public markets and macro volatility.

Notably, both the number of companies accessing the debt market as well as the average deal size increased in 2022. Although the average was skewed by several multi-billion debt raises in the energy tech, the median deal size has also increased significantly – €8m in 2022 versus €3m in 2021. Lending facilities – or loans to fintech platforms backed by portfolios of assets such as SME loans, mortgages or hard assets – have seen the same trend: median deal size increased to €150m in 2022 from €95m in 2021, with the average deal size exceeding €200m. By deal count, less than 40 lending facilities were arranged in 2022. 

Definition: Lending capital – loans to fintech and other platforms backed by portfolios of assets such as SME loans, real estate, and other assets. Debt – loans by banks and non-bank lenders directly to companies and including venture debt, growth debt, AR financing, and other forms of loans. 

In last year’s report, “Credit it. Europe rising”, we expected an increase of debt issuance for technology companies in 2022 but the outcome has surprised even the biggest optimists. Several trends – including the improving quality of the European tech ecosystem, favourable M&A environment from a buyer’s perspective, and the less attractive equity fundraising environment – contributed to debt issuance by European technology companies doubling YoY to €30.5bn in 2022. This is despite 2022 global debt capital markets issuance declining 19% versus the previous year, according to Refinitiv, a global provider of financial market data.

The significant uptick both in the absolute volume as well as the number of deals came despite the increase both in the overall level of interest rates and margin (the latter representing the risk of the borrower) as well as the much lower leverage multiples offered by the lenders. Quality technology assets – those with stable recurring revenues and profitable economics – remain in high demand by lenders. As expected, the vast majority of the debt capital has been raised by late-stage companies. Seed-stage companies normally have neither the revenue nor cash flow stability nor the sufficient assets to obtain debt financing. Only 1% of the amount lent in 2022 went to seed-stage companies. 

Unlike in the US market, banks remain the dominant providers of loans to technology companies in Europe, and they significantly increased their market share to over 50% in 2022, even in view of the overall debt issuance doubling. Banks, on average, committed more capital, with the average deal size in 2022 at over €60m, double the average deal size for debt funds. 

Data indicates that banks tend to have lower risk appetite and mainly focus on larger borrowers, often as part of a syndicate to spread risk. The cost of capital offered is generally lower versus non-bank lenders, while the approval process takes significantly longer. Anecdotally, for smaller regional banks, a direct relationship with the borrower at times outweighs risk-based pricing and terms. We note that the failure of Silicon Valley Bank in March 2023 is likely to create uncertainty in the near term. 

In contrast, the provision of credit by debt funds declined to approximately a quarter of the market in 2022 versus over 40% in 2021. We believe this is due to a more challenging fundraising environment in Europe, partial withdrawal of non-European players, and overall risk aversion in light of macroeconomic and geopolitical concerns.

The share of government and non-profit institutions has increased markedly, reflecting the continued efforts by specific European governments, as well as EU institutions as a whole, in supporting the tech sector as an important driver of job creation and innovation.

We have also seen the emergence of new players in the market, with institutional investors and, particularly, insurance companies providing loans directly, rather than through investments in debt funds. While the absolute number of such loans is still small, given the average deal size approaching €200m, we believe direct LP participation will remain meaningful going forward. 

Source: Dealroom

Source: Dealroom

Source: Dealroom

Source: Dealroom

Source: Dealroom
Note: Inner circle represents 2021, outer circle represents 2022

In last year’s report “Credit it. Europe rising”, we highlighted the changing geographic composition as transformative European tech champions are being built across the continent. For this year's report, we worked extensively with Dealroom and the data outlined below show that the dispersion accelerated in 2022: the Nordic region emerged as the second largest, at 22% of the market. This is not surprising given the strong tech cluster in Stockholm, Copenhagen, and the Nordic region as a whole. 

UK technology companies still remain the largest issuers of debt, nearly doubling YoY from €6.8bn in 2021 to €12bn in 2022. However, the proportion declined from 47% in 2016-2021 to 40% in 2022, a significant shift. The UK's leading position is explained by the large number of fintech companies, accounting for c.€4.8bn in lending capital, nearly the size of DACH’s whole tech lending market. Compared to the UK, lending in the DACH region remained relatively flat in absolute terms, from €4.3bn in 2021 to €5.1bn in 2022.

