SVB risk and the Mezzanine Debt Market
Posted on: March 16th, 2023
The business world is abuzz with concern about Silicon Valley Bank and the risk it poses to the financial markets. Capital availability in the lending markets, especially mezzanine debt is likely to be affected. In times of turbulence, it is instructive to reflect on the proximate causes of this meltdown and what it means to mezzanine debt lenders in both the short and long term. This meltdown was not caused by a deterioration in asset loan quality, unlike the subprime credit fiasco. It was a result of a number of specific causes. There was incompetent portfolio match funding of asset and liability duration, meaning the bank had to liquidate long term assets to meet massive short term deposit demand. This caused a huge loss on the long term high yield bonds that blew a hole in its balance sheet. In addition, SVB grew far too rapidly and lacked the ability to safely and prudently deploy its deposits in profitable investments, especially as interest rates increased. Finally, they lacked proper risk controls and completely underappreciated their exposure to slowing deposit growth from the moribund tech sector. This is a classic black swan event, which hit with hurricane like force. It exposed a flawed business model replete with insufficient controls and lack of diversification. The asset quality of the loans did not take them under. The flawed vision and incompetence of the management team did. This shows the damaging effect that increased interest rates has on a portfolio, and the perils of investing into a rising rate environment. This is likely to create both opportunities and risk for mezzanine debt financed companies. This event will cause risk aversion for technology lenders who will only lend to companies with significant cash runways. It will also result in a tighter screen for bank lending, as bankers will be wary of marginal credits. Mezzanine debt lenders will focus on supporting their portfolio companies and make sure their banking relationships are healthy. Because they have funded them on a cash flow basis, mezzanine debt lenders must ensure that their portfolio companies have sufficient cash availability. If this bank crisis causes a pronounced slowdown, then mezzanine debt funded companies will struggle like everyone else. Mezzanine debt lenders are likely to be more selective and discount projected performance more conservatively. Mezzanine debt lenders are more likely to respond more intelligently to this event than big banks who often overreact and make blunt instrument policy changes. If things get chaotic, mezzanine financed middle market companies are in a better position to capitalize on short term chaos due to the support of their lender. In all, this dislocation will have little to no short term operating impact on these businesses, save a cataclysmic decline in the overall economy. Longer term, credit conditions will likely become more restrictive resulting in less refinancing and take out financing options for borrowers.