Pain in the ARS

Venture capital investors say they’ve all but dodged a bullet from the lack of liquidity in the auction rate securities market, which has sent chills through Wall Street.

“When this news broke, everyone went through their portfolio to figure out what to do,” says Globespan Capital Managing Director Venky Ganesan. “They had to decide whether to sell it to an arbitrage business or hold onto it. It’s reminded everybody to really look at our investment policies.”

When Ganesan looked at his portfolio, he didn’t find any company with auction rate securities on its books. He says it was a matter of luck.

“A lot of our companies bank with Silicon Valley Bank and they’ve really made sure that everybody stays out of this,” he says. “People who have banked with other banks might have more of a problem. We knew immediately that there’s no crisis because none of our companies has come up asking for more cash.”

Auction rate securities are long-term bonds that are periodically bought and sold to reset interest rates. Some brokers have pushed these bonds as an alternative to cash, touting higher interest rates than comparable money market funds, and some startups bought them in hopes of earning a little extra money on venture capital they haven’t yet had to tap into.

The credit crunch and national economic slow down have dried up the market for these bonds, sticking some companies with illiquid long-term, often municipal, paper. There is little question that these bonds will be paid off in the long term, but the lack of liquidity has already hurt some companies. For example, smart phone maker Palm Inc. (Nasdaq: PALM) last month said it had to take a $25 million write-down for auction rate securities that had declined in value.

Not a big problem

While there have been some isolated problems with VC-backed companies, few investors VCJ spoke with expressed concern about financial problems associated with auction rate securities. Lightspeed Venture Partners General Partner Jake Seid says the problem “hasn’t impacted us,” while New Enterprise Associates Partner Patrick Chung says his firm has “not seen any related difficulty.”

Even firms that have companies with exposure haven’t seen any particularly adverse affects. Granite Ventures General Partner Len Rand says that a few of his companies held auction rate securities, but those that hold the securities “haven’t needed access to their money on a schedule that affected them.” The banks that brokered those securities have stepped in to cover the companies that had the most exposure, Rand says.

Sanjay Subhedar, a general partner at Storm Ventures, began talking with his bankers about auction rate securities in February. The bankers pointed out that all of the firm’s cash was in money market funds, which the Securities and Exchange Commission prohibits from investing in auction rate securities.

Just one of Storm’s portfolio companies was exposed, Subhedar says. An executive from the startup wrote to Subhedar advising him that it had $525,000 tied up in auction rate securities from a long-standing policy of investing in them. The company had another $5 million in cash in the bank and did not anticipate any liquidity crisis.

Loan for your own money

The jury is still out on whether the auction rate securities problem will hurt another VC-backed Silicon Valley company that has half of its cash tied up in these debt instruments, according to one of its investors who asked not to be named. The company invested “millions of dollars” in the securities through Comerica Bank.

When the startup asked Comerica about its options, the bank initially said it would provide an “emergency supplemental working capital line equal to 20% of the ARS [auction rate securities] held,” the VC says. “In a subsequent discussion the next week, the bank raised it to 70% of the value of the ARS held.”

Comerica said it would not charge any borrowing fee or covenant, and the interest rate would be set at the current commercial rate, according to the VC. Presumably, the interest fees on the line of credit would be covered by interest paid by the auction rate securities, so the company would essentially just get its cash back.

Since the company has about six months worth of cash on hand, it is optimistic that its auction rate problem will be resolved before it has to tap into the line of credit.

We knew immediately that there’s no crisis because none of our companies has come up asking for more cash.”

Venky Ganesan

No, says Joe

Joe Morgan has pushed his clients out of auction rate securities since he arrived as the head of portfolio management at SVB Asset Management, an affiliate of Silicon Valley Bank. “When I joined in 2004, we owned some auction rate securities and the first thing I did was sell those in case there was a liquidity crisis on Wall Street,” he says. “For our clients who value liquidity over and above return, it didn’t make sense to restrict our holdings to a single Wall Street broker who brokers these transactions. We’ve been recommending against this since 2004.”

Still, for the past several weeks, Morgan’s group has gotten three or four calls a day from public and private companies looking for advice. These companies bought auction rate securities from someone else and have turned to SVB Asset Management for advice.

“The few calls we’ve had are not a tsunami, but it’s a significant number,” he says.

Venture capitalists have also been calling Morgan. About two or three call him each week concerned that their portfolio companies might hold auction rate securities. Others call to see what can be done about the auction rate securities they purchased with their personal wealth.

Morgan’s advice has been simple. Stay in contact with the broker who bought the auction rate securities for your company. That person will be in the best position to help you stay liquid at the same level you bought in at, he says. He also recommends maintaining sell orders at each auction date just in case the market reopens.

Morgan also recommends rethinking your relationship with your money manager.

“Mostly, you will find that the people who have been pushing auction rate securities are brokers, primarily because the securities pay high commissions,” he says. “Corporations thought that they had a relationship there where the broker would look out for their best interests. However, there is no level of fiduciary duty there.”

Additional reporting by Lawrence Aragon

Tip sheet

Here are some quick tips for VCs with portfolio companies that hold auction rate securities.

Stay cool. Auction rate securities aren’t worthless, they’re just illiquid. Unless a startup in your portfolio needs cash within the next 12 months, it may not be worth getting worked up about.

Negotiate. Stay in contact with the broker who originally bought the auction rate securities for your company. That person will be in the best position to help you stay liquid at the same level you bought in at. Some brokers are shouldering the burden of the liquidity crisis just to keep key customers satisfied, according to one investor.

Maintain your sell orders. Putting up your securities for sale at each auction ensures that if the market does open up, you’ll be the first one to get liquid. SVB Asset Management’s Joe Morgan says that the market comes and goes in streaks. There may be three weeks without any buy orders before one finally comes through.

Get a lawyer. At least some auction rate securities buyers thought they were getting a truly liquid asset: cash with an interest rate attached. Was that the product of an inappropriate sales pitch from brokers or just poor decision making on the part of buyers? It’s unclear if there was any direct malfeasance at this point, but it’s certainly something the courts will be looking at as class action lawsuits fly. —A.H.

Mostly, you will find that the people who have been pushing auction rate securities are brokers, primarily because the securities pay high commissions.”

Joe Morgan

Thinking about suing?

Here are some of the key law firms that have filed class action suits over auction rate securities.

Girard Gibbs

New York City

Suing: Citigroup/Smith Barney, Deutsche Bank AG, E* TRADE Financial Corp., JPMorgan Chase & Co., Merrill Lynch & Co., Morgan Stanley, Raymond James Financial Inc., TD Ameritrade Holding Corp., UBS AG, Wachovia Corp., Wells Fargo


Holzer Holzer & Fistel


Suing: Deutsche Bank AG


Levi & Korsinsky

New York City

Suing: Citigroup Inc., Merill Lynch & Co., Morgan Stanley, SunTrust Banks Inc., UBS AG


Source: VCJ reporting