Recent Events Regarding Silicon Valley Bank

As has been widely reported, Silicon Valley Bank ("SVB") was closed today by the banking regulators and placed into receivership with the FDIC.

Over the past 48 hours, we have been following these ongoing developments at Arctos. Earlier, we provided an update on steps Arctos is taking to reduce deposit exposure to SVB. In conjunction with this, we have prepared the below primer for our team internally. We are sharing it with you as a background piece to offer context on SVB, its operations, recent events, and why this matters for the broader private equity and venture capital ecosystems.

This update includes six parts:

We are happy to help you consider immediate next steps, review strategic alternatives, and formulate a long-term plan around the recent events at SVB that are specific to your individual situation.

Silicon Valley Bank was a medium-sized (top-20) US regional bank:

SVB played an outsized role in the PE / VC industry due to a handful of fund-specific products it offered (more on that below). In recent years, SVB grew rapidly by raising deposits from, lending on the homes of, financing the businesses founded by, and backing the VC / PE funds raised by the tech sector. It also provided private banking services to that same ecosystem, as clients founded, financed, and sold their businesses, equity, and investment funds.

Until recent events, the bank served “clients primarily in the technology and life science / healthcare industries as well as global private equity and venture capital industries. The Bank provide[d] solutions to the financial needs of [its] commercial clients through credit, treasury management, foreign exchange, trade finance and other financial products and services.” The bank operated four principal businesses:

We believe there were two primary contributors to SVB’s entering into receivership:

SVB built its client base on the Life Sciences / Healthcare and Technology sectors, where we believe an outsized share of its deposits were generated. It lent to these businesses; helped finance the growth aspirations of their employees and backers; managed their payrolls; handled their fx; and even financed their employee mortgages. In short, SVB faced deep, correlated exposure to the tech and startup ecosystems:

According to SVB’s publicly-available financial statements, since December of 2021, SVB saw ~30% outflows of non-interest bearing deposits (~$36Bn), replaced by only ~$28Bn of more expensive, interest paying deposits. See below:

We believe this was driven by two factors, (A) and (B), as outlined below.

Factor (A): SVB customers moved some of their deposits toward higher returning liability accounts due to rising rates (see fed funds chart below). This pressured Net Interest Margin (“NIM”), the spread between the income generated by investing liabilities and the cost paid on those liabilities.

Factor (B): We believe SVB’s tech-exposed clients saw pressure on both their personal and corporate balance sheets, driving net deposit outflows. A declining wealth effect and tech layoffs led to an increased need to redeem deposits (to pay for things like mortgages and cover margin accounts). Meanwhile, higher cash burn and constrained VC funding pressured corporate / startup balance sheets.

As AngelList notes: “Venture performance saw a slow, and then sudden, decline in 2022… In 3Q22, turbulence in the broader market trickled down to the early-stage market in a major way, with deal volume and positive activity dropping to levels not seen since the onset of the pandemic. While positive activity rebounded slightly in 4Q22, early-stage venture capital (VC) performance remained historically depressed at the end of 2022.”

To summarize, SVB experienced concurrent pressure in three areas: (1) Net outflows from its tech-sensitive clients; (2) A rising rates environment; and (3) Client shifting of deposits into more expensive liability accounts. And as the liability side of SVB’s balance sheet faced pressure, something else was happening on the asset side.

As all of this was happening on the liability side, SVB was beginning to face pressure from the investments it previously made with deposits received in a prior, more expansionary period. As the Financial Times reported, “SVB’s core customers, tech start-ups, needed somewhere to put the money venture capitalists were shoveling at them. But SVB did not have the capacity, or possibly the inclination, to make loans (light blue line) at the rate the deposits were rolling in. So it invested the funds instead (pink line) — overwhelmingly in long-term, fixed-rate, government-backed debt securities.”

As you can see, the pink line in the chart above sat as an asset on SVB’s balance sheet. Specifically, SVB’s balance sheet was 50% invested in non-marketable securities ($120Bn of its $212Bn assets):

And, of this $120Bn, the largest concentrations were in mortgage-backed securities (see below):

… And mortgage backed securities have also faced some recent pressure, evidenced by rising rates / falling prices:

To summarize, SVB saw net deposit outflows, a net increase in the cost of its deposits, and a net decrease in the value of the investments made with those deposits.

As SVB faced this dual asset-liability pressure, it sought to undertake some very similar actions to what the large-cap banks did in 2007 / 2008: It (1) Embarked on a rapid sale of assets, and (2) Sought to raise equity / market-signaling capital from a blue chip investor (General Atlantic):

All of this fits within a broader context. First of all, SVB has noted that as asset values on its balance sheet declined amidst the rising rates environment, it effectively faced two options: (1) Take “drip-by-drip” earnings hits on its asset portfolio over several quarters, or (2) “Rip off the band-aid” by rapidly selling this portfolio and deploying the cash into floating rate, higher yielding assets.

However, as SVB was attempting to reposition its balance sheet, these actions began to appear to the market as something else. When banks see a major change in deposit patterns (inflows / outflows) or the cost of those deposits (rate shifts), they often need to adjust the asset side of their balance sheets accordingly. At SVB, those deposits were being used to invest in loans, investment securities, CapEx projects, revolvers and the like. And if the duration of those investments (assets) is different from the duration of those deposits (liabilities), banks may face a liquidity squeeze. Further, if the value of those assets falls relative to the value of the liabilities used to fund them, banks may also face a credit squeeze as well. One often leads to another, and that appears to be what happened at SVB:

This is why SVB tried to rationalize its asset-liability match funding, to better align deposit levels and costs with its asset exposures. As noted previously, Net Interest Margins are incredibly important to depository institutions. If a bank sees its cost of funds rise above the return on those funds, all else equal, it can quickly begin losing equity and regulatory capital:

The reason SVB mattered so much to the PE / VC community today is because of its Global Fund Banking business. SVB provided lines of credit, subscription lines and cash / treasury / deposit management to the industry, among other financial services. As you can see in the 10-K disclosure below, Global Fund Banking represented >50% of SVB’s total lending business ($42Bn on a $74Bn lending book).

To say that the last 24 hours have been disruptive to private equity funds, firms, and operations would be a massive understatement. Your managers are undoubtedly working relentlessly to establish new banking procedures to minimize any potential damage or losses in their broader ecosystem. Many firms using SVB fund facilities that have near-term deal closings (less than 10 days) may breach their contractual closing timeline obligations without some concession from their counterparties. Funds that were planning on using their credit lines to fund near-term deals and firms being overly cautious about liquidity will likely be calling capital from their investors in the coming days.

Luckily, we are in a period of below-average deal activity broadly, and a simple estimate of the quantum of this risk could be framed as follows:

Obviously, each investor’s experience will be very different but we think this is a reasonable estimate of the broad industry’s drawdown exposure over the coming days / weeks. We hope you have found this research note helpful, insightful and worth your time. We will work to provide material market updates if it feels warranted or necessary.

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