EUVC #274: Hemal Fraser-Rawal, GP of White Star Capital on Debt and Equity Investments

0:00Hello, everyone, and welcome to the first UBC Podcast episode that we're recording in 2024.

0:17Happy New VC, digital asset, and now debt-led hybrid growth financing for companies. Himal has the GP at White Star Growth Capital, investing out of Fund One, mainly into European technology-enabled companies. If you're listening in and you love our show, you know what to do. Drop us a review, follow the pod, and subscribe at EU.VC.

0:41Tear down this wall. It's more than just an ally. This is a union of values. United and determined we can serve as a model for other regions of the world. The nature of a problem requires a European response. Europe is a story of new beginnings. Let's start acting. This episode is brought to you in partnership with Zero 100 Conferences, which organises networking events connecting LPs and GPs in private equity and venture capital firms across Europe. Their upcoming event, the Zero 100 Conference DAG, will take place on February the 28th to the 29th, 2024, at the Hotel Savoy in Vienna. Attendees will include major LPs and GPs like Atomico, AXA Venture Partners, Early Bird, Ers Group, Dawn Capital, Unica and many other LPs and GPs.

1:43Save the date, February 28th to 29th 2024 at Hotel Savoyan. Join us in Vienna. In a world where podcasts outnumber humans, we try at EUVC to be mildly more interesting. Tune in at EU.VC to watch this episode instead of just listening. EU.VC, where the extraordinary is just another Monday. This show is not investment advice and the hosts of this episode may be invested in the funds and companies featured. Hamal, before we start with our normal script, I think this topic grants a short intro. So give us a very, very brief introduction on what debt-led hybrid growth financing for companies actually means.

2:32It's one of those wonderful mouth... It's a mouthful. It's a mouthful. we prefer just to call it structured growth capital that's uh that tends to be the easiest thing but yeah it's very very quickly the the idea behind what we try and solve is we try to bridge the gap between equity financing on one side to debt financing on the other side i think as uh the european environment for companies in particular who are raising funds has become different and they've become more sophisticated. Europe doesn't have as many options as perhaps our peers in the US where this exists, where we basically start off with a loan into a company, we lend to them, and then fundamentally we have the ability to invest in that company by way of equity or some sort of junior loan loan in which they can turbocharge their growth and continue their growth trajectory to become hopefully a European champion.

3:31So in a nutshell, we combine the best of debt and the best of equity into one product for companies to grow. A vanilla chocolate ice cream, I guess. Himal, let's get to our usual script and ask you to tell us a bit about your journey into venture. I will also keep this very, very short as well. Like most things, it was a bit of an accident. So I started off as an engineer and fell into banking in 2007, 2008, because all my friends were getting these internships in banks. I thought it was cool. I thought, why not? And so by accident, I ended up in Leverage Finance and TMT and found out I really liked it.

4:09And really funding tech and telco companies when it was sort of 2011, 2012, where some early stage companies that were nascent in Europe were growing with equity capital. They had raised equity capital through VCs in the US, some very, very early stage companies in Europe. And fundamentally, they came over to us and said, hey, could we have some debt? And we said, sure. What's your big deal? They said, well, we're losing 10 million. We said, go away. That's kind of how this journey started. It got us thinking about, well, at the bank, how do we try to lend to businesses, especially in the technology space, who are not going to grow for profit going forward?

4:46Growth is the main metric versus profitability. But fortunately, I was part of the founding team at Barclays that started the venture debt program many, many years ago, since 2012 or so. And we were perhaps one of the first few pioneers amongst other funds that have been around for a while lending to European companies in this way. The landscape changed massively. I then moved on to work on the internet for a few months to work for global growth capital, found myself in a debt shop there. Great place to learn. And great best of all things. But equally, then moved down to another venture lender, traditional venture finance, and helped to lead their charge and origination in Europe, and some in Southeast Asia.

5:30So did that for a while. But again, you looked at the ecosystem and you said, well, hang on a minute, venture lending hasn't really changed. It hasn't changed since its inception way back when, for the last 20 years or so. And there's got to be a better way of doing this. And what we noticed is the VC community has sort of evolved using the sophistication from the private equity industry. But the debt industry hadn't quite evolved and become more sophisticated by using some of the learnings of its leveraged finance, big brothers and sisters. So what we decided to do was we had a view of this debt led hybrid financing.

