October 17, 2022 – On today’s show we welcome special guest, Trinity Capital President Kyle Brown. Trinity Capital is a provider of venture debt financing, a smart financing option for high-growth venture capital-backed startups.
On the show, Kyle discusses:
- A primer on business development companies
- The basics of venture loans and equipment leases
- How venture debt fits into an investment portfolio
- And more
Welcome investors to The Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies, your hosts, Julian Klymochko, and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by Accelerate Financial Technologies. Accelerate because performance matters. Find out more at accelerateshares.com.
Julian Klymochko: I’m excited to have Kyle from Trinity Capital on the show. Today we’re going to be chatting about business development companies, venture loans, equipment leases, a really interesting asset class that I’m stoked to dive into today. So, Kyle, thank you for coming on to the podcast. How are you today?
Kyle Brown: I’m doing well. Thanks Julian. Thanks, Mike, for having me.
Julian Klymochko: Yeah. Excited to get into it. So, prior to Trinity Capital, just was wondering what were you up to? Where did you build your skills to get into this asset class?
Kyle Brown: Sure. I cut my teeth in real estate. Started a mortgage company in 2003 and really kind of a combination of luck and timing, was a good time to get into that business. And built a business. Had a successful mortgage business and bridge financing business. And which fell apart dramatically in 2008, as did most mortgage companies. But was able to get investors their money back and leveraged some of those good relationships into a new kind of fund management platform that started to build to where we acquire distressed assets. Which being in, you know, in the southwest was kind of rip for opportunities there. Ended up acquiring a significant amount of residential commercial properties. And through that there was really kind of the opportunity because of the share volume to kind of go vertical and build some other businesses as well. So, in insurance and real estate brokerage, mortgage brokerage, et cetera. So really just an entrepreneur and sold that business in late 2014 to join Trinity with the idea that we would build this business, grow it, and scale it into an exciting platform that we’ll be talking about here today.
Julian Klymochko: Yeah, it sounds great. And prior to getting into Trinity specifically, can you give us a quick primer on business development companies?
Kyle Brown: Sure. I have become a pro over the last couple years learning myself about business develop companies. But for investors out there who maybe have some experience or more experience with REITs, it’s very similar structure. We are governed by the 40 Act. We have special tax privileges, meaning it’s a pass-through entity. There’s not this double taxation at the corporate level. And so, the interest income that we generate flows directly to investors. And so, there’s some really unique tax benefits. Most of the BDCs out there, I’d say probably all of them are very focused on income. Most investors are very interested in the dividends that BDCs shoot off. And so, we are also required to distribute out our earnings annually, 90 plus percent. And so, for investors out there looking for income, it’s a great option. The one differentiator and something that I want to focus on as we talk today, because we are very different than the majority of BDCs out there is, there’s an entity and assets that are managed by some management company. We are a little bit different that we’re an internally managed BDC. We don’t have a management company. There is no fee, there’s no carry. And myself and our executive team hold the same shares as our shareholders. So very different. I think there’s only three or four internally managed BDCs out of all BDCs. But anyway, I’ve been around since the eighties, been a successful option for income investors.
Julian Klymochko: Now my experience with BDCs is for the most part, are the ones that I’m aware of generally stick to leverage buyout financing and things such as that, leverage loans, et cetera. However, Trinity Capital is focused in a different area, specifically venture loans and equipment leases. Can you talk to us about the basics of those specific asset classes? Kind of the main things we should know about them.
Kyle Brown: Sure. So, we’re a growth stage lender, so we’re focused on companies growing at a 50 plus percent annual growth rate, who have raised institutional capital significance amount of capital, 30 plus million of equity really on average. You know, think about it like 20 to 30 million ARR and growing. They are bankable to an extent, but really, they can’t get the amount of capital they need from banks. And so, we serve as this kind of alt bank option for them. Helping to bridge between where they’re at today and where they’re going to be tomorrow. Helping them extend their runway 6 to 12 plus months so they can achieve milestones and build that valuation as they head towards a fundraise, liquidity events, IPO, profitability, et cetera. So really kind of industry agnostic. Our capital has a lot of different case studies and sometimes it could be used maybe to tack on, do some acquisition financing.
