Venture Debt: How to Be a PEST When Analyzing Markets and Industries
Zack Ellison, CFA, CAIA
Investment Fund Manager | Podcast Host | Doctoral Business Student | Author | 100,000+ Newsletter Readers | LinkedIn Top Voice
This article (#9 in the series) was originally published in Venture Capital Journal as part of my monthly column on venture debt. In each piece, I share insights on the latest trends and strategies in this growing segment of the private credit market. Venture debt offers a powerful way to invest in innovation, providing lower risk and attractive returns while complementing traditional venture equity.
Remember flipping through Yellow Pages to place a landline call so you could order a pizza to eat while watching your rented video cassette? Fast forward to today, and those industries have morphed beyond recognition. This transformation underscores the critical importance of understanding market and industry dynamics in venture lending.
Before transitioning to venture lending, I managed billions in loans and bonds at global financial firms like Scotia Bank, Deutsche Bank and Sun Life. My experience provided a front-row seat to the evolution of effective credit analysis frameworks and how they can be adapted for venture debt.
In venture debt, a deep understanding of market and industry dynamics is foundational for success. While similar to traditional credit analysis, venture debt also utilizes the perspective of venture capital investors to navigate emerging and rapidly evolving industries.
Although approaches vary, core principles of credit analysis remain consistent. In venture lending, five core areas must be considered: market and industry; company fundamentals; leadership team; deal structure; and portfolio management. Understanding these elements allows lenders to assess borrowers comprehensively and strategically.
Throughout this series, we've explored various aspects of venture debt, from deal structuring and operational due diligence to risk management techniques. This installment focuses on how market and industry analysis shape successful venture lending decisions.
Market and Industry Analysis
According to a Harvard Business Review article, in a survey of over 900 venture capital firms, 68 percent considered the market and 31 percent the industry as crucial factors in pursuing deals, with founders and business model ranking more frequently, at 95 percent and 74 percent, respectively.
Although market and industry analysis are related, they focus on different aspects of a company’s operating environment. Market analysis zooms in on the specific segment a company targets, dissecting customer demographics, demand-supply dynamics and the competitive landscape. It assesses how snugly a company's offerings fit within its market niche and predicts its growth trajectory and profitability.
Industry analysis takes a broader view, assessing industry-wide trends, regulatory influences, technological shifts and macroeconomic factors to identify risks and opportunities, and ensure long-term sustainability.
A strong company operating in a struggling industry can face significant challenges. For instance, during my tenure as a media and telecoms loan underwriter 17 years ago, I observed how once-dominant players in the Yellow Pages sector swiftly became obsolete due to the rise of internet search engines and the launch of the iPhone in 2007.
Conversely, industries such as software technology and artificial intelligence have proven to be fertile ground for exponential growth, highlighting the substantial rewards of riding industry booms.
Choosing the Right Frameworks
Selecting the appropriate analytical frameworks and models for market and industry analysis is crucial for accurately assessing a company's operating environment. Several accepted frameworks simplify this complex process, with each offering unique insights into distinct aspects of the business landscape.
? Porter’s Five Forces evaluates the competitive forces at play within an industry, examining competitive rivalry, supplier power, buyer power, threat of substitution, and threat of new entry.
??SWOT analysis identifies internal and external factors that can impact a company's performance, focusing on strengths, weaknesses, opportunities and threats.
??PEST analysis explores the macro-environmental factors affecting a company, covering political, economic, social and technological influences.
The choice of analytical framework and its factor weightings depend on the business and industry. For instance, social factors significantly impact consumer-focused industries like consumer packaged goods and retail, whereas technology-driven sectors like enterprise software are more influenced by innovation and operational efficiency.
For early stage companies, key factors in assessing opportunities and threats include potential size of the market, competitive rivalry, customer analysis and technological outlook.
Potential Market Size
For early-stage companies in emerging or fast-growing industries, assessing market size is paramount. This involves estimating the current market size and its projected growth rate.
? TAM (total addressable market) represents the total revenue opportunity if a company captures 100 percent of its target audience.
? SAM (serviceable addressable market) denotes the portion of TAM that the company can realistically target within its operational capabilities.
? SOM (serviceable obtainable market) refers to the realistic portion of SAM that a company can capture in the near to medium term, considering factors such as existing technologies, competition and regulatory constraints.
Understanding market size establishes the upper limit of a company’s potential. Venture lenders prioritize SOM to ensure repayment within a two-to-five-year loan term, unlike equity investors with longer horizons.
Further factors
Once the size of the market is known, you must dig into a company’s competition, customers, and technology:
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? Competitive rivalry focuses on the differentiation and market positioning of other firms. Understanding the strengths and weaknesses of competitors can provide insights into potential opportunities and threats.
? Customer analysis involves understanding the target demographic, their needs, preferences and buying behavior. In very simple terms, the company should be solving a problem that others have not yet solved and that customers are willing to pay for. Thus, the product fits the market by filling a gap. The lender must determine what customers think about the service or product and if they will pay for it.
? Assessing the technological landscape involves understanding its current state, ongoing innovations, and potential disruptions that could impact the company's products and services. Given the early stage and tech-focused nature of the borrowers, there are material technological risks. The first risk is that innovative technology will not be sufficiently adopted. The second risk is that the technology could become obsolete quickly.
Other Considerations
Analyzing barriers to entry, regulatory frameworks, and macroeconomic conditions is also crucial. For instance, stringent data protection laws can pose significant challenges for startups in the healthcare, fintech, and adtech sectors. Similarly, environmental regulations can heavily impact companies involved in climate technology. Additionally, macroeconomic factors, such as rising interest rates, can greatly affect capital-intensive industries like renewable energy, life sciences, transportation, robotics and agriculture, influencing market dynamics and investment potential.
After conducting a thorough market and industry analysis, the next step involves analyzing company fundamentals, including unit economics, capital structure and the company's path to free cash flow. In my next article, I will delve into these aspects, continuing to build a comprehensive framework for evaluating venture debt opportunities.
Articles in the Series by Zack Ellison
Zack Ellison is a LinkedIn "Top Voice", the Founder and Managing General Partner of Applied Real Intelligence (A.R.I.), and the Chief Investment Officer of the A.R.I. Senior Secured Growth Credit Fund, which provides growth credit and venture debt to premier startups.
In his 20-year career, he previously worked as a media, telecom, and technology loan underwriter and structurer, corporate bond and CDS trader, and fixed income portfolio manager at five publicly traded firms, including three with over $1 trillion in assets – Scotia Bank, Deutsche Bank, and Sun Life.
He holds an MBA from the University of Chicago Booth School of Business, an MS in Risk Management from NYU Stern, and has completed all of the coursework in the Doctor of Business Administration program at the University of Florida. He holds the CFA and CAIA Charters and previously served concurrently on the Boards of CFA Society Los Angeles and CAIA Southwest.
Learn more about Zack and A.R.I. at www.arivc.com.
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