Talk Your Book: Growth Stage Debt Investing

0:00Today's Animal Spirits Talk Your Book is brought to you by Trinity Capital. Trinity Capital is a private credit alternative asset manager focused on growth stage sponsored backed direct lending. Learn more at trinitycap.com. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:35Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:43Welcome to Animal Spirits with Michael and Ben. We talk a lot about private equity and venture capital, and when people invest in these privately held companies, most of the time, what we hear is equity. They're buying stock in these companies. But as we know, there's two parts of the capital stack. It's not just equity. There's also debt. These companies, sometimes they don't want to be dilutive, especially if they're successful and further along in their life cycle. It could be cheaper, even with interest rates where they are, it could be cheaper to borrow money than to dilute the company. There was a thread on Twitter a couple weeks ago about a VC investor saying how hard it is to get like a 10x return because you do get diluted so much.

1:28So yeah, you'd think if there's so much money sloshing around venture capital, why would you ever need to borrow money in going to debt? The reason is so your equity investors don't continue to get a smaller and smaller piece of the pie. So Trinity Capital is an alternative asset manager. They provide debt to these companies that are, I forget what he said in the show in terms of where they are. I think they're close to cash flow positive. Yes. I think the term, so we talked to Kyle Brown today, who's the CEO, president and CIO. And I think he said EBITDA negative or neutral, which I guess neutral means like we're breaking even kind of on everything.

2:04And yeah, these are growth stage companies. They're not like early stage angel investments. They're growth and getting there and I guess probably getting close to that IPO. Yeah, these are not companies that are looking for product market fit. These are companies that very much have it. And then there's also, they do other things. There's equipment financing and all sorts of interesting stuff that we've never really spoken about. and the structure of the company. I don't want to step into too much material, was really fascinating. So I think that you're going to enjoy the show. Here is Kyle Brown from Trinity Capital.

2:35Kyle, welcome to the show. Hey, thanks for having me, guys. Really appreciate it. We're excited to have you on. I don't think we've ever spoken to a company quite like yours. So let's start high and then we'll drill deep. For the audience, who is Trinity Capital? So Trinity Capital is a diversified asset manager focused on growth stage companies. Think about us as like investing in companies right on the cusp of EBITDA neutral. So we've got venture backed, late stage, growth stage, 50 to 100 plus percent annual growth rates who have raised 50 to 100 million of venture capital backed by top tier sponsors, Kostlas, Kleiners, and Dresdens of the world into that$3 to$50 million of EBITDA, private equity backed.

3:19They've made it to that cusp. They've had private equity come in. And we've done what we call sponsor finance. So we kind of live on that cusp of EBITDA neutral for growth stage companies, pretty diversified in terms of industry. So if they're past that venture stage, what are these companies coming to you for? Is it a different type of financing that they need? Yeah. So prior to EBITDA neutral or EBITDA positive, it's an extension of runway. These guys are all pre-IPO rounds. They're heading towards some liquidity event. They have raised a significant amount of equity to help prove out a technology, find a product market fit, get to scale.

3:57And they're looking for less dilutive capital to continue growing as they head towards that liquidity event, whether it's an IPO, whether it's a PE firm coming in to take a ownership stake in the company, but it's an extension of runway with less dilutive capital to complement the equity they've raised to get them another six to 12 months and beef up that balance sheet as they grow. Less dilutive capital. Is that like a Winnie the Pooh monogram way of saying debt? It's debt. It's senior secured debt. Senior secured debt in our world on that venture back side, what we get is warrants. So I say less dilutive because we're still getting warrants.

4:35So if the company goes Google, they become the next Google, we do get some significant upside potential in the investments we're making. So it's not just a straight debt deal, though the majority of our income is derived from the debt per pay. All right. Well, we'll come back and double click, as I say, in the podcast industry back onto this. But what's your story? You guys have been around for a while. Yeah, we started in 2008 doing equipment financing to like small to mid cap companies, kind of EBITDA positive or neutral companies. We ended up partnering with Silicon Valley Bank back in 2008 on some deals, kind of discovered venture debt and really started scaling the business that way, providing a complimentary piece alongside their receivable line.

