Source: World Biz Magazine
When asked what he thought about diversification, Warren Buffett produced one of his sage one-liners, “Diversification may preserve wealth, but concentration builds wealth.” SVB Financial Group (SIVB) lives by that motto; they operate almost exclusively in loan-origination for the private equity and venture capital industry, and they are very good at what they do – outperforming the broader KBW banking index since the start of the pandemic. With the meteoric rise of the private equity and venture capital industry, SIVB is uniquely positioned to become the next decade’s banking growth play.
The rise of the private equity and venture capital (PEVC) industry will more than offset the lingering effects of net interest margin (NIM) deterioration. Low interest rates are a blessing in disguise for alternative investments; yield is increasingly hard to come by in the saturated bond and public equity markets. Industry deregulation has opened the floodgates for the PEVC industry. The rebound in startups will supply SIVB with plentiful debt and equity opportunities over the next decade. Strong fundamentals, a well-defined corporate strategy, and a satisfactory margin of safety led me to recommend a Buy rating at a 10-year price target of $421.84.
In late February, media reports out of the West Coast confirmed that the coronavirus had arrived in the US and that its effects were more sinister than previously anticipated. On March 13, the rapid spread of the virus led President Trump to declare a state of national emergency. On March 15, in an emergency session, the Federal Reserve cut the national interest rate down to 0%-0.25%. By March 23, the ensuing stock market crash, dubbed the Coronavirus Crash, had resulted in a 30% fall in the NASDAQ from its February 19 high.
Early investors in the post-Covid rebound benefitted handsomely, but high valuations and low yields as a result of the Fed’s rate cut make hitting return targets increasingly untenable. With major indices trading above historical EPS multiples, a growing number of investors expect a slight correction in place of a Santa Rally to finish out the year. Without significant government stimulus or improvement in fundamentals, it is unlikely that equity markets will replicate 2020’s stunning performance for the next few years. Still, portfolio managers have to hit their return targets, so how should they go about doing that?
Few investments can sustainably outperform public equity markets, but PEVC is one of them. Real estate, global infrastructure, and developing markets also perform well, but the federal government made two announcements this year that got me more excited about the PEVC industry than the other alternatives.
In June, the Department of Labor issued an information letter granting access for 401(k) plans and other defined contribution plans to access PEVC investments. The effect: PEVC’s total addressable market for retirement assets grew by 44% by adding the $8.2T defined contribution market to the existing $18.8T defined benefit market. Not a moment too soon – the growth of AUM in defined contribution plans far exceeds that of defined benefit plans, and defined contribution plans will likely overtake defined benefit plans in total AUM over the next decade.
Source: The Wall Street Journal
A few months later in August, the SEC expanded the definition of “accredited investor” in response to years of PEVC lobbying. Accredited investors are a special class of investors the SEC deems worthy to invest in high-risk alternatives such as PEVC. Traditionally, accredited investors had to have net assets – not including homes – in excess of $1M or greater than $200,000 in annual income. Under the new regulation, stockbroker’s license-holders and other “knowledgeable employees” can invest in PEVC. The PEVC industry now has the opportunity to raise funds from millions of CFAs, MBAs, JDs, and others.
Last month, SIVB and research firm Campden Wealth released a report on family office asset allocation strategies for the next 2 years. In conjunction with broader industry deregulation, family offices are planning to increase their PE exposure by 37.3% and VC exposure by 14%. Exposure to other alternatives is expected to fall -3.4% and public equity exposure will dip by -7.1%. Industry deregulation has unleashed unparalleled demand for PEVC investments.
America Is Starting New Businesses
As Covid-induced lockdowns shuttered businesses, millions of Americans were laid off. By April, the federal unemployment rate reached 14.7% – the highest since the Dust Bowl droughts of 1939. The subsequent recovery has been rapid but tapered off again as rising infections forced a fresh round of lockdowns.
