Collapse of SVB could turn some VCs into zombies

Silicon Valley Bank's collapse could turn some capital-starved venture capital firms into the walking dead, that is, unable to raise new funds.

Venture capital was already suffering reversals from the heydays of 2021 and 2022, with low returns or losses, pricier debt and fewer transactions, including exits.

But the Silicon Valley Bank debacle is expected to deal a deadly blow to some venture capital firms due to a lack of liquidity.

When interest rates were low and there was ample financing, venture capital firms "could take on more risk and more leverage, which in turn created a lifeline for zombie funds that were able to continue to exist as a result of access to cheap credit," said Mina Pacheco Nazemi, Charlotte-based head of Barings LLC's diversified alternative equity business, which creates customized private equity and real assets solutions across co-investments, secondaries and primary funds.

"However, bankruptcy could now be looming for startups that are unable to obtain additional sources of financing and as increasing costs compress profits. And there could theoretically be an increase in zombie venture capital firms that can't raise new funds," Ms. Nazemi said.

Already posting poor returns, VC firms could linger in the venture capital ecosystem for years, surviving off the management fees of their existing funds, industry insiders said.

Typical performance fees are 20% and management fees usually are 2% on aggregate commitments during the investment period, with larger funds generally charging higher fees regardless of how the funds perform, according to PitchBook Data Inc.

Venture capital returns haven't been pretty: venture capital delivered a -14.9% internal rate of return year to date as of Sept. 30, lower than the -6% buyout return in the same period, according to McKinsey & Co.'s Global Private Markets Review 2023 released March 21.

This was the first time venture capital posted negative returns and underperformed buyouts since 2017. And returns for existing funds are poised to keep falling, although consultants say 2023 vintage funds could be top performers due to lower portfolio company valuations, a tough macro environment and fewer exits hampered by the closing of the initial public offering window.

"There will be venture capital firms that move to a zombie state," said Maelle Gavet, New York-based CEO of accelerator program operator and venture capital firm Techstars Central LLC, with $1 billion in assets under management.

Emerging managers will have the toughest time, she said.

"Because valuations are going down it will be hard for emerging managers to prove themselves," Ms. Gavet said.

And with investors affected by the denominator effect — that is, their public portfolio loses value, boosting the value of the private capital portfolios above target allocations — they will focus on the venture capital firms proven to be safer and more stable, making it much harder for emerging managers, Ms. Gavet said.

"What is happening for Silicon Valley Bank is a real shock to the system," she said.

Valuations for venture capital-backed companies "have effectively come down," said Faraz Shooshani, San Francisco-based managing director, senior private markets consultant at Verus Advisory Inc. Portfolio companies are now getting so-called flat rounds, venture capital funding without an increase in value from the last round.

Venture capital firms traditionally base a portfolio company's last round of venture capital investment by dividing the amount of money invested in the company by the percentage of the company's shares the investor received in exchange. Until now, many entrepreneurs were getting increased valuations for their companies each time they closed on a funding round, Mr. Shooshani said.

"The market is not going to pay that anymore," Mr. Shooshani said.

Now, to get another slug of money from investors, portfolio companies are giving investors a bigger share of the equity in the companies, which values the company the same or lower (a "down round").

For venture capital firms, "the days of jump into a deal this week or get left behind are gone," he said.

Those days were already over in 2022 when the venture capital industry starting adjusting to public market prices, Mr. Shooshani said. The result: lower overall expected venture capital returns, he said.

The down public equity market also closed a big exit route for venture capital-backed companies, IPOs, with volumes down 70% in 2022 year-over-year.

Silicon Valley Bank's key to the success of venture capital firms is hard to overstate.

It was the main provider of credit facilities to venture capital and growth equity firms that these money managers traditionally used for funding in between capital calls, Mr. Shooshani said.

As interest rates on credit facilities fell lower and lower, with some hitting zero, many venture capital firms kept the loans longer than the traditional 90 days, with some firms keeping the credit facilities outstanding for a year, he said.

Any investments made by a venture capital fund with a zero interest loan "blew through the J curve or minimized it," he said.

The J curve refers to the early part of a private capital commingled fund's life when returns are negative.

"Their IRR (internal rate of return) would get boosted by these credit facilities," Mr. Shooshani said.

These credit facilities are not going away, he said, but they are getting more expensive.

Before the sale of the new entity, Silicon Valley Bridge Bank, to First Citizen Bank & Trust Co. out of Federal Deposit Insurance Corp. receivership on March 26, the new bank's CEO Tim Mayopoulos assured the market that Silicon Valley Bridge Bank was making new loans and "fully honoring existing credit facilities."

First Citizen is acquiring "substantially all loans" from Silicon Valley Bridge Bank amounting to $72 billion.

Despite those assurances, some private equity managers were shopping around and "evaluating which lenders they are using for their subscription facilities," said Benjamin Kozinn, a New York-based partner at the law firm Schulte Roth & Zabel LLP.

"Managers should be carefully evaluating their overall counterparty (lender) arrangements at the management company, fund and portfolio company level and ensuring that they are comfortable with the safety and soundness of such counterparties," Mr. Kozinn said.

What's more, Silicon Valley Bank was an important player in the venture capital and startup ecosystem, providing banking and lending services to half of all U.S. venture-backed startups at the time of its collapse, Barings' Ms. Nazemi said.

Barings' diversified alternative equity business has $5.7 billion in assets under management. Barings had about $347 billion in AUM as of Dec. 31.

Without Silicon Valley Bank in the picture, it will be "materially harder" for startups to get loans, as the new owner is not likely to show the same level of flexibility and support, especially as scrutiny, litigation and regulation are expected to increase, Ms. Nazemi said.

This new reality "in turn can create a higher cost of capital and liquidity issues for venture capital firms and their startups," Ms. Nazemi said.

"The failure of SVB could not have been more poorly timed for the venture capital environment," she said.

Cautious venture capital investor sentiment had already slowed deal activity in recent months, and companies requiring more capital already were suffering from limited avenues for liquidity, Ms. Nazemi said. "Alongside that trend, the bar for successful financings had risen materially, with many companies pursuing down rounds for the first time in years," she said.

Ms. Gavet of Techstars Central said that in addition to cash flow problems for startups, Silicon Valley Bank's demise would have an impact on valuations.

"There's been more liberal usage of venture debt in the last few years that allowed leverage in any type of fundraising," Ms. Gavet said.

Venture debt meant company owners needed less money from venture capital firms, which diluted their ownership of their own companies, providing company founders more opportunities to take in venture capital with good terms and higher valuations, she said.

"If that doesn't exist anymore, suddenly startups would need more equity in an environment in which equity is drying up," Ms. Gavet said. At the same time, investors have been concentrating their portfolios and investing with fewer managers, with most capital committed to mega funds, she said.

That trend, plus the current lower valuations of portfolio companies, translates into a number of venture capital firms not producing the returns they need from existing funds to raise new funds, Ms. Gavet said.

With the Silicon Valley Bank collapse and "what is happening with lines of credit, it will be interesting what comes out," she said.

"What is happening for Silicon Valley Bank is a real shock to the system," Ms. Gavet added.