But we’re a little bit unique and different for BDCs in that we are a direct lender. We own our pipeline. We’re working directly with these companies, they’re CEOs, we’re referred directly in by their board members typically. And we’re not buying syndications of other deals or typically not focused on acquisition or M&A type financing. So, the space is a little bit unique. You said venture debt, venture debt is one product we provide. We also provide equipment financing. We’ll do some ABL kind of traditional ABL financing. The general theme though is the corporate entity is growing at a rapid pace. They’re spending to grow, right? And so, they’re typically not able to get the amount of debt they need from a bank, but we provide this really interesting non-dilutive, less dilutive option that helps get them further down the road.
Julian Klymochko: That’s interesting. Now getting into the specifics, I was wondering if you could provide some details on a typical loan. Like what would be some key aspects that would be different from traditional bank loans? Like, is there some aspect of payment and kind, what’s the term? Are there warrant kickers? You know, what sort of unique features would these have?
Kyle Brown: So, another unique aspect of our business is the majority of our returns. And if you look at them and historically, we we’re kind of best in class from a gross asset yield standpoint. But it’s made up primarily by rate and fee, right? And so, we have very upside from warrant or equity gains. They’re really interesting and they’re there and we can talk about that. But most of the income is generated by current pay rate, and it ranges from high single digits to low double digits with a kind of success fee in the back end as at the conclusion of the facility, pay an upfront fee. They’re structured as interest only for some season. So maybe contrary to most middle market lenders or banks, it’s, you know, that are doing more bullet type structures.
These are really structured to get off risk, right? And the combination of amortization, early and quick amortization payments combined with a senior position against real IP and value. So, one of the ways we underwrite these deals. If it’s a senior secured loan, which the majority of our loans are, we’re digging in deep to the technology. We’ve got our technology experts on hand so we can dive deep and understand what the IP is worth. We have a lean against all assets. So, whatever, you know, we’re in a first position against all assets. So, in a liquidity scenario we’re the first payout, you know in that scenario, if it’s equipment, we’re looking to the value of that equipment and we are, you know, it’s going to be more of an true kind of equipment type backing where we’re looking at what is this equipment worth? It’s fully amortizing, typically over 36 months. So, we rapid amortization, get off risk quick. We’ll hear that a lot in the way we structure deals plus the value of the equipment in a liquidation scenario. That’s how we get off risk, right?
Michael Kesslering: You did mention the warrant kicker, and I was curious if you could describe a little bit more of how you structure those in your deals?
Kyle Brown: Yeah, so you know, a unique part of our business is the warrant component. These growth stage companies you know, will typically negotiate somewhere between a, you know, think of a half a percent or to a percent or more in some scenarios. The option to buy shares at the price when we invest, right? And so, the idea is that these companies are growing at this fifty to a hundred plus percent growth rate. Our capital helps them get further down the road that we would share in some of that upside. And we currently have, I think last reported a 70 plus kind of war portfolio, company portfolio. We have seen significant warrant gains. If you look at our history, we’re actually still paying out for anyone who wants to buy the stock right now. We’re still paying out the 50 million we made early this year from our warrants on Lucid the car company. So, there are significant upside. Typically, the way we talk about warrants and think about warrants, it’s going to cover our losses and then it’s going to provide some extra juice. That’s how we think about the warrants. And then every once in a while, you know, a Lucid happens and Matterport is another company. We saw significant gains earlier this year.
We’ll have this out size gain, and then we’ll have these special dividends. And you can see it’s building up. We just stated a 60-cent dividend this this quarter. You know, 15 cents of that is spill or is special dividend. And then we’ve got 60 plus millions of spillovers. And the idea that, you know, these special dividends would continue. It makes a lot of sense. We talked about it before, we have to pay out 90 plus percent of what we generate income wise. And so, you know, I think special dividends are just a part of our business. And some of that comes from these warrant gains.
Michael Kesslering: From the perspective of your investors, where would you say that equipment leases fit in part of a normal portfolio?
Kyle Brown: So, I think I understand the credit question correctly. It’s 25 to 30% of our deployment is equipment. I think the other really important thing to understand about our equipment business, which is going to be different than your typical leasing business. These companies, you know, these are equipment financings. So, there’s an obligation to fulfill the full commitment and schedule those payments. And so, there’s not really a scenario that exists where companies are sending us the equipment back and saying, hey you know, we don’t need it, don’t want it. They’re on the hook for the full schedule of those payments. So, it’s a little bit different from a traditional equipment business where, you know, we would be holding the asset and then collecting rent payments.
