The following views are personal and based on my experience working in and around technology, venture capital, and the financial services industry. They do not represent the views of any employer or client of mine, past or present.
(2023-3-11 4:48pm ET Update: This two part (part 1 and part 2) Twitter space with VC Bill Ackman among others may also be of interest; he also discussed as the start of part 2 and idea about creating a consortium of VCs to address all this).
(2023-3-11 3:24pm ET Update: the “All In” podcast from this week goes much deeper into what’s below as well as other related issues.)
(2023-3-12 9:00pm ET Update: The Federal Reserve, US Treasury, and FDIC issued a statement, and concurrently the Fed announced a new program, the Bank Term Funding Program, to back stop SVB depositors. I have made some updates, in italics, to what I wrote below Saturday to reflect this latest development.)
Since we’ve all moved on from generative A/I explainers to venture capital explainers, I thought I’d do a VERY simple explainer for my non-tech, non-VC, non-investment banking friends about why this Silicon Valley Bank (“SVB”) thing is a big deal.
1. Organizations with large endowments – think universities like Harvard and pension/retirement funds as well as family offices – usually invest most of their money in relatively safe investments. Most of them also take a small %, usually single digits, and invest it in higher risk investments .
2. A primary, though not only, vehicle through which they do their higher risk (and hopefully high reward investments) is by investing in venture capital (VC). Specifically they write a check for, say, $10M to a VC and become a Limited Partner (LP) into one of a VC firm’s funds constructed and offered by a VC firm (here’s a list of First Round Capital’s funds for example; note nearly all these funds are open only to high net worth individuals and institutions). A fund essentially represents a group of a VC firm’s investments during a period of time (and a specific year’s investments are sometimes called a “vintage”) as well as potentially a specific investment strategy/focus (e.g., a VC firm may also offer a fund up that is just focused on, say, AI/ML or biotech).
3. The general partners (GPs) of the VC firm — think folks like Ben Horowitz at A16Z or Jason Calacanis — then make investments to entrepreneurs (startup founder/CEOs). So, for example, to make the math easy, Jason Calacanis might in his most recent (hypothetical) $100m fund have 10 LPs that invest $10M each ($100M total) and with that $100m he, as the GP, will write, say, 20 checks of $5M ($100M) each to 20 different startups (again, I’m simplifying the math). The VCs get paid (usually) by the “2 and 20” also common in hedge funds and private equity (VC effectively being a flavor of PE though not all VCs like being grouped in like that) — they charge a 2% management fee to those LPs and keep 20% of any investment return. That 20% may be realized a decade or more later (e.g., when, say, 1 of those 20 companies has a multibillion dollar IPO after a decade of the company being built and growing, while the other 19 have failed and gone out of business — VC business model is built on 1-2 big winners, a few other decent exits, and most companies going to 0), which is also how long the LPs may need to wait (I am glossing over a ton of stuff here about how/when GPs may choose to distribute gains along the way; tl;dr is that the ROI for LPs is nearly always measured in years. These are long term investments).
4. When the entrepreneurs – the CEOs of a startup – get those $5M checks they have to deposit them in a bank of course. As has been widely reported in the press, >50% of those funds end up in Silicon Valley Bank as that is by far the most dominant bank in this space that provides startups with the core banking services any small business would recognize (checking, loans, etc). It is NOT just startups in California — SVB is (was) the dominant commercial (== checking, etc) bank for technology startups generally.
5. Then there was the triggering event, the failure of SVB. Why did it fail? That’s where a deeper, longer discussion of banking is required. I’d refer you to explainers like this one from Marc Rubinstein. You also may find yourself googling “It’s a Wonderful Life”, “Liquidity Coverage Ratio”, “Held to Maturity”, and “borrow short, lend long”. It’s this last phrase that is key. SVB “borrowed short” by taking deposits. At it’s simplest, banks make money by taking deposits and lending (or investing) those deposits to get a return. They may return to depositors a portion of that return (i.e., the small interest rate you get in your checking or savings account — btw, a side effect of all this is those rates may rise to encourage you to keep your deposits in banks rather than taking them and investing them in, say, t-bills yourself), but the amount the banks keep from the money they make with depositors money is how they make money.
As we now know, a significant portion of SVB’s depositors’ money (i.e., the startups capital they received through VCs that is ultimately the capital of LPs) had been invested in longer term fixed income such as US treasuries when, critically, interest rates were historically low. While these fixed income investments are considered very safe (compared with, say, the complex derivatives that were at the root of the 2008 banking crisis), they lost value, in current terms (“mark-to-market”) if they needed to be liquidated on short notice, as interest rates rose, which they did dramatically last year. This twitter thread from January goes into depth on what was going on.
Recall from Macro Econ 101 that when interest rates rise, prices (i.e., how much those bonds could be sold to someone else for — their “mark-to-market” value) of (previously issued) bonds at the now comparatively lower rates go down.
To provide a very simple example, if you bought a 2%, 1 year bond at $100 (pays you $2 at the end of one year), and then the very next day there are 4%, 1 year bonds for sale at $100 (that pay $4 a year), no one is likely to want to buy your 2% bond for $100. How much would you be able to sell that bond for? Probably $50 (actually just a tad more, given the pay out will be one day earlier, but I digress). Why $50? Now that there are 4% bonds in the market, by paying you $50 for that exiting bond, they’d realize that same 4% rate given $2 is 4% of $50.