The significant increase in the Nordic market share is partially explained by the €3.5bn debt raise of Swedish company H2 Green Steel in October 2022, which accounted for c.59% of Sweden’s overall debt raised in the past year. Adjusting for this megadeal, we still find that the Nordic market share rose nearly 4x versus 2021, to 11% in 2022. As highlighted in our 2022 report, we expect to see continued redistribution of market share away from DACH and the UK to other regions, in line with maturing tech clusters across the continent.

The most notable feature of the tech lending market in 2022 was the significant amount of debt raised by companies seeking to transform the energy sector. Four out of the top 10 largest debt raises in Europe were by companies working on the energy transition and the two biggest raises were by H2 Green Steel (€3.5bn) and Britishvolt (€2bn). Compared to the year prior, energy as a sector multiplied the amount of debt raised by a factor of 12, from c.€0.5bn in 2021 to c.€5.9bn in 2022. This indicates an increasing velocity of capital in Europe backing clean energy and energy storage companies amid the continent’s commitment to leading the global energy transition. H2 Green Steel’s raise financed by a bank syndicate showed a “willingness to support initiatives that will help fulfil the target of the Paris Agreement,” said H2 Green Steel's CEO.

Consistent with last year, fintech accounts for the largest share of the tech lending market and nearly doubled the amount of debt raised from c.€4.3bn in 2021 to c.€7.8bn in 2022. While none of the top 10 debt raises in 2022 were by fintech companies, the sheer volume of debt raises explains their overrepresentation compared to other sectors.

 Source: Dealroom

 Source: Dealroom

Source: Dealroom

Source: Dealroom

We’ve seen more volatility in B2C-related companies, with ecommerce and ecommerce enablers under most pressure in our current portfolio. As structurally more volatile models, marketplaces and volume/take rates-based models have been the fastest to follow the general market downwards, with contractually committed SaaS models showing more resilience. 

Transactional business models like ecommerce or B2C marketplaces had a tough 2022, following the peak in 2020-2021. Exceptions were segments like business and consumer travel platforms, which outperformed pre-Covid levels in H2 2022, for every stage. Other strong segments post-Covid are climate tech and future-of-work with business models in B2B software subscriptions, licensing or with recurring enterprise transactions. In 2023, things might slow but B2B subscriptions remain a healthy business model for most tech entrepreneurs and are loved by investors. For example, at Endeit we have specific in-house fintech expertise and are bullish on this segment. We also work on embedded finance opportunities within our portfolio firms. Especially together with entrepreneurs and their CFOs who have a deep understanding of their real-time data, which enables them to easily scale their spend up or down, and manage cash flow.

The risk-return expectations have changed rapidly with rising interest rates. Later-stage companies will benefit in 2023 simply because they have more flexibility to reduce costs or diversify between regions, clients and products. However, this won’t work for more capital-intense business models or later-stage companies that cannot show prudent metrics to get to profitability in 12-18 months. Earlier-stage companies are more vulnerable now if margins come under pressure and the cash runway is drastically reduced given the current macroeconomic climate. That’s when VCs are put to the test, and where the right debt partner can make a difference in being flexible on covenants, amortisations or in capitalising interest payments to bridge operational fluctuations. Interestingly, seed-stage funding was least affected in 2022 in terms of funding YoY compared to early- and later-stage. There is still a long-term trend and demand to finance new entrepreneurs. 

Except for the sub-sectors that received significant tailwinds (like energy and climate), we have seen capital-intensive models or hyped models with unclear unit economics being most affected in terms of access to capital. Looking at the fundamental impact, we can see a difference between models addressing what we call tier 1 spend versus others; tier 1 spend being expenses a customer does not cut in a recession or downturn (such as ERP software and HR management systems). In terms of differences based on stages, it is clear that growth-stage funding has essentially dried up and there are only very selective ventures being funded. While there is still plenty of funding available to early-stage companies, we see the willingness of customers to enter trials, POCs and other, decreasing due to tightening budgets.