There is an obligation by the parent company to fill the full obligation. So, but it’s about 25 to 30% of our portfolio and deployment going forward. That’s a big and growing business for us. It’s also a very big differentiator. It has a little bit different, you know, referral sources. It’s also a different market. It’s a little upstream in many cases, a little more mature companies. And its really kind of right before, you think about it like this, it’s just right before companies can get that Wells Fargo type equipment financing typically or maybe they’ve tapped out as much as they can get from a bank. And so, you know, in many cases, even a different profile, a company for our equipment business, but a nice differentiator and a nice you know, a nice business for us.
Julian Klymochko: Now, within the niche that you are in, I was wondering how competitive is it, and are there a lot of firms looking at the same deals? I know that you mentioned you’re working with these companies, so is it all sort of proprietary, internally sourced, or is it pretty competitive on some of them?
Kyle Brown: So, we are, you know, I said it before, we own our pipeline. We are getting, you know, a majority of our referrals are directly from the growth stage investors, you know, who sit on the board of these companies. You know, if we’re looking at a deal and there’s, you know, five or six competitors on or a lot of people are looking at it, that’s really not what we’re looking for. You know, I mentioned it before, but we have some of the highest kind of gross asset yields out there. So, we’re not the cheapest deal in town. We win deals because (A), this is a relationship business. We built these relationships with the banks and the investors over a long period of time. We do what we say we’re going to do.
We help these companies get across the finish line. We’ve got technical expertise, entrepreneurial expertise in house, so we can actually sit in that seat and help these companies, when need be, when things don’t go to plan. You know, we are also getting a significant amount of referrals from the banks, you know, the banking partners. We’ve got inter creditor and subordination agreements in place with the major tech banks out there across the U.S. So, you know, the last five years, it’s been incredibly competitive. Our sector generates pretty appealing yields, right, and returns. And so, but over the last six months, we have seen some of the tourist leave and some of the hedge funds, maybe chasing yield family offices, chasing yields. And really honestly even more so than that is, some of the venture capital equity that was very cheap before, is now very expensive.
And so, we’re seeing this really interesting dynamic of definitely more deal flow, right? Companies looking for less dilutive capital to kind of get into 2023, 2024, and just get further down the road past this period of time we’re in right now. But we’re also seeing more mature companies because you have companies who maybe be raised an evaluation that was a little frothy, you know, over the last year or two, they don’t necessarily need capital but they want to beef up the balance sheet a little bit and they don’t want to deal with a damaging down round or flat round, a dilutive equity raise. And so, we’re actually getting a look at some more mature companies, maybe even better profile in many cases. And so, it’s a very exciting time because it has been very competitive and in market conditions like this. This is where we really can really shine and maybe provide some outsize returns, you know, by seeing these valuations come down, our warrants end up coming in at a better valuation, right? So yeah.
Julian Klymochko: So, in terms of the current equity bear market that we’re in, and you know, you’ve seen growth stocks in particular get hit quite hard. How has that affected your business? I know there’s some tailwinds in terms of lower competition and perhaps some deals that you wouldn’t have seen in a bull market, but are there headwinds as well, or is it pretty balanced?
Kyle Brown: So, a couple things. Our companies are all private companies, and we have a handful of public companies. We have some equipment with, I think that the vast majority are all private companies funded by private companies, right? These equity investors. So, we primarily focus on companies that have been funded by funds that were raised in the last couple years. So that there is the availability of dry powder to support them on an ongoing basis. The conversation that we have about our portfolio, about the deals we’re looking at, it’s much less about a liquidity crunch. There’s actually a significant record amount of capital in our space for growth stage companies. It’s about at what valuation, right? And so, what’s very different between now in 2000 or 2008, these are companies that there’s something there, there, right?
This is not an idea on the back of a napkin. These are real companies providing real value. These are very disruptive technologies. The plan was always going to take 5 to 10 years to break into these spaces. And so, you know, headwinds right now, it doesn’t necessarily change the investment thesis of the investor or the business plan of the company. What companies are struggling with, and the conversation is much more about, in our world at least, is at what valuation are you going to get that next money, right? And so, we’re seeing companies cut. In fact, our space, I was just having this conversation the other day. In our world, you know, cuts happened three to six months ago or even before that, you know, significant cuts to cost, reduction of burn to extend runway to get further down the road so that companies could try to avoid a damaging down route, you know, as they need more capital. But many companies are faced with it. They need to raise capital and they’re doing it. They’re seeing it that valuations that were different in the last 24 months.
Julian Klymochko: That makes a lot of sense. Now from someone who’s looking to invest in Trinity Capital what can they expect? What are Trinity’s investment objectives?
