2023-03-21 14:00:00 ET
Summary
- Silicon Valley Bank is no more. One domino has fallen and investors are scattered in panic.
- When opportunity knocks, are you prepared with fresh cash in hand?
- We look at two excellent opportunities yielding up to 14%.
Co-produced with Treading Softly.
When the financial news sinks its teeth into a topic, it's bound to create fear and confusion. They recently set their unwavering attention to the potential and complete collapse of Silicon Valley Bank ("SVB") of SVB Financial Group (SIVB). While a bank failure is a concerning situation, the Federal Deposit Insurance Company, FDIC, exists for this exact reason. It is designed to resolve issues and protect consumers' deposits - up to $250,000 per bank.
So why was the SVB failure such a news item? Well, it's partially due to its size - among the top 20 banks in the U.S. by size - and also due to the amount of uninsured deposits - over 80%. In essence, SVB had a higher concentration of ultra-high account balances vs. a more diverse spread of accounts.
Imagine having a portfolio with only ten picks; if one drops to zero, you've lost 10% of your portfolio at the very least. Now, if you have a portfolio of over 100 picks, a single failure is not going to sink your ship. This is why we encourage High Dividend Opportunities members to follow our Rule of 42 - holding at minimum 42 individual unique positions in their investment portfolio.
So when SVB faced a bank run - multiple depositors taking out all their available cash - they couldn't keep operations going, and the FDIC was forced to step in.
This caused wide-spread panic and worry in the market. The regular anti-bank pundits claimed foreknowledge and pushed their ideas. But for income investors, we took a moment to evaluate the situation and started buying up on-sale securities that took a sympathy fall with the financial sector.
Our income from them is unchanged, but now we're getting even better yields than before. Today, I want to look at two such picks.
Let's dive in!
Pick #1: ARCC - Yield 11%
Business Development Companies ("BDCs") sold off in response to the failure of Silicon Valley Bank. Are they at risk of a similar meltdown? No, because BDCs are not banks.
One major difference is that a bank takes customer deposits and then uses that capital to lend and invest. The agreement is that the customer can demand the cash back anytime. After all, would you put your money in a bank if you couldn't take it out when you wanted it?
What happened with SVB is that an abnormally large number of customers were requesting withdrawals, and it had to come up with the money. It doesn't matter that the funds were invested in securities that SVB intended to hold until maturity - the customers wanted their money now. It was the ability of customers to pull capital out of the bank anytime that caused a liquidity crisis.
BDCs don't have that problem. They get their capital from two sources: Debt and common equity.
The debt that a BDC borrows is owed on the maturity date that is known well in advance. That maturity date can be planned for, and it is typical for refinancing to be in place a good year before it is due. The lender does not have the right to just randomly call the BDC and demand that it be paid back today.
Common equity is sold, and once the buyers have it, they cannot demand the company redeem it. They can go sell it to someone else, but for the company, the capital stays there until the company decides either to buy shares voluntarily or pay a dividend. Both events that the BDC can control the amount and timing of.
We can look at the lessons learned from the Great Financial Crisis ("GFC"). BDCs that struggled fell broadly into two problems:
- Credit losses cause declines in NAV and put them above legal leverage limits, forcing them to deleverage.
- An inability to refinance their loans, forcing them to deleverage.
BDC regulations have evolved, and BDCs are now allowed to carry a leverage ratio of 2x debt to equity. During the GFC, the limit was 1:1, and BDCs averaged around 0.7x debt to equity, providing a cushion of only 0.3x before being forced to deleverage. Today, the limit is 2.0x, and most BDCs operate from 1-1.4x, providing a much larger cushion of 0.6-1x equity before hitting the ceiling. Credit losses could still cause underperformance, but they are much less likely to be severe enough for leverage to hit the legal limits for BDCs that are using a responsible amount of leverage - generally under 1.4x.
The second risk has more to do with banks than BDCs. The big fear for any leveraged company is that it is unable to refinance debt on reasonable terms as the maturity dates approach. During the GFC, there was a period where there was a "credit freeze," and many banks were tightening up lending standards preventing many otherwise creditworthy borrowers from refinancing at any rate.
We can look at two things to limit this risk - a high credit rating makes it more likely a bank will be willing to refinance or that the bond markets can be accessed, and maturities being appropriately "laddered" so that the company doesn't have to deal with refinancing everything at what might be a poor time. It's easier to refinance $200 million than $2 billion.
So when Ares Capital Corp. ( ARCC ) sells off, we smile and buy. What is the absolute worst case? Well, some have been comparing the Silicon Valley Bank failure to a "Lehman" moment. We think that Lehman was far worse, but let's look at what happened to ARCC during that period starting September 1, 2008, two weeks before the news hit:
ARCC did sell off worse than the overall market. Yet even investors who bought before the Lehman impact outperformed the S&P 500 by May. By the end of 2009, they were rolling in the gains while the market was still red.
The market's fear of what systematic financial troubles might mean for ARCC was far greater than reality. This is why we are content to buy ARCC and hold even through a recession and even a credit freeze.
History does not guarantee future results, so we want to look at ARCC's current metrics. As discussed above, we are comfortable with a BDC that is leveraged under 1.4x. ARCC is currently leveraged at 1.21x.
ARCC also has its debt obligations well under control. It has no maturities until 2024, and it has $3.9 billion in liquidity, along with an investment-grade credit rating. Source .
