The start-up and technology bank SVB Financial (SIVB.Q), which is the parent company of Silicon Valley Bank, struggled in 2022 as tech valuations fell off a cliff, venture capital (VC) activity slowed, and client cash burn accelerated.
These headwinds will likely continue in the first half of 2023 as VC firms and start-ups wrestle over valuations and as VC activity remains depressed.
But in the second half of the year, SVB's management team thinks there could be an inflection point, as client's businesses normalize and the bank once again sees widening margins. Let's take a look at what would need to happen for this scenario to play out.
Riding out the storm
After incredible growth in 2021, SVB fell victim to many of the woes plaguing the tech industry, including rapidly rising interest rates that put bloated tech valuations out of favor. SVB banks nearly half of all U.S. VC-backed tech and life-science companies, so when VC activity begins to slow, that hurts its business as well. Additionally, start-ups and early stage companies that do business with SVB began spending their cash at a much faster clip in the second half of 2022.
Image source: Getty Images.
This has resulted in deposit outflows, specifically in non-interest-bearing (NIB) deposits, which SVB pays no interest on and are extremely valuable for banks. Since March 2022, SVB Financial has seen more than $47 billion of NIB deposits either leave the bank or shift into higher-cost, interest-bearing deposits.
Management also mistakenly (in hindsight) went too heavy on deploying excess deposits into bonds, which are still underwater due to rising interest rates. Normally, bonds are considered extremely liquid assets, but management is not going to want to sell these while they trade at a loss and will really want to wait for bond values to recover.
As NIB deposits declined, SVB had to rely more on short-term borrowings in the quarter, a source of funding that requires paying much higher interest rates than deposits. This has cut into net interest income (NII), the money banks make on loans and securities after funding those assets. Rising funding costs have also cut into the bank's net interest margin (NIM), which is essentially the difference between the interest banks pay on interest-earning deposits such as loans and interest-bearing liabilities such as deposits.
The inflection point
Management is hopeful that in the second half of the year, VC investment and client cash burn will start to stabilize. That might lead to fewer deposit outflows and potentially even some growth, which will help stabilize NII and NIM.
Chief Executive Officer Greg Becker said on the company's earnings call that the inflection point does not incorporate VC investment returning to the record levels seen in 2021. In fact, it doesn't incorporate much of a VC rebound at all.
Becker said VC investment could actually decline another 10% to 20% in the first half of the year and then pick up slightly. VCs and start-ups are still in the process of reconciling valuations, which shot much higher during 2021 and have remained elevated as start-ups have been reluctant to accept down-round funding valuations.
But those could start to pick up, according to SVB president, Mike Descheneaux. "I think you have the auditors that are in at the various companies here that are looking at the valuations, and you're going to start to get these audit reports that start to come out, and there'll be some valuation adjustments between the companies who have been holding off in terms of readjusting evaluations. So, I think that's really helpful," he said on the earnings call.
But the key to stabilization really depends on client cash burn adjusting to lower VC investment, which should help reduce deposit outflows.
The bigger picture
I do think investors are going to continue to have some concerns over SVB with so much still in flux about credit, liquidity, and how the VC and start-up ecosystem will perform as the year progresses.
Ultimately, though, there is still a big long-term opportunity for the bank, given the moat SVB has built in this market. The bank added a record number of new clients in 2022, and VC and private equity firms are sitting on more than $2.5 trillion of dry powder.
Ideally, once start-up valuations adjust, client cash burn rates cool, and the economic outlook starts to become clearer, that might allow VC and private equity firms to use that dry powder, which would turn into a huge tailwind for SVB.