6:09and we said well why don't we take some of the learnings that we've had in our previous lives especially in leverage finance and start to apply some of the flexible slash perhaps slightly more grown-up ways of financing businesses in that space to meet the current need that they have so that's when we left and we we joined white star capital who um i can go into a bit more but but uh yeah we are interest aligned could i could i ask you to you know when you started talking about your journey into this beautiful world. If I got the dates correctly, in 07-08, you started in Leverage Finance, right?

6:46Yeah. That was an interesting... Exactly. Can you share your reflections of that time, maybe some core learnings? And obviously, it's interesting to understand how that informs you as an investor today. Yeah, look, I mean, it was a very, very, very interesting time. And I have to admit, I was very, very junior coming in from an engineering background, not having a clue about what the hell was going on and seeing everyone getting fired. So it was a very, very strange time where most of the work that was being done was actually restructuring. So a lot of work at the time was, you know, I didn't know it then, but I was living through one of the greatest recessionary periods that we ever had.

7:29But I think in those sorts of situations, that's when you really learn how to do what we do, understanding businesses inside out, understanding how to effectively make wrongs right, if you like, and restructure things to make sure that from a lender's perspective, you make sure you get your investment money back. But equally, helping those businesses that are really on some sort of trajectory grow even better. So we found that in that 08 period, 08 to 10, there's a lot of money to be made, not just for investors, but also for founders' companies. And if you look at some of the best companies that we have today, the Justines, the Zooplas, the Mindcasts, et cetera, that were the first wave of companies that were born in that recessionary environment, they went on to become the unicorns and do very well.

8:15So discipline, understanding how to do a lot with little, and really being sure that you drove growth very well was a big learning in that period. I'd love to ask you, because you hear a lot, because I'm not in private credit, right? You hear a lot from the VC ecosystem about, well, LPs are looking for private credit opportunities right now. Could you hear us a bit about, you know, you're out there on the fundraising trail. Are you really welcome with open arms everywhere? Across 2023, Andres, the interesting concept was everyone was saying this was the golden age for private credit. And I think every single conference or anything I went to, the first opening was, this is the golden age for private credit.

9:00I was thinking, great, but private credit issuance is not as high as previously. So if it's the golden age of private credit, get lending. I think, look, it's one of those things where, yes, it is a great time for private credit. I think we're going back to an environment where we were pre-7, 8, where I think the credit quality is now in focus for people. Businesses can raise debt financing, but there is now a flight to quality of company. Ultimately, people are looking at the best companies to lend to. And fundamentally, I think risk-reward pricing has come back to where we perhaps were a while ago.

9:42So I think things are going to be very different with regards to how we go forward, because we've had 10 to 15 years of monetary stimulus through central banks, where it's made credit very, very cheap to come by. Having said that, 2023 has been a bit of a shift in mindset where I think people are seeing interest rates going to be held where they sort of are, if not come down a little bit, but never going back to sort of zero or negative, or at least until the next crisis, should we say. and I think people are now sort of looking at the readjustment in BC and in PE on the equity side and saying, hang on a minute, we need to perhaps diversify where we're lending, or say where we're investing, should we say, because lots of people who have pigeonholed themselves into just PE and BC have sort of had a bit of a rough ride over the last sort of 12 to 18 months.

10:29So the attitude is certainly changing it is still exceptionally tough um to to fundraise um i have to say but i don't think it's going to get any more difficult i think there are people that are very receptive and 2024 i think the first half will be pivotal to how we how well private credit raising goes what are the questions when considering the market that lps are asking sure i think i think the The biggest question I always get is, well, look, you know, how long are rates going to be where they're going to be? And how long are you going to continue to have to price loans where you're pricing them?

11:09And I think that's very, very sector and sort of asset class dependent. I think the interest rate hike has been quite prevalent in the traditional private debt leverage finance markets where you've got a clip of, say, 200, 300 basis points over floating rates. But when the floating rate has gone up by 300%, 400%, it's a big, big move versus in the growth markets where actually the risk of taking your pricing high anyway. So someone paying 10%, 11 % versus paying 13%, 14 % with the floating rate included isn't as much of a hit on the cash flow of those companies as a traditional leveraged finance business would face.