An increase in PEVC demand must be met with an increase in supply for sustainable growth. In the PEVC industry, entrepreneurs provide the supply of businesses to invest in. A silver lining of the pandemic has been a renewed focus on entrepreneurship. Americans are taking the risk of starting a new business at record levels. The Small Business Administration has been overrun with new business applications – application numbers outpaced those of 2006 and 2007 – creating even greater opportunities for PEVC firms to deploy their dry powder over the next decade.
Source: The Wall Street Journal
Recessions have created a precedent – harsh economic conditions force innovation resulting in disruptive businesses. PEVC darlings Uber, Airbnb, and Slack all started in the wake of the Great Recession. The next Uber or Airbnb is currently nothing more than an SBA application. However, judging from the graph above, these unicorns will continue to drive outsized returns in the PEVC industry, and likely in higher numbers than ever before.
Another boon for America’s startups is the rise of alternative exit strategies. In addition to the direct listing approach pioneered by Spotify in 2018, the traditional IPO process is seeing competition from the advent of the special-purpose acquisition company (SPAC). Initially called “blind pools” in the late 1980s, SPACs have rose to prominence this year raising almost as much capital as traditional IPOs – providing even more lucrative exit opportunities for early PEVC backers.
Source: The Wall Street Journal
Within the PEVC industry, SIVB’s assets are highly concentrated in technology, healthcare & life sciences, and wine. Incidentally, technology and life sciences investments are expected to outperform within the PEVC universe. Jon Gray, president of private equity giant Blackstone (BX), emphasized BX’s focus on technology and life science to drive alpha going forward. In their recent Q3 earnings call, he underlined what BX and many of their PEVC peers will aim to do amidst high valuations:
The challenge [is], can you buy them at reasonable prices. And one of the ways to do that is to buy things that are sort of one derivative-off, maybe you can’t buy a media company or tech company, but you can own their real estate. In Life Sciences, we made an investment in tactical opportunities in the cold storage logistics area.
To quote his verbiage, SIVB can be looked at as another “one derivative-off” investment. Its loans to PEVC firms and founders, while low-margin in the current environment, will create significant free cash flow (FCF) as the next decade accelerates demand for PEVC investments and the Fed hikes rates in conjunction with the post-Covid recovery.
Investors are starting to look for the strategic opportunities SIVB specializes in with the rise of thematic investing. The investing community is starting to realize the value of concentrating wealth in the “winners” – technology and life sciences – as opposed to diversifying it elsewhere. An analysis of the thematic fund returns from the top publicly-traded PE firms reveals superior returns to those found in the traditional equity and bond markets.
The Carlyle Group’s (CG) and Ares Management’s (ARES) thematic fund returns may not seem stellar compared to their peers or historical public equity returns, but JPMorgan’s (JPM) new Long-Term Capital Market Assumptions report indicates US public equity markets will generate 4.1% annually on average for the next decade while US bonds will generate little more than 2%. Investors will likely be forced to strategically reallocate and reconsider where PEVC fits in the traditional 60/40 portfolio if they hope to retire by 65.
Perhaps the most exciting element of SIVB’s corporate strategy is its vertical integration. In an era of low interest rates, SIVB is trying to grow with the client throughout the funding process – from startup to IPO – to avoid margin contraction and open new opportunities for growth. So, what does that process look like?
First, SIVB engages with PEVC executives and founders by sponsoring accelerators and networking events. Its brand has prospered by becoming the “bank of the global innovation economy.”
Second, its Private Bank for PEVC executives and founders makes its banking model more “sticky” – wealth management has arguably the strongest client loyalty across the financial sector; once you entrust your net worth to an institution, it is a hassle to transfer elsewhere.
Third, equity warrants often accompany its loans. As a result, SIVB aligns incentives for mutually-beneficial partnerships; SIVB succeeds when its clients succeed. In Q3, gains on equity warrant assets made up 5% of total income.
Source: Q3 Earnings Call Presentation
Finally, the acquisition of Leerink Partners complemented its legacy lending business by providing clients with investment banking services, diversifying its revenue stream, and providing SIVB with a presence on the East Coast. As a result, SIVB will be a presence throughout the startup life cycle; acquire clients with lower rates and fees; and dominate its high-growth, highly-profitable niche.
