March 12, 2023
We're writing while listening to CNBC - on Sunday afternoon! The financial news channel has thrown together a special edition called unimaginatively Banking Crisis about the reverberations of the Silicon Valley Bank (SVB) failure. (By the way - why does Jim Cramer not let anyone get a word in when he's on a panel ?). The Fed has just announced a new 1 year Bank Term Funding Program (BTFP). Here's the key language:
The financing will be made available through the creation of a new Bank Term Funding Program (BTFP), offering loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. These assets will be valued at par. The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress.
With approval of the Treasury Secretary, the Department of the Treasury will make available up to $25 billion from the Exchange Stabilization Fund as a backstop for the BTFP. The Federal Reserve does not anticipate that it will be necessary to draw on these backstop funds.
As a result, going by the futures, the markets are likely going to jump on Monday, pushing stock prices up. As a result, all the Target Returns we're showing in the Expected Return Table - which are stratospheric - are going to melt away as quickly as snowfall in the desert. Still - for the record - here's what returns looked like after the BDC sector dropped by nearly (10%) in one week - the worst performance in that sort of period since the darkest days of the pandemic.
Even if not quite as rich as the Expected Return Table promises, the prospective gains for the long-term BDC investor are as attractive as they've been all year. The big question is whether this crisis - which emerged out of nowhere as recently as Thursday - has materially altered the outlook for BDC earnings and distributions. The question is most pertinent for the venture-debt BDCs - whose performance has been excellent of late and whose long-term outlook has been very attractive. If we have to go and change many of the assumptions on which our projections are based the huge prospective returns on offer might be Fool's Gold.
Unfortunately, it's too early to tell if something has been irremediably broken in the financial system that will result in permanently lower profits for BDCs. We could make an argument that the potential destruction of smaller banks that the SVB situation has engendered, with clients of all sorts moving to the larger banks, could be a boon for BDCs. Big banks have no incentive to be aggressive in the lending market, especially with regulators double-guessing their every move because of their very all-importance to the system.
This leaves an even greater gap than already exists for unregulated, low-leverage investment funds like BDCs to provide a broader range than ever before of loan products. That might include a greater proportion of secured, first-lien revolving lines of credit - currently a product dominated by banks. Moreover, the BDCs might face far less competition for first lien Term Loans as some banks pull back or disappear. In a way that would secretly delight the regulators, this would result in many more loans having covenants and other lender-friendly features.
Over in the venture-debt space, the demise of SVB and the mantra by every venture capitalist to never again be dependent on any one institution might open an opportunity for the 5 public BDCs serving this sector to increase market share. This would come principally in the form of those secured revolvers, right at the top of the borrowers' balance sheet.
Not So Fast
Yet, yet...There are so many other factors at play. Will the current crisis bring on the very recession that the Fed has been flirting with in its monomaniacal attempt to bring down inflation? Would BDCs be able to access enough capital to meet borrowers' needs if there's a major pullback by the banks? How will the VC eco-sphere be impacted by this setback? Will there be a huge drop-off in new deals - already at a multi-year low through all of 2022? Will there be a surfeit of credit problems amongst existing companies as VC money for follow-on rounds evaporate and the companies involved have the additional challenge of dealing with a weaker economy?
Clearly, there are too many uncertainties to make a decision. Imagine that we are on a large ocean liner in the North Atlantic - thought to be unsinkable - and we have just hit an iceberg. There is seawater pouring into the bows. Can the pumps be primed, the holes sealed and the liner make its way to port? Or should the lifeboats be lowered? That's where we are as we write this.
Sometimes The Best Thing To Do Is...
The Best Idea right now for both short-term and long-term investors with capital to put to work is not to do anything. Bargain hunters might be getting much lower prices shortly, so why hurry? We'll be keeping a very close eye on what is happening and our fingers are crossed. We're not going to get a repeat of the 2008-2009 GFC if only because no two financial meltdowns look the same, but that does not mean this could get ugly in its own distinctive way.