“Not all private equity people are evil. Only some.”— Paul Krugman
One of SVB’s financial indicators that were considered a missing red flag was its superior return before its collapse. SVB’s return exceeded that of large banks such as JPMorgan Chase. The returns were more in the caliber of those alternative investment funds such as Private Equities (PEs) than banks. The similarity, however, does not end here. In fact, a close examination of SVB’s business model reveals a practice at the heart of the firm that has yet to be known even after its collapse. SVB extensively used a piece of financial engineering known as “fund subscription lines (SL).” Technically speaking, SL is a form of bank credit. However, they are distinct from traditional commercial loans. Banks become a fund’s creditor by issuing bank loans. On the other hand, SL, in practice, transforms banking from being a fund’s creditor to one of the PE shareholders. In addition, the SL establishes a tight relationship between the bank and private equity managers themselves. This relationship with these fund managers attracts a growing stream of deposits. These deposits, in return, became the bank’s primary funding source. However, the implied role of SL in bringing new deposits from VC and PE funds to the SVB converted the bank’s deposit-taking activity into a Ponzi game.
The subscription lines were one of the SVB’s primary businesses. However, it turned out that they were not a lucrative business. Unlike traditional commercial loans, SL does not fund companies and “operating businesses.” Instead, it subsidizes the venture capitalists and PE managers themselves. As a result, the loans generated very low returns, even compared to commercial loans, which yielded little due to the low-interest-rate environment. Nonetheless, the subscription lines brought new clients and deposits to the bank. In return, these deposits became the bank’s primary source of funding. In other words, the SVB’s deposit-taking business was more like a Ponzi scheme than a banking service to highly specialized businesses.
To understand SL, and the changing world of corporate loans, we should start the business model of the clients that SVB served and replicated. Over the last 40 years, the PE industry has grown from a relatively small niche for skilled bankers to an across-the-board area of modern finance. Importantly, buyout (BO) funds became the largest subsegment of PE. The primary business model of BO funds is to purchase a business through borrowed money using the business’s assets as collateral. Eventually, the PE would sell levered stakes of companies to generate profits. To finance their acquisitions, almost all BO funds are structured as closed-end vehicles in which a PE firm serves as the general partner (GP) and various (institutional) investors provide capital as limited partners (LPs).
PE fund managers receive lucrative compensations for their services. These financiers typically receive a fixed management fee of 2% of the committed or invested capital. However, they are mainly compensated by variable carried interest equal to 20% of the fund’s profit. However, before the fund managers are paid any carried interest, the PE investors should be compensated based on their contribution with a preferred interest of 8%. From a PE’s economic perspective, the relevance of SL mainly is the ability of this facility to artificially boost the internal rate of return (IRR) of the investment.
Fund managers’ compensation primarily depends on the IRR they achieve. The IRR, in return, has an inverse relationship with the amount of capital that the PE general investors would inject into the investment. Traditionally, such funds would call the investors to inject more capital, known as a “capital call,” as soon as the fund needs additional funding. However, in modern days, funds employ credit facilities. This is because IRR, the key assessment metric for PE fund managers’ performance, depends on when an LP’s capital is put to work. SL reduces the ultimate cash flow to investors because they pay the fees and interest on the bank loans. However, it helps the managers to delay the date when client money enters the fund and goose the fund’s internal rate of return.
SL transforms banking into alternative investment through at least two fronts. First, it makes deposit-taking into a Ponzi scheme. Second, SL makes banks, such as SVB, a private equity managers in disguise. Let us start to understand the latter effect. From a banker’s perspective, in SL, the bank funds limited partners themselves. However, in doing so, instead of becoming entitled to the businesses’ assets in case of default, the bank receives a “power of attorney” (POA) and “steps into the shoes” of the general partner or the investment manager. POA is a written agreement wherein the PE manager provides advance authority to the bank to make certain decisions or to act on the principal’s behalf, generally or in certain circumstances.
In the case of PE managers’ default to make payments in a timely manner, the bank could take any necessary actions without the requirement to provide prior written notice or obtain written or other consent from the PE managers and investors. Most importantly, banks can utilize POA to issue capital call notices or become a PE general partner. In the latter case, the bank becomes a private equity investor and will be compensated based on the fund’s return. In other words, if managers clear the loans promptly, banks receive the principal and interest payments on the loan. This is not a very lucrative business. However, if managers default, the bank becomes a private equity investor itself and receives a share of the return on investment.
In addition, the SL establishes a tight relationship between the bank and private equity managers themselves. This relationship with these fund managers attracts a growing stream of deposits. At the heart of SVB’s growth were the deals with thousands of venture capitalists and private equity firms that invested in everything from experimental medicines to artificial intelligence, with checks ranging from $5 million to more than $30 million. These financiers deposited their money with the SVB. These deposits, in return, became the bank’s primary funding source. However, the implied role of SL in bringing new deposits from VC and PE funds to the SVB converted the bank’s deposit-taking activity into a Ponzi game. In this scheme, the SVB relied on SL as a backchannel to bring more institutional deposits and used the same deposits to fund this hidden activity.
The systemic risks of subscription lines are under-appreciated by both investors and regulators. Nonetheless, this technique has already become part of banking DNA. Many PE managers are using subscription lines more aggressively than a decade ago. The SVB crisis revealed that such dirty practices put a ticking bomb at the heart of the commercial banks’ balance sheets. It also destabilizes the alternative investment world by creating a more oversized interconnectedness between the banking system and such funds. After the SVB’s failure, banks recalled the subscription lines, forcing private equity managers to ask investors to deliver vast sums of cash immediately. This could create a downward spiral if investors are forced to sell assets into a falling market to meet their existing promises to private equity managers. SVB was not just a banker to alternative investment funds. It also transformed traditional banking to become a form of alternative investment. This creates a new threat to the stability of global financial markets.