Fitch Ratings reports that increasingly, lenders to middle-market firms, also known as business development companies (BDCs), are turning to venture lending for additional investment opportunities and enhanced yields, as declining yields on traditional middle-market investments continue to squeeze net investment income. Fitch Ratings expects execution and underwriting risk to rise as BDCs continue to reach for yield in a low-rate environment.

Venture lending, typically characterized by loans to fast-growing start-up companies, has the potential to generate appropriate risk-adjusted returns. But venture firms often lack positive cash flow, the hallmark of traditional middle-market underwriting. Still, amortization schedules are generally more favorable for lenders in these deals, and venture lending often comes with equity warrants that can provide meaningful earnings upside for the BDC.

Hercules Technology Growth Capital, an internally managed BDC formed in 2003, has a long track record in venture lending. However, more recently Ares Capital Corporation (Ares) and Fifth Street Finance Corp (FSC) announced their intentions to enter the business as well.

In March 2012, Ares hired a team of venture investors from BluCrest Capital Finance GP. Ares is focusing on senior secured debt financings in sectors such as communications, information technology, semiconductors and alternative energy. Its first venture investment was made in August 2012 in a $6 million secured credit facility to a medical device company. The investment has an 11% yield, matures in July 2015, and comes with preferred-stock warrants.

FSC's manager announced on Aug. 6 that it too was entering venture lending through the creation of Fifth Street Technology Partners (FSTP). The group will be led by the former co-head and managing director of ORIX Venture Finance LLC. FSTP plans to make structured and secured debt investments ranging in size between $5 million and $50 million in venture-type deals.

While venture lending is expected to account for a relatively small portion of Ares' and FSC's balance sheets, the fact that many venture deals come with equity warrants could introduce increased leverage volatility if initial equity gains are levered, and equity valuations decline in subsequent quarters. Fitch believes that an increase in equity exposure should be met with a corresponding reduction in overall leverage.

Venture lending is also highly competitive, with significant advantages afforded to other players with longer track records and broader industry contacts. This could be a headwind for new entrants, but Fitch views Ares' and FSC's respective decisions to bring in experienced industry veterans as an appropriate first step.

Given the typically small portfolio sizes of companies that receive BDC investment under a venture strategy, BDCs are generally able to obtain Small Business Administration (SBA) funding. FSC currently has two SBA licenses, with $225 million of total funding capacity, and Fitch believes Ares may also pursue an SBA license for its venture business. We view the SBA facilities as an attractive and relatively cheap form of funding, with debt maturities that extend for 10 years, but we also consider them as part of the BDC's overall debt profile when calculating leverage.