So this is the key –> As interest rates rose, the current market value of SVB’s bond portfolio, which represented a large chunk of their depositors’ money, declined to such a point that it was no longer clear that the current value of those bonds could cover all of SVB’s deposits. Their “lend long” bond value was less than their “borrow short” deposits which need to be returned to depositors (in the form of, say, an ATM withdrawal) at a moment’s notice. (It also appears that SVB may not have sufficient hedged their bond investments, but that’s way beyond scope of this piece).
6. With SVB failed, these entrepreneurs and startups can’t (couldn’t) access to some or all of that $5M they had deposited in SVB — that money they had received from through VC’s GPs and which really originally came from those LPs like universities and retirement plans. (If a CEO withdrew all of her company’s $5M before this week they are ok of course. Ditto if they did not use SVB.) Key things to keep in mind — that money in SVB is really at the end of the day university and pension fund (i.e., VC LPs) money.
7. This is where the FDIC comes in. The FDIC backstops the first $250K. From there, what happens to the rest of what was deposited (if it was not withdrawn over the last couple days) is the open question that startups and their VCs are working through this very morning. This link from the FDIC is the primary source to read on what the FDIC is doing — read this FIRST. “Insured deposit” means a company’s deposits (up to) $250K. “Uninsured deposits” mean everything there and above for which the FDIC on its site says “Uninsured depositors will receive a receivership certificate for the remaining amount of their uninsured funds”. (Note this was written before the announcement Sunday evening of the Bank Term Funding Program)
8. What’s a “receivership certificate”? It’s basically a piece of paper that says “we need to figure this all out and when we do you may get some or all of that uninsured deposit.” How much, and when, is TBD.
9. So, for many startups, especially if they had all their money in SVB (i.e., all of that $5M check they got from a VC which originally came from the LPs), and had withdrawn nothing prior to the run, the only money they can count on is the $250K (“All depositors will have full access to their insured deposits no later than Monday morning, March 13, 2023”)
10. If over the weekend, someone acquires (had acquired) SVB, this situation with the deposits may end up remedied and the entrepreneurs will have access to all of their deposits (e.g., the full $5M in the hypothetical above). Of course, there are still the SVB employees, many of whom, depending on how an acquisition goes, may be out of job. And depending on how the acquisition is done, those who own stock in SVB (technically its’ parent org, SVB Financial Group), which was traded on the NASDAQ, may lose some or all of their money. Nonetheless, there is general consensus that someone buying some or all of SVB over the weekend is the best case (again, I’m simplifying a lot here and I’m not getting into creditor priority in liquidation which I’ll let my former colleagues from Deloitte and KPMG opine on.)
10. In the short term the issue facing startup CEOs is (was) having funds to make payroll and continuing to run their business (and this, the payroll and jobs implications, was why there was so much pressure for action over the weekend). There are reports of companies that had planned layoffs and now can’t do those layoffs as they don’t have access to the funds to pay severance event — a real chicken and egg. This puts these startups, and their employees, in an extremely precarious situation. The afore mentioned receivership certificates may end up converting back to 100% of the original deposit, but in the short term a receivership certificate cannot be used to make payroll (unless someone is willing to accept these certificates as collateral, which would assume the lender has a high degree of confidence things will be worked out. Again, the best hope is SVB gets bought).
11. So now there’s all these startups, not just in California, but around the US and world, that are stuck. Employees may not be able to get paid, which in turns means those individuals may not be able to pay their own mortgages, bills, etc. This might also accelerate the failure of these startups, leading to more tech layoffs, in turn impacting the wider economy. This also slows the innovation happening at these startups of course.
12. And on the other side of this stream of capital the LPs like universities are now rightfully concerned that their investments, which flowed through the VCs’ funds to startup CEOs/CFOs and were sitting as cash deposits in SVB, may have been lost, either wholly or in part (there are hedge funds bidding on them this weekend to the tune of 60 to 80 cents on the dollar). Again, greatly simplifying –> if an LP invested $10M in a VC fund, and figuring half the entrepreneurs used SVB, up to $5M of their investment may be in question right now. That was a high risk investment to begin with, but this is likely not the type of bad ending for which they accounted – to quote VC Bill Ackman in a Saturday Twitter space, “People (LPs) want to take the risk they intended to take.”
13. Meanwhile VCs (i.e., GPs and their teams) right now need to be focused almost exclusively on helping their portfolio figure this all out, and likely are not going to be able to dedicate much time or capital to new investments for new startups for the foreseeable future.
14. tl;dr is that given the amount of capital involved, the multiple institutions and industries involved, this whole situation could impact the larger economy. This is the “second and third order effects”.
Retirement Plan (LP) -> Venture Capital Fund -> GPs of VC firm write Series A check to entrepreneur -> check gets deposited into SVB -> SVB invests those funds into bonds -> Depositors need those funds back to run payroll but the value of the bonds has fallen such that there wasn’t enough to cover all deposit withdrawals needed to run payrolls to startup employees.
I have greatly simplified A LOT here. Again, target audience is not my friends in VC, tech, and investment banking but my family and friends back home in Maine.
I hope this was useful.
(Disclaimer again: I’m writing this as an individual and speak for no organization or company. This is also not investment advice and should not be construed as such. This is just for education purposes.)