SVB Capital Credit remains bullish on long-term prospects for investing in the Innovation Economy.

Jim Ellison, managing partner and head of the SVB Capital Credit Platform, is responsible for leading the credit investment team. At year-end 2022, SVB Capital Credit had over $2.2 billion AUM, focused primarily on tech, healthcare and life science investments. He says despite the market’s current challenges, accelerating digital adoption is driving a wealth of investment opportunities across the tech, life science and healthcare sectors.

With all the negative headlines and volatility in the public markets, why is it a good time to invest in the Innovation Economy?

Great companies are created across business cycles, not just during boom times. Historically, periods of market disruptions have produced major innovations.
We believe the tech, life science and healthcare sectors—what we refer to as the Innovation Economy—will continue to grow despite the current headwinds. We also think the Innovation Economy is better equipped to weather the impact of an economic downturn than it was in previous periods, because these companies often have differentiated business models that tap into strong secular trends. We expect that companies with differentiated business models will demonstrate resilient revenues and earnings during periods of market disruption that lay the groundwork for powerful future growth. We believe that companies will continue to invest in enterprise software and other technology that improves efficiency and enables employees to perform more effectively at the workplace and beyond. Healthcare, in particular, has long been considered a defensive sector, and historically it has performed well during economic downturns. Healthcare today is approximately 20% of US GDP, and most healthcare spend is non-discretionary.

Our debt investment pipeline remains robust going into 2023. We are seeing high-quality companies that are seeking to increase their cash runways. Many of the companies that we work with are ramping up their businesses, and they benefit from the backing of strong VC or PE sponsors that have significant capital to deploy. Meanwhile, we believe lower market valuations are driving companies to shore up their balance sheets with non-dilutive sources of capital, including debt.

We believe these trends will drive an ongoing need for debt, as companies seek to continue to invest in growth and M&A opportunities. With the IPO market effectively closed for now, we believe that there are opportunities to provide highly customized, flexible capital solutions at pricing and terms that would have been unattractive to borrowers even six months ago.

Why is private debt attractive now?

A depressed public market has hit the PE and VC ecosystems through falling valuations, allocation adjustments and slowing investment activity. Meanwhile, private equity investors have record dry powder of $1.2 trillion, positioning them to take advantage of attractively priced assets. We expect these dynamics to drive greater need for debt financing, and that much of that financing will come from private debt, which can deliver customized solutions to borrowers in both good and tough times.

In the credit market, prices have been more stable for direct loans than for broadly syndicated loans or public fixed income. The trend of banks pulling back from leveraged lending has accelerated with the increased volatility of the debt capital markets in the latter half of 2022. With the syndicated and public markets essentially closed, private credit lenders continue to take market share by providing speed, confidentiality and certainty of execution to borrowers and PE sponsors. Non-bank lenders now make up 90% of the sponsor middle market leveraged loan market.

We expect rising interest rates will extend the attractive credit cycle for private credit lenders. Higher rates have been positive for private debt strategies, which typically employ floating rates and short durations. These qualities cause cash coupons to reset higher as base interest rates increase, usually every 30 to 90 days, providing a significant boost to interest income for direct lenders.

We are seeing what we believe are attractive risk/reward opportunities, with better pricing, more investor-friendly structures, and lower leverage than we’ve seen in recent years

As a result, in this rising interest rate environment, direct lenders such as SVB Capital are earning higher interest rates on both existing and new loans. In addition, we believe that when a borrower’s performance deteriorates, private lenders tend to be a more patient than holders of syndicated loans and public debt, making direct lenders an attractive financing partner for companies and their sponsors.

Direct loans tend to have relatively short maturities and low weighted average life compared to corporate bonds, and typically offer financial covenant protections as well. Like other direct lenders, our status as secured lenders and resulting relative seniority in the capital structure provides better downside protection than unsecured debt or equity.
In addition, historically, middle-market lending has shown resilience. Between 2004 and 2021, the middle market had below-average default rates during periods of rising rates, and healthcare and technology had some of the lowest default rates of all industry sectors.

