As a former boss of mine once said about Free Trade, “Only donkeys never change their minds.”
For years, the Wellington team has thought that the best way to succeed in our business over the long term is to find good companies and provide them with appropriately-priced, flexible capital. By flexible, I mean useful. I mean, “no am.” Rather than the traditional amortizing loan product that pervaded the tech debt industry for two decades prior to our firm’s founding in 2000. The credit check on the “no am” structure was a financial covenant, which was meant to ensure that one could have a meaningful conversation with your portfolio company should they go wildly offside the business plan that you funded against.
Some U.S. venture debt funds avoided utilizing a financial covenant, preferring to allow the amortization of the loan to manage their exposure to any individual loan. Regulated banks, however, didn’t have that luxury, even in the tech space. As any CFO will tell you, A/R margins, borrowing base certificates, and amortizing term loans (with a short principal holiday at most) were the norm throughout all of the last decade. Commercial bank credit officers understood that a loan without a covenant was merely a form of secured equity (as is a VC pref share) but at debt pricing.
They knew that the concept would put the bank’s capital at unnecessary risk, and even if they could get comfortable with a specific company, they were be confident that the bank inspectors from FDIC, OCC, OSFI or the Federal Reserve would slap them for it…so why bother?
Over the past 24 months, we’ve noticed that several tech-focused commercial banks have decided to dispense with covenants altogether, including MACs, just as the larger commercial banks have let leverage levels grow to all-time highs (see prior post “Bloomberg: Regulators stand by while U.S. bank lenders get footloose” May 14-14). All while dropping loan rates to 4-5% all-in for sub $25 million revenue firms that are losing money. Those rates are below what high-yield bonds cost a company with $250 million of EBITDA.
With that in mind, it seems to me that our commercial response should be to start doing “no am”, “no cov”, no MAC, no collateral deals at rates that are as low as they’ve been since WWII.
If bank regulators don’t have a problem with it, despite the fact that banks are levered 20-1 and are ultimately guaranteed by the taxpayer, why should our pension fund limited partners feel they’re at risk?
I mean, what could go wrong?
(disclosure: yes, this is an April Fool’s joke; the last part anyway)