11:54And that's what you'll see. I think that's one of the questions you always get asked. But also, it's interesting that not a lot of people, not a lot of LPs really truly understand the growth debt markets in our sector. They understand average finance, for sure. They understand public credit or publicly traded credit. But unfortunately, we've been on the massive learning curve or educational curve of talking to LPs about how credit works in our environment. What is the parallel to valuations having been slashed 50%, 80 % in equity markets in venture debt? Because, you know, is that you're going from 3 % to 10 % in interest rate?

12:44Or how does it even, what are the dials that you're moving? they're sort of related but they're not i don't think they are uh truly related in earnest and here's the reason i think equity valuations coming down in in in venture-backed businesses is is almost a separate issue i think you have a lot of cheap money you have a lot of funds who are you know pricing the next best thing at 20 30 40 times our hour in some cases we've seen when I think perhaps some have lost a little bit of discipline on how to price some of these businesses. Does that really have a direct correlation on debt pricing? Not really.

13:26I think the interest rate environment probably has more of a correlation on debt pricing versus the valuation drop-off. I think for companies like us who are always looking to lend and invest in the best tech-enabled businesses, we're looking at quality full-stop. if the business is credit worthy, that is what we're going to lend to and this is the price it's going to be. And fundamentally, what you've seen in the last couple of 12 to 18 months has not been an increase in pricing per se from us. We're pricing at high-sick religious low teens. But it's when you add on the fact that loans are over floating rates.

14:06That's the movement. And that's been the key driver between that. I don't think it's really linked to the valuations. But fundamentally, valuations have dropped off. And because we have seen businesses, a lot of businesses, raise at low rounds and or flat rounds, we still look at the fundamental underlying quality of these businesses and whether they're lendable or creditworthy, should I say. And how do you think about, we've been in SVZ's repricing portfolios and that has led to significant markdowns. what is the parallel in a fund like yours? And has the issue of having been a bit too frisky with putting money into very starry-eyed projects been the same in credit as it has been in VC?

15:01In credit, you are valuing on two different bases. You're valuing your loans, which are pretty steady state. it's very easy to see interest rate fees etc the component at risk or should we say at that's the most volatile in that phase is your warrant so at one point you strike warrant at x and fundamentally you can you can sort of theoretically produce what your value of the warrant is as that valuation goes up or down that's what yeah but because the warrant typically is not a huge part of the return for a traditional debt fund, it doesn't really drive the portfolio up or down too much unless you have an absolutely massive war position and it's your portfolio.

15:44In some cases, that's happened. So where you're ultimately getting the difference in the VC market is, yeah, we've been talking about TBPI for ages on the VC side. I think that's been the flavor of the month for many. And DPI actually returning cash back to investors has been a bigger topic. But I think the difference in value in portfolios really from a private credit standpoint is very different. And that's what I think investors also should understand, where it doesn't really matter whether the valuations of these companies go up or down. The debt is priced at whatever it is. It's fixed. It's contractual.

16:19And provided the company continues to grow and has the cash register service short ahead, well, the valuation of that debt is what it is. It's there. It can be calculated quite easily. So less volatile, but again, it's risk-reward, right? So this is where the difference comes between VC and prime credit. And let's talk then risk-reward. What is juxtaposing, because you know VC very well, what is the IR expectations for a fund like yours versus a VC fund? I think first, perhaps to introduce that, I think it's worth talking about. where we sit and we always look at this in sort of three circles.

17:01We look at the sort of the equity market where it's sort of higher risk but higher reward. You're investing money in an early stage with the hope that at some point you build a business so high that your multiple is 10x per deal, et cetera, and you sell it or IPO in eight to ten years' time. Fantastic. On the other hand, traditional private credit doesn't rely upon that. It's quicker money, but you're taking a senior secure position in the business and fundamentally getting a contractual return repaid over three to four years. And your loan gets repaid, your cash comes back quicker. So your perceived risk is lower technically and therefore less volatile because on the equity side, you have winners and losers.