We’ve never been a “growth at all costs” investor and have always kept a close eye on cash level, opex base, and path to profitability. We’ve taken advantage of the 2023 budgeting exercise to signal very clearly to all of our portfolio companies that this focus will be strengthened in the current context and it has been generally well accepted by founders across the board.

The focus will be reaching operational efficiency. Equity investors and debt providers seek a foreseeable profitability point combined with the highest possible sustainable growth rate. Key metrics for this are, for example, Net Retention, Payback time, YoY ARR growth, ARR per FTE, Burn Multiple, CLV/CAC, and Net Magic Number (=QoQ net new ARR versus prior Q S&M spend). At Endeit we specifically focus on detailed CLV/CAC cohorts and CAC Payback period as a proxy for solid product market fit and accelerated scaling potential with new funding, assuming there is a big enough SAM market size. Our team and entrepreneurial LPs lean on more than 16 years of VC experience in various economic cycles, dealing with volatility, and managing longer-term value-add metrics. We sincerely care for our portfolio companies and founders, hence our typical long-term commitments in funding and board contributions until the exit phase.

We have always focused on business models with attractive unit economics from the beginning or at least with a clear path towards it, and the market sentiment has shifted from growth at any cost to profitability. We see this as a correction/normalisation of the market to a more sustainable level and hence expect to continue observing the same in 2023 and beyond. While ventures do not necessarily need to move towards profitable growth, they should move much closer to profitability to be able to react at any time and have a clear path towards it.

Similar to other equity, we view debt as a useful extension of runway in uncertain times and believe that there has been a very strong uptick in this market over 2022. This uptick has led to heightened competition among providers and generally relaxed terms from what we’ve seen, especially in terms of equity upside (warrants) and debt amortisations.

The terms have not yet materially changed in my experience, relative to increased interest prices. We did see more debt funds last year, which should keep the terms competitive. We help entrepreneurs in comparing debt funds and reviewing terms with the CFOs and help with cash management strategies. We also invested in alternative funding platforms; for example, Floryn. With the structural end to cheap credit and rising interest rates, there will be a credit crunch for companies that cannot sustainably grow towards profitability.

We have seen interest rates rising in line with changes in the base rates. Further, equity warrants seem to be losing importance for debt providers while focusing on tighter controls and covenants.

In addition to providing runway, debt could indeed help instil cash discipline in management teams. That being said, most of our portfolio is now on the more mature side within the venture capital investment spectrum, and – again – we are quite cost-conscious investors. As a result, most of our founding teams already have a cautious approach to spending either by nature or as a result of existing debt lines or board composition, and we have not seen a significant change in their behaviour beyond a questioning – shared with us – on being able to raise in satisfactory conditions over the next 12 months.

A proper balance between debt and equity can be a strong incentive for founding shareholders, management, and VCs to stimulate investment in growth and innovation while building a culture of tight cash management. Ultimately this should benefit both the company and equity holders, assuming the terms of debt were reasonable and flexible along the way. However, raising debt is not for everyone. The stage of the company, product-market fit, and growth roadmap should be quite grown-up and proven to ensure a certain level of visibility in revenue growth. Recurring revenues via SaaS business models or subscription-like marketplaces will benefit most from debt due to better terms and larger-sized tickets. For high-risk or semi-turnaround situations, where equity holders can only do so much, raising venture debt in parallel is also a valid and strong case to share risk and upside with the debt holders. It is, however, more an exceptional case, as equity holders should preferably finance these pivots or turnarounds. The right mix of debt and equity will vary with a company’s specific circumstances. The more debt you take on, the more accurate your prediction of the future and clearer your plans for the capital need to be, or you risk net-net losing capital in the long-term to interest and fees.

