A post from George Neville-Jones, Cambridge Future Tech’s CFO and Co-Founder
For many of us in the tech sector the allure of Silicon Valley is tangible. It is the heart of the venture capital ecosystem and the home of many of the most successful technology companies worldwide. Silicon Valley Bank (“SVB”) fulfilled a core function within Silicon Valley: managing the money that underpinned these successes. An unexciting, and yet fundamental role.
A bank’s function in the economy is to connect pools of capital. It leverages deposit balances to provide credit lending where required. To facilitate this activity banks are often very well networked in their area of operations. The traditional bank manager would leverage connections and knowledge to ensure their customers were successful, leading to greater deposit balances or lending requirements, a virtuous circle.
Today banks remain well networked, but their networks are less human. Online services, sophisticated marketing and a small number of highly qualified evangelists (generally “Corporate Relationship Managers” et al) enable the bank to extend its reach significantly.
SVB leveraged geography to position itself as the bank of choice for the technology sector. It maintained and grew this position with just two specialist products.
First, banking a venture capital fund (“VC”) is hard. Most banks have specialist teams to do so, many don’t bother at all. In recent years regulations have tightened, further reducing the number of banks open to this sort of work. Conversely, for SVB, this was a flagship product and over time they came to dominate the market.
Second, few banks lend money to investment funds and fewer still to the cash-burning technology companies they invest in. Basic credit analysis doesn’t support lending without positive cashflow. Therefore, the risk of loss from “venture debt” lending is high. This means that the bank needs to make a very large number of loans to justify the relatively low rate of interest it charges. Very few, even the biggest, have the risk appetite to achieve that scale. SVB, at the heart of the Silicon Valley ecosystem, had the access to achieve scale and has therefore become a leading provider of venture debt.
These specialisations yoked SVB to the ebb and flow of the venture capital market, particularly in its core geography in the United States of America, and to a lesser extent via SVB UK in the United Kingdom. In 2022 the world began to realise that the venture capital market was cooling after a decade long bull run. SVB seems to have realised later than most.
The collapse of SVB caught many of us by surprise, including myself, but with hindsight the writing was on the wall a year ago. After a huge increase in deposits through 2021, in early 2022 SVB decided to lock away almost half of their deposit book in ten year bonds. It is this decision which led directly to the Bank’s failure. Let’s explore this.
A bank relies on the knowledge that most of its customers don’t need most of their money most of the time. It uses this knowledge to leverage some of those deposits and lend money to other customers.
Technology companies like to “move fast and break things”. They are highly changeable. They accept negative cashflow as a function of positive growth. Even the most conservative scale-up technology company may only have cash in the bank to support operations for two or three years. As a result their deposit balances are highly volatile.
Venture capital funds tend to deploy capital over a five year term, with a further five years to realise the value of the investments made. You would think that this makes them a little less volatile, but remember that VCs have to support the cash burning technology companies they have invested in. They balance this cash outflow downstream with inflows from larger investors upstream.
In 2021, frustrated with the hiatus of global lockdowns the previous year, the VC industry poured money downstream into their portfolios, who started spending it rapidly. In 2022, concerned about inflationary pressure and poor economic data, the investors who would normally invest into the VCs themselves stopped doing so.
The result was a ~30% decrease in funds within venture capital during 2022.
For SVB this was a problem. They had locked away nearly half of their deposits in 10 year bonds, but in the space of a year they needed access to those deposits to stabilise their balance sheet. They elected to sell some of their bonds for a $1.8Bn loss and raise the balance from shareholders. This fundraise failed.
News of this failure reached the market on Wednesday the 8th of March 2023. It prompted many of the largest deposit holders at SVB, those VCs and tech companies it had long supported, to withdraw their funds. The run was over within 24 hours with over $40Bn withdrawn. SVB failed.
Fortunately for the venture capital and tech communities, the governments in the USA and UK have stepped in to ensure continuity of service. Without this action there would have been a wave of insolvencies among the VC and tech communities. This would have hobbled the commercialisation of innovation for a generation. Both governments are to be applauded.
In the USA the Bank’s customers are now being supported by the Federal Deposit Insurance Corporation. This is a mechanism, funded by a levy on banks, to ensure depositors don’t lose money in the event of bank failure.
In the UK we have seen SVB UK acquired by HSBC. This is a brilliant move delivered at lightning speed by a huge number of civil servants, bankers and members of the investment community. It has saved the UK’s venture capital and technology ecosystem from an existential shock.
Prompt action has ensured that the customers of SVB will barely notice the failure of their bank. Despite these apparent successes, there are learning points for the Regulators in both countries.
In both the USA and the UK Silicon Valley Bank was not considered systemically important, meaning that it would not be bailed out in the event of failure. Given the vital importance of the venture capital system this was an oversight that must be addressed. In the future the Regulator should consider more than size when assessing systemic importance. I oversimplify hugely, but the principle of the change for which I advocate is valid.
In the UK SVB has been acquired by HSBC for £1. This deal appears to be a fantastic reward for their willingness to move fast. They now employ a large cohort of the UK’s specialist bankers in an important sector. They have purchased a valuable book of deposit customers. Most of all though,
they have purchased a loan book which, even at a relatively high rate of loss, will generate cash and income as those loans are repaid.
I suspect the government chose HSBC for the following reasons: 1) they have a good presence in the technology sector in the UK, employing a number of excellent specialist bankers at all levels in their organisation, 2) they have a very strong balance sheet with the capital to support any further shocks to the balance sheet of SVB UK, and 3) they have the scale to accommodate the significant challenge that comes with a distressed acquisition at short notice.
These reasons make the choice of HSBC as acquiror a robust one. This despite the hard truth that the acquisition of a small bank by one of the largest doesn’t promote competition in the UK’s banking sector. Competition in banking is a longstanding priority of His Majesty’s Government, but for all I know there is some agreement to mitigate that aspect of this deal. Overall, it is a wonderful outcome for the staff of SVB UK, for HSBC and for the UK’s venture capital and tech communities.
I am sure I join many others in extending my thanks to the many people who made this rescue happen.
Footnote: The risk of further contagion is a real one. Credit Suisse is an imperfect canary in this regard: structural issues there were catalysed by internal factors. If we begin to see other small banks wobble the situation will fast become difficult. Smaller banks make better canaries.
George Neville-Jones Views are my own.
NB: Neither Cambridge Future Tech, nor our portfolio, maintain banking facilities with SVB or HSBC.