17:44On this side, you have a steady state of people returning your capital. what we think is when you are on the debt side and you have that lovely sort of less volatile nice clean cash generative business model where your money's coming back with interest every month or every quarter what we have access to is data and that that data is very very interesting because not only do you have data but you've worked with the management teams you work with the investors for such a long time, you can tell which business models are going to be successful and which ones aren't. And you really can see it. You can see it very, very early on.

18:24And fundamentally, what we do, which is slightly different to private credit, but it's not the VC world, is we take that data, we understand it, we look at the qualitative stuff by working with the founders and then making selective equity investments on top of that, and meaningful equity investments on top. And thereby, you blend the best of two. So on one side, you're probably looking at sort of on that 12 % to 15 % net on the debt side, IRR just on the debt and the warrants, et cetera. On the equity side, hopefully you're hitting 25%, 30 % plus IRR. And we're sort of saying, well, okay, look, 20 % plus IRR for us, a strategy combining the debt and the equity.

19:05That's pretty good. And we should sort of think of ourselves as a medium-term strategy in that sense. Do you consider yourself a VC or a banker? Neither. We consider ourselves a growth capital shop. That was the cop-out.

19:22Certainly not a bank. I've been there. Don't go wrong. Love the banks. Been there before, but the bank is an interesting place. But I think genuinely, I think we have a slightly different mindset to VC, and we have a slightly different mindset, very different mindset to a bank. so um i would say we take more of a pe lens private equity approach um a little bit more calculated we're not after 10 15 20x on the equity etc we're slightly different but uh that's the closest i'd align myself to on that side i was wondering i'd love to hear you expand on something you know most of our guests are early stage vcs right so you your own portfolio is designed for right of for failure right it's part it's part of it it's it's from the get-go you know that's going to happen when we're talking about a hybrid approach like yours where you do that first right is there such thing as a write-off in the designing of your model and what what does what's the comparable actually because it's not technically speaking a write-off right i think you know look this is the world of investing you're going to have write-offs um whatever you're doing whether it's debt equity hybrids bitcoin whatever it is you're doing you're going to have some form of a ride off somewhere i think that the difference in both if i look at the early stage equity where as you said you're expecting most of them to be written off but you're those golden numbers are really great and really return 10 times your fund the difference here is because the standard deviation of pricing but also standard deviation of sort of how much risk we're taking is pretty narrow you know the loans start to get repaid you're in for a short time you're on you the The model is built with less defaults in mind or lower defaults in mind.

21:07Don't get me wrong. Defaults happen, right? But it's how you work your way through the default and how you get the most back out of that default situation, which is what investors sort of back us to do. In the good times, it's all great and you're wrong. But in the bad times, it's how can you recoup your money when something's going a bit sideways? So, look, defaults are going to happen. But if you have the amount of defaults in depth or credit-led funds, should I say, as you're going to have an early stage fund, then that credit stage fund is wiped out. Can't afford as many. I imagine that very often you come into the picture actually not as much from the founders reaching out, but actually from other VCs that know you and trust you and like the way you work.

21:57Could you share with us a bit about how that's different from normal VC? And I ask this question to our audience so that they know, because we've done a session before where we spoke about revenue-based financing. We've spoken earlier also to more traditional debt providers where it's very apparent that it really matters to a VC who they get on as the credit supplier. But it's interesting. I mean, I think capital like ours, historically, we've had a mixture of sort of the investor or the sponsor, the VC reaching out, but also CEOs reaching out directly to us or CFOs or chairmen. I would say it's been pretty even split, given that I'm sort of starting to get gray hair and some of it's starting to fall out.

22:50I'm not as bad just yet as you've addressed, but it's getting there. the fact that we've been around for a bit of time where we've backed founders who have exited and are now coming back to the table you know that sort of recycling of that ecosystem for lack of a better word is what is actually driving deal flow for the hybrid capital right now it's people that are the CEO to CEO or the CFO to CFO or so forth is actually where we get half of the inbound from but again there's no So just like every other early stage VC or even VCs in general, there's no shying away from grinding out your own work and trying to follow markets that you're interested in and sectors that you're interested in and try to actively reach out to people yourself.

