The SVB meltdown: A shift towards a new financial system?
13 March 2023
The SVB saga that unfolded over the weekend is ushering the western world towards a new financial system, and like all crises entails many opportunities.
The Silicon Valley Bank saga is now well known by everyone: last week, the bank did a fire sale of a $21bn bond portfolio and tried (without success) to raise $2.3bn in capital. This resulted in the stock slumping 60%, the beginning of a bank run, and a contagion effect reverberating throughout the financial sector. The issue became so pressing that over the weekend, the FDIC, the FED, and the U.S. Treasury had to intervene to provide a backstop.
SVB was gone in less than 48 hours! The speed of SVB’s bank run will remain in the history books.
We have no direct exposure to SVB, but due to our investment style and convictions, our certificates and The AtonRâ Fund have a large exposure to the technology sector in the U.S., many of which are or were clients of SVB. With the state guarantee granted to SVB, effective today, these companies now have unrestricted access to their bank accounts.
Impact on our Investment Case
The need for a new financial system
What this episode proves is that the current economic and financial system cannot withstand high and fast-raising interest rates anymore.
We also believe that more regulation in the financial system might be necessary, driving banks' profitability lower and risk assessments higher.
SVB did nothing particularly wrong as, at the end of 2022, it was perfectly in line with the regulatory requirements regarding capital and liquidity. It had a common equity tier 1 capital ratio above 12%, and its assets base was diversified with investments in U.S. Treasuries and mortgage-backed securities, among others. This obviously was not enough to protect against a bank run.
Putting in place a mechanism to backstop U.S. banks in case a bank run occurs is a good decision, but it comes with significant consequences for the future of the banking system.
Capitalism, and by extent, modern economies, are built on credit, which implies leverage. Designing a financial institution able to withstand by itself a bank run, i.e., able to cover all its deposits instantly, would mean the end of leverage and therefore of capitalism. We do not believe this is something governments (and people) want. De facto, this implies once again massive support plans from governments and a likely reversal in interest rates. Again, this feels like a déjà vu from 2008, and sets the stage for another crisis a few years down the road, much likely even bigger due to the ballooning debt.
How to exit this infernal spiral? Two possibilities come to mind:
- The elegant one: governments would implement a liquidity mechanism only targeting bank runs. Easier said than done, but it would leave time for low-yield bonds to mature and be reimbursed, paving the way for a smooth transition to a higher ("normal") interest rates environment. This, of course implies some technical hurdles, as well as an ethical problem ("let the culprits pay").
- The rough one: inflation. For all its drawbacks, it has historically often been a solution to large debt crises. Of course, this creates its own set of problems, and does not address the fundamental bank-run problem. But it is "easy" to implement and is a "natural" solution to the problem.
A key role for cryptos?
Any alternative to the current financial system should not be discarded. By its intrinsic nature of decentralization, transparency and immutability, the blockchain ecosystem is designed to be part of the solution. With all the recent regulatory pressure (e.g., on staking services and stablecoins), the U.S. regulators want to control the industry. But eventually, the will of the people can have more influence, but it also depends on how the blockchain adapts next.
For it to work, the blockchain ecosystem should be separated from the traditional finance. If a stablecoin has no ties with any financial institutions (and therefore receives no interest), it would be completely immune from contagion risk (e.g., algorithmic stablecoins, crypto-backed stablecoins, or even Bitcoin). This is precisely what many central banks are planning to do with their own digital asset (Central Bank Digital Currency, or CBDC), which would compete with any cryptocurrency that is not attached to traditional finance.
Our exposure and impact of the themes we are invested in
SVB had a leading role in the Silicon Valley tech ecosystem, and its impact will not go unnoticed. Nevertheless, of our technology-oriented portfolios, only Fintech required minor adjustments to better ensure risk control. We trimmed our two top positions as the regulatory risk is clearly on the rise. Moreover, we added a couple of new names to increase diversification, added exposure to non-USD currencies (including Bitcoin), and positioned to reduce the risk from the coming increase in banks' capital requirements.
For the other Tech portfolios, we kept our positions. We expect the FED's change of stance on interest rates to be a strong driver.