SIVB holds riskier-than-average assets and does not pay a dividend. As a result, the growth story behind potential capital gains for this stock is the most important part of the investment thesis. However, even the best growth stocks do not hold up well with an imminent threat of bankruptcy or no viable path to profitability. As a result, I wanted to dedicate a section to SIVB’s fundamentals to appeal to value investors.
The Basel Committee on Banking Supervision is an international regulatory body that sets the Common Equity Tier 1 (CET1) ratio – the minimum amount of equities such as cash and stock that a bank must hold against its assets. Meeting the CET1 requirement is important to qualify a bank as “well capitalized” in case of a financial crisis – SIVB’s CET1 ratio of 12.31% against the required 7.0% lets investors rest easy.
Another important metric is the efficiency ratio – how well the bank is able to control fixed expenses. An efficiency ratio of less than 50% is considered optimal. After the Leerink acquisition, expenses increased and SIVB’s efficiency ratio spiked above 50%. However, management expects a return to sub-50% levels as Leerink gets integrated. SIVB’s efficiency ratio is currently at 56.86%
Other key ratios, presented below, demonstrate that while SIVB experienced a slight downturn during the pandemic, its strong fundamentals have set it up to continue its impressive growth trajectory into the next decade. Management expects NII and core fee income growth to outpace non-interest expenses heading into 2021.
Source: Q3 Earnings Call Presentation
SIVB is facing several headwinds leading into 2021. First, tax hikes are often beneficial for growth stocks – many of which are unprofitable and thus unaffected by tax hikes. This is not the case for SIVB. President-elect Joe Biden’s proposed 28% corporate tax rate would put downward pressure on the cash flow-positive company’s ability to generate strong ROE going forward. Wolfe Research analyst Bill Carcache highlights SIVB as particularly vulnerable, in part due to its high, but shrinking, efficiency ratio.
The Democrats have also discussed closing the carried interest tax loophole for the PEVC industry. Carried interest is the compensation used to compensate PEVC portfolio managers for profitable investments. Tax law recognizes carried interest as return on investment, not income, so it is taxed at the capital gains rate instead of the income tax rate. Rewriting the law on carried interest could remove some of the incentive for PEVC portfolio managers to maximize the profit on their investments. Biden could be kind to the PEVC industry, however. The Wall Street Journal reported that PEVC employees gave a record $62M in direct contributions during the election races, with 59% going to Democrats. PEVC also gave $69.5M in indirect contributions, although the majority of these contributions went to Republicans.
Lastly, SIVB’s wine loan portfolio could be at risk from California’s wildfires. Over the last five years, damages from California wildfires have trended upward – particularly in the Napa Valley, making up a significant portion of SIVB’s wine loan portfolio. SIVB may have to look outside the state or abroad to ensure against the quickly-deteriorating situation in California.
Source: LA Times
Rather than use a traditional DCF, I used the Excess Returns model developed by Dr. Aswath Damodaran at NYU to value SIVB shares. Excess Returns works well for financials because of the special accounting and regulatory rules around their business models. It simplifies the process down to forecasting the amount by which the ROE generated exceeds the cost of equity.
My model starts with forecasting a 16% ROE for next year, in line with management’s expectations for growth offset by Biden’s tax hike, and a gradual rise in the ROE to 20% in four years, followed by a gradual decline down to 11% by the end of the decade. The model then assumes a 2% terminal growth rate. TTM ROE of 16% and a cost of equity of 12% yields an intrinsic value of $421.84, or a 21.2% upside as of Wednesday’s closing price of $348.13. Even after last month’s run-up, SIVB still has room to run.
SIVB is set to ride the impending wave of PEVC, and dominate its niche in the technology and life sciences market. I recommend SIVB as a buy and hold strategy for investors interested in adding a growth element to their portfolio. Buyer beware – with a beta of more than 2, SIVB provides plenty of opportunities to dollar-cost average into a lower cost basis. However, initiating a position with a 20%+ margin of safety is a good place to start.
Disclosure: I am/we are long SIVB, JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.