23:36So I think mainly it's VCs that come to us, typically at a Series B and Beyond level. That's where we get involved. That's not always cast iron. It just so happens to be if companies have revenue by that point, they have established business models, they can service debt. That's the key parameter. But equally, it's a bit of both. Okay, so now I want to go to our Take a Stand section, which is going to be a bit different. Take a start.

24:13Hey, man. I am listening these days to Einstein by Walter Isaacson. And Einstein is very famously quoted by many for saying that the definition of insanity is doing the same thing over and over again and expecting different results. That, of course, connects very well to what you started out explaining as your origin story of White Star Capital, growth, fund, whatever we called it. Sorry for not nailing the name. Tell me, what's your take on that quote? it's a very very apt quote for the time that we live in i think um you know venture debt has been traditionally a very good tool but it's been pretty mono product this is what you get seen as secure and amortizing sound loan the flexibility comes from an interest only period but that's about it right so it's it's it's priced in a particular way you take the warrants let's behave in the same way and here is a product but the funny thing is and you'll know some of this yourself you probably have lots of founders on the show too but founders want to raise for different things and you know it's always square peg around whole they need different types of solutions in order to fulfill their financing requirements right and so having more and more and more venture debt shops doing the same thing ever again and hoping that they can fundamentally find the flexibility to meet the requirement that a founder has, is where that code fits.

25:46So we have to do something different. In order to try to keep European companies private for longer, which is, I think there's some stats out there that show European companies sell out much quicker to US peers, simply because there is a lack of funding, even though a lot is being done by ELPs in the European market to try and bridge that gap. backing the same old thing over and over again, it's not going to work. You've got to back something different. These sorts of products like we offer exist in the US and allow founders to be able to say, okay, let's take a piece of less-to-date capital first, but from the same provider, let's turbocharge the growth before we raise the mammoth equity realm by getting some more equity or some sort of junior capital to the debt.

26:28So it's that that we, you know, companies are seeking alternative ways of being financed in more sophisticated methods. The world in 2012 is very different, 12 years on now in 2024. People understand that there are ways in which you can find those companies and solutions that we now try to offer. But there's still, I mean, one last thing I'd say, there's still a huge funding gap. There aren't that many alternative options out there at the moment. I think that's where we as the Europeans of the community need to improve.

27:08I'd like to dive a bit deeper into the specifics of White Star Growth Capital. And Andreas, that's the name. So give us a one-on-one of what you do over at White Star Growth Capital. And I think later on, we can talk a bit more about what's the value for founders, for companies, for investors, LPs, how you collaborate with others, your edge, etc. But let's really start with the basics of what you do. I think most people will know White Star historically as first and foremost of EC. That is what they're famous for. We're now close to some good news, I think, next week. So I won't ruin that just yet.

27:46But we do very, very well at that stage in venture capital and investing in early stage technology companies. It's a global platform operating in North America, Europe, Southeast Asia, and now I mean it. but equally what White Star Growth Capital now fits into is adding the third leg because it's White Star's first been VC but they have a digital assets platform and now we're I guess the debt side of the business but the hybrid debt side of the business and what we continue to do is it's sort of like that step change so apart digital assets for the time being but sort of the The VC portion of our business comes in and invests in sort of late C, mainly series A, and follows money into series B.

28:30Whereas what we come in and do is perhaps start at series B, look at things in a slightly different lens from a debt angle versus a direct investment angle to start with. And we're basically backing the growth, the future growth of the company. So once the company have got product market fit, they've got proper revenue, they've got KPIs they can sort of deliver, they've got a proper financial model, they've got a big team, etc. A lot of the hard lifting has been done by these early stage equity investors. We come in later to really turbocharge that growth and we aid expansion. So that's fundamentally what we do and that's how we get involved.

29:03We come in with a debt check to begin with and then we track these businesses, we work with the businesses. In particular, we take board observer rights. And I think the reason we do this is because we want to get involved. We want to be part of the table with the founders, with the investors. We want to try and bring a level of value add where historically, I think lenders have perhaps not really done as much. And fundamentally saying, well, look, we're part of this growth journey. So that's what we do at Whitestown. And the aim is to try and turn European, for us, we operate in Europe and Southeast Asia, but probably Europe, is to try and grow unicorns in this market.