The Edges of Growth

Silicon Valley Bank's demise reminds us of the eternal tension between growth and risk

The story is simple: aggressively growing your lending book, using lobbyists to loosen up the regulatory framework and then failing to protect your downside in a prudent manner. The Silicon Valley Bank (SVB) collapse is basically a very old story, although with new features such as start-ups and rapidly rising interest rates. Indeed, we have been banking and investing for generations and at times it is just too tempting to let a proper risk assessment constrain your growth, your ability to make money and fork out bonuses at the end of another successful year. Prudence, modesty, wilfully dialling back in situations that are too good to be true: it is so hard that a lot of us, even the best financial pros, get it wrong from time to time. In any financial institution the tension between the business development people and the risk assessment team is omnipresent, the pressure to make profits by its very nature overrides the human instinct to stay safe. Remember the Asian currency crisis, Enron, Lehman Brothers?

As a former banker now working in the same area as SVB, I cannot resist weighing on this. In fact I was trying to put a venture loan deal together with the collapsed bank for one of my companies only a few weeks ago. So let’s analyze and focus on the two core dynamics at work here and see what it may bring.

Growth

First, the start-up frenzy has unleashed a wave of companies that all of a sudden were able to raise large chunks of equity from investors, from individual angels to seed funds to venture capital firms (VCs). With low interest rates and traditional asset classes tapping out in returns, early stage tech was the new area for those digging for gold or, in a lot of cases, simply diversifying their portfolio. Publications like TechCrunch and Betakit were providing an endless stream of success stories with photos of teams smiling after yet another round closed or another exit done. Money in the bank, new ideas, endless growth, it was the place to be. Early stage tech even acquired a sort of Hollywood aura, with stars, opulence, extravagant parties, scandals, deranged personalities, you name it, it was all there.

So many tech companies get funded by VCs. The presence of VCs in a deal mitigates the risk of the company’s chances to fail. If a VC is there then if things go bad the VC will probably step up and inject more funds, or so the reasoning goes. VCs de-risk a start-up. Which makes it easier for banks and other lenders to advance money to these early stage companies, even though their cashflows may not be stable or all that predictable, there is enough certainty to lend money to them. And the VCs really loved this: say they invested $10m for a 30% ownership in a company, involving a lender like SVB to put in $3m as a loan means the company now has $13m to play with, but the VC still has its 30%. Non-dilutive loans are huge benefit to equity investors, in particular if they come at relatively low interest rates which was the case for the sort of debt SVB provided. There is nothing wrong with this, it is plain and simple business arithmetic: how can we get the best result for all parties involved at the best possible price while we allocate the risks across all participants: founders, investors and lenders.

But note that companies are often pushed into a ‘growth scenario’: they project strong revenues to impress and get investment from VCs and lenders like SVB, and the VCs and lenders like to believe the numbers in order to justify doing the deal. The fear of missing out on hot deals relegates risk assessment to a lower tier and everyone literally banks on the growth scenario. Again: this is plain and simple business logic as long as the assumptions work out in reality. Economic headwinds however can ruin the best prepared spreadsheet and that was what was starting to bite the start-up community over the past 12 months. And this was felt in particular by lenders who are relying on cashflows to get repaid. SVB, which as a bank also took start-up deposits which started to dwindle during the downturn, was in the firing zone.

Interest Rates

SVB was exposed to its loan book and on the flip side it was also subject to the interest rate environment. No one believed that central banks would aggressively increase rates as the world had become used to endless debt at a low price and a non-inflationary world. Post financial crisis of 2008 and post-Covid the world was over-leveraged and any rate increase would tank the economy and put mortgage holders out on the street again, at least that was the train of thought. But the inflationary pressures were such that central banks did start to increase rates starting in 2022 and in doing so delivered the first blow to the venture world: all of a sudden the rate of return on risk free assets increased and it made investing in start-ups a lot less attractive. It brought valuations down and put real pressure on SVB’s clients who started to draw on cash available at the bank (from deposits or loan facilities). In order to cover these drawdowns SVB had to sell billions of treasuries it owned which had a low interest coupon and thus were less attractive and they were consequently sold at a loss.

So low interest rates did two things: it pushed huge amounts of capital into early stage tech, but at the same time it left that sector exposed to a potential reversal of interest rates. SVB got caught on both the lending and the deposit side, alarm on social media set off the bank run and on Friday it was all over.

So?

Again, the features are different each time, but the dynamics are not. The human quest for never-ending growth and huge returns has its limits when pushed too far. When former UK prime minster Liz Truss promoted a ‘growth’ economy with deep tax cuts the markets and her colleagues corrected her swiftly: you can only take certain risks, but you cannot risk breaking the bank. It is reckless gambling and while SVB was probably managed by good folks, they played on the edges of what was responsible. They took too much risk in their portfolio, failed to quantify the downside, banked on having sufficient capital to cover losses and probably subconsciously hoped that a relatively low interest environment would prevail. Like in 2008 other banks may pick up the pieces of what was otherwise a great business.

No economic crisis is alike. Right now we continue to have growth, low unemployment, but also global turbulence (China) and a war (Russia-Ukraine) while some countries are pushing a costly and complicated energy transition. All of these are unique as a set of circumstances. But they will frustrate the human sentiment that we can keep growing unhindered in one direction. These crises of course will create new opportunities, but they will impact those unprepared in a pretty dramatic way. SVB and its clients are the unfortunate victims. That is all that happened.

As I write this it will be hard to say if we will fall into another deep crisis or that the SVB debacle can be contained as a small piece of a soft landing that is correcting the money printing economy of the early 21st century. As of this morning, things looked not all that bad with the Fed stepping in. What will happen regardless is that some colder weather will envelop venture investing and lending. People will retrench and take a wait and see approach and look for a new and more stable environment where market forces settle on some sort of new equilibrium. Expect start-up valuations to take another hit. And: central bankers will have to assess the unintended consequences of the rapid rate increases, if inflation remains unaffected and banks start to collapse then it may be time to look for other prescriptions to fix our economy.

For now the latest growth spurt, which actually lasted quite a while, will be halted a bit. Some retrenchment, some broken deals and some jobs lost. But out of the rubble new shoots will emerge and we will get back on the growth train again. All the crises from war to energy to housing to health to food do require innovation and that will continue to require venture capital and taking risks. We skirted the edge, but the human fascination with growth will continue. And although SVB will change the trajectory a bit, that basic thrust will continue as it has for thousands of years.

Image: ‘The Moneychanger and his Wife’ by Marinus van Reymerswaele (1490 - 1546)