5:22They do the receivable debt. We do the term debt. And we created this great partnership and really scaled the business that way, raised multiple funds as just a private lender, private company. And we became a lender of choice for Silicon Valley Bank across the country. Started discovering new opportunities as we continue to scale doing equipment financing. A lot of companies that are manufacturing something have capex needs. And so we started building a senior secured kind of term debt business and an equipment finance business parallel to one another, all the support venture-backed companies.

5:55So we started in 2008, had multiple funds running. And then in 2018, we decided, hey, this is a massive opportunity. The market just keeps growing. There's no real significant market share with any one company. Let's become the best in the world at this. And so, you know, access to capital, you know, we're selling money. And so, you know, and our raw material is capital. And we decided, you know, let's become a BDC, which we talked about this before. It's kind of the REIT equivalent. We distribute out all of our earnings to our investors annually, 90 plus percent. And so that structure, because we generate so much income, was a perfect structure for us.

6:38It would give us access to the capital markets. So we consolidated in 2019 all of our funds into one entity. And this is actually important for your viewers to understand. It was an internally managed BDC. So we're very different even compared to all the other BDCs out there. We're not a management company that's charging fees to a pool of assets like most financial companies. We're just one company. No management fees, no incentive fees. We did that so that we would trade at a premium to all of our peers so that we could access capital more efficiently. So since 2019, since becoming a BDC, and then subsequently listing on the NASDAQ in 2021, we've raised over a billion dollars while increasing earnings.

7:19So I think it's working. We've gotten to a nice scale, but we have access to the capital markets now. So if the opportunity to grow is there, we've got access to capital. So what is the incentive there? If these other BDCs are charging management fees and you're not, how are you able to do that? So most BDCs are a pool of assets. And that pool of assets has a contract with some management company charging a management fee, usually one and a half to 2 % and an incentive fee of 15 to 20%. So their costs are just going to be, their costs are always going to be a little bit higher than ours. We do not have a management fee.

7:55We do not have an incentive fee. I have the same shares as anybody who buys the stock, as every single person in my company has the same shares. And so when you buy a trend, you're buying a pool of assets, just like all the other BDCs, but you're also buying into a management company as well. And so inherently, we should be valued significantly higher than just the pool of assets because we have an 80 employee operating entity that's generating a significant amount of income. So we did that intentionally so that we would trade at a premium to the other BDCs that are out there. All right. I have a million follow-up questions on the structure of the company.

8:32But before we get there, I want to talk about just the process of venture debt. So a company comes into your office and what is the conversation like? What happens? So they've typically, I'll just give you a typical profile of our venture debt business. So it, which is, you know, our venture debt business is about 35 % of our deployment right now. I can circle back to that. We really operate five different businesses that focus on growth oriented companies, venture debt, meaning cash burning companies that are venture backed about 35 % of our deployment. They've typically raised 50 to 100 million of equity.

9:04They're anywhere from five to 10 years old business. Our average kind of ARR, annual recurring revenue is going to be around that 30 million mark, 30 to 100 million and growing at some 30 to 100 % annual growth rate. And so they're spending intentionally. They're spending because they're getting an incredible payback for every dollar they spend. They're getting X amount of subscribers or new customers and revenue growth. And so if they're spending and they're burning, you can do that with equity. Or if you get to a certain scale, you can actually start doing that with debt. So we're underwriting what is the inherent value of this company?

9:43What technology do they have that is differentiated? We're looking for a moat around that technology where they're two, three, four years ahead of all their competitors. We want to make sure they've got two plus years of runway, even at the current burn levels, and that they have a plan that they can execute in a management team that's done it before to help them get to either that liquidity event that they're shooting for or another fundraise. And so - Banks don't want to touch these companies yet? Is that the deal? So 10 years ago, banks didn't touch them. Over the last 10 years, banks became our biggest competitor.

