Friday Letter: SVB collapse leaves big hole in venture debt

“In the midst of every crisis lies great opportunity.” Those words, often attributed to Albert Einstein, once again come to mind as we consider the failure of Silicon Valley Bank. In particular, the bank’s demise presents an enormous opportunity for venture debt providers.

Zack Ellison, who is in market raising a venture debt fund for Applied Real Intelligence, is betting that other banks will not fill the void. I first wrote about Ellison’s fund last June and circled back with him this week to get his thoughts on SVB.

“For nonbank lenders, this is once-in-a-generation event,” he told me. “Two-thirds of the supply of [bank] venture debt is now offline – and it is not going to come back quickly.”

He estimates that the annual venture lending market has been about $30 billion to $35 billion for the past three years. Of that total, about 70 percent was provided by banks, principally SVB, Signature Bank, Pacific Western Bank, Bridge Bank and Comerica, he said.

Now consider this: both SVB and Signature Bank have been taken over by federal regulators. Meanwhile, Fitch Ratings announced that it put Pacific Western Bank and its holding company on “rating watch negative,” and Moody’s Investors Service said it was reviewing Comerica and six other banks for a potential downgrade.

The perfect storm means those banks will be more hesitant to make new venture loans, and that provides “a really amazing opportunity for the 10 to 12 private venture lenders,” Ellison said.

Not so fast

Jun Hong Heng, founder and chief investment officer of Crescent Cove Advisors, a multi-asset investment firm based in San Francisco, is a little more cautious about filling the gap left by Silicon Valley Bank. “The near term will be difficult,” he said, noting that banks in general provide non-dilutive capital, so if a lender that was once there is no longer extending new loans or refinancing current loans, it could be difficult when it is time for the company to refinance.

At the same time, “a decrease of liquidity in the ecosystem is likely not positive for most parties,” Heng said. “Alternative lenders will be able to step in but it is a sizeable hole to fill.”

Moreover, venture lending is an extremely specialized business, and any lender inexperienced in extending credit to the sector would have to hire specialized teams to understand the business. For example, private credit manager Monroe Capital last month announced that it had acquired venture debt provider Horizon Technology Finance Management, which has deployed more than $3 billion in loan commitments across more than 315 venture-backed companies since its founding in 2004.

“We continue to look for ways to strategically differentiate and scale our asset management platform and Horizon augments our nearly 20-year track record and expertise in specialty lending areas, including software and technology, specialty finance, independent sponsor finance, opportunistic, media and entertainment, sports, fintech and real estate,” Monroe Capital chairman and CEO Ted Koenig said in a statement.

In addition to Horizon, nonbank lenders positioned to take advantage of the absence of SVB include Hercules Capital, the largest BDC focused on venture lending; TriplePoint Capital, Runway Growth Capital and Western Technology Investment (WTI), which was acquired last year by P10.

WTI, which said it has made loans to more than 1,400 VC-backed start-ups since its founding in 1980, is currently in the market with Venture Lending & Leasing X. Fund X is targeting $460 million and has secured a $25 million commitment from Texas County and District Retirement System, according to affiliate publication Private Debt Investor.

LPs in previous WTI funds include Boston Retirement System, Massachusetts Bay Transportation Authority Retirement Fund, San Antonio Fire and Police Pension Fund, The Leona M and Harry B Helmsley Charitable Trust and The Pension Boards–United Church of Christ, PDI reports.

The Boston Retirement System reported that as of as of June 30, 2022, WTI’s Fund IX (vintage 2018) generated a TVPI of 1.44x and IRR of 19.04 percent, Fund VIII (vintage 2015) produced a TVPI of 1.58x and IRR of 13.05 percent, and Fund VII (vintage 2013) recorded a TVPI of 1.77x and IRR of 12.40 percent.

LPs who aren’t averse to backing emerging managers may want to consider the A.R.I. Venture Debt Opportunities Fund, which is targeting $150 million. Ellison expects to hold a first close on an “eight figure” amount at the end of the month for his debut fund, which will charge a standard 2 percent management fee and 20 percent carried interest.

Fundraising, which began last summer, has been a bit trying, especially with large institutions, because venture debt “is relatively new to them and it’s a niche product,” Ellison said. But he noted that “even before SVB went down, we were starting to get some traction. I do have a couple of pensions and a couple of well-known endowments that will probably invest.”

Where Ellison is seeing the most interest is with independent registered investment advisers who represent wealthy individuals and families and manage $1 billion to $25 billion in assets.

Understanding risk

Investors are slowly coming to understand that venture debt isn’t ask risky as it sounds. The average loss rate for venture debt has been less than 50 basis points per year since 2005, compared to about 6 percent per year for an SBA loan, Ellison said.

This is probably a good time to remind readers that SVB’s collapse had nothing to do with its lending. It failed due to a bank run by depositors who pulled out $42 billion in a single day. Depositors were freaked out because the bank had taken a loss of $1.8 billion when it sold a bond portfolio and because of substantial unrealized losses on mortgage-backed securities and Treasury bonds that the bank bought before the Federal Reserve substantially raised interest rates.

All of this is to say that SVB didn’t fail because it made loans to VC-backed startups. In fact, SVB’s net loan charge-offs as a percentage of average total loans were just 0.15 percent in Q4, compared to an industry average of 0.36 percent, according to data compiled by BankRegData.

Now that SVB has been sidelined, other lenders are hoping to find some gems by sifting through its old borrowers. “We can be exceedingly conservative for the deals we choose to underwrite,” Ellison said. “The demand for capital from start-ups far exceeds the supply.”

Additional reporting by Robin Blumenthal, Americas Editor, Private Debt Investor