The SVB collapse is disrupting the climate tech sector. The bank had a crucial relationship with more than 1'550 technology firms working on solar, hydrogen, and battery storage projects, with up to $3.2bn issued in loans to innovation projects in these fields.
Sunrun, the largest residential solar company in the U.S., is one such company that has been hit hard by the collapse of SVB. Sunrun has significant debt with the bank and has been a major user of community solar financing. The company's stock has fallen sharply as investors worry about its ability to raise capital for future growth. Note that Sunrun was one of the company we divested last year (after performing a liquidity stress test) due to its risky business model in a high interest-rates context.
In contrast, the situation appears more stable in China, where SVB's contagion risk is less of a concern, and interest rates are lower. Given China's dominance in both the supply and the demand of clean technology, we see the current context as a key opportunity for Chinese companies to strengthen their market leadership.
As investors in the cleantech sector, we seek profitable companies with proven technologies and sound financials. Our Sustainable Future strategy has a high exposure of over 35% to Chinese actors, reflecting our confidence in the potential of China's clean energy industry.
SVB is a significant player in the healthcare and biotech sectors of the U.S., holding 12% of the bank's $173bn in deposits in both industries. Most of the accounts are private start-ups, and our portfolio includes only four companies with deposits, none of which accounts for more than 5% of their cash.
We expect three potential outcomes following SVB's failure:
- There may be reduced competition from start-ups since the valuation of VC-backed companies will decline, and the risk of start-up bankruptcy may increase. Consequently, the net present value of remaining assets (notably the strongest ones) in clinical trials from listed companies will likely be higher.
- As we have previously said, the biotech sector is moving towards a lean model, which will likely result in a greater willingness to explore or continue leveraging virtual organizations (e.g., partnering with various vendors such as CRO, CMO, CDMO, etc.) to create operational flexibility. This may also result in increased ventures into decentralized autonomous organizations, as Pfizer has already begun to do.
- In line with our view on cash deployment by pharma, deals and mergers and acquisitions (M&A) should increase. Today is the perfect example, as Pfizer has just announced the acquisition of Seagen (in our Biotech360 portfolio) for $43bn and 32% premium.
Business development teams across pharmaceutical companies will actively search for cash-strapped biotech with ties to SVB that may present interesting opportunities.
Stress testing our portfolios
Apart from looking for quality growth opportunities, a significant part of AtonRâ's investment process focuses on ensuring that all portfolios come with limited risk for our clients. Part of the risk assessment includes regular "cash burn stress testing," which has proved essential in light of recent events.
Our approach involves two metrics - (1) Operating Cash Flow burn and (2) Free Cash Flow burn. For each, we divide cash reserves by either the latest cash burn or "3-year average cash burn based on EBITDA" to determine the number of years remaining at the considered spending rate. We assume a 20% drop in revenue directly impacting EBITDA. More details on our approach may be found here.
Our most recent cash burn analysis identified 42 companies (detailed table available on request) out of 177 across all our strategies that were potentially at risk, accounting for approximately 18% of The AtonRâ Fund (i.e., 82% of the portfolio's positions generate high free cash flows and/or have sufficient cash for at least four years of operation). One of these companies, Rocket Lab (a constituent of the Security and Space portfolio), has about $38mn or 7.9% of its cash with the failed SVB. However, even if the SVB had not been saved, the company would have a healthy cash account of $470mn (50% of total assets), a 2.8x cash ratio (vs. current liabilities), and 2.7 years of continuous operations should our stress test scenario occur.
We are strong believers that no matter the economic climate, a company's financial stability is vital. While having superior technology, products, or a competitive edge is desirable, it is of little use if the company's balance sheet is not strong enough to weather extended macro and geopolitical storms, or extreme events such as the SVB's downfall.
We believe that with the likelihood of lower interest rates, as the Fed injects liquidity into the market, our portfolios (notably the technology-related strategies) should perform very well in the near term. Furthermore, our Blockchain & Digital Asset product should equally perform well in the short-to-medium term as investors increasingly understand the importance of holding assets not linked to the banking system.
Companies mentioned in this article
Pfizer (PFE); Rocket Lab (RKLB); Seagen (SGEN)
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