A well-functioning business should not need debt to install cash discipline but should have controls and planning in place independent of it. This right ratio and relationship between equity and debt depends on different dimensions. The first one is the business model: for models that require an asset-intensive balance sheet or have high working capital requirements, debt is often the only option to grow to scale. Another dimension is the cost. While it is clearly the cheaper option for the models described above, often debt comes at a similar cost to equity but exposes the business to a more significant risk due to repayment obligations. In all these considerations the stage of the business plays an important role as well, given the risks and costs of debt decrease with increasing reliability on cash flows. 

The sharp sell-off of technology stocks in 2022 has revived the common misconception, perhaps arising out of the dot-com bubble, that the technology sector is a particularly risky asset class. Working closely with S&P Global Market Intelligence, we have looked deeper into whether this is true or not for the sector as a whole by using several S&P Credit tools, including the likelihood of defaults per industry as well as actual observed default rates. S&P’s Credit Analytics models are able to capture the default likelihoods of not just the public-rated universe, but also the largely unrated private companies.

We conclude that the technology sector has exhibited lower actual default rates as well as a significantly lower probability of default versus the broader market. It is a trend we expect to continue through the upcoming cycle. Using S&P’s extensive toolbox of credit analytics data, we have used three different methods to comprehensively analyse default risks of tech as an industry. The first method uses S&P’s CreditPro data to compare the historical observed default rate of the high-tech industry to other industries. The second and third calculate the probability of default in the next 12 months, using both the fundamental financial data of each company (PD Fundamentals) as well as wider market, industry, and sovereign risk (PD Model Market Signals).

Our findings from all three methods show that the high-tech/software industry has had one of the lowest observed corporate default rates over the last four decades. Using S&P’s CreditPro data, we present the observed corporate default rates by industry for the rated universe of companies for the past four decades. For high-tech, the weighted average was c.1.3% in 1981-2021. Observed default rates are also significantly lower through the two most recent credit crises in 2008-2009 and 2020-2021.

By looking at the probability of default, the tech sector has outperformed compared to other sectors since 2008. This suggests that, on aggregate, tech has become increasingly more resilient through the recent credit cycles as the sector has matured. A more granular look at the historical likelihood of default by industry shows that technology overall, and software in particular, has had increasingly lower probabilities of default. In the last two credit cycles, the Global Financial Crises in 2008-2009 and Covid in 2020, the spread between the stable, relatively low default rates of software companies versus the much riskier industries, like oil & gas or consumer-facing industries, has widened by 150-300 bps. This data suggests that, as we enter a recessionary macro environment with rising interest rates and tighter credit, debt investors should, as always, focus on company fundamentals but also potentially overweight certain business models, like enterprise software, that exhibited lower default rates historically.

S&P’s PD Fundamentals and Market Signals data measure the likelihood of default over the next 12 months (or for longer and shorter periods if required), offering a leading indicator of credit risk. Using S&P’s leading PD Market Signals data, the model below plots the probability of default of various industries since 2003. With tech sectors highlighted in red, we find that post the dot-com bubble the tech industry exhibited probabilities of default of c.5-7% in 2003. However, tech not only recovered through the 2008-2009 credit crisis but its performance relative to other industries improved markedly, with software outperforming more traditional industries, like oil & gas or real estate development. In the 2020-2021 credit crisis, software had a remarkably low probability of default of c.2%. Comparatively, real estate was twice as likely to default compared to tech at c.4%, the consumer-facing goods sector was 3x at 6%, and oil & gas was 5.5x at c.11% at their peaks. 

As investors consider their credit allocations today, our findings suggest that they should continue allocating to technology among other resilient asset classes that have shown a historically low rate of default. This is further supported by a large addressable market in Europe, with c.3,000 growth-stage tech companies valued at €100m+, allowing the lenders to be more selective. The overall better investment terms available to lenders today, including higher all-in IRR, lower leverage, and tighter covenants – will further benefit investors in the asset class.

