Mar 14, 2023
The global venture capital industry was in a significant crisis over the weekend as Silicon Valley Bank (SVB), the banker to the US VC industry, collapsed on Friday. SVB’s demise made it the largest bank failure in the United States since Washington Mutual went bust in 2008. The implosion of SVB – a storied US financial institution – has more to do with how it was run than it’s about the broader financial services industry. At the end of last year, SVB was ranked the 16th largest bank in the US with assets of about $209 billion. According to the Federal Reserve, there are over 2,000 banks in the US with $19.8 trillion of domestic assets—the top 10 account for $10.5 trillion, or 53% of the total.
The failure of Silicon Valley Bank highlights many issues:
1.The structure and regulation of the US banking industry do a terrible job of supporting the VC industry
2.How can it be that a VC company successfully raises capital from institutional investors but can’t easily bank the cash?
3.The Fed’s missteps on policy and endless miscommunication with the markets are leading to trouble
4.The Fed and US government need to rethink the institutional support of VC and small companies
5.Unless the authorities move quickly, VC will be assigned a higher risk premium, only crimping the flow of capital and impacting global growth
Below, we highlight the structural and cyclical challenges that contributed to SVB’s failure and the challenges it presents to the global venture capital industry.
The SVB crisis highlights the significant structural problems inherent in the US banking industry that affect the VC industry. The largest banks in the US provide little help to the VCs, focusing instead only on big corporate customers and turning a blind eye to onboarding VC companies and startups. While the Fed deems big banks as ‘too big to fail’, the tighter regulations on what these banks can and can’t do have made them significantly more risk averse. VC companies have therefore turned to smaller banks and the so-called shadow banking industry for their capital requirements.
It’s ironical that the US financial sector has failed the entrepreneurs who have been the backbone of the entrepreneurial spirit that characterises the US. Shockingly, nearly 50% of US venture-backed tech and life sciences startups parked their funds at SVB. Such a significant market share in the hands of a single bank was also reflective of the failure of the incumbent banking industry to provide alternative sources of financial services.
Consider this real example: Company A, incorporated in the US as a fintech business with three years of track record, raises $20 million from very high-quality venture capital funds at a $95 million valuation. With its investors’ commitments, it seeks out a bank to deposit its fresh capital funds. It approaches the larger US and UK banks but get turned down repeatedly because it needs to have the requisite track record of passing the larger bank’s rigorous checks, or are deemed too small. It is then encouraged by its institutional VC investors to approach SVB as one of the few banks that will onboard it quickly and allow it to deposit its cash. As the past few months have played out, it (luckily) managed to withdraw its money and seek another institution. Other tech companies were not so lucky.
Cyclical challenges exacerbated by inconsistent Federal Reserve communication and policy making
Economic cycles bring challenges for the financial system; however, the volatility of this cycle has created real issues. The ultra-loose US monetary policy for far too long left companies and investors with a false sense of security. Then, inflation slowly reared its ugly head and the Fed was caught completely off-guard. Recent communication from the US central bank has been inconsistent, which has only added to the volatility in interest rates.
In terms of its treasury management, SVB, like many others, harboured a false sense of security about the likely path the interest rates were to take. The Fed initially termed inflation as “transitory” and, in what appears to be a classic case of indecisiveness, only discussed the need for measured rate increases. Month-by-month and data-point-by-data-point, the Fed kept changing its stance, sending different (and confusing) messages to the market.
SVB erred in relying too much on what it heard from the Fed. To make matters worse, a bank that featured in Forbes’ annual ranking of America’s Best Banks for five consecutive years, did not have a risk officer for eight months! In its mistaken belief that there would be little volatility in interest rates, the bank moved a large proportion of VC deposits into its hold-to-maturity bond portfolio. Those bonds had a relatively long maturity. Hence initially, the bank had a boost to its profitability as it earned a little more income from its portfolio of bonds. However, those holdings also tied it into a portfolio positioning that would ultimately lead to its demise.
