In a matter of hours, decades of brilliance is undone at SVB

"Reputation is like fine china: Once broken it’s very hard to repair."

Until early last week, I’d been competing and collaborating with the team at Silicon Valley Bank for 23 years. With the shares of SVB now down 70% over the last 24 hours, our sector is gripped by what is transpiring at one of the cornerstones of the global innovation economy. President Lincoln knew a thing or two about “reputation,” and SVB’s stock market flogging is putting things on the edge for SVB’s clients and thousands of highly-skilled staff members.

Hugh Son, CNBC.com’s banking reporter, summarized the situation this way earlier today: “The consensus is, ‘I don’t know if Silicon Valley Bank is under duress or not, but it’s better to panic early than late.’ This is like 2008 for crypto and start-ups. Term sheets for start-ups are going to get pulled.”

While CNBC’s Becky Quick and Jim Cramer put the situation down to “what happens when rates go up quickly,” I don’t agree. SVB’s situation is entirely of senior management’s own making, and that’s the sad (tragic?) part for most of us — competitor, SVB employee, entrepreneur or venture capitalist. For years, I’ve reviewed the detailed quarterly investor relations reports that SVB produced. Given the bank’s prominence in the space, one had to know where they were finding both opportunity and challenge. It’s a great business model, and the fact that SVB was awash in billions of extra deposits as VC funding levels hit all-time highs in 2021 / 2022 is not the problem; the disaster is what SVB’s C-suite did with those excess client funds over the past few financial quarters.

As CEO of Wellington Financial, SVB was our primary senior bank partner, on either side of the Canada/USA border. A classic situation would be a California-based, VC-backed, Series B-type company that arranged a $9 million revolving line of credit with SVB, and a $6 million subordinated loan from our firm. Everyone got what they wanted.

We did so much business that way over the years, with a similar patient approach when entrepreneurs missed a quarter or two, that Wellington eventually negotiated a “treaty intercreditor agreement” with SVB HQ’s top legal and risk officers. This was a real validation of our approach to business at the time, as not every venture debt fund was so lucky. A couple of our high-profile U.S.-based fund competitors had been very tough on their portfolio companies during 2008-09, and no senior lender wants a trigger-happy junior lender in the mix if they can avoid it.

Following CIBC’s acquisition of Wellington Financial in 2018, SVBers were among the first callers; the bank was naturally interested in what form this new competitor would take. Given SVB’s market prominence, most of our early high-profile client wins were SVB clients: firms such as Hootsuite, Lightspeed POS, Expensify and so forth. But with thousand of clients, and hundreds of new start-ups being founded each week, no one competitor was going to slow them down.

If you were paying attention to SVB’s investor relations bumpf in early 2020, you’d have seen some impressive stats (Q1):

• 1,100 new clients in the quarter

• $165B of client funds; $62 billion of deposits ($41B of which was zero-interest bearing, or 67% down from 77% from Q1-19), with $103B off the balance sheet

• 24 bps cost of funds

• $5.3 billion of loan growth yr/yr (19%) to about $33.7 billion with an average yield of 4.57%

As we entered the Covid-19 window, you can imagine how happy shareholders were to see loans generating 4.57%, and deposits costs running at 0.24%. That the company loan book had been flat at $9.9 billion for the prior 12 months wouldn’t have been a bad thing, given the economic crisis that was unfolding around us. $4.3 billion of that $5.3 billion of yr/yr loan growth came via capital call loans to venture capital and private equity funds, a relatively newer asset class. Although these facilities come with a lower yield than a basic tech company term loan, they also have a far better credit rating; good business, and chunkier than small ticket lending.

There was nothing on the balance sheet at the time that looked troubling, with $7.2 billion of available cash on hand, and $27.1 billion of “investment securities.” Relative to $165 billion of client funds, 16% of those client funds (assuming the $103B of off-balance sheet funds were available to be brought back onto the balance sheet as profitable deposits should the need arise) being in longer term investment securities doesn’t feel imprudent.

Fast-forward to the Q4-2022 presentation released in January of 2023, and shareholders had plenty to be happy with, but for the fixed income portfolio:

• $341 billion of end of period client funds for Q4; $173 billion of deposits, with $168 billion off-balance sheet (think money market accounts)

• $74 billion of loans, of which $16.3B was in tech and life science companies (growing yr/yr) and $40.5B is in capital calls, with the balance in private bank and wineries (small)

• $117 billion of fixed income securities (55% of which was in Agency Residential Mortgage-backed Securities)

• $87 billion (50%) of deposits were still non-interest bearing

• 15 bps net charge-offs

• loan utilization dropped from 60.3% to 54.3%, speaking to good liquidity across the system, despite the overall drop in venture funding

The industry’s nay-sayers were fussed that funding was shutting down and valuations were off dramatically, but I took a more constructive view: there was >$400 billion of dry powder sitting on the sidelines, and while VC fundings were down in 2022 to $283 billion from $345 billion, 2022’s volume is still dramatically higher than the $90 billion that came into company coffers in 2017, for example. As for deal volume, 11,600 per annum in 2017 had grown to almost 18,000 over a five year period.

In January 2023, it was still a great time to be an SVB shareholder or team member. Having bought some SIVB shares for the first time ever last fall, I was clearly a believer in the business model.

What wasn’t clear to any of us was the nature of the fixed income securities that had been bought by SVB’s C-suite with the excess liquidity. The $27 billion investment portfolio had grown to $117 billion, and as a percentage of $348 billion of client funds at the time, we were now just shy of 30% in longer term stuff. That’s a huge jump from 16% over a three-year period, and is the driving reason why things will never be the same again for this 40 year-old firm.

Now, I had taken great comfort that VC funds were still deploying almost double the dollars as the pre-Covid window, and that the off-balance sheet funds could be easily be brought back on to the balance sheet in the event that SVB’s borrowers burned through a bunch of cash this year. All of that may still be true, but what I hadn’t expected was that SVB’s C-suite would tie us up in such long-dated paper. It wasn’t a secret that fundings had peaked, and for SVB’s senior leaders to take those excess funds and lock them away in a proportion that was inconsistent with prior years is inexplicable. Unless they assumed the off-balance sheet client funds were easily accessible, but, even then, what none of us shareholders anticipated was this week’s decision to crystalize $1.8 billion of paper losses on $20 billion of those securities and raise new capital as a show of “strength.”

It wasn’t that long ago that CEO Greg Becker told the Financial Times that the institution had plenty of liquidity. If so, why the change of heart? Investors didn’t know that we needed to raise capital, which kicked-off the crisis of confidence that has now driven shares down to $36 in the pre-market as of 8:00 EST. They were at almost $300 late last week.

For the incredibly talented and hard-working staff at SVB, this is a nightmare that they do not deserve; the impact on their financial future given the nature of deferred comp structures will be brutal. For the sector, the repercussions aren’t entirely knowable at this stage. Entrepreneurs will have a harder time raising debt, at least temporarily. LPs will frown, for sure, which will could make it harder for VCs to raise their next fund. The risk managers at competing banks will conclude what they’ll conclude, but SVB will no longer be easily held out as a proof-point of the appeal of lending to the innovation economy, even if this crisis had nothing to do with the credit quality of SVB’s loan book.

For shareholders, our losses are a result of senior management’s self-inflicted wound. Whether SVB is still an independent company on Monday morning isn’t assured, and this is certainly a defining event in the sector’s history. But it’s no reflection on the ongoing opportunity in our sector.

That none of it had to happen is the true shame.

MRM

(this post, like all blogs, is an Opinion Piece)