The Venture Capital Industry Loses its Deposit

March 14, 2023

 The Venture Capital Industry Loses its Deposit

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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.

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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.

Structural problems
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.

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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.

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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.

What's next?
To be fair the authorities have moved decisively to stem the immediate fallout 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.

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Market contagion
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
term
It’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 Fed
Equity 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.

The initial reaction to the speech was logical; equities retreated, and longer-dated US
government bonds rallied. We expect the recent run-up in equity markets to continue to
unravel. Initially, we expect the S&P500 to correct to around the 3800 level, which is a further
6% downside from Friday’s close. A more substantial fall, if at all, may take time.

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Gary Dugan
Johan Jooste
Bill O’Neill (Consultant)
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