10:16And as of March of last year, banks have backed off and are no longer lending in the same way they were before. Yeah, I wonder why. Yeah. I mean, if you think about it, you know, if we're generating, we have, we're generating 15.5 % gross yields on our assets, unlevered returns. You can't generate mid-teens returns without taking some risk, right? Yeah, no kidding. So to that point, I'm curious, like, what does a normal sort of default rate look like within your portfolio of companies? Well, this is why banks started doing it because the loss rate, the realized loss rate for us is actually negative.

10:49It's inverse. So because I mentioned it, we get it, we get warrants in all of our deals, right? So if you look back over, if you can look back over 15 years, our realized gains offset our realized losses. So that whole world, the venture debt world, part of the model is you're going to have losses. Companies will go bankrupt at some point, but you're also going to have a bunch of Googles and a bunch of pops, right? I'll give you one example. We had last year, we had a$55 million realized gain on warrants from Lucid when they went public, the electric car company. That was a$30 million loan. So you get paid, we got repaid 30 million plus interest and 50 million equity realized gain.

11:27That offsets a lot of mistakes. And so the model, that model, you end up, you and your warrants end up covering all of your losses and then providing a little incremental upside for investors. So when you say we, what does this mean exactly? Do you guys have funds that individuals invest in? Or is this because you guys are a publicly traded company. So when you say we got that, what does that mean? Like Trinity investors, how do they get access to these deals? So our investors, we'll just stick on that same, that realized gain. Our investors, anybody who held Trinity shares during that time, we ended up doing supplemental, so extra dividends to distribute out those earnings, which were capital, treated as capital gains, which is kind of nice too.

12:09So anytime we do have a big upside like that, our investors, we distribute all of it, you know, 90 plus percent of it to investors, and that's a capital gain. So we have a couple of unique things going. One, we're an internally managed BDC. We own the same shares as our investors. So inherently, the incentives are aligned, right? I'm not going to just grow this business and raise a ton of capital because it would be dilutive to me, just as it would our shareholders. But we also, last year, we got SEC approval to manage an RIA. So now Trin, publicly traded company, T-R-I-N, now owns an RIA. And now we're managing, raising private money as well.

12:44So we needed access to the capital markets to make sure we could grow the business, have access to capital if we could grow. But there are also investors out there, whether they be wealth managers, whether they be insurance companies, or just institutional investors that don't want a public stock, but they want access to our space. We saw that. We said, hey, let's start raising money privately and let's charge management fees and incentive fees, all of which 100 % of it flows to Trent, our shareholders. So now we've created this really interesting way to generate income above and beyond just our loans that we issue.

13:17We have this vehicle that now can generate substantial new income by simply raising money privately, which we've done. We started doing that this year. We've raised a few hundred million dollars and deployed it. And over time, I think you'll see our private funds continue to grow and generate great new income for investors. I'm curious about the volatility of the income stream because, I don't know, high yield corporate bonds are probably yielding 8 %-ish right now. Are you tied to some sort of benchmark where you're saying, we're high yield plus this, or we're 10-year treasury plus this, or does it not work like that because this is kind of a unique space.

13:52It doesn't really work like that. I mean, if you look at the stock right now, I haven't checked it today, but I imagine our dividend yield is probably 14 % based on what we said we're going to distribute out. That's a, I mean, our stock, because it's, again, because we're a dividend stock and we typically trade based on what we're going to dividend out. I think that's incredibly high. That's not a function of us doing risky deals. That's just as simply a function of the price of the stock is relatively low compared to our peers because we're new. We're still, you know, we're four years in as a public company, still relatively new and not known by a lot of retail outlets yet.