A bank can invest in its available-for-sale bond portfolio (AVS) or hold-to-maturity (HTM) portfolio. As the bank loses deposits, it sells down its AVS portfolio and takes any gain or loss on the bonds it sells. If the company sells anything from its HVM portfolio, it is forced to take a profit or loss on the whole portfolio.
SVB made a mistake in splitting its assets poorly between the so-called “available for sale” (AFS) assets and hold-to-maturity (HTM) assets. It substantially increased its holdings in the long-duration (riskier) HTM assets on the now-mistaken premise that it would not need to sell them because its deposit base was growing.
With a booming VC industry encouraged by the ultra-low interest rates set by the Fed, the VC companies placed a large base of their deposits with SVB. At that point, even if a VC burnt through its cash, it almost appeared confident that it could raise more money in a subsequent round of funding. SVB obviously thought it was going to be business as usual and that the deposits it held were more secure than they really were.
By September 2022, the bank’s mark-to-market losses on its HTM portfolio had swelled to $16 billion due to a 17% loss on its book of investments. At that point, the company was technically insolvent; however, even as the bonds rolled off, the bank with a “growing deposit base” thought it could ride out the storm.
SVB believed that the deposits would be sticky and that interest rates would remain unchanged. Fed commentators had fully endorsed the latter for some years. Hence, SVB placed much of its deposit base in longer-dated bonds to pick up higher yields and boost its profits.
However, it also designated those securities as “available-for-sale”; the rules are that you need to mark to market the market price of the securities. The sharp increase in market and policy rates made SVB quite vulnerable to mark-to-market losses on its bond portfolio, which in turn spooked both equity investors and depositors.
This wouldn’t have been a problem if the bank didn’t need to sell any bonds in the held-to-maturity bucket. Unfortunately, cash withdrawals picked up a staggering pace with $42 billion withdrawn in one day. The bank was forced to cover deposit withdrawals by selling some of its AFS assets, which forced it to book losses that essentially wiped its equity.
To be fair the authorities have moved decisively to stem the immediate fall out from the crisis. US regulators have promised to fully repay funds to Silicon Valley Bank depositors. In addition, The federal reserve announced a new lending facility aimed at providing extra funding to the banking industry to ensure that “banks have the ability to meet the full needs of all of their depositors”.
While the failure of SVB did not represent an overwhelming systematic failure of the US banking system, it does represent a significant setback for the VC industry. In a mature economy, it is simply not acceptable that all the hard work put in by the entrepreneurs to raise capital goes to waste because the custodian of that capital goes bust.
The ramifications of SVB’s failure are being felt beyond the US. SVB had branches in China, Denmark, Germany, India, Israel, and Sweden, too. The authorities in these countries were hard at work over the weekend to find a solution to the crisis.
The SVB collapse only adds to the existing challenges in the markets. Nevertheless, it’s wrong at this stage to draw parallels with the global financial crisis. The troubles of the VC industry are no match for the mortgage market of 2006-07. In 2008, the Emergency Stabilisation Act amounted to $800 billion, which failed to stem the problem. The Bank Term Funding Program announced over the weekend amounts to a commitment by the US Treasury of $25bn.
Bond markets rally – but probably can’t ignore the ongoing inflation risk over the medium termIt’s a tough job trying to conclude what would represent the right 10-year bond yield level at this juncture. On the one hand there’s been an almighty scare in the financial sector and on the other hand inflation risks remain very real. We do not believe a 10-year US government bond yield below 3.70% reflects the inflation risks and hence we would see it as a tactical selling opportunity.
Equity markets will enjoy the capital injection from the FedEquity markets were a sea of red on Friday but are pleased to see the ‘save’ by the Fed come Monday morning. The SVB crisis is a wake up call to the risks to the economy that come from the ongoing monetary tightening. Last Friday’s employment report that showed stronger than expected job creations only adds to the pressure on the Fed to tighten further. In our view equities still have downside.