Kyle Brown: So, slide 19 on our website of the investor presentation is a graph of a growing net income and growing dividends. And since we have been a publicly reporting company at the beginning of 2020, we have consistently raised the dividend. We have continued to grow the platform, but not at the expense of the investor. Returns continue to go up as we grow the business. One of the benefits is an internally managed BDC, and this is all public information as well. We’ve, registered for RIIA, executive relief with the SCC to manage funds. And so, you know, the really interesting thing for Trinity compared to our peers is, we have a focus on are we. We want investors to think of us as a very consistent dividend play, best in class in the BDC space, but also focused on growth and not growth of AUM for the sake of AUM, as most of our peers would be, because there’s fee and carry components there that really drive some of those behaviors.
In our world, it doesn’t make sense to raise equity for the sake of raising equity to grow the platform in AUM because we do not have a fee in a carry. We’re focused on ROE. We want earnings per share to be up into the right. We want that dividend to be up in the right. And that’s what we’re trying to do. And so, you can see a story, it’s a two plus year story at this point from a public standpoint, but we’ve been delivering those returns since 2008 as a fund manager. But that’s what we’re trying to build. We’re trying to build a very consistent dividend play for investors. The combination of on balance sheet growth with off balance sheet growth. If you think about what you can do with an RIA where we can manage funds and provide products to customers that maybe aren’t a perfect fit for the BDC.
There are some, you know, doing international deals. There are some restrictions as a BDC, some things that don’t necessarily fit on our balance sheet that would fit great in a fun type structure. And our investors at Trin, T-R-I-N own 100% of the RIA by law. So, there’s not, you know, me and my executive team or somebody else is not going to have ownership of that GP, of the RIA. 100% of it is owned by our shareholders at Trin. And the benefits of any funds that we raise and anything we do off balance sheet flows right up into the investors. So, you can see this story over time of new income coming in and growth of the business, but also growth of the net income via on balance sheet and off-balance sheet growth. That is the story we’re trying to build right now.
Julian Klymochko: And how does that play into the structure, the BDC structure? Because I understand it, you need to pass through the income and you can’t be like, you know, Berkshire Hathaway where it just takes it all in and then reinvests it.
Kyle Brown: Right? So, that’s right. We will continue to distribute out to retain that brick status. We have to distribute out 90 plus percent of our earnings. It’s just a fact. And so, you’ll see we’re going to max out at Trin. There will come a day where we will get to a certain scale and then we’ll have some efficiencies there with our cost. You’ll see as we grow and scale the business in the balance sheet at Trin, there should be some efficiencies, right? Our cost of debt will probably go down. You could probably see some expense ratios improve, right? Then off balance sheet activity gives us the ability to generate income above and beyond what we can do just on the balance sheet, which will increase the amount we can dividend and send out to investors over time.
Michael Kesslering: You mentioned that the relationships with venture capital firms is really important for you with investing into their growth stage companies. How would VC firms describe Trinity and their relationship with business development companies in general?
Kyle Brown: So, you know, there was a handful of groups that focus on the space that are BDCs. And we have tried to create a reputation with top tier institutional and venture capital firms and PE firms across the country as a first thought for anything one of their company’s needs. Above and beyond that cheap receivable financing you can get from a bank, right? If there’s a receivable, some bank out there will give you some advance against it. That’s not what we do. We provide everything above and beyond that. And that comes in the form of term debt.
Senior, subordinate. Can come in the form of, you know, warehouse lending against assets that might sit in SPV or bankruptcy, for fintech companies that might come the form of financing their Capex, right? Equipment financing. So, you know, top tier VC firms across this country, and I can list off you if you looked at the list of the top 10 VC firms from a return standpoint and amount of dry powder right now, those are our referral sources and then some. And so, we have built a reputation of being a first thought for all of those financing needs and an extension of runway because it’s really good for the VC firm who’s able to help the company get 6 to 12 additional months down the down the road. They’re going to build that valuation; it’s going to increase their return as well. So, you know, a third or more of our referrals are coming directly from those top tier investors, yeah.
Julian Klymochko: Now, can you talk about risk management? How do you approach it? Do you guys utilize leverage at the Trinity Capital level? And you know, what would be a potential risk that investors should consider?