14:29So we think about it in terms of dividend. So our goal, if you look back at like the dividend chart for Trinity over the last four years has become a public company. I think it's 13 or 14, it's 13 straight quarters of increasing the dividend. We can do that because, A, we're not to scale yet, meaning we still, every time we grow, TRIN grows, we actually, our costs go down, right? So there's efficiencies of scale there. But then we're also generating new income that flows to TRIN so we could keep increasing the dividend if we're successful doing that. So it's almost like a closed-end fund in a way.

15:05It's not, but in terms of how the investors are treating you. They're like, prove to us first, be around for a while and then will the price will go up and the dividend yield will go down. Yeah. We've got peers trading at 100 to 60 to almost 200 times their NAV. We're trading in 115 % of our NAV. Those companies have been around for five to 10 years longer than us. So I think there's just a prove it kind of mentality. Now we've been around for a long time, but in the public sphere, we've only been around for four years. So I know you guys do things other than venture debt. We'll get to that. I'm curious to learn about equipment financing, but on the venture debt side, I'm curious, like, so you guys, this is not just traditional investment bank underwriting where you're like showing me the financials.

15:45I mean, at some point you have to also be a bit of a futurist or real business people to understand the sustainability of these companies. So with that in mind, how do you like win these deals? Like, obviously you want to offer an attractive rate, one that will get the deal done versus your competitors, but not, you don't want to win by overpaying, meaning that like the rate that you're charging is too low for the risks that you're bearing. Yeah. So I think about it like this. In the venture debt world, it's two thirds, actually what you just said, which is the science behind it. It's the financials.

16:16We're getting three years of financials, historic. We're looking at forward-looking financials. The KPIs have to make sense. So a lot of it is your traditional kind of underwriting. And then one, but one third of it is more art, right? You have to be able to understand technology at a granular level. So we on staff, we have multiple electrical engineers, engineers on staff to make sure we can dive in and understand the technology in a way that what we don't want to do, we don't want to take technology risk. So we want the technology risk to be taken by equity players. We want to take execution risk.

16:51So part of the underwriting, yeah, it's not numbers on a spreadsheet. It is truly getting into the business, understanding that technology with people who know how and who have built technology. One of my chief technology officers internally built the Samsung fingerprint technology. These guys know how to get in and understand whether or not technology still needs to be proved out or if we're at the execution stage of the business. So we get deep on the tech. We get deep on the management. The success rate of repeat entrepreneurs is significantly higher than first-time entrepreneurs. So we're getting in there.

17:26That's one of our underwriting metrics. So every deal goes through the exact same process. We're making sure that the plan that they've put in front of us is achievable. We're taking execution risk. We're not taking technology risk. That's the biggest difference. On the one hand, investors love higher yields. And of course, a lot of that is a function of the benchmark being so much higher than it was in the past. On the other hand, is there a level at which you're like, well, shit, I love 15 % yields, but how is this company going to be able to pay me back. How do you think about that? Now, I mean, any company we lend money to, they have to be able to service our debt, right?

18:00Even the companies that are burning cash, if things don't go exactly to plan and they need to dial back spend and get to where they can just service the debt, these are things we're underwriting, right? So we need to make sure they have levers in place to be able to pay us back if they don't continue to hit the mark. So in a lot of ways, it is similar to traditional financing in that sense. They need to be able to pay us back. But they are spending because they're able to grow so efficiently. So you mentioned that this is a publicly traded BDC. Anyone can go buy it on their brokerage or whatever.

18:37Do you have a sense of who your investors are in the actual fund? So we've got a significant amount of institutional support, actually. I'd say, I think last reported, it was 30 % to 35 % institutional investors, notable names, you'd know. A good portion of that, I'd say 10 % to 20 % because they're shareholders we've had for over a decade. These are high net worth family office type investors. And then the rest of it's going to be retail that's been added in over the last four years. So kind of a healthy mix. I think we're seeing more and more retail activity as the name gets out there. but our institutional investors have been a strong hold and then buy since becoming a public company.