What differentiates SVB Capital Credit from other direct lenders?

Our team has significant experience lending to venture capital and private equity-backed tech, life science and healthcare companies, which we believe makes us an attractive source of capital and partner for both companies and their sponsors. We lend primarily to technology and life science companies backed by top venture capital and private equity firms. We typically target companies with high growth, durable enterprise value, strong sponsorship, and expected IPO or M&A exits within the next one to five years.

We believe access and sourcing are other key differentiators. Our origination model draws on SVB’s long-standing relationships with venture capital and private equity firms that SVB has built over decades. Deal origination typically requires significant resources. We leverage the broader SVB platform to source investment opportunities—SVB has more than 490 relationship professionals with domain expertise in key parts of the Innovation Economy, including cyber, climate tech, fintech, insure tech, life science, bio pharma, and medical devices. In addition, SVB’s sponsor originations team includes more than 50 professionals focused exclusively on private equity firms. These professionals typically generate hundreds of referrals per year that often lead to high-quality investment opportunities for SVB Capital.

We believe our significant experience lending to venture capital and private equity-backed tech and life science companies, together with the broad footprint of Silicon Valley Bank and SVB Securities give us insight to the overall health of the Innovation Economy. What’s more, senior members of our investment team are among the few Innovation Economy lenders that has been through multiple credit cycles, giving us experience we use to guide portfolio companies during challenging times.

We believe that Innovation Economy companies, and the VC and PE firms that invest in them, favor capital partners such as SVB Capital with deep sector experience.

We primarily focus on first- and second-lien senior secured loans and unitranche structures. We believe that these secured structures, together with the strong loan to value targets and covenant protections that we seek to include for these structures will provide significant downside protection in the event of an extended downturn. Our underwriting and diligence process is independent from Silicon Valley Bank, but it benefits from access to four decades of internal data and SVB’s deep institutional relationships. We also have robust early detection systems to monitor companies in the portfolio and seek to address issues proactively.

What are your expectations for deal flow and credit quality over the next 12 to 18 months?

We believe the deal environment will remain favorable for technology and software. We think the long-term trends of increased digitalization and tech innovation will continue to drive attractive growth opportunities in the sector. We believe enterprise software is especially dynamic as companies seek to do more with the same or less given that software is often mission-critical to achieving higher productivity and efficiency measures.

We believe consumers are feeling stretched due to the pandemic and inflation. In healthcare, we believe those dynamics have acted as a catalyst for lower-cost, higher-quality care and the services and technology needed to make that model possible. We believe that companies are increasingly innovating to serve these demands.

For now, credit quality generally seems to be holding up. However, given the difficult fundraising environment, we expect companies to experience more challenges as companies cycle through their existing cash reserves. We believe that many companies and their investors are beginning to understand that raising debt to hedge against a tight liquidity market in 2023 and beyond can help protect their businesses.

Already, we have seen a significant increase in requests for debt financing

We believe that most PE firms see the current market as an opportunity to buy growth companies in technology and healthcare at reasonable valuations. PE firms have ample dry powder, and we believe they are likely to remain active buyers of companies despite headwinds from the rising cost of capital and inflation. We believe SVB Capital Credit will have the opportunity to be highly selective in choosing credits and retaining favorable deal terms with the changing market dynamics.

SVB’s proprietary information (Q4 2022 GFB Outlook Report (svb.com)) indicates that current private market portfolios are beginning to adjust valuations to the current environment of slower business growth and the drop in public market company comparable multiples. We believe that PE investors especially will find promising investment opportunities in the Innovation Economy as the markets settle. We expect the convergence of these trends, combined with record-levels of PE dry powder, will lead to an increase in PE buyout activity in 2023 as VC Firms continue to look for non-IPO exits for their portfolio companies and that this investment activity will continue drive demand for the flexible debt capital structures from private credit lenders like SVB Capital Credit.