Sources: S&P Global Market Intelligence, PD Model Market Signals as of 9 March 2023. For illustrative purposes only
Note: Software includes Application Software and Systems Software; Real Estate includes Real Estate Development, Real Estate Operating Companies, Real Estate Services; Energy – Oil & Gas includes Oil & Gas Drilling, Oil & Gas Equipment & Services, Oil & Gas Exploration & Production, Oil & Gas Refining & Marketing, Oil & Gas Storage, Transportation; and Consumer includes Apparel, Accessories & Luxury Goods, Movies & Entertainment, Packaged Foods & Meats, Soft Drinks. PD Model Fundamentals looks at financial risk and business risk to measure the likelihood of default for millions of public and private banks, corporations, and REITS over one- to 35-year time horizons (As of March 2020). PD Model Market Signals provides a point-in-time view of credit risk for public companies based on a sophisticated model that uses stock price movements and asset volatility, providing signs of potential default for more than 85,000 public companies.

Sources: S&P Global Ratings Research and S&P Global Market Intelligence's CreditPro® Copyright © 2022 by Standard & Poor's Financial Services LLC. All rights reserved. 
Note: High tech includes high technology, computers, and office equipment; AACGM includes aerospace, automotive, capital goods, and metals; Forest includes forest and building products and homebuilders; and E&NR includes energy and natural resources  

We have seen an increasing concentration of capital, as illustrated both in terms of surging average fund size as well as the majority of LP capital flowing to an ever-smaller number of managers. Globally, the average fund size rose above €1bn. For European-focused funds, the average fund size doubled between 2018 and 2022 from c.€600m to €1.4bn. Further, the proportion of capital raised by the 10 largest private debt funds peaked at 31% in 2021 from 20% just three years prior.   

An interesting trend has been the decline in allocations towards multi-regional funds, the vast majority of which focused on developed markets in the US and Europe: the proportion declined from 37.7% in 2019 to under 27% in 2022. In addition to geopolitical and macroeconomic considerations, many investment funds, and ultimately also LPs, realised that to be successful in a specific geography one has to have “feet on the ground” as well as a deep understanding of local legal, cultural, and insolvency factors. Sourcing quality German deals while sitting in New York, or an Ohio transaction from  Frankfurt, does not often work in practice.

As an increasing number of technology companies turn towards debt to finance both organic and inorganic growth, understanding the sentiment towards this asset class among the ultimate providers of capital, institutional investors, is important. We worked extensively with news and analysis platform Private Debt Investor, and the data outlined below shows that global private debt fundraising continues at a strong pace. Although the overall amount of capital raised by private debt funds declined by 14%, it was 2021 that was an outlier. Capital raised in 2022 was higher versus each of the years between 2018 and 2020.

 

We believe there are multiple reasons behind this trend. A key component is that absolute volume of allocations of large institutional investors simply cannot accommodate smaller fund sizes without running into diversification issues. There are clear benefits of diversification. At the same time, some sophisticated investors have long recognised that smaller specialists often offer better risk-adjusted returns versus large generalist funds. Additionally, larger funds have been perceived as safer due to larger deal sizes (and thus investments in correspondingly larger companies). However, larger deal size does not necessarily imply a safety margin as weak covenants, high leverage ratios and significant adjustments to the EBITDA definition, together with normally weak relationships between the lenders and the borrowers, in syndications particularly, may negate any such benefits. 

Source: Private Debt Investor

Source: Private Debt Investor

Source: Private Debt Investor

Source: Private Debt Investor

Source: Private Debt Investor

Source: Private Debt Investor

Source: Private Debt Investor

Allocations to European-focused private debt funds showed a significant slowdown last year. Total capital raised in 2022 was down 28% versus 2021 and was also lower than the amounts raised in both 2019 and 2018. The impact of the war in Ukraine, the first large-scale conflict on European soil in 80 years, combined with the concerns about the macroeconomic and inflationary impact on the continent played a significant role.

How much capital do you plan to invest in private debt NTM versus LTM?

Regarding private debt, how do you plan to invest in the following fund strategies NTM versus LTM?

Dealroom.co is the foremost data provider on startups, growth companies and tech ecosystems in Europe and around the globe. Founded in Amsterdam in 2013, Dealroom.co now works with many of the world's most prominent investors, entrepreneurs and government organisations to provide transparency, analysis and insights on startups and venture capital activity.

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