The collapse of Silicon Valley Bank, the problems at Credit Suisse and the $30bn injection by several major banks into First Republic has brought the topic of the fragility of the banking system back into focus. While the causes of the problems are different – SVB is a result of an old-fashioned bank run after it failed to raise sufficient new funds, Credit Suisse has been hit after disclosures in its annual report about its accounting issues and risk factor and First Republic is the contagion effect – the effect has been to raise concerns about whether there will be a domino effect.
For what it is worth, I do not think we are seeing a repeat of the 2008 financial crisis and SVB and First Republic are not big enough to have such an effect (Credit Suisse but its issues are not similar to Lehman’s). However, there are going to be some serious questions asked, not least why the potential problems at SVB were not picked up sooner since it has been buying long dated, fixed interest rate Treasury bonds (the heart of the problem) since 2021 and anyone paying close attention to its financial disclosures should have seen trouble was coming given the rapid rise in interest rates. However, one of the side effects of the crisis may be a focus on the valuations of many of the firms involved – and the Tech sector in general.
SVB had $73bn in loans and an unstated proportion of these loans would have had as their collateral the equity of the loanees and / or potential IPO or sale proceeds. There are already been questions asked about the quality of the loans made and it is fair to say that any buyers of the loans is going to be casting a critical eye over just how much some of the collateral is actually worth. SVB also has over $62bn of off-balance sheet commitments, another potential area of contention.
However, there is a wider question here around valuations and how they are made. As you will know, I was an Equities Analyst for over 20 years in the financial markets and a key component of that role was in valuing companies and / or highlighting potential valuation issues. Perhaps the key message I give to people when looking at valuations is not to focus on the output of a valuation but on its inputs, and the assumptions made. That will tell you far more about a company and its potential worth than any end result produced.
I think that is an issue that has been under-appreciated. Valuation is an art, not a science and my hunch would be that there are many firms – not just in the SVB case but also across the wider tech spectrum – where valuations have been ‘generous’ and/or where there may be questions asked about the methodologies and processes applied. While the rise of interest rates will have had some effect (most valuations are based on a Discounted Cash Flow model, which uses a Discount Rate where a critical component is the relevant Central Bank interest rate), it will still likely mean that too many valuations are not reflecting current reality.
If that is the case with SVB, then expect this to become a major issue over the coming weeks and months, and it is likely to bring about another round of soul-searching when it comes to the Tech sector. However, there is a wider point here for most companies in the space, and not just those impacted by the SVB collapse. Your assumptions are going to come under a lot more scrutiny and you are going to have justify them in a way that you did not have to not even two years ago. Those that lend are not just becoming stricter on valuations but also your views of the world. And that is not likely to be a temporary move.
As usual, this is not investment advice.