19:19So there's a nice stable base in there. So you said that venture debt is, forgive me, what percentage of your business? It's about 35%. 35 % of our deployments is venture debt. So what's the majority of your business? So the way we think about our company is we've got multiple verticals that all focus on growth oriented companies. Venture debt, senior secured loans is a big piece of that. Equipment financing is another big piece of that. That is really kind of traditional equipment financing. We're financing some tractors, trailers, steel, manufacturing lines, testing equipment. This is non-specialized equipment to companies that are manufacturing something and have massive CapEx needs.

20:00And we actually don't have a lot of competition there. Most of that is us going out and educating companies that, hey, this equipment's worth something. We'll provide an advance against that. We structure it in a way that it's fully amortizing. So we get off risk pretty quick. Again, we don't want to take technology risk. We want to take execution risk. But in the equipment world, we're actually just financing mission-critical equipment, equipment that they cannot survive without. That's about 20, 25 % of our deployment. That's a differentiator for us. If these companies were EBITDA positive for three years, they would get all their financing from a bank because that's how solid the equipment is.

20:37So the underwriting thesis really there is, hey, this thing is worth off the shelf X. Let's provide an advance of 50 % to 70 % of that. That's probably a good just metric for you to think about. Are these also tech firms that are building out cloud warehouses or are these actual manufacturers that you're helping here? So a little bit of everything. Yes. To your later point there, so AI, it's getting a significant amount of equity right now, but there's going to be a lot of winners and losers in that space and it's yet to see who they are. So we're not doing a lot of venture debt in that arena, but we will do equipment financing, right?

21:11If NVIDIA servers are two years in back order and we can finance NVIDIA's H100 or H200 servers, we're doing that. We're actually doing a fair bit of that. Kyle, when you go on CNBC, you say we're investing in picks and shovels. Yeah. Okay. That's how you sound intelligent right there. Picks and shovels. That's true. I mean, you know what? It's a nice way for us to kind of dip our toe in that water because there's such massive activity, but not take the risk that everyone's taken, right? At the end of the day, we're getting paid off in two to three years on those NVIDIA servers, and there's a two-year back order, right?

21:42So I think we figured out a way to de-risk ourselves doing that. But to the other point, manufacturing equipment, we're doing stuff for companies like Footprints, doing renewable-type technology, Impossible Foods, that was a big name. this was many, many years ago, but we provide all the manufacturing equipment for them to roll out the impossible Whopper, if you remember that back in the day. But that's all pretty standard equipment for a very specialized type of new product, right? Axiom Space is a big one for us. They've got the contract to build the next space suit for NASA and the next space station.

22:18They're using our money for tools, right? To do all that, to build all that. So it can be anything from manufacturing equipment to cranes and steel, but it is pretty special. It's not specialized equipment, but it is mission critical equipment that they need for their products. So that sounds like a less risky investment than venture debt. I would assume that's reflected in the yields or maybe not. What do the spreads look like between those two? I mean, the business side of it is it's going to be a little bit higher yields, but they're shorter duration. So our multiple is lower. So you got to do a lot of business.

22:51There's a lot of turnover there. So we've got a nice team, a lot of big pipeline of deals you have to have. And actually, historically, loss rates are almost identical. So inherently, you would think it's less risky because you've got this collateral that if they don't pay you, you could go pick it up. But on the venture debt side, they have a real technology there that somebody is going to pay something for or you can pick up and sell it. So, I mean, it's IP versus hard equipment, but both have a very similar collection rate. So I don't know how maybe this is just a labeling thing. It might be semantics.

23:21But do you consider yourself part of the private credit side of things? And since you've been around since you said 2008, was all of this kind of born out of that crisis where independent companies like you were having to help finance some of these other businesses that are growing? Yeah, I know those are big words right now, right? Private credits, alt lending, direct lending. I mean, that's what we've been for 15 years, right? So we work directly. We own the pipeline. We're not out there doing big syndicated deals. We work directly with the CEO, CFO. This is going to be a differentiator for us.