SVB Collapse: The Value of Hedging
We wanted to provide a quick update to our investors following the events of last week, which saw the largest bank failure in the United States since Washington Mutual in 2008. The S&P 500 was down over 4.5% on the week, and is now down over 7.6% from its early February highs, and close to flat on the year. Volatility, as measured by the VIX, spiked over 34%. We’re happy to report that our internal estimates show Lions Bay was up over 1% over that week and is now up over 5% on the year. As scary as events like these are, they often create a phenomenal trading environment for Lions Bay, and demonstrate the value of hedging.
While the dust is still settling on the SVB failure, based on what we know today, it provides an interesting opportunity to better understand how we think about risk management with your capital.
From what we know currently (and we acknowledge that new information may still come to light) this looks like a fairly straightforward failure in risk management, specifically related to concentration and correlation risks. This is not like MF Global or FTX where bad actors were making bad bets with customer deposits. This is just a bank that failed to appreciate it was structured as one-way bet on interest rates.
SIVB’s first risk management failure was customer concentration. The vast majority of SIVB deposits and banking engagements were from high growth, early-stage tech companies. SIVB enjoyed exponential growth while the 2020-2021 tech bubble was inflating, yet they never diversified. When the tech bubble burst in Q1/2022, it hit every aspect of their business.
Their second risk management sin was underestimating correlation. SIVB deposits, banking business, and assets, were all highly correlated to long term interest rates. SVBs deposit base were almost entirely from the tech ecosystem, a sector whose valuation is directly tied to long term interest rates. SVB then invested these deposits in long term bonds… whose valuation is tied to long term interest rates. If rates rise, their banking business slows, their deposits will decline (early-stage companies burn a lot of cash), and the asset side of their business is invested in securities that lose money when rates rise. Imagine Barrick converting all the cash on their balance sheet to gold bullion, and spending all future cash flow buying more gold bullion.
The number one philosophy at Lions Bay is to protect our clients from market risks, both known and unknown. Our clients will know that our largest investment is, like SIVB, a California based financial institution: Houlihan Lokey. One of the reasons we love this business is it is counter-cyclical by design – they have a corporate finance business that loves bull markets and a bankruptcy advisory business that loves bear markets. They have created a business that does not suffer from correlation or concentration of risks.
We don’t just rely on the defensive characteristics inherent in HLI’s business model and acknowledge that in an economic downturn there may be a long gap between the slowdown in corporate finance revenue and the uptick in restructuring business. That’s why we are disciplined about hedging HLI with other financial peers in the sector that do not have the same counter-cyclical balance and will go down more during a cyclical downturn.
Silicon Valley Bank is in fact one of our go to hedges for HLI. We did very well shorting it in 2022 and we were long SIVB puts into the sell off on Thursday. Luckily monetized them before shares were indefinitely halted on Friday.
We were also long puts on a European based M&A advisory firm with a large asset management franchise, a boutique investment bank in the US, and a large asset management firm that engages in direct lending that has enjoyed exponential growth as US banks have tightened lending standards. The gains on all these hedges more than offset the decline in HLI specifically and our portfolio broadly, and led us to a profitable week.
We were bearish to start the year, and we are more bearish today. We’ve introduced the risk of a bank run into the market and have had a major confidence shock yet are still trading at the same levels we started the year.
We don’t know whether SVB will be bailed out, acquired, or left to fail. Bailing out SVB kicks the can down the road but won’t stop a recession. Letting them fail pulls forward that pain and likely means a durable market bottom is much closer. None of these outcomes changes our view, and all of them will lead to short term trading and long term investment opportunities for Lions Bay.