Whatever bank-related turmoil occurs in 2023 or 2024, ARCC has plenty of time to deal with it before it has significant debt maturities.
In the long run, banks tightening up and being less willing to lend creates an opportunity for non-bank lenders with plenty of capital. ARCC is a non-bank lender, and it has the capital to lend to large borrowers. ARCC has the ability to lend up to $500 million in a single transaction, making it a viable option for even large borrowers.
ARCC is a BDC we can have confidence in during the good times and the tough times. So as the market sells it off, I'm happy to grab more shares!
Pick #2: TPVG - Yield 14%
TriplePoint Venture Growth ( TPVG ) was one of the hardest hit BDCs from the failure of Silicon Valley Bank. After all, the prevailing story in the press talks about SVB's close ties with the venture capital community and Silicon Valley startups. As the name suggests, TriplePoint Venture Growth swims in those waters.
TPVG likely is not materially directly impacted by the failure of SVB, but when a shark attacks, the market runs from any company in the same waters. You don't hear us say this often, but the selloff is completely rational. If there is any BDC that is going to have a measurable impact from this, it is TPVG. We don't know how many of TPVG's portfolio companies had material bank accounts with SVB, but we are very confident the number is greater than zero.
As smaller companies, it is also more likely that these are businesses that would have pressures from a bank account being frozen. Roku, Inc. ( ROKU ) can absorb a nearly $500 million reduction in cash on hand without any real fear of missing a bill payment. For the businesses that TPVG lends to, having $5 million in an account with SVB could make it difficult to cover payroll. The funny thing about workers, they tend to stop showing up for work when they don't get paid.
In addition to the businesses themselves, a significant number of Venture capitalists that TPVG partners with could have money tied up with SVB, which means that they might not be able to cover the capital they intended on investing in these companies.
So you can see the potential risks. Some number of TPVG's borrowers are undoubtedly hurting, and until TPVG tells us, we have no way to have a good estimate of what that number is. Some borrowers might have a disruption. TPVG dealt with similar things during COVID. Some borrowers had difficulties brought on by the pandemic.
One key difference is that this disruption means nothing to the borrowers' day-to-day business. COVID significantly changed the profit outlooks for a number of businesses. A business plan that was perfectly sound and effective before the pandemic might have become a failure after the pandemic. TPVG had to reassess the underlying businesses of its portfolio companies.
In this case, the businesses are experiencing a cash squeeze through absolutely no fault of their own. They are still making the same revenues, have the same customers, and they have the same profitability. They just have a liquidity problem brought about by being unable to access the funds in their bank account.
Hmm, if only there were a way for them to get a bridge loan matching the amount in their bank account so that they could continue to pay expenses, and they could repay the bridge loan as soon as they recovered that cash and payoff whatever balance is not recovered. What kind of company would provide such a loan, maybe in exchange for an equity position?
This is TPVG's wheelhouse. SIVB was a venture capital bank that lent money to venture capitalists and their startups. They just left a vacuum, there are a bunch of venture-stage companies that will be looking for a new lender. Demand for TPVG's services just went up!
Yes, some borrowers might have problems, but what is better than lending to an already known and proven borrower that is just having a temporary liquidity crisis? Especially when the liquidity crunch is caused by no fault of their own.
Is it the end of the world for TPVG if a few borrowers don't pay this month? No. TPVG has ample cash flow to absorb it and, in the long run, will collect more interest. TPVG has the liquidity to offer additional loans to its portfolio companies that might be unable to access their bank account. For a price, of course, cash or equity.
TPVG is currently operating at 1.36x leverage. It has already been taking advantage of increased demand for loans from the Venture community. Source .
This, combined with rising interest rates, drove TPVG to earn a record NII last year of $1.94/share and hike its dividend 11% year-over-year to $0.40/quarter. TPVG's return on equity and return on assets increased considerably in the second half of 2022.
With interest rates still high and demand for loans in TPVG's Venture Capital niche growing, the opportunity for TPVG is large. Yes, this kind of disruption creates risk, yet it also presents opportunities for the companies that have the potential to be part of the solution. TPVG is in a prime position to be part of the solution, which could be extremely profitable for investors. So while the market is responding in fear, we will be buying.
Conclusion
Both ARCC and TPVG faced selling pressure due to the collapse of Silicon Valley Bank. Both are strong BDCs with healthy outlooks that are benefitting from elevated interest rates.
So while others panic and run for cover, the intelligent income investor is able to enter into the fray and buy outstanding income opportunities using fresh cash provided by their recurring income streams. We have not faced a single cut in our portfolio's income from the SVB collapse, but we have been able to grow our annual income by investing in oversold securities.
When the SVB failure occurred, High Dividend Opportunities members were provided unique insight into the situation from the perspective of income investors as well as a list of excellent investment opportunities for all levels of risk tolerance to grow their income rapidly. We took advantage of the market crash to add several high-yielding stocks to our 'model portfolio'. This model portfolio, which consists of +45 stocks and securities, currently yields +9%.
Opportunity knocks at different times via different avenues, and having a strong recurring flow of cash into your portfolio allows you to capitalize on those opportunities and see the bountiful fruits of your labor in due season.
Once you've taken measured action to the present opportunity, income investing lets you kick back and relax, knowing your work is done and your rewards are sure to follow. This is why I love being an income investor. Sounds great? Perhaps it's time you become an income investor as well.
For further details see:
Bank Crash? My Income Is Still Growing