Kyle Brown: Right. So, you know, we have maintained, you know, since being a public company, somewhere between one to one or one up to 1.3 equity to leverage ratios. You know, that’s probably a good, sweet spot for us at ebbs and flows in there. That ratio gives us the ability to really generate some best in class returns for investors. We’ve been near those ratios for a long time. It’s a very comfortable space for us. Our loss ratios are extremely low, right? 2% on a 2% default rate. And if you include our realized returns, it’s actually a negative return. But you know, from a risk mitigation standpoint, we’re very focused on principle preservation. So, we’ve been able to figure out how to lend to growth stage companies without taking the type of kind of venture risk associated with it.
There’s a combination of senior secured, so having a lean against all assets. We have internally from an underwriting standpoint, we have the ability to underwrite technology that a granular level. Understand what that IP is worth in a liquidation scenario. We’re doing appraisals, third party reviews on those assets. And then we do the same for equipment. You know, we’re actually getting appraisals on this equipment. We know what it’s worth if we had to liquidate it. The combination of that plus the payments that we’ll receive based on the amount of runway these companies have. That’s how we get off risk. That’s how our loss rates stayed so low over the course of our business history.
If the equity markets for venture capital completely dried up you know, some of our companies would have some serious pain I think, so that’s a real risk. But I mean, if you look back historically, even after, you know, 2000, 2003, significant amount of capital gets invested in downturns and recessions and some incredibly high-flying companies come out of these times. If you look at a Silicon Valley Bank, you know, who’s been kind of lending in this space, servicing this space for a long time, they have grown during every recession over the last 20 plus years. And so, we see a similar track for Trinity. Headwinds are not necessarily hit bad thing for us. It means less competition; it means more opportunity. Our companies do need equity finance going forward. But we are not currently experiencing a liquidity crunch for equity for our sector. We’re just simply seeing values reset right now.
Julian Klymochko: Now, in terms of the BDC market in general and adventurous lending specifically, what would you say are some keys to success? I know you spoke of relationship-built business. You have your risk management the way you’re structuring deals, and in addition the way you’re sourcing deals. What else would you say are keys to success in the space?
Kyle Brown: So, you know, there’s two major barriers. One is understanding whether or not you’re taking technology risk. We are are laser focused on companies that are, it’s execution risk, right? So, they have raised capital to develop a technology. They’ve raised capital to build a team to start selling that technology. They’re far down the road and we’re looking to come in and take execution risk for that growth, right? So, they can sell more. A lot of our capital is just simply going into hiring people in marketing, right? So, that’s a big key. Making sure that we are funding growth and not some type of bailout type situation or making sure that we’re, you know, not taking technology risk. Because that is one of the ways, again, how we mitigate lending into the space.
We do not want to take technology risk, which is why we have such an emphasis internally on having technology experts to be able to underwrite that technology to granular level to make sure that we’re not taking tech risk and it’s all about execution risk. So that’s a big differentiator for us. Also, you know, loan to value. So, one of the differences between us and maybe other BDCs you know, most BDCs that are lending into the middle markets. Those are highly leveraged companies, right? And they do not have institutional investors behind them. And so, when there’s headwinds like we have now and maybe EBITDA starts to dip, who’s going to be there to support those companies? I don’t know. I like our position better because we have true institutional support behind our companies who can fund them through difficult times. We’re also, you know, the venture net space has been able to weather storms, I think even historically a lot better than the middle market. So, we think technology is a great place to invest and it will continue to be a great place to invest in.
Julian Klymochko: That makes a lot of sense. Now, Kyle, prior to letting you go, I did have one last fun question. You know, what’s your favorite productivity hack? What helps you be most efficient to new job?
Kyle Brown: So, you know, what’s really interesting about our space, and it’s probably my favorite part about our business is, this continuous learning. It’s one of our core values here at Trinity. You know, every five years some new market has developed and turned into a significant space. And there are new products needed and new companies to finance. And so internally we call it continuous learning. You never can know everything. And the minute you think you got it figured out that’s when you’re going to see losses and you’re going to have difficulties. Every single person in our organization is continuously learning. No one has it all figured out and it’s, you know, I don’t know if that’s a hack but, in our world, you have to be quick on your feet and ready to learn something new because new markets are developing all the time. So continuous learning for sure.
Julian Klymochko: And that’s a great tip to our listeners. So, thanks so much Kyle for coming on the show today. And I like the theme of continuous learning, learned a lot about BDCs, venture loans, et cetera. So, thank you for sharing today. Wish she the best of luck.
Kyle Brown: Thanks, Julian. Thanks Michael. Appreciate you having me.
Julian Klymochko: All right. Take care. Bye everybody.
Kyle Brown: Yeah.
Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at www.AccelerateShares.com. The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.